Bond
Ladders Give Fixed-Income Investors a Lift
As
investors watched interest rates climb in 1999 and 2000, few could have
predicted the historic U-turn they would take in 2001. After a record 11
reductions, the Federal Reserve’s federal funds target rate finally settled at
1.75 percent — its lowest level in 40 years.
If the recent past has taught fixed-income investors anything, it is that
interest rates can fluctuate considerably and may be difficult to predict. To
temper market uncertainty, many are turning to bond ladders as a way to
capitalize on market highs and cushion against interest-rate lows.1
Setting Up a Ladder
A bond is essentially a loan made by you to a bond issuer. When you set up a
bond ladder, you spread out several loans, or bonds, over time. For example, to
set up a five-year bond ladder, you would divide your investment into five equal
parts and buy five separate bonds with maturity (expiration) dates of one, two,
three, four, and five years, respectively.
Bull’s
Eye
Assume interest rates rise by the time the first bond reaches maturity. Instead
of having your entire investment locked away for five years at the lower rate,
you are able to reinvest the matured portion in a five-year bond that takes
advantage of the higher rate.
Bearing Down
On the other hand, assume interest rates fall by the time the first bond
matures. In order to keep your ladder going, you’ll have to invest the matured
portion in a new five-year bond at the lower rate. But thanks to the ladder,
only one-fifth of your total investment will be affected by the lagging market
— your other bonds will still be earning the higher rate.
Interest rates are bound to rise and fall. By building a bond ladder, you can
seek to balance market fluctuations and help create a more stable, predictable
income stream from your bond investments.
1) The principal value of bonds may fluctuate due to market
conditions. If redeemed prior to maturity, bonds may be worth more or less than
their original cost.
© 2002
Emerald Publications
