Bond Ladder Basics
In order to achieve stability of your investment portfolio, many financial experts recommend the inclusion of bonds. Despite their many advantages, bonds have their hidden traps such as the rising and falling interest rates, which may have a negative effect on the financial goal you have set.
Since over the long-term bonds experience higher fluctuations of interest rates the potential yield is increased the longer the maturity period.
Typically, bondholders will experience below market rates for the term of the bond, if before the bond reaches its maturity the interest rates rise. In such a case, the bondholder faces two options. The first one is to sell the bond by incurring the losses. The second one is to survive the below market rate and hope that when the bond matures, the principal can be invested at a higher rate.
In order to protect yourself against the fluctuations of interest rates while you continue to manage the cash flow from the bond investment the bond ladder can be applied. It allows you to put the interest rate risk at a minimum level. By applying this device you continue to efficiently manage the cash flow acquired from your investment.
The bond ladder provides you with the possibility of purchasing more bonds with lower values, but with maturities that vary from one to ten years. As a result every year you will have a bond that matures and thus avoid to a great extent the fluctuations of interest rates.
Bond Ladder Advantages
One of the advantages of the bond ladder is that you have acquired a portfolio that includes bonds of a short-, mid- and long-term character. In this way you ensure yourself with an attractive yield. Another advantage is that in case interest rates increase, you can reinvest the principal of this year's maturing bond. However, you should keep in mind that in order to continue the ladder you should buy a bond with a ten-year maturity.
However, in the case of decreasing interest rates, the bond that matures within the year should be invested back at this lower rate. Additionally, the bond ladder provides you with an opportunity to match the cash needs you have with the prospects of the ladder.
You should try to construct the ladder in such a way to meet the financial needs you have.
Bond Ladder Setting Advices
- Carefully select the time period over which the ladder will stretch. It doesn't have to be ten years. But the longer the maturity the higher the potential yields.
- The maturities of bonds don't have to follow each year sequence. The ladder may be constructed in such a way that the bonds can mature every two or so years. However, you should keep in mind that this tactic is deprived of flexibility that each year maturity ladder provides.
- Keep in mind that diversification in every of its forms is the best tactic that can be applied. So, the more bonds with differing maturities the better.
- You are also allowed to make combinations between different types of bonds. This should be done with your needs in mind.
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