The Wealth Chronicle

Fighting Inflation with a Bond Ladder

One of the biggest determinants to reaching your financial goals will be the imminent rise in Inflation. If inflation rises your money will not buy as much as it currently does. For example, today you may pay $2 for a gallon of gas. Once inflation rises the price of gas may rise to 3, 4, or even 5 dollars a gallon. Inflation does not stop at the price of gas. When inflation comes the price of everything rises. Examples include groceries, travel, apartment rents, and cars.

This article continues on the theme of inflation and different options on how to combat it. Most people like the safety of fixed income investments such as bonds and CD's, especially after the stock market crashed in 2008. Usually fixed income is the last place you want to be when inflation rises. The interest you earn from your "fixed income" investments is fixed. For example if you have a bond that pays 5% interest, that is what you will receive 5% for the life of the bond. If inflation rises there is a lot less you will be able to buy with the interest you will receive from your bond.

The following is a strategy called a "Bond Ladder" and is a way to invest in Fixed Income and still combat inflation. The premise of the bond ladder is that you set up your portfolio with bonds that have expiration dates in subsequent years. When one bond matures you take the money from that bond and buy a new bond with a maturity date at the end of the ladder.

The following is an example of the bond ladder in practice

Initial Portfolio
When setting up the account (Jan 1, 2010), you purchase the following bonds (bonds with longer durations usually have a bigger coupon payment

January 1, 2012
Bond 1 matures, and you are paid your principal back. You use that money to purchase a new bond set to mature in 2032 (Assume inflation has set in and interest rates are up) Your portfolio would now look like this

January 1, 2014
Bond 2 matures, and you are paid your principal back. You use that money to purchase a new bond set to mature in 2034 (Assume inflation continues) Your portfolio would now look like this

You can continue this process as long as you want and it is a great combat against inflation. This does not mean that all risks are covered. There is now a Credit or Default risk that you have to stay on top of. Since you will be buying individual bonds, if one defaults there will be a 10% loss on your principal. One way of addressing that is to buy high quality bonds for the ladder

For more information on Bond Ladders the following two articles provide good information.

http://www.kiplinger.com/features/archives/2008/04/build-bond-ladder.html

http://www.investopedia.com/terms/b/bondladder.asp