Bonds #14: Laddering Coupon Dates

In the last article, we identified several different investment needs that require thoughtful, and quite different, solutions.

One was the need for a steady income stream, unvaried month to month. What bonds will provide for this need?

NOTE: you do NOT want zero-coupon bonds! You need coupon interest.

First solution:

You could buy a single Treasury bond or corporate bond, and this would pay interest twice a year.

For example, $60,000 invested in a 6% coupon bond will pay $3,600 a year ($60,000 x .06 = $3,600) or $1,800 twice a year. Bonds pay interest in the same month as their maturity date, and again six months later.

This solution is simple and inexpensive, as there is only one transaction (and transaction fee) and one bond to keep track of.

The disadvantages are:

Budgeting

Credit risk

Reinvestment risk

1. Budgeting:

You will have to budget your semi-annual income, making each of the two payments last for six months. Each $1,800 payment will give you $300 per month. Can you make it last?

2. Credit risk:

If you bought a Treasury bond, you have no risk of default.

But it would be particularly unwise to invest in just one corporate bond, and “have all your eggs in one basket”.

No matter how much extra yield this bond will give you, or how excellent its credit rating at the time you bought it, prudence MUST be exercised. Diversity is the key.

3. Reinvestment risk:

Again, you “have all your eggs in one basket”. The one bond could mature (pay off) at a time when interest rates are low, and you will have no defense against this reinvestment risk.

A better solution - use a ladder!

Creating a ladder of the coupon dates will give an even cash flow over the year, and avoid the need to budget semi-annual payments.

You could buy twelve bonds of equal size, one maturing in each month of the year. You will get two payments a month. If this were April, you would get one semi-annual payment from the bond maturing in April, and one semi-annual payment from the bond that matures in October.

Want this made easier?

Buy six bonds, one from each of these PAYMENT PAIRS:

(January & July) (February & August) (March & September) (April & October) (May & November) (June & December)

Whether you buy a bond that matures in January or July, you will get a semi-annual payment in both months.

This way, you will receive a single payment each month from one of your six bonds.

If we use the same total of $60,000, you could have bought six bonds of $10,000 each. If they each have a coupon of 6% (as nearly as possible), each one will provide $600 a year, paid in two payments of $300.

A ladder of coupon dates gives you an even flow of cash for expenses.

But what about credit risk?

Again, if you buy only Treasuries, you have no default risk. But, if you are investing for income, then you should consider corporate bonds.

And, having six (or more) different bonds gives you some diversity in corporate names. If you have decided that you are comfortable with high quality investment-grade issuers, like GE, Citicorp, Ford, etc., buying corporate bonds will yield an extra 1% to 1 ½% per year, or $600-$900 on your total of $60,000.

That still leaves reinvestment risk….

Use a ladder!

Interest rates do go up and down. While the shifts are not completely random, they are difficult to predict. For this reason, you do not want all you bonds to mature in the same year. You know Murphy’s law – you can bet that interest rates will be at historic LOW levels if you need to reinvest all your savings at once.

Next week - ways to structure a ladder of maturity dates…