Fidelity: How to earn steady income with bonds

Key takeaways

  • Interest rates have risen high enough that bonds can deliver reliable income with less risk than stocks.
  • Owning bonds with a variety of maturities can help provide you with a source of predictable income even if rates move lower in the future.
  • Ladders should be built with high-quality, noncallable bonds.
  • Fidelity’s bond experts can help you build a ladder that reflects your need for income, tolerance for risk, and time horizon.
  • Fidelity’s bond ladder tools can help self-directed investors who want to ladder bonds.

People who are retired or are nearing retirement likely want reliable income to meet their needs. While some people may have pensions to supplement Social Security payments, most must rely on investments to deliver additional income to cover expenses.

Over the past decade, investors facing super-low interest rates on bonds, certificates of deposit (CDs), and cash have turned to stocks. But recent painful declines after a long bull run have many people looking for less risky options. The good news: Yields on high-quality bonds and CDs have risen to a point where they can deliver returns that are comparable to those of stocks but with far more predictability and less risk.

If you want to generate retirement income while also preserving the size of your portfolio, building a ladder of individual bonds could offer reliable income as well as peace of mind well into the future.

What’s a bond ladder?

A popular way to hold individual bonds is by building a portfolio of bonds with various maturities: This is called a bond ladder. Ladders can help create predictable streams of income, reduce exposure to volatile stocks, and manage some potential risks from changing interest rates.

The Federal Reserve is expected to continue raising interest rates until it decides inflation has been brought under control but could stop raising and potentially even lower rates if the economy weakens. A ladder may be useful when yields and interest rates are increasing because it regularly frees up part of your portfolio so you can take advantage of new, higher rates in the future. At the same time, if and when rates begin to fall, a bond ladder structure will ensure that at least part of your bond portfolio is maintained at the (higher) yields that prevailed when you had originally invested in the ladder. If all your money is invested in bonds that mature on the same date, they might mature before rates rise or after they have begun to fall, limiting your options.

By contrast, bonds in a ladder mature at various times in the future, which enables you to reinvest money at various times and in various ways, depending on where opportunities may exist. Ladders can also offer some protection from the possibility that rising rates might cause bond prices to fall, since bond holders are paid the full principal value of the bond when it matures (assuming the issuer stays in business and can make good on its borrowing as they come due).

“Laddering bonds may be appealing because it may help you to manage interest-rate risk, and to make ongoing reinvestment decisions over time, giving you the flexibility in how you invest in different credit and interest rate environments,” says Richard Carter, Fidelity vice president of fixed income products and services. (Note that the chart that follows is for illustrative purposes only and that yield rates are subject to changing market conditions.)

Fidelity:  How to earn steady income with bonds

How ladders may help when rates are falling

Interest payments from bonds can provide you with income until they mature or are called by the issuer. When that time comes, there’s no guarantee you’ll find new bonds paying similar interest because rates and yields change frequently.

Laddering bonds that mature at different times lets you potentially diversify this risk across a number of bonds. Though a bond in your ladder might mature while yields were falling, your other, longer-dated bonds would continue generating income at the higher older rates.

Things to know before building a bond ladder

Before building a bond ladder, consider these 6 guidelines.

1. Know your limitations

Ask yourself—or your advisor—whether you have enough assets to spread across a range of bonds while also maintaining adequate diversification within your portfolio. You don’t want all of your money in any one type of investment and even bond enthusiasts recommend leaving at least 40% of your portfolio in stocks. Bonds are often sold in minimum amounts of $1,000 or $5,000, so you may need a substantial investment to achieve diversification. It may make sense to have at least $350,000 toward the bond portion of your investment mix if you’re going to invest in individual bonds containing credit risk such as corporate or municipal bonds.* For smaller amounts, consider a Treasury or CD Ladder, where credit risk is considerably reduced.

Make sure that you also have enough money to pay for your needs and for emergencies. Also consider whether you have the time, willingness, and investment acumen to research and manage a ladder yourself or if you would be better off getting help with your ladder or opting instead for a bond mutual fund or separately managed account.

2. Hold bonds until they reach maturity

How many issuers might you need to manage the risk of default?

Credit rating # of different issuers
AAA US Treasury 1
AAA-AA municipals 5 to 7
AAA-AA corporate 15 to 20
A corporate 30 to 40
BAA-BBB 60+

You should have a temperament that will allow you to ride out the market’s ups and downs. That’s because you need to hold the bonds in your ladder until they mature to maximize the benefits of regular income and risk management. If you sell early, you will risk losing income and may also incur transaction fees. If you can’t hold bonds to maturity, you may experience interest-rate risk similar to a comparable-duration bond fund, which you may want to consider instead.

3. Use high-quality bonds

Ladders are intended to provide predictable income over time, so using riskier lower-quality bonds makes little sense. To find higher-quality bonds, you can use ratings as a starting point. For instance, select only bonds rated “A” or better. But ratings can change, so you should do additional research to ensure you are comfortable investing in a bond you may potentially hold for years. If you are investing in corporate bonds, particularly lower-quality ones, you need more issuers to diversify your ladder. The prior table suggests how many issuers you may need.

4. Avoid the highest-yielding bonds

An unusually high yield relative to similar bonds often indicates the market is anticipating a downgrade or perceives that bond to have more risk than others and has traded its price down and increased its yield. One potential exception is municipal bonds, where buyers often pay a premium for familiar bonds and bonds from smaller—but still creditworthy—issuers that may have higher yields.

5. Keep callable bonds out of your ladder

Part of the appeal of a ladder is knowing when you get paid interest, when your bonds mature, and how much you need to reinvest. But when a bond is called prior to maturity, its interest payments cease and the principal is returned to you, possibly before you want that to happen.

6. Think about time and frequency

Another feature of a ladder is the length of time it covers and how often the bonds mature and return principal. A ladder with more bonds will require a larger investment but will provide a greater range of maturities. If you choose to reinvest, you will have more opportunities to gain exposure to future interest-rate environments.

How to build a bond ladder

Here’s an example of how you can build a ladder using Fidelity’s Bond Ladder tool. Mike wants to invest $400,000 to produce income for about 10 years. He starts with his investment amount—though he could also have chosen a level of income. He sets his timeline and asks for a ladder with 21 rungs (that is, 21 different bonds with different maturities) with approximately $20,000 in each rung. Then he chooses bond types. In order to be broadly diversified, each rung contains a range of bonds and FDIC-insured CDs with various investment grade credit ratings.

Mike lets the tool suggest bonds for each rung. The tool suggests bonds and shows a summary of the ladder, including the expected yield and annual interest payments.

Displayed rates of return, including annual percentage yield (APY), represent stated APY for either individual certificates of deposit (CDs) or multiple CDs within model CD ladders, and were identified from Fidelity inventory as of the time stated. For current inventory, including available CDs, please view the CDs & Ladders tab.

While a well-diversified bond ladder does not guarantee that you will avoid a loss, it can help protect you the way that any diversified portfolio does, by helping to limit the amount invested in any single investment. Also, a bond ladder leverages the cash flow features of bonds in terms of their coupons and principal repayments: This gives it the potential to be an efficient and flexible vehicle with which to create an income stream tailored to the time period, with a payment frequency to meet your needs.

Author:Com21.com,This article is an original creation by Com21.com. If you wish to repost or share, please include an attribution to the source and provide a link to the original article.Post Link:https://www.com21.com/fidelity-how-to-earn-steady-income-with-bonds.html

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