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Income Investing

Build a Bond Ladder for More Income

Our four portfolios will help you harness higher interest rates.

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It's a sure bet that interest rates have settled into a higher range and are poised to rise further. But don't let that scare you away from bonds (when rates are rising, bond prices tend to fall, and vice versa) or from certificates of deposit. If anything, the volatile stock market should be nudging you toward more bonds and CDs, not fewer.

SEE ALSO: Why Bonds Are More Important to Your Financial Portfolio Than You May Realize

Still, the rate outlook demands some caution in your fixed-income strategy. The market value of long-term Treasuries and other bonds is apt to shrink more, especially if inflation rises enough to shock bond traders into demanding higher yields on new investments.

But it's worth remembering that when a bond matures, the issuer returns the entire face amount. So a bond whose price falls to 95 cents on the dollar will eventually pay you back 100 cents, unless the borrower defaults or you sell in the interim. Income-seeking investors can stick to a simple plan to protect bond principal from getting nicked by rising rates, while collecting a decent income and reinvesting returned capital for a higher yield as rates continue to climb. You can accomplish this with an old-school technique called laddering. It works well with certificates of deposit and with individual bonds.

Bond funds don't work for ladders because the bonds in them are rarely held to maturity. But some exchange-traded funds have found a work-around, holding portfolios of bonds that all mature in a target year, and such ETFs can be a low-cost way to build a laddered income stream.

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The analogy to a ladder is straightforward. You own a series of bonds that represent the rungs, with the bottom ones paying the lowest interest rates and maturing soonest, and the yields and terms climbing as you go higher. Recently, a six-month Treasury bill paid 1.96%, a one-year note paid 2.08%, a two-year issue paid 2.31% and so on, until you hit 2.85% for a 10-year bond and 3.08% for a 30-year. (Rates and prices are as of March 16.)

A survey of corporate bonds rated A to AAA shows coupon rates starting at 1.97% for six months and rising to 2.12% for one year, 2.38% for two, 2.88% for five and then to 3.54% for 10 years and 4.11% for 30.

An ideal government-bond ladder might start at six months and step up to a one-year note, then one rung at a time to seven-year T-notes, each yielding a little more than the previous one. If you invest the same amount at each maturity, the average yield currently is 2.35%. That's reasonable, considering you get the full faith and credit of the U.S. Treasury. When the six-month bill matures, simply buy a new one. As the note on the next-lowest rung on the ladder matures each year, reinvest the proceeds in the longest maturity on the ladder, in this case a seven-year note. (With other bonds, yields on the ladder might not always rise rung-by-rung, but in a rising-rate environment, you will be replacing maturing bonds with higher-yielding ones.)

How much you'll need. The amount of money you need to build a ladder of individual bonds varies. Treasury Direct (www.treasurydirect.gov) fills orders as small as $100. Consider any dollar amount in government bonds safe, in the sense that there's virtually no risk of default.

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With corporates and municipals, advisers typically recommend that you invest at least $100,000 to adequately diversify and protect against defaults or bond downgrades from rating agencies that weigh in on companies' creditworthiness. But most tax-exempt issuers and investment-grade corporate borrowers are healthy and as likely to win higher credit ratings as to be downgraded to so-called junk status. So $50,000 to set up a 10-rung muni or corporate ladder is probably enough. Even $25,000 may be adequate if a broker fills small-enough orders across a wide spectrum of issuers.

Assemble a CD ladder by splitting your money among certificates with one- to five-year terms, rolling the one that matures each year into a new five-year CD. Nationwide, current rates range from 0.75% on a one-year CD to 1.69% on a five-year. Bank or credit union CDs are insured, up to $250,000 per depositor, at each institution.

SEE ALSO: Municipal Bonds Will Survive Tax Reform

For a bond ladder, consider the following portfolios as a guide. You may not be able to replicate them exactly, but you should be able to get close.

ETF bond graphic