Laddered bond investment provides earning stability

Bonds are back. Stock market fluctuation, a lower federal-government deficit and a low inflation rate have sent many investors flocking to bonds and bond mutual funds in the last six months.

If you're one of those interested in bonds but a little nervous about which way interest rates might go in the future, consider building a bond ladder.

You build a bond ladder by buying individual bonds with different maturities the date the bond issuer agrees to pay back the principal on your bond.

For example, you might buy roughly equal dollar amounts of two-, four-, six-, eight- and 10-year Treasury or corporate bonds. Every two years, you cash in the bonds that have matured and reinvest the proceeds in the longest-term bonds on your ladder in the case above, 10 years.

Why go to all this trouble? Because it smoothes out the risks of interest-rate fluctuations, and, in time, it means you generally are earning the highest interest rates possible from the type and quality of bonds you're buying.

Here's how:

One of the big risks of buying bonds is the rise and fall of interest rates. When interest rates fall, bonds issued before the drop generally become more valuable because of their higher interest rates. Investors are willing to pay more for the higher rates, and the bond prices rise.

When interest rates rise, bonds issued before the rise become less valuable because investors want new bonds offering higher interest rates, and pay less for lower-rate bonds.

The longer the maturity of a bond, generally, the higher the interest rate earned by that bond compared with shorter-term bonds of equivalent type and quality. However, that means that the price of the longer-term bond usually rises or falls faster than a shorter-maturity bond when interest rates change.

If you stick to shorter-maturity bonds, you can roll them over sooner if interest rates rise, but if interest rates fall, then you're forced to reinvest sooner at lower interest rates.

That's why you build ladders by staggering the maturities.

Let's return to our ladder of two-, four-, six-, eight- and 10-year bonds. If rates rise in the future, you use the money from the shorter-term bonds as they mature to buy new, higher-interest-rate bonds.

If interest rates fall, most of your ladder will remain invested in higher-earning bonds. You'll only be forced to reinvest a small portion (one-fifth in our example) in the lower interest-rate environment.

Typically, when you use the money from a maturing bond to buy a new bond, you buy the longest-term bonds on your ladder. In our example, your ladder will eventually be made up only of higher-interest-rate 10-year Treasury bonds.

That may sound risky, but remember that a portion of those bonds in our example will come due every two years in the event you need some of the principal or want to reinvest.

Like most hedging strategies, laddering won't maximize your bond returns. What it does is keep most of your bond returns relatively stable, regardless of which way interest rates go.

Also, laddering isn't as feasible for investors with only small amounts of money to invest. They'll probably have to stick with bond funds (one can conceivably ladder with bond funds, but it isn't easy and it is not as accurate).

Keep these points in mind when laddering:

?You can use the same method to ladder certificates of deposit.

?The more money you have to invest, the more rungs on the ladder you can employ. The minimum generally is three rungs short-, intermediate- and long-term maturities.

You can make the rungs fairly close say six months apart, if you want to reduce risk.

If you know you'll need extra money for a specific purpose at a certain date in the future, such as college, you can put in more bonds at a particular rung.

(The preceding article was produced by the Institute of Certified Financial Planners and provided by William O. Woody, CLU, ChFC, CFP, of Stovall Woody Associates.)

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