A common frustration with investors is how to capture both the higher yield that long term CDs and bonds usually give with the liquidity that money markets give. One answer might be the Bond Ladder.
Using the bond ladder for income
In a normal yield environment, short term (3 months for example) CDs and bonds give lower yields than longer term (1 year for example) CDs and bonds. An investor, and portfolio managers, want the extra yield a longer CD or bond provides, but they are reluctant to tie up money for too long a time period. Enter the bond ladder.
If someone has $20k allocated to fixed income, but wants to retain some liquidity, we often split that $20k up into 4 equal parts of $5k each. We’ll put $5k in a 3 month CD, $5k in a 6 month CD, $5k in a 9 month CD, and $5k in a 12 month CD. The portfolio will have $5k per quarter coming due, and each quarter when that CD or bond comes due, we’ll buy a new CD or bond that is 12 months in maturity.
The result is that the client has CDs and bonds coming due every 3 months, but absent any cash needs, the money gets reinvested at 12 month rates. This leapfrogging of 3 month maturities to one year purchases can continue as long as the portfolio needs liquidity. The ladder can be one year in length or several years in length, whichever works best for the client in the yield environment presented.
Next time you find yourself torn between yield and liquidity, consider splitting the money up in this fashion to capture the best of both worlds.
The visuals below help illustrate the mechanics of a bond ladder.
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