Building a bond ladder is a multi-step process. Before you can select the specific bonds you want to buy you need to determine your investment objectives.

 

1. Tax Considerations

 

The first decision you need to make when you build a ladder is whether you are buying tax-exempt or taxable bonds.(NOTE: You should consult a tax professional before making any final investment decisions.)

 

Tax-exempt Bonds: These are generally appropriate for individuals in high income tax brackets who are investing cash held in taxable accounts. Coupons from tax-exempt bonds are not taxable (although certain exceptions apply) so you are able to keep the proceeds from the investment with no tax penalty.

 

Taxable Bonds: Individuals who are investing cash held in tax-deferred accounts (e.g., IRAs, 401k plans, etc.) frequently purchase taxable bonds. Coupons from bonds held in tax-deferred accounts are not taxed until the funds are withdrawn at retirement, allowing you to take advantage of their generally higher interest rates with no immediate tax penalty.

 

2. Bond Type

 

Once you determine the tax status of the bonds in your ladder, you need to decide what kind of bonds you want to buy (e.g, CDs, Treasuries, Corporates, etc.). Please refer to this site's Fixed Income Asset Types if you have questions about the behavior/features of each bond type.

 

3. Credit Quality

Most bonds are exposed to some degree of credit risk, the possibility that the borrower will not be able to repay their debt in full. In general, bond returns increase as risk increases.

 

Credit rating agencies – S&P and Moody’s – assign letter grades to each bond so you can quickly assess the relative risk of each bond.

 

Your risk tolerance depends on both your willingness and your ability to take risk. You should consult a financial advisor if you need help determining your risk tolerance.

 

4. Time Horizon

 

The final variable in building a ladder is your time horizon. As discussed in our Introduction to Bond Ladders, your ladder’s horizon reflects your expectations about interest rate movements. If you think rates are likely to go up in the near future, you want to build a short-term ladder so that you have cash available when rates rise. On the other hand, if you think rates are near a peak you want a long-term ladder so that you can lock in high rates for as long as possible. If you don’t know, you can settle on a medium-term ladder.

 

It is important to note that the horizon for your ladder can be significantly different than your overall investment horizon. For example, even if you are 20-years away from retiring you could build a 5-year ladder if you think rates are likely to increase in the near future. Once they increase to a level you like you can extend your ladder as you reinvest the matured proceeds from your short-term bonds.

 

5. Select Bonds

 

Finally, at the conclusion of the above decision-making process you will be able to select the bonds you need for your ladder. Assuming you have carefully evaluated each of the above options you will end up with a portfolio of bonds that is well-suited to your investment needs.