Managing Volatility with a Ladder

(Written October 2009)

During the past decade, income focused investors have faced a remarkable period of interest-rate volatility. In the past 10 years ending in 2008, the Federal Reserve adjusted the federal funds target rate, which influences the interest rates that consumers pay and bondholders earn, 41 times.

One way to help manage interest-rate risk and cash flow from income focused investment is to construct an investment ladder. This allows the investor to benefit when the rates are high and to help minimize the effect when rates are low. Implementing a ladder investment strategy is easy and can be done with bonds, CDs or annuities.

Step by Step Using Bonds

Bonds, which are debt obligations of the issuer, are issued with maturity dates ranging from a couple of years to 30 years or more. Interest payments are generally every six months with the face value of the bond due at maturity. The interest rate paid by bonds is established when the bond is issued. If interest rates later rise, the issuer will pay a below market interest rate. Conversely, if interest rates fall, the issuer is straddled with paying an above market rate interest rate.

Although the interest paid by the issuer will remain constant, the principal value of a bond may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investors seeking to achieve higher yields may also face a higher degree of risk. The interest earned may also be taxable at both the state and federal level.

To set up a six-year bond ladder, you would purchase five different bonds with maturity dates of two, three, four, five and six years, respectively. If these are new issue bonds, you will earn an interest rate close to the prevailing market rate. When the first bond matures after two years, you purchase a new six-year bond to keep the ladder intact. Each year when the bond matures, you simply purchase a new six year bond. If interest rates have risen, you benefit from having cash available to invest in a new bond at the higher rate. If interest rates have fallen, only a portion of the portfolio is subject to the lower rate.

An alternative to buying individual bonds is to invest in a bond mutual fund or ETF. Interest is paid monthly instead of semi-annually and you don’t have to worry about reinvestment interest rates.

Using Annuities

Annuities come is many flavors ranging from simple savings annuities to complex variable annuities. The ones we are interested in for an annuity ladder are the short term, no fee and no commission savings annuity. This type of annuity is available from several insurance companies. They can be purchased for various time periods ranging from two to ten years or more and generally have a minimum investment amount with $20,000 to $50,000 being common. These annuities offer a fixed rate of return for a fixed period and the purchaser has no market risk.

For example, in mid September 2009, a simple $100,000 2-year saving annuity contract can be purchased earning 1.75%. A $100,000 5-year saving annuity will earn 3.65%. You can buy this directly from the company with no fees, no commission or salesperson involved. You simply give them a check for $100,000 and in two years they give you back a check for about $103,560. The 5-year annuity would earn about $20,000. Unlike bonds and CDs, the tax on the interest earned on an annuity is deferred.

Constructing an annuity ladder is similar to that of a bond ladder, but you may be limited to the term lengths offered by a single company. For example, some companies offer 2, 5 and 10 year saving annuities. Others offer may offer 3, 5, 7 and 10 year terms.

The interest rate paid on an annuity contract is also influenced by the Federal Funds Target Rate. Like bonds, you will want to keep the ladder short with five to six years probably being the limit. To construct a two-year annuity ladder, purchase a two-year annuity this year and one year later purchase another two-year annuity. When the first one comes due, you may be able to do a 1031 exchange into another two-year annuity which may be paying a higher rate of guaranteed return. The 1031 exchange will allow you to defer the tax on the interest earned.

If a company allows for a three-year annuity contract, the ladder is constructed over a three year period. Or you could build a five year ladder by buying a five-year contract every year for five years. The longer the ladder the more stability the annuity ladder will offer but may subject you to interest rate risk.

Using CDs

Constructing a CD ladder is very similar to the bond and annuity ladder but with more choices. Term lengths on CDs range from three months to five years. In mid-September 2009, the highest rate available on a one-year CD is 2.15% APY.

To construct the CD ladder, buy five separate CDs with maturity dates of 1, 2, 3, 4 and 5 years. As the first one matures reinvest in a new five-year CD. Unlike annuities, you will pay the tax on the interest earned each year even if the money earned will not be received until the CD matures.

With CDs it pays to shop around. You may purchase the CD from practically any bank located anywhere within the USA. Interest rates vary widely between banks with a high today of 2.15% APY down to a low of 1.25% APY. You can find current rates on www.bankrate.com. It may also pay to call the bank directly to request quotes or check the bank’s Web site.

There is no trick to CD laddering. Only due diligence is required in order to minimize risks. You may pay a surrender charge if you cash in a CD before its maturity.

Income investing using a ladder strategy can help provide stability during periods of interest-rate volatility. Remember to read all the fine print before purchasing.

Where to Use a Ladder

All three ladders will create taxable income so it would be wise to consider which investment vehicle: a Traditional IRA, Roth IRA or Saving Account would be the most appropriate. The Roth IRA would by far be the best location because all income is receive tax free after you reach 59 ½. It would not make sense to place an annuity ladder in a Traditional IRA. An IRA already has deferred tax status. It’s a duplication of effort. Both the bond and CD ladder would fit nicely in any of the three investment vehicles.

Written by David Snellen
© 2009 USA Living Financial Group