In the aftermath of the stock market crash, most investors have a heightened concern about the riskiness of their investments. Seemingly secure investments often turned out to be much more speculative than anticipated, and the future does not offer any indication that stocks will become less risky.
For those reasons, many investors are turning to bonds. A bond is basically a loan that an investor makes to a government or a business. The lender lends his money today, and the borrower promises to pay it back over a period of time, and with some rate of interest. Many bonds are considered much less risky than stocks because they come with a legal obligation to pay the debt and have been issued by governments or corporations that are considered to have the ability to pay. Lower risk is the good aspect of a bond.
However, because bonds are less risky, the borrower does not have to offer as high of a potential return as does a seller of stock as an investment. Bonds offer stead returns, which is great. But they offer low returns, which is not great. A person who locks in a return of 1% per year for 20 years through a bond will be able to “sleep at night” with confidence that the bond will be repaid, but he will wake up after 20 years with inflation having eroded the value of his investment. That the negative aspect of a bond.
Bond ladders are one technique to reduce the impact of being locked in to bonds at very low interest rates. Given that rates on low-risk bonds in 2009 and 2010 are extremely low, bond ladders make a lot of sense for an individual investor. Here’s how they work. Instead of buying a single bond at a single maturity (that is, a bond that exists for a single length of time), the investor instead splits his investment into several equal pieces and buys bonds of different maturities with each piece. Then these short-term bonds are “rolled over” into new bonds each time they mature. In this way, the investor stays safely invested in bonds, but is not locked-in for a decade to bonds that pay poor rates of interest.
An example might help. Imagine having $100,000 to invest. You could buy a US Treasury Bond that pays 1% for the next 10 years. That is, you would be paid $1,000 per year of interest, and then at the end of 10 years, you would get your original $100,000 back. The alternative with a bond ladder is to buy 5 different bonds of $20,000 each. Each bond will last a different period of time, and each will pay a different rate of interest. Maybe you would buy bonds that last for 6 months, 1 year, 2 years, 5 years, and 10 years. The shorter bonds will pay less interest than the longer bonds.
But if those shorter bonds pay less interest, what’s the advantage? Here’s the benefit. Remember that interest rates on bonds are extremely low right now. This is because the economy is weak, so there is little demand for investment dollars. Also, governments around the world have kept interest rates low in order to stimulate the economy. This makes bonds a bad deal right now. But imagine in 3 years that the economy is better and that over those years, the rate of interest on bonds has gradually risen to 3%. If you bought a single bond that lasts for 10 years, you would be stuck with your poor investment. If you have a ladder, you will have been able to “roll over” the bonds that expired, and each time purchase a new bond that paid a higher rate of interest. This type of scenario is exactly what many experts are predicting.
Which bonds should you buy? There’s no simple answer, but the good news is that US Treasury bonds are easy to purchase and can be bought by even the smallest investors ($25 bonds). Depending on how Treasuries are purchased, they can be bought without commissions, too, which makes them the ultimate in low-cost investing. So, if you are concerned about your financial security and are seeking a safe source of steady returns, consider building your bond ladder today.