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What’s a Bond or CD Ladder?
Are interest rates on the rise? Or are they peaking now, certain to head lower? At best, all you can do is make an educated guess. But is that really the best way to manage your hard earned invetment dollars?
Creating your own bond or CD ladder can eliminate this guesswork, and more. Before we look at an example, let’s review some fundamentals:
Fixed income means the security will pay a set rate of interest, established when the instrument was first sold, so the annual income or earnings is the same (or fixed) throughout the life of that security. For practical purposes, think bonds, CD's, municipal bonds, and U.S. Treasuries; and
When interest rates rise, the value or price of a bond falls. That’s because other investors aren’t willing to pay the face value of the bond when they can invest the same amount of money in a similar new bond paying higher interest. The reverse happens in a falling interest-rate environment. Investors are willing to pay more for an existing bond that hasn’t reached its maturity in order to hang onto higher interest rates (if you hold onto individual bonds until they mature, you'll receive their full face value, unless there’s a default, regardless of any price changes during the holding period).
A bond ladder is a strategy designed to manage fixed-income (or interest-paying) investments. As an example, assume a $50,000 "safe money" investment in CD's. Rather going out and plunking it down in one CD, you might build a ladder by investing $10,000 into a 1-year CD, $10,000 into a 2-year CD, $10,000 into a 3-year CD, $10,000 into a 4-year CD, and $10,000 into a 5-year CD. Each year represents a rung on the ladder. At the end of year one, when the first CD matures, you buy a 5-year CD with the proceeds. From there on, you'll have a CD maturing each year and you simply repeat the process.
When adhered to, this strategy can eliminate guesswork, reduce reinvestment risk, and even potentially increase your long-term rate of return ... a nice combination of benefits, especially for your serious money.
Interest rates are unpredictable. Building a ladder for your fixed income investments helps you avoid committing all your resources to a single rate of return, averaging rates over the period of the ladder (5 years in this example). It also provides you regular liquidity free from penalties should you need the funds.
You can build ladders out of most types of securities, such as Treasuries, corporate bonds, CDs, and municipal bonds, depending on what’s appropriate for you and what level of risk you’re willing to take. You also can build your ladder only as far out in maturity as you feel comfortable or that you need.
Like the idea but don’t have time to execute it? Maybe we can help. We can custom build a ladder to your liking via one convenient account. If you’d like to find out more, feel free to e-mail us anytime at info@LongViewPFA.com. (0505)
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