Imagine the retiree who’s watched the interest rate on a one-year certificate of deposit (CD) fall from 5.5 percent a year ago to a paltry 2.5 percent by late October, and on the ten-year Treasury note from 5.9 percent to 4.4 percent. That makes it tougher to meet living expenses. One can search out higher-earning alternatives, such as real estate investment trusts or dividend-paying stock, but the alternatives are usually riskier. Careful shopping can help, too. But another way to improve interest income, while at the same time minimizing the impact of fluctuations in interest rates, is to build a bond ladder.

Here’s how a ladder works. You buy individual bonds or CDs with a mix of maturities—the date on which the bond or CD issuer agrees to pay back the principal. For example, you might buy roughly equal dollar amounts of various U.S. Treasury securities, each maturity date representing a different rung on the ladder (running from short to long maturities). In mid-November 2001, the approximate yield on 6-month T-bills was 1.8 percent, 2.8 percent for 2-year notes, 3.9 percent for 5-year notes, 4.6 percent for 10-year notes and 5 percent for 30-year bonds. As each shorter-term bottom rung matures, you reinvest the proceeds in the best-returning rung on the ladder, which usually is the top rung of securities with the longest maturity.

In time, the shorter-maturity, lower-paying rungs will gradually be replaced by higher-paying longer-maturity bonds. At the same time, you’re minimizing interest-rate risk. The price of bonds rises or falls inversely to the rise and fall of interest rates, and bond prices rise and fall faster the longer the maturity. For example, today’s low interest rates will inevitably rise at some point in the future, driving down the value of longer-term bonds issued while rates are low.

One could avoid the problem, of course, by buying only short-term bonds, but then you’re stuck with the lower yields. On the other hand, if you buy only long-term bonds for higher yield, you face the risk of greater volatility and perhaps being forced to sell before maturity at a loss of principal should you need the cash.

However, with a laddered bond portfolio, a portion of the longer-term securities are maturing every three months, six months or year, depending on how many rungs you build into the ladder and how large the spread among the maturities. If you need to sell a bond for emergency cash, you can sell one at or near maturity with little or no loss of principal, regardless of whether interest rates have gone up.

When building a ladder, you can choose whatever combination of maturities you need. For example, you may not want to go as far out as 30-year Treasuries (the government has discontinued issuing new ones, but they are available on the secondary market). Instead, you might use CDs only up to five years in maturity, or only up to ten years in Treasuries.

While Treasuries and CDs are most commonly used to build a ladder, you can construct one out of higher-earning high-grade corporate bonds, mortgage-backed securities or, for investors in higher tax brackets, municipal bonds. However, these ladders will carry more risk than Treasuries or CDs.

It’s possible, but more difficult, to build a ladder out of bond funds because there’s usually no definite maturity date in a fund and redemptions are not controllable. However, some funds focus on bonds with certain maturities, such as ultra-short, short, intermediate or long-term bonds. Investors who don’t have enough money to buy sufficient diversity of bonds (research suggests at least $50,000 to $100,000 to sufficiently diversify) may want to consider bond funds.

The ladder of bonds or CDs produces a smoother income flow at a blended interest rate that’s not as high as the longest maturity but better than the shorter maturities, while managing interest rate volatility. It’s not exciting, but fixed income, especially for retirees, isn’t supposed to be exciting—only comforting.

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December 2001 — This column is produced by the Financial Planning Association, the membership organization for the financial planning community.