Basic Financial Concepts: Yield Ladders
In today’s volatile stock market, you run the risk of loss—which can become more dangerous as you approach retirement. Unfortunately, going with “safe” investments like CDs or bonds can also present financial hardship due to their low interest rates. So, how can you keep your principal safe while generating a higher return? Yield ladders can help.
A yield laddering strategy works by investing money into bonds, CDs, or other safe fixed interest financial vehicles with a wide range of maturities and reinvesting funds that come due into longer-term options.
For example, longer-term bonds will usually pay a higher rate of interest. But to generate that higher rate, your money must be “locked up” for an extended period. Therefore, by “laddering” the yields and splitting your investment into bonds with both short and long-term maturities, you will eventually have all of your funds in the higher-paying options while regularly having money come due.
Yield Ladder Advantages
In addition to generating a higher return (as opposed to investing in only short-term vehicles), there are other benefits that investors can attain by using a yield laddering strategy. For instance, yield ladders can help maximize return without the need to guess whether interest rates will likely rise or fall in the future.
Plus, during periods of low interest rates, like the U.S. has had for more than a decade now, yield ladders can also help you avoid having to lock in a low return for an extended period. This can help reduce the risk of lost opportunity costs.
Pros and Cons of Yield Laddering
A yield laddering strategy can provide investors and retirees with some nice benefits, including a higher overall return, increased liquidity, inflation protection, and reduced exposure to interest rate fluctuations.
Even so, however, there are also some potential tradeoffs that you may need to make to attain these benefits, such as:
- Making a substantial monetary commitment (in this case, to divide your funds among several different yields adequately, it could require you to invest 5- or even 6-figures)
- Regular payment of capital gains taxes
Constructing a Yield Ladder
Using a yield ladder entails placing equal parts of your principal investment into vehicles with different maturities. That way, you will always have some of your funds in long-term, higher return options, and other funds that are coming due so you can meet your liquidity needs.
As an example, if you have a total of $30,000 to invest, and you plan to split the money evenly into bonds that have three different maturities, you would place $10,000 into each of three bonds—one with a three-year maturity, one with a two-year maturity, and one with a one-year maturity. Hypothetically, these bonds could have interest rates of 4.5%, 3.5%, and 2.5%, respectively.
Given that, the bond with the one-year maturity will pay out $250 ($10,000 X 2.5%), and it will come due in just one year. Therefore, after Year 1, the two-year bond will only have one year until its maturity, and likewise, the three-year bond will mature in just two years.
Therefore, if you take the $10,000 that comes due from the one-year bond and reinvest it into a higher-yielding three-year bond, you can generate a higher rate of interest on that money while at the same time still having funds come due every year.
If you repeat this step each year, you will eventually have your $30,000 invested in higher-yielding bonds yet still access $10,000 in annual liquidity as the “next” bond in line comes due.
In doing so, by the fifth year, the average yield on the entire $30,000 portfolio will be 4.5% (assuming that the rates remain the same), offering you the ability to access $10,000 penalty-free every year.
When Yield Laddering Does and Does Not Work Well
Although yield laddering can undoubtedly offer some nice return and liquidity-related benefits, there are times when this strategy may or may not work well. For instance, yield ladders will typically perform better when interest rates are stable or even when rates are falling.
This is because you can lock into a higher long-term rate than what you could get if you had to purchase only short-term investments. That being said, yield laddering may not work well when interest rates are on the rise—although this investment method can help reduce volatility with your interest income.
Regardless of how long your maturities are and how many different investment maturities you have, the key to success with yield laddering requires that you keep the ladder going over time.
Is Using Yield Ladders a Good Strategy for You?
Because everyone’s financial goals, risk tolerance, and time horizons are not exactly the same, a yield laddering strategy may or may not be suitable for you. If you would like to discuss your potential options further with a retirement income planning specialist, please feel free to contact us directly by phone at <phone number> or via our secure online contact form at <email address>. We look forward to hearing from you.
