What’s an effective investment strategy for when interest rates are low?
The problem with investing during periods of low interest rates is that your returns may not beat inflation and your money may lose its real value.
One practical solution is to invest with a bond ladder.
What is a bond?
To understand why bond ladders are a frequently used investing strategy, you need to know how bonds work. A bond is a loan that you make to a corporation or government. Each loan has a set time period (term) and rate of interest. When the bond reaches its maturity date (the end of the set time period), you get back your original loan in addition to the final interest payment.
What is a bond ladder?
A bond ladder is a portfolio of individual bonds or CDs (certificates of deposit in a bank) that you buy to diversify your account. Each bond matures at a different date and has its own rate of interest. Buying bonds/CDs in this manner means that you don’t tie up all of your money in a single issue at one set interest rate. For example, you may buy a ladder of individual bonds that mature in one, two, three, four, and five years. If you have $100,000, you may decide to put $20,000 into each bond, which will then mature over consecutive years.
Why this is helpful to lock in good interest rates
If you invest the $100,000 mentioned above into a single bond with a rate of 1% for five years, you won’t benefit if an interest rate rise occurs during this time. But if you build a bond ladder and interest rates rise, as each bond matures you can reinvest the money at the new, hopefully higher, rate.
Bond ladders allow you to earn current income while also maintaining flexibility to reinvest in higher yielding bonds if rates rise.
Bond ladders are a form of diversification.
A good chess player diversifies moves and tactics on the board, so that if one strategy fails there is another one to fall back on. This method follows the same principle as a bond ladder. Diversifying your money in bonds with different maturity dates instead of investing all of your money into one bond reduces interest rate risk.
Bond ladders are a common tool, and though they have risks which you should discuss with an investment professional before you invest, they are often appropriate for people nearing or in retirement. To find out more about this investment strategy, watch these two videos about how to set up a bond ladder.
Douglas Goldstein, co-author of Rich As A King: How the Wisdom of Chess Can Make You a Grandmaster of Investing, is an avid chess fan, international investment advisor and Certified Financial Planner (CFP®).