July 29, 2008, 6:00 am

How to Do a Bond Ladder

by: The Financial Blogger    Category: Financial Planning,Investment, Market and Risk
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Are you looking for a way to maximize your fixed income strategy? For most people, having fixed income in their portfolio in a certain percentage is a really good idea. In fact, most asset allocations offered by financial institutions will include this investment category.

bond ladder

 

Fixed income are pretty useful to stabilized your portfolio and reduce its fluctuation. I guess that it will become even more popular with what is going on on the stock markets.

Therefore, several people will simply buy “the best bonds” on the market, i.e. the one with the best yield. They are usually tempted to do the same thing with GIC’s. Even though I am not a big fan of this product, GIC’s can still be optimized through a ladder system. So you can apply the bond ladder strategy to GIC’s with the same success (with probably a lower interest rate!).


The first thing to consider is your investment horizon. If you plan that you need your money within the next 5 years, chances are that the bond ladder won’t be of any help. However, this strategy will help you out getting the best return on your fixed income over a long period of time. I would suggest this strategy for RRSP portfolio for example.

How does this thing work?

The simplest example is to do it with a 5 years strategy. Let say you have $100,000 to invest; the logic would be to find the highest paying bond/GIC on the market and wait 5 years to renew it, right? Since nobody can predict the future and you might freeze your money for five years and rates could go up in six months from now. If this situation occurs, you won’t be able to benefit from the situation. You could also secure your amount today with a very good rates but having super low rates in 5 years at the time of your renewal.

This is where the ladder comes into play. You have to take your 100K and split it into 5 equal parts. So each 20K is invested for a different period according to the rates offered on the market. Then you will get the following portfolio:

1 year 20K

2 years 20K

3 years 20K

4 years 20K

5 years 20K

One year from now, you will have 20K to be renewed. At that time, you will have 20K in liquidity (to be reinvested) and no more 5 years investment. You take your 20K and invest it for another 5 years on the market.

If you repeat this strategy year after years, in 5 years from now, you will benefit only from 5 years investments (which usually have better interest rate than 1 years) and you will also be able to benefit from the best rate every year. Sometime you will renew the amount for a smaller rate but you will be sure to get the best deal every year.

Along with providing the best rates possible, this strategy also allows you to benefit from liquidity every year. Therefore, if you need money for an unexpected expense, you know that you will have enough liquid assets to face it. If you have a very long term investment horizon, you can do the same ladder with investments to be renewed every 2 years (so 2, 4, 6, 8 and 10 years bond will be available).

image source : flickr.com

 

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Comments

I enjoyed your posting on building a bond ladder. I have been an advocate of this approach on my site, using where possible provincial bonds. Bond ladders save you costs and help protect against interest rate changes.Your readers can learn more by checking out the Fixed income (debt) section on our site: http://www.independentinvestor.info.

I like this. It’s simple and excellent for maintaining both liquidity and a longer term investment.

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