Laddering Helps You Maximize Your Interest-based Income over Time
by Shane Flait, ©2011

 

Retirees who have to live off their interest-based income investments are often a victim of interest rate swings that can lower their income significantly. Chasing after high interest rates without a strategy can often leave them with less income than they could get with a laddering strategy. Here’s the situation…

 

Interest-rate based investments and their behavior

Interest-based investments come from certificates of deposit (CDs), bonds, and annuities. These types of investments tend to be more secure than stock-based investments. And that’s what makes them attractive to those who depend on them for their living expenses.

 

But interest rates fluctuate over time; sometimes rising and then falling. This causes interest-based earnings – and the income they supply to people – to also vary. Everyone wants to lock in their interest-based investment when rates are high and not have to suffer through the low interest rate periods with a low income.

 

Additionally, at whatever the prevailing interests rates are¸ interest rate-based investments typically offer their higher rates for longer maturity investments. It’s always nice to get the highest of the prevailing rates, but that means being locked into a longer maturity. That’s a problem if prevailing rates are low – and especially if they may be going up soon.

 

Chasing a higher interest rate can be a problem

If you invest all you have when rates are historically high, that’s great; you’ll earn allot for your investment before they mature.  But when interest rates are low when you want to invest because you need the income but you don’t want to be locked into low rates for a long term maturity in case interest rates go up.

 

If you try to sell out of a long term maturity investment early to buy into rising rate investments, you’ll generally pay a stiff penalty or suffer a loss of principal – as on a bond. You could buy shorter maturity units to preserve your ability to buy when rates go up but that leaves you with even a lower rate than you could get at that time. 

 

Without a strategy, you’re forever chasing after a higher interest rate while getting less than the best rate at any one time. There is a better approach. And that’s laddering your investment.

 

The Laddering Principle

Laddering is based on dividing your investment money into equal parts – three, four, or even up to 10. You need to work into the situation where each of these parts is invested at the longest maturity time to garner the highest prevailing rate when bought; you hold all to maturity, and each will mature at successively later times. As each reaches maturity, you reinvest it again at the highest prevailing rate.

 

Under this circumstance, you’ll still be subject to changing interest rates, but your time-staggered investments will smooth out your income fluctuation and have them arise only from the highest rates that prevailed when bought.

 

How do you begin to implement your laddering strategy?

For CDs and Bonds, you begin by dividing your full investment into perhaps 5 equal parts.  The number of parts depends on the amount of money you have. Invest one part into the longest maturity investment to get the highest prevailing interest rate. Invest each remaining part into an investments with consecutively shorter time to maturity; you hold all them to maturity, though. Obviously you’ll get a lower interest on the shorter times; but that will change.

 

Now as each investment comes to maturity, you’ll reinvest it into the longest maturity possible. That’ll get you the highest prevailing rate at that time. Keep this up, and you’ll have all your parts invested at the longest maturities invested at the highest prevailing rates. Now you’re properly laddered.

 

Annuities are handles somewhat analogously. That’s for another article.

 

Putting a bond investment into the Laddering Strategy

A simple example of preparing a bond investment for laddering may be helpful. For simplicity, we’ll you divide your $30,000 ‘income investment’ into 3 parts – refer to the table. Begin your 1^st year by investing each part at a different ‘years-to-maturity’ – not all at the longest maturity (which gives the highest rate)! These parts are investments A, B, and C in the table. (The ‘maturity term’ reflects the term of the bond).

 

The 1^st year summary shows the average maturity term is ‘2 years’, the average rate is ‘3.5%, and total earnings you get on your $30,000.  Let’s assume that rates at each maturity stay the same (i.e. interest rates don’t change for the while).

 

At the beginning of the 2^nd year when the shortest time to maturity occurs, you reinvest money from A into the longest term bond (highest rate) as D. The other two bonds’ ‘years-to-maturity’ shorten by 1 year. Now see that the 2^nd year summary gives a longer average maturity, a higher average interest rate, and an increased annual earnings.

 

By the 3^rd year, following the same reinvestment procedure, you’re earnings come from all longest maturities, at the highest rates, but you still some short liquidity as 1/3 of your investment matures each year.

 

However rates change you’ll be able to invest in the ‘long term’ rates with your ‘soon to mature’ investment part.

 

 

Laddering Illustration for Dividing Investment in Thirds
Investment year	Investment	Years-to-maturity	Maturity term	Interest rate	Investment	Annual earnings
1st year	A	1	1	2.5	10,000	250
	B	2	2	3.5	10,000	350
	C	3	3	4.5	10,000	450
1st Year summary	3  equal investments	1 year Shortest time to liquidity	2 is Average maturity	3.5 is average rate	30,000 is total investment	1050 is total earnings
2nd year	B	1	2	3.5	10,000	350
	C	2	3	4.5	10,000	450
	D	3	3	4.5	10,000	450
2nd Year summary	3 equal investments	1 year Shortest time to liquidity	2 2/3  is average maturity	4.17 is average rate	30,000 is total investment	1250 is total earnings
3rd year	C	1	3	4.5	10,000	450
	D	2	3	4.5	10,000	450
	E	3	3	4.5	10,000	450
3rd Year summary	3 equal investments	1 year Shortest time to liquidity	3  is average maturity	4.5 is average rate	30,000 is total investment	1350 is total earnings

 

 

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