Do You Need a Bond Ladder?

If you're nearing retirement or planning an extended sabbatical, you can face a dilemma when looking at your investments and savings. How do you generate reliable cash flow when you have most of your portfolio in domestic and international equity funds? Sure, most years stock markets go up. But what if you end up wrapping up work just when the stock market is beginning to swoon?

In the parlance of retirement planning nerds, this is called sequence of return risk. Generally speaking, this comes into play when you have a poorly performing stock market in the initial stage of financial independence. Retirement researchers concur that poor market returns in the initial years of retirement can threaten your ability to support future spending. This risk is so important that it is one of the fundamental underpinnings of the 4% rule of thumb for sustainable annual retirement withdrawals over 30 years. The reason this percentage is lower than you may expect has to do with a series of poor market returns and high inflation in the early 1970s.

Bond ladders are one way to address the problem. The reason we call it a bond ladder is that it consists of a series of high-quality bonds, each maturing and returning its principal in a specific year. These are the "rungs" of the ladder. The amount the bond pays upon maturity should be close to the cash flow you'll need that year.

As an example, let's say you're planning on leaving work at the end of 2028. Your current level of spending is $7,000 a month. You can purchase $84,000 in Treasury bonds that mature at the end of 2028, and then roughly the same amount maturing in each year between 2029 and 2032. Once you purchase those bonds, you have locked in the money you'll have available over those five years, regardless of fluctuations in the stock market. If you have a pension or Social Security that will be starting or expenses that will be ending, such as a mortgage payment, you can adjust the rungs on your bond ladder to only provide the income you need. These purchases can be made in a brokerage account at one of the major custodians.

This strategy does not prevent your stock holdings from declining in value. It does give you a source of high-quality cash flow that you can rely upon even amid stock market declines. If the stock market goes up in a year, you can sell some of your equity investments to cover your annual spending. Then you can use the bond proceeds to buy another bond for the far end of the ladder. That way you always have at least five years' worth of future spending that you know will be available. If the stock market is down, you can simply spend the proceeds of the maturing bond.

One of the lesser-known benefits of a bond ladder is the psychological support that it imparts to its owners. While some finance professors may pound the desk for 80% equity portfolios for financially independent investors, they may be making recommendations for the fabled homo economicus, the largely mythical investor that makes cold, data driven decisions in the midst of market calamity. Knowing where your cash flow will come from for the next five to six years will hopefully enable you to make it to the other side of the next bear market with minimal panic selling.

You need the bond ladder to be rock solid, which is why I generally recommend Treasury bonds (or target maturity Treasury ETFs that hold them) or other very high-quality alternatives. While high yield bonds may have alluring yields, their credit risk is highest during the very market conditions when you most need your bond portfolio to be dependable.

Do you need a bond ladder? Not everyone does. You may have enough income coming in through pensions, Social Security or rentals to cover your expenses. You may be able to mirror this strategy by using a diversified bond fund along with stock funds. But in my experience bond ladders provide an almost tangible way to support spending when you're no longer working or on sabbatical, even when stock markets don't cooperate. For some investors, that may be the strategy that helps prevent the biggest mistake of all — selling stocks after they've gone into a bear market.

David Gardner is a certified financial planner in Boulder County and is admitted to practice before the IRS. He can be reached at entreewealth.com. As financial planning is only possible after knowing the client, the column is not intended to be personal financial or tax advice. Data presented is believed to be accurate at the time of writing.