How to Make a Bond Ladder

Sooner or later, today’s low interest rates will rise. When they do, you don’t want to be stuck earning today’s low yields. But there’s an ingenious antidote, called a bond ladder. It allows you to get steady retirement income with stability and safety.

Here is how you do it.

First, let’s start with the concept: A bond ladder takes a portion of your retirement savings allocated to interest-earning investments and devotes it to a specific year in the future when you need funds to supplement your expenses.

The ladder’s rungs represent a given year in the future. Rungs are made up of individual bonds that mature in that year. Ideally, each rung should be an amount at least equal to your cash needs in that year. You can reinvest any additional cash flow.

A bond ladder made of government-backed bonds carries plenty of advantages. It:

•         Adds stability by taking away the need for more volatile and higher-risk bonds and income schemes to overcome investment fees.

•         Places your retirement needs for cash in the safest, most secure financial instruments available. No matter what happens in the stock market, your principal is secure.

•         Protects against deflationary economic cycles and rate changes.

•         Promotes prudent investment strategies, such as rebalancing when economic conditions warrant.

•         Provides peace of mind to not worry about a money manager’s bets going well or a company or financial product’s performance.

To illustrate how a ladder works, let’s look at a hypothetical example.

After discussing retirement income with their financial advisor, Bill and Susan determined that between their expected pensions, Social Security and other income, they need approximately $45,000 per year from the portfolio when they retire, five years from now.

The couple determined that half of their portfolio should be in equities and half in fixed income. On their $800,000 portfolio, this means placing $400,000 into interest-earning investments, including a bond ladder.

To produce the required income from the portfolio, they purchased $45,000 face value of bonds for each of the first 15 years of retirement at staggered maturity dates. This strategy guarantees Bill and Susan’s retirement cash flow needs through age 76 at a significant markdown. They invest the remaining $400,000 in low-cost equity investments.

Five years from now, the first bond matures, giving the couple $45,000 for the year. Then, they meet with their financial advisor to decide whether to spend the cash from the maturing bonds, or instead sell stocks that rose in value to maintain the desired asset allocation for the portfolio. The year after, another $45,000 matures.

If the portfolio’s stock portion rose due to a good year in the market, Bill and Susan might sell some of their stock gains to rebalance their portfolio. The bond proceeds are then placed back into the portfolio as another rung in the bond ladder.


If, on the other hand, stocks fell that year, the bond proceeds can be used for that year’s expenses. This balances the portfolio by removing assets from the fixed income part of the equation.

This annual portfolio review with your advisor promotes sound investment strategies, including buying stocks when prices are low and selling them when prices are high.

Protection against deflation and rising interest rates. For retirees, we typically recommend a higher allocation to assets that do well with inflation. However, in the less likely, but possible event of deflation, when prices and rates drop, those same investments fare poorly.

During times, assets that respond well to inflation are subject to price bubbles, and they can decrease significantly in value. Investors flee to high quality, low-risk investments such as bonds. These investments become expensive, since prior to deflation they were used less. It helps to be proactive and have safe investments handy before investors dump risky stock and bond investments.

Right now, bonds are out of fashion because investors expect the Federal Reserve to end its policy of very low interest rates. Bond values move inverse to interest rates. If Bill and Susan put all of their fixed income allocation into 10-year Treasuries now, they get around 2% yield. If rates rise later, they are stuck with the lower rate for the remainder of a decade. By laddering bond maturities so they always have $45,000 coming back, they minimize this risk.

Also, because of compounding inflation, I don’t recommend purchasing any bonds with maturities longer than 10 years. It’s difficult to estimate inflation several years out, let alone more than 10.

Which Bonds to Use

Because they are stable, reliable, marketable and liquid, U.S. Treasury securities are the most logical choice for bond laddering.

The value of U.S. bonds is historically more reliable than other local, corporate or foreign issues. And while the value of your bond can decrease if rates rise, you can still sell it on the open market. As long as you hold your bonds to maturity, you receive back the face value, regardless of the price fluctuations before maturity.

For bond laddering, I recommend U.S. Treasury STRIPS bonds (STRIPS stands for Separate Trading of Registered Interest and Principal of Securities). Like short-term Treasury bills, you buy STRIPS at a discount to their face value. Unlike longer-term Treasuries, they do not offer regular interest payments.

With STRIPS, you purchase the principal portion of eligible Treasury bonds without receiving interest payments. When you buy a STRIP, you only receive the face value at maturity. The amount that you pay is lower than $1,000, and fluctuates every day with rates.

With other types of bonds, you have to collect all of your interest payments when they come due, and usually reinvest the interest income. If interest rates fall, that money gets a lower rate of return. This phenomenon is called reinvestment risk. With STRIPS, this isn’t a problem because the yield only comes when the bond matures.

A key part of any investment strategy, and particularly with the ladder, is reviewing the plan regularly. Consulting a financial advisor who works with you for all your financial needs, not just investing. The advisor must understand your personal cash flow needs.

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Robert Schmansky is a financial at Clear Financial Advisors LLC in Royal Oak, Mich. Website:

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