Today's steep yield curve is at a historically sharp incline. For Treasury bond investors, the dilemma is whether to tie up money in long-term securities paying the highest rates or to go for short-term paper that pays less. And there's always concern that interest rates might spike up, sending bond prices plunging.
One solution is a bond ladder, a procedure that allows for considerable flexibility, reduces rate-spike risk, and promises full return of principal, because you hold the bonds until maturity. Since your money is in Treasuries, any fear of default is nonexistent.
EVEN SPREAD. With a typical bond ladder, you divide your money, say $50,000, equally over Treasuries ranging from 1-year (3.6% yield) to 10-year maturities (6.7%) at $5,000 for each. A bond will mature annually, which permits you to spend the cash, invest it elsewhere, or put it on another step of the ladder.
Each year, you can roll over the maturing principal into bonds at current rates. If you want the ladder to continue into a second decade, you may put the proceeds into 10-year bonds. Or if not, reinvest in shorter-term securities. During the first of the 10 years, your interest income is $2,770, or 5.5% overall--not too bad on your $50,000 principal. That is the equivalent of tying up the whole sum in five-yearpaper.
It's not worthwhile to invest in Treasuries beyond 10 years: You're spanning most of the yield curve between 1- and 10-year issues. The difference between the two is 3.1 percentage points, while the gap between a 10- and a 30-year Treasury (7.5% yield) is just 0.8 of a point. Besides, price volatility hurts the longest maturities most, which can be a concern if a need for cash compels you to sell your bonds early.
The bond-ladder strategy is no use to traders who seek to sell before maturity, reaping capital gains. A ladder works best for retirees or tuition-paying parents who want a reliable income stream. "Bond ladders are not for a 45-year-old whose kid is far too young for college and who wants to build wealth," says Philip Springer, editor of Executive Wealth Advisory newsletter.
Bond ladders require discipline. Says Jay Goldinger, chief investment strategist at Capital Insight, a Beverly Hills (Calif.) brokerage: "People often don't follow these automatic reinvestment systems." To make a bond ladder work, you have to stay on it.
HOW A BOND LADDER WORKS Invest $5,000 each in 1- to 10-year Treasuries, hold until they're due, and collect the income Maturity Current Income yield 1 3.6 % $180 2 4.2 210 3 4.7 235 4 5.3 265 5 5.6 280 6 6.0 300 7 6.2 310 8 6.5 325 9 6.6 330 10 6.7 335 TOTAL INCOME $2,770 AVERAGE YIELD FOR FIRST YEAR 5.5% DATA: DRI/McGRAW-HILL, BW