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Better
Build a Ladder
Consider the plight of a
hypothetical investor who used $1 million of his retirement savings to purchase
five-year Treasury bonds in March 1998 and began receiving a $56,000 annual
income. If the investor reinvested his entire principal in five-year treasuries
at prevailing interest rates when the bonds reached maturity in March 2003, his
annual income would have fallen to less than $28,000.¹
Interest-rate fluctuations are a
key consideration for fixed-income investors.² One way to help manage
interest-rate risk is by constructing a bond ladder to benefit when interest
rates are high and to minimize the effect when rates are low. Here's how it
works.
Step
by Step
A bond is essentially a loan to a business or government agency that ends on the
bond's maturity date. In a bond ladder, the maturity dates are spread out over
time. Instead of all maturing at once, the bonds mature in intervals.
If the same hypothetical investor
had divided his money among bonds with maturity dates of one, two, three, four,
and five years, a portion of his portfolio would be available for reinvestment
each year. In years when interest rates were high, he would be able to use the
matured portion to add higher-yielding bonds to his portfolio. In
low-interest-rate years, only a portion of his principal would be exposed to
bonds with a lower return. This strategy also can be used with certificates of
deposit.³
Interest rates fluctuate with
regularity. Constructing a bond ladder may help build a more stable, predictable
income stream from fixed-income investments.
1) Haver Analytics,
2003. Performance described is the March 1998 and March 2003 monthly yield from
five-year Treasury notes. The example assumes that the investor purchased $1
million in five-year Treasury notes. Past performance is no guarantee of future
results. Treasury bills are backed by the full faith and credit of the U.S.
government as to the timely payment of principal and interest.
2) The principal value of bonds will fluctuate due to market conditions. If
redeemed prior to maturity, bonds may be worth more or less than their original
cost.
3) The FDIC insures CDs and bank savings accounts, which generally provide a
fixed rate of return.
© 2004
Emerald Publication
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