A bond ladder is more of an investment strategy than an investment product. You can create a bond ladder by purchasing a number of different bonds with different maturity dates, rather than investing all of your money in a single bond issue. In theory, this reduces your risk of declining market value due to increases in prevailing interest rates. You can use a bond ladder strategy in a regular account, or in an individual retirement account.
An IRA is, by law, a custodial or trustee account. While the Internal Revenue Service doesn't place many restrictions on the kinds of investments you can hold in your IRA, your custodian might. For example, if your bank serves as your IRA custodian, it might limit the investments it will hold to bank-offered products, such as certificates of deposit. Before you begin building a bond ladder, make sure your IRA custodian will allow such investments.
Determine Your Rungs
A bond ladder is made up of different rungs. Each rung represents bonds that mature at that specific time frame. You must determine how many rungs you want in your bond ladder, and how far apart you want the rungs to be. For example, you might wish to have five rungs, each set five years apart. You would need to buy bonds that mature in five years, 10 years, 15, years, 20 years and 25 years. As each rung matures you have the option of creating a new rung, or of reinvesting those funds in a different security.
Bond laddering is a risk management tool, but you can reduce your risk even further by choosing investment quality bonds for your ladder. For safety, U.S. Treasury bonds are backed by the full faith and credit of the U.S. government, but hey also don't pay much in the way of interest. Corporate bonds that are rated in the top four grades by an independent credit ratings organization, such as Moody's or Standard & Poor's, are rated as investment grade due to their perceived low risk of default. The higher interest typically offered by investment grade corporate bonds can add a boost to your bond ladder return.
Risks and Benefits
You run the same risks with a bond ladder in your IRA as you would in your regular account. No matter how safe the bond is, if prevailing interest rates rise, the market value of all of the bonds in your ladder will decline. This won't matter if you hold the bonds to maturity, because they will pay off then at face value. Since you will have some bonds maturing at regular intervals, you can regularly upgrade a portion of your ladder to prevailing rates. As long as the bonds in your ladder remain in your IRA, the interest isn't subject to current income taxes.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.