Which Bond Strategy Is Right for You?

Solution: Bond ladder

A bond ladder is a portfolio of individual bonds with staggered maturity dates—say, from one to 10 years. Barring default, if you hold each bond to maturity you'll receive regular interest payments over the life of the bond (typically every six months), plus the repayment of your principal at maturity.

Buying longer-term bonds can mean missing out if interest rates rise, but because bonds in a ladder generally mature every year or two—and you typically reinvest the proceeds to keep the ladder going—you continuously capture prevailing rates.

It's important to consider a bond's credit quality when building your ladder. Lower-rated bonds, like high-yield bonds, have a greater likelihood of default, which could undermine your ability to generate steady income and preserve your investment capital.

"A bond ladder is a good all-weather strategy," says Collin Martin, CFA^®, a director and fixed income strategist at the Schwab Center for Financial Research. "If rates are rising, you lock in higher yields as bonds mature; if rates are falling, you benefit from the longer-term bonds purchased when rates were higher."

That said, there are two significant drawbacks to building a bond ladder:

• Startup costs: Schwab recommends holding bonds from at least 10 issuers to achieve adequate diversification. Prices of individual bonds vary, but it's generally recommended that investors have at least $100,000 on hand to create a ladder.
• Time: Vetting bonds, particularly corporate and municipal issues, can be a significant time commitment—especially when establishing your bond ladder. What's more, ladders require regular research as you seek to replace maturing bonds.

Solution: Barbell

Like a ladder, a barbell strategy involves purchasing bonds with different maturity dates. However, a barbell focuses exclusively on short- and longer-term bonds—and avoids medium-term bonds entirely. While bonds with longer maturities tend to offer higher yields, shortening your bond maturities generally reduces income and interest-rate risk.

"A barbell is more of a tactical strategy for a rising-rate environment," Collin says. That's because short-term bonds (those with less than three years to maturity) frequently free up cash to reinvest as rates continue to rise, while longer-term bonds (those with seven to 10 years to maturity) generally pay higher rates to compensate investors for locking up their principal for longer. 

This strategy may make less sense as the Federal Reserve pulls back on its recent schedule of relatively aggressive rate hikes. "Once interest rates start falling again, investors utilizing a barbell approach may wish to shift more of their maturing principal back toward longer-term bonds, similar to a traditional bond ladder," Collin says.

Solution: Bullet

Unlike ladders or barbells, a bullet doesn't rely on multiple maturity dates. In fact, the goal is to purchase multiple bonds that all mature around the same time to generate a large influx of cash.

For example, say you plan to buy a house in five years. Instead of putting the money for your down payment in a savings account—whose interest rate might be relatively high now but isn't fixed—you can generate predictable income from bonds set to mature around the time you'll need the money.

With a relatively shorter timeline, investors may be tempted to take on riskier bonds in the chase for better yields. However, bonds from issuers with strong credit ratings are most appropriate for this goal. "If you're using a bullet strategy as a short-term planning tool, you won't want to run the risk of default," Collin says.

Choosing individual bonds takes work, but it gives investors the greatest control over their cash flow and exposure to credit risk. Of course, some investors simply don't have the time or interest in managing a portfolio of bonds, in which case a bond fund—which holds dozens or hundreds of bonds with varying maturities, coupon payments, and credit ratings—can be a good alternative.

"Bond funds don't offer as much control over your cash flow or interest-rate exposure, nor is your principal investment guaranteed as it is with individual bonds, assuming you hold such bonds to maturity and barring default," Kathy says. "However, they can be a great fit for investors looking for diversification and regular, albeit sometimes unpredictable, income."

"In some cases, a combination of strategies can offer the best of both worlds," Collin adds. "For example, you might invest in a bond fund for diversification but also create a bullet for a near-term expense." Whichever strategy you choose, working with a bond professional can help you navigate the vast bond market and vet individual issuers.