Climb a Ladder

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Climb a Ladder
by the Schwab Center for Financial Research
July 30, 2007

Reprinted from the July 2007 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

With the recent rapid rise in Treasury yields grabbing the headlines, you might be thinking it's a good time to lock in those higher interest rates. But what if bond yields go even higher?

The problem is that it's extremely difficult to predict interest rates. The good news: You don't have to. If you buy individual bonds, there's a straightforward strategy that can provide reliable income and the chance to capture higher rates: It's called a bond ladder.

In simple terms, a bond ladder is a portfolio of bonds that mature on different dates, built with two primary goals in mind:

Minimize risk. By staggering maturity dates, you avoid getting locked into a single rate. For example, if you purchase only a single five-year bond, you won't be able to capitalize if interest rates spike—as they have recently. Or if rates drop by the time your bond matures and you're ready to reinvest, you'd be stuck with a low yield. By holding to maturity, you avoid selling at a price less than par value in a rising-rate environment.

Using a ladder smooths out fluctuations in interest rates and minimizes reinvestment risk because you have a bond maturing every year, quarter or month, depending on how complex you build your ladder. And diversifying your holdings protects you from overall credit risk because you're not lending all of your money to one issuer.
Manage cash flow. A bond ladder enables you to manage cash flows to your particular needs. For instance, since many bonds pay interest twice a year, you can structure a monthly income based on coupon payments from laddered bonds by picking ones with different maturity dates, as shown in the table below, "Six-Rung Bond Ladder Means Income Every Month."

Regular cash flow can be particularly important for retired people who depend on bonds for income. But even if you don't, steady access to cash can be valuable. And if you foresee a particularly large cash need down the road—say, college tuition or a tax bill—you can make sure you have a specific amount maturing at just the right time to fill the need.

Six-Rung Bond Ladder Means Income Every Month
Par value	Maturities	Coupon rate	Jan. and July	Feb. and Aug.	March and Sept.	April and Oct.	May and Nov.	June and Dec.
$100,000	01/01/08	3.5%	$1,750
$100,000	08/01/08	4.0%		$2,000
$100,000	03/01/09	4.5%			$2,250
$100,000	10/01/09	4.75%				$2,375
$100,000	05/01/10	5.0%					$2,500
$100,000	12/01/10	5.5%						$2,750

Total portfolio of $600,000, weighted average yield of 4.54%, producing annual income of $27,250.

Hypothetical example for illustrative purposes only; depending on credit quality and other attributes, more than six bonds may be required for adequate diversification.

How to build your ladder
The ladder itself is fairly simple to create. Picture a real ladder:

Rungs. Take the total you plan to invest, and divide by the number of periods for which you wish to have a ladder; that's the minimum number of bonds you'll need, or the number of rungs on your ladder. The greater the number, the more diversified you'll be and the better protected you'll be from any single issuer defaulting.
Size. The distance between rungs is determined by the duration between the maturities of the respective bonds, which can range from months to years. The longer you make your ladder, the higher your average return should be, since yields generally increase with duration. However, this higher return is offset by reinvestment risk and the lack of access to your funds (assuming you hold to maturity). Making the distance between the rungs smaller reduces your average return, but you have better access to your money.
Materials. Just like a real ladder, yours can be built with different materials. You can enjoy the tax advantages of municipal bonds, the credit guarantee of U.S. Treasuries or the generally higher yields of corporate bonds. But try to avoid having the products in your ladder callable (redeemable early) by the issuer—unless you want a ladder with collapsible rungs.

Is a bond ladder right for you?
To start a ladder of municipal bonds with six rungs would cost around $60,000, since munis generally trade in $10,000 minimums. But the great thing about a bond ladder is that you can build it one rung at a time. You can start with one or more rungs at $10,000 per bond and then, whenever you have another $10,000 to invest, buy another—but do so thoughtfully so you cover another payment month and begin building a maturity structure to meet your needs.

Whatever path you take, a bond ladder will help to ensure your eggs aren't all in one basket so you can control risk exposure, have greater access to emergency funds and have the chance to capitalize on ever-changing market conditions. To learn more, call your Schwab consultant or our fixed income specialists in Schwab Bond Investor Services at 800-626-4600.

Important Disclosures

When a bond is purchased or sold, Schwab charges a commission, markup or markdown. Individual bonds are subject to the credit risk of the issuer. Changes in interest rates can affect a bond's market value prior to call or maturity. Bonds are subject to credit, interest-rate and inflation risks. In addition, bonds incur ongoing fees and expenses.

Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications and other factors.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. Any examples included are for illustrative purposes only and not representative of results your portfolio should expect to replicate.

Past results are not indicative of future performance. Diversification and asset allocation do not eliminate the risk of investment losses.

This information 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.

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