This Is How Bond Ladders Generate Reliable Cashflow in Retirement

This Is How Bond Ladders Generate Reliable Cashflow in Retirement

Retirement is a long-term investment goal, and many people choose to save through several different products, such as bonds. When you are investing in bonds, you need to think about the current interest rate and the direction that the Federal Reserve rate is headed since that will impact return. Unfortunately, return rates have been notoriously difficult to predict, and they often take dives for the worse even when they seem to be on an upward trajectory.

While price fluctuations can be a real source of worry for people who trade in and out of funds or own shares in exchange-traded funds (ETFs) or mutual funds, they generally are of no concern to investors who hold bonds to maturity. These investors can be certain they’ll get back their investment, plus interest (as long as the issuer doesn’t default).

The Basics of Creating and Maintaining a Bond Ladder

One strategy that retirees who are relying on bonds for steady income should consider is the bond ladder. With this strategy, you buy bonds that mature at different points. For example, you would buy bonds that mature every six months or year up to 10 or 20 years.

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Creating a bond ladder provides a more predictable source of income during retirement. When the bond matures, you simply reinvest the proceeds back into the ladder with another bond. When interest rates rise, you will be able to secure higher yields. As interest rates fall, you will have several other bonds locked into a high income rate. The ups and downs of the interest rate tend to even out to generate a more predictable retirement income.

You can ladder with a range of different types of bonds, including Treasuries, corporate bonds, and municipal bonds, but you should first learn about the benefits and potential drawbacks of these options, from default risk to tax exemptions, to figure out what will work best for your situation.

Before creating a ladder, think about your risk tolerance, time horizon, and expectations for return to make sure you are making the best choice possible. Many investors who take a do-it-yourself approach will invest in Treasuries, which can be purchased easily online in affordable increments. These securities have little credit risk, and they allow you to build a solid ladder with as little as $1,000. Furthermore, Treasuries are fairly liquid since there is always a secondary market for them.

How Bond Ladders Can Fit into Retirement Strategies

To generate a sustainable income throughout retirement, you will need to invest much more than $1,000. Every situation is different, but a good starting place is dividing $50,000 across 10 different bonds. Most finance professionals recommend sticking with AAA-rated municipal or corporate bonds if you want to venture outside of Treasuries.

When taking a riskier approach, it makes sense to spread risk across many more issuers. To make this approach work, you will need to dedicate significantly more money to the ladder to achieve your ideal level of diversification. Wealth management firms can help you build customized bond ladders or match you to preconstructed options that meet your needs.

You can also build bond ladders using ETFs that target specific maturity dates. The benefit of this approach is the built-in diversification in terms of exposure to corporate bonds, emerging markets, and even high-yield bonds, without committing hundreds of thousands of dollars to the ladder.

The primary problem with the ETF approach is that it does not come with a neat end date as individual bonds do. Thus, you will need to get creative with how you reinvest your money over time, which requires a bit of planning. However, this strategy can be beneficial if you are worried about the credit risk of individual bonds and want a higher yield than is possible through Treasuries. ETFs help mitigate much of the risk of default.

Making Bond Ladders Work for Specific Financial Goals

Another strategy is combining bonds with mutual funds. If you are worried about your short-term cash needs, you can create a bond ladder to handle this and provide some guaranteed income moving forward without a lot of concern about long-term needs. Then, you can invest in mutual funds to take care of long-term investment growth. This strategy automates investing more so than a ladder, which can prove fairly labor intensive.

Mutual funds are managed by people paid to follow daily market fluctuations in the larger context of global economics, so investing in them is often a good choice if you are concerned about long-term gains. With this strategy, you would create a bond ladder for about 5 to 10 years to keep cash flowing. Notably, returns on short-term bonds are generally less than those of long-term bonds.