What You Need to Know
- Bonds are generally less volatile than stocks and can help diversify client portfolios.
- Mutual funds or ETFs and a ladder of individual bonds are two options for adding bonds.
- Both offer opportunities for advisors and their clients to build the fixed income allocation in their portfolios.
Bonds are a popular investment offering the prospect of a steady income stream. Bonds are generally less volatile than stocks and can help diversify client portfolios. Bonds have been a bit more volatile amid high inflation and rising interest rates.
Two of the most popular ways to add bonds to a portfolio are through the use of bond funds or by building a ladder of individual bonds. Both offer opportunities for advisors and their clients to build the fixed income allocation in their portfolios.
What Is a Bond Ladder?
A bond ladder is a series of individual bonds that mature over time. The maturities are typically staggered at regular intervals; for example bonds in the ladder might mature over a period of five to 10 years.
The investors earn the interest paid by the bonds in the ladder while they are held, and they have options as to how to reinvest or use the money as each bond matures. In some cases, this might entail buying another bond at the long end of the ladder. In other cases, they might invest the money elsewhere or use it for another purpose.
A bond ladder might look like this:
|Time to Maturity||Par Value||Coupon Rate||Annual Interest|
|Bond 1||1 year||$25,000||2.5%||$625|
|Bond 2||3 years||$25,000||2.9%||$725|
|Bond 3||5 years||$25,000||3.4%||$850|
|Bond 4||7 years||$25,000||3.8%||$950|
|Bond 5||9 years||$25,000||4.0%||$1,000|
The total amount of annual interest payments on the bond ladder is $4,150. As each bond matures, the investor will receive the par value, which they can choose to reinvest in another bond at the far end of the ladder or use in another way.
Benefits of Bond Ladders
- Stability and predictable returns: “As long as you hold the bonds to maturity and the issuer doesn’t default, you know exactly what your return will be,” says Taylor Schulte, a certified financial planner, founder and CEO of Define Financial. Bonds held in a bond ladder should generally be noncallable and have fixed interest rates to help ensure this stability.
- Minimizes interest rate risk: “Many advisors see bond ladders as a way to lock in the current rates by holding the bonds to maturity,” says Mike Sanders, portfolio manager and head of fixed income at Madison Investments. This minimizes the risk of incurring capital losses that could occur if bonds were sold in a rising interest rate environment prior to maturity.
Drawbacks of Bond Ladders
- Trading costs: Many individual investors will not have the money to allocate to bonds that would allow them to get the best pricing on bond transactions. Acquiring the number of bonds needed to build an effective bond ladder may be cost-prohibitive for some investors.
- Lack of bond expertise: Most individual investors and many financial advisors may not have the capability to research the quality of numerous bond issues as well as the characteristics of bonds they might consider in building a solid bond ladder.
In constructing a bond ladder, it is generally suggested that you use noncallable, high-quality bonds to minimize the risk that the bond issuer will be unable to continue to make their semi-annual interest payments. This way, your client will have a bond maturing at regular intervals and a stream of income that they can depend on.
What Are Bond Funds?
Bond funds are professionally managed mutual funds or ETFs that invest in bonds. Bond funds can be actively managed; the managers buy and sell bonds to construct a portfolio of bonds that meets the fund’s objectives. Bond funds can also be passively managed and track a bond market index.
Bond funds may be short, intermediate or long in their overall duration. They may focus on certain types of bonds, such as corporate bonds, Treasurys, municipal bonds, foreign bonds or other types.