A bond ladder is a relatively reliable source of passive income — here's how to build one

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  • A bond is a loan between an investor and an entity that needs cash, like the federal government or a municipality.
  • When you buy a bond, you lock in an interest rate to be paid out on a set schedule — that's passive income. When your bond matures, you get your principal investment back.
  • With a bond ladder, you'd invest in several bonds with progressive maturity dates. As each bond matures, you can reinvest it or hold onto your cash.
  • Bond ladders can be a wise retirement investment, but they do tie up your cash for the duration of the bond agreement.
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If you've done any kind of research on investment options, you've likely come across the term "bond ladder." The first time I read this term, I thought about taking my old savings bonds and lining them up like rungs on a ladder. The reality isn't all that much different. 

With bond ladders, you make a series of timed investments that enable you to collect interest throughout the year as a form of passive income. It is a long-term investment strategy that pays off in the short term and can deliver good returns if you have enough to invest and your timing is right. To learn more, I spoke with a few financial planners to see what they think about bond ladders and when they're a good idea to look into.   

What is a bond?

A bond is a loan between an investor and some kind of entity that needs to borrow funds, such as the federal government, municipalities, private companies, and other organizations. When you invest in a bond, you agree to give the borrower a specific amount of money for a set period of time. During that time frame, they will pay you interest at a mutually agreed-upon annual rate, which is called a coupon rate. 

Interest payments are made on a regular schedule throughout the term of the investment — usually annually or semiannually — providing you with predictable income. When the bond matures, the borrower pays back the initial amount you invested and the contract is fulfilled.      

Bonds can be purchased through a brokerage, directly from the US Treasury or other government entity, or as part of a mutual fund. Daniel Patterson, a Certified Financial Planner with Sweetgrass Financial Planning in Mount Pleasant, South Carolina, says that most people should have some kind of bond investment as part of their overall portfolio. Because bond investments deliver a static return, they're generally less volatile than purchasing stocks and can keep your broader portfolio more stable. 

What is a bond ladder?

A bond ladder is a group of bonds with staggered maturity dates designed to provide a set amount of income through interest payments. Instead of placing all of your investment money into a single bond, you would purchase multiple bonds, each lasting for a different term. For example, if you have $100,000 to invest, you could purchase 10 bonds for $10,000 each with maturity dates 12 months apart. 

After the first bond reaches maturity, you will have collected all of your interest and gotten back your $10,000. You could keep this money and use it however you wish, while still collecting interest payments on the other nine bonds you own. However, you could also reinvest the cash into another bond that will reach maturity one year after your longest-term bond, which would keep growing your ladder and ensure continued income.

This ladder approach to buying individual bonds helps to minimize risk by allowing you to continue reinvesting your money if rates go up. Bond rates are set at the beginning of the term and do not change throughout the course of the agreement. During the time your money is committed to a bond, rates could increase and you would be earning less than the market rate. 

"Generally, bond ladders work when you think interest rates will go up in the future," explains Taylor Jessee, director of financial planning and Certified Financial Planner with Taylor Hoffman in Richmond, Virginia. "Because you own bonds that mature at varying levels, you would be able to take the bonds that mature first and reinvest them in the future in bonds that are paying a higher interest rate."

Jessee gives an example of buying $10,000 in bonds with 1% interest and a maturity date of 12 months. If market rates rise to 2% during that time, you could choose to reinvest your proceeds into a new bond at this higher rate. 

The opposite could also happen. Rates could decrease during the course of a bond term, which means you would be earning more than the market rate. When your bond matures and it comes time to decide if you want to hold onto your cash or reinvest, rates may not be great and you may choose to wait. This kind of situation is more common with longer-term bonds, as rates can fluctuate greatly over the course of five to 10 years or longer.    

Pros and cons of bond ladders

One of the big advantages of building a bond ladder is having a relatively reliable source of passive income. This can help during periods of economic stress, like we are experiencing now, or work as part of a retirement strategy. 

"If you have a lot of wealth and your expenses are low, you could secure your entire retirement income from a large bond ladder," says Adam Beaty, a Certified Financial Planner with Bullogic Wealth Management in Pearland, Texas. "For instance, if you needed $50,000 a year to live off of (keeping it simple without inflation) and you had $1.5 million to invest, you could buy bonds that would mature for $50,000 every year for the next 30 years."

Another positive of building a bond ladder is that your investments are relatively stable. Market rates go up and down, but if you have bonds locked in at a good rate, those changes will only impact you when it comes time for reinvestment. Because you're staggering out maturity dates, you should have cash available within a reasonable time frame should rates go up. 

On the downside, bond ladders keep your cash tied up for the amounts of time it takes for each bond to mature, which could make accessing money you might need difficult. Since this is more of a long-term investment strategy, your income needs may change due to unforeseen circumstances. You may be able to sell your bonds, but may also sacrifice principal and/or interest you would've earned by keeping them until maturity. 

"The good news is, your expenses are secure and will not sway as the market goes up and down," Beaty says of his example above. "The bad news is you just tied up $1.5 million for 30 years, which can be a problem if your situation changes."

When bond ladders are a good idea 

Bond ladders can be a good investment strategy if you have a significant amount of money you can invest and keep in bonds for a prolonged period of time. 

"If you don't have at least $250,000 to $500,000 that you're wanting to invest in the bond portion of your portfolio, then you're probably better off investing in a solid bond mutual fund that can give you broad exposure to the bond market," advises Patterson.   

He adds that the income generated through bond ladders can be an effective financial strategy for retirement. Building a scenario where your bond investments are providing you enough income to sustain your annual expenses can be a sound retirement goal. 

Another thing to consider is where interest rates are, both for the general market and for specific bonds. 

"Bonds will fluctuate in market value the opposite direction of interest rates," Jessee explains. "If interest rates go down, then bond values go up (and vice versa). The reason this happens is because if new bonds are paying a lower interest rate than the bond you own, your bond becomes more attractive to potential buyers so the value goes up (all things being equal)."

He adds that bond ladders are not a good idea when interest rates are falling, since you risk reinvesting in new bonds with lower rates than when you started. 

"For example, a year or two ago no one really thought interest rates could possibly go down," he says. "Yet, here we are now with COVID where interest rates are basically zero."

Depending on your current financial situation and the goals you want to achieve, bond ladders can help you diversify not only your income but also your long-term investment portfolio. However, knowing which bonds to invest in can take a lot of time, research, and market know-how, so it may be a good idea to work with a financial planner if you're interested in setting one up. 

Another route for bond investment is through mutual funds that can build a diverse portfolio that may not be possible to attain on your own. When in doubt, ask a pro.

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