Thu 25 Jan 2007
Who: This post is for people who do not know what a fixed income ladder is or for people who want to learn about starting one. A familiarity with the basics of bonds and CD’s is assumed.
What: This post discusses a basic strategy for controlling cash flow and earning income from fixed income investments. The example used in this post will be a Certificate of Deposit (CD) ladder.
What is a CD Ladder and Why Do I Want One?
For those of you who like to keep a small (or large) portion of your savings/investments in bank CD’s, a CD ladder can solve the possible associated cash flow and liquidity problems. A CD ladder is just an investment strategy which calls for investing money in CD’s that have different maturity dates. The advantage of this is twofold. First, if long-term yields are higher than short-term yields (or vice versa), you have the opportunity to take advantage of both long-term and short-term yields. Second, if you are uneasy about locking up a large sum of money away for a long period of time (because you may need it for something else), a CD ladder gives you the opportunity to wait a short period of time before a part of your investment becomes available, solving many (but not all) cash flow issues.
Want an Example?
We will assume that you are a high roller and you have $100,000 to invest. You are not sure what sort of large expenses may come up over the next 4-5 years but as the time goes by, you will have a better idea of what you want to spend the money on (reasonable, right?). For simplicity’s sake, let’s say that the CD’s interest rate is equal to the number of years the CD locks up your money for, up to 5 years: (1 year CD = 1%, 4 year CD = 4%). This is slightly unrealistic, but it allows us to appreciate how the yield curve *normally* looks.
A CD Ladder approach would call for something like this:
As you can see, the maturities are staggered and some of the CD’s will earn more than the others. If you need some money after 1 year, you can take the payout of CD #1 and use it. Otherwise, you can just take it and invest the money in another 5 year CD. By that time, CD #2 would mature in 1 year and CD #5 would mature in 4 years. You can continue in this manner to keep the ladder intact.
If your life is particularly volatile, you may want to shorten the length of time between maturities to maybe 6 or even 3 months. If you have a more stable life, a 1-2 year gap in maturities should not be too much of a problem. The larger you make the gap, the less cash flow benefit you receive from your CD Ladder. It is obviously not necessary to always continue the ladder once some of your original CD’s come to maturity. Based on the interest rate environment, you may decide to use your cash from an old CD for longer term CD’s or shorter term CD’s.
So, Why Did You Tell Me About a CD Ladder?
As was alluded to above, there is no magical advantage of using a CD Ladder. A CD ladder is a way to manage cash flow while still maintaining returns better than that of very short-term investments. If you chose to invest all of your money into the longer term CD’s, then a potential emergency or large purchase may require the breaking of a CD (and paying the associated penalties) which severely erodes returns. With a mix of different maturities, the overall return may be lower, but the potential to use cash when needed is readily available.
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