Building Bond Ladders for Income
- Bond ladders can help investors earn current income and have the flexibility to reinvest in higher-yielding bonds if interest rates rise.
- Investors often build bond ladders to help generate predictable cash flow and help reduce some of the volatility resulting from rising or falling interest rates.
- Find out how to build a bond ladder.
Even in a low interest-rate environment, bonds can potentially offer benefits to an investor's portfolio through steady income, stability of principal, and diversification. But when rates are low, should investors sit on the sidelines and wait for yields to rise?
Unfortunately, it's extremely difficult to predict when interest rates will rise or fall. For investors who rely on income today, or who want to maintain a well-balanced portfolio, it's not easy to sit and wait for rates to move higher.
For those choosing individual bonds for a portion of their portfolio, a bond ladder can help balance the desire for income today with the opportunity to benefit from higher rates later if interest rates rise.
What is a bond ladder?
A bond ladder is a portfolio of individual bonds that mature on different dates. Picture a ladder with several rungs and spacing between the rungs. The individual bonds are the rungs and the time between maturities is the spacing between the rungs. Below is an illustration.
Source: Schwab Center for Financial Research.
A bond ladder is built with two primary goals in mind:
- Reduce risk. By staggering maturity dates, investors avoid getting locked into a single interest rate. For example, say an investor bought a single five-year bond. If interest rates were to rise two years from now, the bond would still be paying interest at the lower rate.
However, a ladder helps smooth out the effect of fluctuations in interest rates because there are bonds maturing every year, quarter or month, depending on the number of rungs in the ladder. When a bond matures, an investor could reinvest that principal in a new longer-term bond at the end of a ladder. They'll benefit from a new, higher interest rate and keep the ladder going.
- Manage cash flow. A bond ladder also helps to manage cash flows for particular needs. For example, since many bonds pay interest twice a year on dates that generally coincide with their maturity date, investors can structure monthly bond income based on coupon payments with different maturity months as well as years.
The table below shows a hypothetical six-rung bond ladder, comprised of a mix of short- and long-term bonds that generate income every month. Investors can benefit from higher rates on longer-term bonds to boost income, and can reinvest principal maturing on shorter-term bonds if rates rise.
Rungs (par value)
Jan. and July
Feb. and Aug.
Mar. and Sept.
Apr. and Oct.
May and Nov.
June and Dec.
Note: Total portfolio of $60,000 with weighted average yield of 2.58%, producing annual income of $1,550.
Source: Bloomberg, as of January 21, 2013. Yields shown are representative yields for AA corporate bonds for respective maturities. Hypothetical example for illustrative purposes only. For adequate diversification, Schwab generally recommends at least 10 individual bond positions in an investor's portfolio.
As shown in the table, when interest rates are low, generating enough income solely from a bond ladder is difficult—the sample $60,000 bond ladder above generates just $1,550 in annual income. It would likely take a large portfolio to meet all of an investor's income needs with a bond ladder alone. But over time, if interest rates rise and the principal of the maturing bonds is reinvested, income would rise. A bond ladder can be used to help preserve capital and generate income with less interest-rate risk if rates change.
How to build a ladder
The bond ladder itself is fairly straightforward to create. The overall length of time, spacing between maturities, and types of securities are primary considerations when building a bond ladder. Even in a low, or rising interest rate environment, bond ladders can help to balance the need for income while managing interest-rate risk.
- Rungs. Take the total amount that an investor plans to invest, with the goal of extending the ladder as long as possible. For example, in the table above, a total of $60,000 was invested in six rungs, with six individual bonds purchased for $10,000 each.
An additional benefit to having at least six rungs is that an investor can create a ladder structured to generate income every month of the year.
- Spacing. The distance between rungs is determined by the span of time between the maturities of the respective bonds, which can range from months to years. Generally, the spacing should be roughly equal. In the table above, two-year spacing was chosen to help extend the ladder further with the amount of money invested.
The longer the ladder, the higher the income is likely to be, since yields generally increase with longer maturities. But interest-rate risk is also higher (price sensitivity to changes in interest rates). Shortening the maturity or decreasing the time span between the rungs generally reduces income and interest-rate risk, but an investor usually has a greater ability to reinvest principal from maturing bonds at higher rates should interest rates rise.
- Materials. Just like a real ladder, investors can build their ladders with different materials—in other words, different types of bonds. Moreover, investors can also utilize the potential tax advantages of municipal bonds, the credit guarantee of US Treasuries or the generally higher yields of corporate bonds.
We also suggest that investors limit the number of callable bonds (those that can be redeemed early by the issuer) in their ladders, if possible. If a bond is "called" by the issuer, the principal would be returned to an investor at the issuer's discretion. When this happens, it's usually after interest rates have fallen, so principal may have to be reinvested in a lower interest rate environment. With some bond sectors, like municipals, the majority of longer-term bonds may be callable, so the non-callable option may not be available for all bonds in a portfolio.
How much does an investor need to invest?
For the most basic ladder with six rungs using relatively "safe" investments such as Treasuries or (for shorter maturities) Certificates of Deposit (CDs), investors could start with the bare minimum of $6,000 (both CDs and Treasuries typically must be purchased in $1,000 minimums). Bond ladders can be customized to accommodate an investor's time horizon and income needs.
To help boost income, investors may want to add more rungs to increase the maturities on the ladder (remember, longer-term bonds tend to pay higher interest), or add higher-yielding securities like corporate bonds. Municipal bonds also may be added for the potential tax advantages—interest payments from municipal bonds are generally exempt from federal income taxes as well as some state and local taxes. If an investor does add municipal bonds, we suggest considering holding them in taxable accounts. It's important for investors to remember, also, that adding higher-yielding or longer maturity bonds generally adds risk to the portfolio. We suggest finding a proper balance between desired income goals and each individual's risk tolerance.
Building a ladder that includes municipal or corporate bonds may increase the cost to around $30,000 at minimum for a six-rung ladder, as munis and corporate bonds generally trade in $5,000 minimums.
That said, if an investor chooses munis or corporates, they may desire more rungs (or issuers) for more diversification—we'd suggest at least 10 to help manage the risk of any individual issuer or bond defaulting.
Whatever path an investor takes, a bond ladder can help ensure that his or her eggs aren't all in one basket, and give:
- Better control over exposure to interest rate risk.
- Predictable access to principal and ability to reinvest it when some bonds mature.
- The opportunity to help manage an ever-changing interest rate environment.
Fixed-income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.
Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third-parties and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
This report is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
Municipal bond income may be subject to the Alternative Minimum Tax (AMT), and capital appreciation from discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
Past performance is no indication of future results.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
All expressions of opinion are subject to change without notice in reaction to shifting market, economic or politcal conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.