Strategies for investing in individual bonds

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.)

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.

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.