You want to draw some income while preserving some of your capital. So, you decide to take a look at fixed-income investments. A little research shows you that 10-year Treasury notes haven’t yielded more than 2% since July 2019. One-year T-bills haven’t yielded 1% since February 2020. You shrug and think, “Ah, well, low-interest rates, what can you do.”
Treasury bonds aren’t your only choice in the world of fixed-income investing. Far from it. There are various other vehicles you may want to consider as part of a fixed-income strategy, and some of them offer potentially higher yields than Treasuries. It comes down to how much risk you want to shoulder as a fixed-income investor.
The market value of fixed-income investments will fluctuate with changes in interest rates. As rates rise, the value of existing bonds typically falls. If an investor sells a bond before maturity, it may be worth more or less than the initial purchase price. By holding a bond to maturity, an investor will receive the interest payments due plus your original principal, barring default by the issuer. Investments seeking to achieve higher yields also involve a higher degree of risk.
The federal government backs U.S. Treasury bonds, so default risk isn’t an issue for those securities. Corporate bonds have varying degrees of it, and the degree of risk does influence the interest rate, which may be higher than that of a Treasury bond. (You could say that Treasuries carry an opportunity risk: the risk that you might get a better return from another type of investment.)
Rating agencies classify bonds at different grades, from AAA (least likely to default) to “junk” (a comparatively higher chance of default). Often, a higher default risk corresponds to a relatively greater interest rate for the bond and vice versa. Bond yields are also affected by bond prices; when prices rise, yields generally fall, and when prices fall, yields generally rise.
Often, fixed-income investors build a “bond ladder,” a set of individual bonds with staggered maturity dates, to structure cash flow across a period of years. A bond ladder can contain Treasuries, corporate bonds, municipal bonds issued by state and local governments, international bonds such as those issued by emerging-market nations, and even ultra-long bonds with 30-year or 50-year maturities.
Bond laddering is an approach to help manage risk. It does not eliminate the risk of loss in a bond investment.
While constructing a bond ladder sounds simple, it can be rather tricky. You have to consider where you locate the bonds (taxable or tax-advantaged account), the credit ratings of bonds you may want to add, what to do with the interest income that the bonds provide, and the tax treatment of that income.
Keep in mind this article is for informational purposes only, and it is not intended as real-life investment advice or a recommendation of a particular fixed-income investing strategy. Consult a professional prior to attempting any kind of long-run investing approach.