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Strategies for investing in individual bonds

Using certain strategies can help you achieve your investing goals, provide you with an income stream, and minimize risk.

POINTS TO KNOW

  • Ladders, barbells, and swaps are some of the trading strategies you can use for buying and selling bonds.
  • Callable bonds can be redeemed by the issuer before the maturity date, exposing you to interest rate risk.

Climbing the ladder, exercising with barbells & more

Investing in bonds involves more than just finding the security with the highest yield. Among other things, there are strategies that minimize risk, enhance liquidity, and offer diversification.

Here's a list of the commonly used strategies, how they work, and their advantages and disadvantages.

Bond ladder

A bond ladder contains bonds of relatively equal amounts with staggered maturities. It allows you to invest at regular intervals, minimizing both interest rate and reinvestment risk.

How it works

When you consider constructing a bond ladder, picture a real ladder.

Each rung of the ladder represents a bond. As each bond matures, you can reinvest the principal at current interest rates.

Say your ladder has bonds that mature in 2, 4, 6, 8, and 10 years. When the first bond matures in 2 years, you reinvest the money in a bond with a 10-year maturity, maintaining the ladder you've constructed.

The advantages

  • Takes the guesswork out of interest rate swings.
  • Offers a consistent interest revenue stream.
  • Provides ongoing turnover and the opportunity to invest again.
  • Offers diversification of maturities and returns.
  • Can potentially lower expenses.

The disadvantages

  • Is a conservative strategy that doesn't maximize your returns.
  • May not be the best strategy for anyone with small amounts of money to invest (usually below $50,000 per issue, considering expenses).
  • May lead to bonds being called if maturities are longer than 10 years. (Understand the call features of any fixed-income security you buy.)

Barbell

A barbell is a bond portfolio whose assets are mostly in short- and long-term bonds with few, if any, intermediate-term bonds.

How it works

This time, picture a barbell. Your heavy concentrations of investments comprise the ends of the barbell, with lesser amounts, if any, in the middle.

Since this strategy includes a lot of short-term bonds, you'll need to continually trade maturing bonds for new ones.

The advantages

  • Captures high yields from longer maturities and uses lower maturities to help minimize interest rate risk.
  • Offers diversification.
  • Provides liquidity and flexibility to handle emergencies.

The disadvantages

  • Tends to shortchange a middle-of-the-road strategy by minimizing exposure to intermediate-term bonds.
  • Requires consistent monitoring of short-term investments to replace those that are maturing.
  • Is vulnerable to loss of principal on the long-term investments when interest rates rise.

Bond swap

A bond swap is simply selling one bond and immediately using the proceeds to buy another.

How it works

You decide to sell a bond at a loss and use the proceeds to buy a better-performing bond. You can write off the losses on the sale but potentially get a better return on the purchase.

The advantages

  • Can reduce your tax liability.
  • May get you a higher rate of return.
  • Offers portfolio diversification.
  • Allows you to act in anticipation of interest rate changes.
  • Can improve the credit quality of your portfolio.

The disadvantages

Wash sales

Your swap could create a "wash sale" if you're not careful. That is, the IRS won't recognize any tax loss generated if you sell and repurchase the same or a substantially identical investment within 30 days before or after the trade or settlement date.

Tax implications

You'll need to understand the differences in the tax treatment of short-term capital gains and losses and long-term capital gains and losses. These differences can affect how you apply the losses and your tax rate on the profits.

Your bond's been called. Now what?

If you invested in a bond with a high interest rate—and a "call feature"—you might not enjoy that rate until the bond matures. That's because the bond issuer could choose to pay back your principal before the stated maturity date.

The risk of callable bonds

What's good for you isn't necessarily good for the bond issuer.

When interest rates fall, the issuer is likely to want to refinance the debt at a lower rate and call the bond.

Meanwhile, you're very happy with the higher rate that callable bonds customarily pay. Now you have to reinvest the money in an interest rate environment that doesn't pay as much.

How to protect your investment

Protecting your investment starts before you buy a bond:

  • Know if your bond is callable.
  • Find out if it has call protection—a time frame during which the bond can't be called, assuring you'll receive the interest rate for at least that period regardless of what's going on in the markets.
  • Try to find bonds that are non-callable and compare their yields to callable bonds.

If you have a callable bond, keep up with interest rates and have a plan to invest the proceeds if the bond is called.


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REFERENCE CONTENT

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Bond

A loan made to a corporation or government in exchange for regular interest payments. The bond issuer agrees to pay back the loan by a specific date. Bonds can be traded on the secondary market.

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Yield

The income return on an investment usually expressed as a percentage of the investment's cost, current market value, or face value.

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Risk

Usually refers to investment risk, which is a measure of how likely it is that you could lose money in an investment. However, there are other types of risk when it comes to investing.

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Liquidity

A measure of how quickly and easily an investment can be sold at a fair price and converted to cash.

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Diversification

The strategy of investing in multiple asset classes and among many securities in an attempt to lower overall investment risk.

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Maturity

The length of time between a bond's issue date and when its face value will be repaid.

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Interest rate risk

The possibility that a security will decline in value because of an increase in interest rates.

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Reinvestment risk

The possibility that reinvested dividends or interest from a particular investment will earn less than the original investment because of falling rates.

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Principal

The amount of money originally put into an investment.

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Interest/Interest rate

Income you can receive by investing in bonds or cash investments. The investment's interest rate is specified when it's issued.

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Return

The profit you get from investing money. Over time, this profit is based mainly on the amount of risk associated with the investment. So, for example, less-risky investments like CDs (certificates of deposit) or savings accounts generally earn a low rate of return, and higher-risk investments like stocks generally earn a higher rate of return.

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Callable security

A security that allows the issuer to repurchase or redeem it prior to its maturity date.

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Short-term bond

A bond with a maturity of less than 1 year.

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Long-term bond

A bond with a maturity ranging from 10 to 30 years.

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Intermediate-term bond

A bond with a maturity of 1 to 10 years.

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Credit quality

A measure of a bond issuer's ability to repay interest and principal in a timely manner.

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Trade date

The actual date on which shares are purchased or sold.

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Settlement date

The date by which a broker must receive either cash or securities to satisfy the terms of a security transaction.

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Capital gain/loss

The difference between the sale price of an asset (such as a mutual fund, stock, or bond) and the original cost of the asset. A capital gain/loss is "unrealized" until the investment is sold, when it becomes a realized gain/loss. Realized gains are taxable and they may be considered short-term (if the investment was owned one year or less) or long-term (if the investment was owned for more than one year).