Laddering Your Bonds

Diversification is as important in bond investing as it is in stock investing. It's best to spread your risk over a series of different maturities, while maintaining an average maturity of your liking in your portfolio. The best way to do this? Set up a bond ladder -- in essence, a series of bonds with a range of maturities.

Here's how it works. If you were to buy, say, equal amounts of Treasurys due to mature in one year, three years, five years, seven years, and nine years, that portfolio would have an average maturity of five years (1+3+5+7+9 divided by five equals five). The next year, when the first batch comes due, you would reset the ladder by putting the money into new 10-year notes. Your portfolio would then have an average maturity of six years.

Two years after that, when the 3-year notes matured, you would buy more 10-years, and continue to do so whenever a note matures. That would always keep the average maturity in the five- to six-year range.

The advantage is that you don't need to worry about interest rates -- especially if the ladder you construct has notes coming due every couple of years or so. If rates do rise soon after you bought this year's bonds, you can take comfort in the fact that soon you will have money coming available to take advantage of the change. Similarly, if rates decline after you buy, you've managed to lock in the higher rates for that portion of your portfolio. The bottom line is, you won't get stuck one way or the other.

A bond portfolio can be built with any kind of bond, but Treasurys are commonly used since they have relatively little risk and are widely available. You can purchase Treasurys either on the secondary market (i.e., from another investor) or directly from the government through a program called Treasury Direct.

The beauty of buying Treasurys from Treasury Direct is that there are no transaction costs. The minimum investment requirement is also a low $1,000. To open an account, just download an application from Treasury Direct's Web site and mail the completed paperwork to the nearest Treasury Direct office. You can also obtain general information and maintain your account by calling Treasury Direct's toll-free number (800-722-2678).

Unfortunately, there's a catch. Since you can only buy new issues from Treasury Direct, creating a neat laddering structure is pretty much impossible. That's because these days, Treasurys have maturities of six months, two years, five years and 10 years. So if you created a ladder with these durations you could miss some big interest-rate swings between the time the five- and 10-year Treasurys come due.

To avoid that, you're going to have to use the secondary market to buy at least some of your bonds. This way, you can buy bonds that have already been in existence for a while, and you'll simply buy those that have remaining years in the durations you seek. Any large, reputable broker with a trading desk dedicated to Treasury bonds should be able to get you the maturities you want at a competitive price. Unfortunately, due to the extra transaction costs you'll pay (plus commission, in many cases) this method might not be worthwhile if you're making Treasury purchases of $1,000 or less.

Keep in mind, a ladder may also be constructed of municipal bonds, but that would typically require a bare minimum of $100,000 in capital to gather a diversified group of issues. Trading in munis, which you can do through most brokerage firms, also creates higher transaction costs, but if your tax rate is high enough -- probably anything above 25% -- the tax savings will likely make the costs worthwhile.

Lastly, if all this seems a bit more complicated (or costly) than you anticipated, for many investors, a low-fee bond fund is a fine alternative. While no bond fund will come out and say that they've set up a laddered portfolio, money managers stagger bonds within their funds so that different maturities come due at various times. For example, if you wanted a bond fund that mimicked the ladder example above, you could buy the Vanguard Intermediate Term U.S. Treasury fund (VFITX). This fund has very low expenses and an average maturity of 5.4 years. But because it holds approximately 65 bonds with maturities of three to 27 years it's a bond ladder with a lot of rungs on it.