Further Limiting Your Risk with CDs or Bonds

By: Nilus_Mattive

It’s now official: As I suggested last week, Social Security recipients are not getting any cost-of-living increase in 2011. This marks the second straight year of flat monthly checks.

That fact, combined with the paltry interest rates on many traditional income investments, is certainly causing a lot of people major angst right now.

The key question: How do you secure reasonable income from your personal nest egg without taking on big risks?

If you read this column regularly, you know that my primary answer is “conservative dividend stocks.”

But I have also been discussing other alternatives, including CDs. Two weeks ago, in fact, I went so far as to suggest that even CDs are safer than Treasury bonds.

Now I want to talk about a technique that can further limit your risk whether you’re buying CDs, bonds, or both.

Laddering: A Terrific Way to Hedge Against Interest Rate Swings …

As I mentioned in my comparison of CDs and Treasuries … assuming you hold them until maturity, both are “risk-free” investments. In other words, your principal is protected against losses by the full faith and credit of the U.S. government. (Hey, stop snickering!)

But seriously, barring a complete collapse in Washington, the biggest risk of CDs and Treasuries is not related to your principal … it’s related to interest rates and inflation.

Say you lock up your money for ten years at 2 percent interest a year. And within two years, inflation is running at 4 percent a year. You’re not losing principal but you are losing purchasing power for at least the next eight years. In reality, that’s just as bad, especially if you’re a fixed-income retiree.

So what’s a CD or bond investor to do?

While there’s no perfect antidote to this dilemma — short of perfect timing — there is a strategy that allows you to mitigate the risk.

It’s called laddering, and it’s pretty easy for anyone to implement.

Here’s how it works in two simple steps:

Step #1. You buy fixed-income investments with various maturities.

Step #2. As they mature, you re-invest the proceeds into new investments at the higher rungs of the “ladder” (i.e. investments with the longest maturities).

The approach allows you to always put some money to work at current rates while protecting your portfolio from taking a big hit in the event of sharp moves.

That way …

If rates are falling, you have some of your money in longer-dated bonds.

If rates are rising, you get to keep buying at higher and higher rates.

How would this work with CDs?

Well, let’s say you have $20,000 you want to invest in CDs right now.

You could put $5,000 in each of the following:

A. A 1-year CD with a rate around 1.2 percent

B. A 3-year CD with a yield of about 1.6 percent

C. A 5-year CD with a rate near 2.3 percent

D. A 7-year CD with an APR of 3.5 percent

Your overall ladder will be paying an average one-year rate of 2.1 percent, twice as high as you could get with all your money at the short-end of the spectrum.

Plus, over the next few years, you’ll have the opportunity to reinvest the proceeds from your 1- and 3-year CDs.

So if interest rates have risen sharply, you can buy new 7-year CDs and boost the overall return of your ladder. Meanwhile, your existing 5- and 7-year CDs have essentially become your shorter-duration investments because they’ll be closer to maturity.

There you have it: The basic idea of a ladder!

And as I mentioned earlier, the same strategy works for bonds, too.

Together with a solid portfolio of dividend-paying stocks, a fixed-income ladder can be a great way to build a better overall retirement nest egg.

Best wishes,

Nilus

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