When you are nearing retirement, you will want to lower risk and prepare to live on a fixed income. You may have retirement benefits coming in, but if you’ve been learning to invest or paying someone to invest on your behalf, you should have funds coming from a personal retirement account. Some retirees have real estate, stocks, mutual funds and the like but if you are really looking for specific cash flows, you might want to take a look at bond allocation in your portfolio. Bond laddering is a way to invest in bonds for the purpose of creating a cash flow stream that will match the cash outflow you expect in retirement. Bond laddering is the process of purchasing coupon paying bonds in order to create a fixed income stream of payments. As each bond matures and the principal is returned, that cash is reinvested in a bond so that the bond ladder continues to throw off cash flows.
Benefits of Bond Laddering
Minimize Risk and Manage Cash Flows
There are several benefits to bond laddering. One is the ability to reduce risk through the actual fixed income security itself. Bonds are seen as more safe than stocks because of the reduced movement or volatility. This will depend on the type of bond. Bonds that are backed by the government will be seen as less volatile than bonds that are backed by a corporation. However, the risks associated with bonds should be carefully researched and if you are unsure at any point, you should contact a financial advisor that can walk you through the process of selecting bonds. Bonds are called fixed income securities for a reason. They give you the ability to manage your cash flows. You can create a bond ladder using coupon bonds that will pay quarterly, monthly, or even weekly. It all comes down to creating your desired cash flow with the proper bonds.
Diversify Bond Holdings Within a Portfolio
Buy Bonds with Differing Maturities
To begin your bond ladder, you would start by looking at bonds with different maturities. There are a few benefits to selecting bonds with different maturities. When a bond’s maturity date reaches closer to the present, the interest rate becomes more sensitive to changes in the market rates. For example, the 30 year bond rate may only move a small bit when economic changes cause current yields to fall; while the 3 month rate could change widely. Laddering using bonds with differing maturities is necessary in order to smooth out wide swings in your bond portfolio.
How to Create a Bond Ladder
There are 3 basic steps to creating a bond ladder. You will need a screwdriver, some wood and a hammer. Ok, just kidding. But you will need some tools. Namely, you will need a few bonds of differing maturities, you will need to know how long you plan to maintain this bond ladder and you will need to know what type of bonds or fixed income securities you want; corporates, treasuries, municipals, CDs, etc. You should also be ready to start with about 20 thousand dollars. Most bonds are sold in 1000 dollar denominations. As each bond matures, it would be reinvested in the bond ladder and you would continue to receive the coupon payments. If you are not ready to begin investing with that level of cash, you may want to consider bond funds instead. A bond fund can replicate the benefits of a bond ladder and help you get to the level of cash you need to start bond laddering.
Have you considered a bond laddering strategy? How do you plan to control cash flows in retirement?
This post was written by Latisha.