There are a number of factors I’d consider intriguing, to say the least, about this current macroeconomic climate. Investors are now operating in an environment with both higher inflation and slower growth than many thought was possible just a couple years ago. In this environment, yields have also remained elevated, offering investors looking to create passive income streams with an opportunity we haven’t seen for more than a decade (when interest rates were held at or near zero, at least for the Federal Funds rate).
In such an environment, investors may certainly be thinking about investing in monthly dividend paying stocks or in investing in income-generating rental properties. Those are great sources of monthly income, and should certainly be considered by those looking to live off of one’s savings in retirement.
That said, I’m going to discuss another key strategy many investors use to create a dividend-like passive income stream: setting up a bond ladder.
Key Points in This Article:
A bond ladder is a safe way to use debt securities to scale your fixed income.
Those who are able to lock in strong bond rates may benefit to an outsized degree.
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What Is a Bond Ladder?
A ladder in a cave area
One of the most prominent time-tested strategies for creating a passive income stream that pays out in regular increments over a period of time, what a bond ladder does is effectively allows an investor to spread out their fixed payments from their bond holdings over specific intervals. By purchasing quarterly bonds that mature at a specific point each month, investors can create monthly passive income streams. And for those looking to get even more creative, purchasing bonds which mature on different weeks can create even more frequent and predictable cash flows over time.
A typical bond portfolio will consist of specific durations of bonds; for government bonds, the most common durations are 1 month, 3 month, 6 month, 1 year, 2 year, 5 year, 10 year, 20 year and 30 year bonds. However, an investor looking for monthly income over the course of the next five years could create a monthly income bond ladder by purchasing 5 year bonds that expire in July of 2030, August of 2030, and September of 2030 (each rung paid out quarterly).
Setting up a bond ladder is just one piece of the puzzle for investors. Maintaining said bond ladder is a whole other ordeal (as these five year bonds age, investors will need to re-up and add new 5 year bonds or other maturities as well).
Of course, this fixed income investing strategy can really get about as complex, or as simplistic, as investors want. It really depends on the ultimate goal, and how much time and effort someone is willing to put into managing a fixed income portfolio.
Why This Strategy Is One that Makes Sense
I’m personally of the view that interest rates are more likely than not to come back down toward the near-zero range. That’s what the Federal Reserve has signaled at least – that any time there’s some serious disruption to the functioning of the economy, that’s an excuse to cut rates to zero (again).
With the Fed holding some serious dry powder in the form of a much higher effective federal funds rate than we’ve seen over the past 15 years, it’s entirely likely that we could see rates trend back down toward the pandemic era levels which really benefited bond investors. If that’s the case, those who are able to lock in what could be considered in hindsight sky-high yields today may benefit to an outsized degree when we look back on today from, say, a decade from now.
No one really knows how bonds will perform relative to equities. And it’s also true that stocks have vastly outperformed fixed income assets, particularly as rates have increased amid this recent inflation scare.
But with bonds providing a predictable income stream, while allowing investors to minimize their interest rate risk and diversify their credit risk (while adding liquidity and flexibility to their portfolios), a bond ladder is a truly overlooked and under-utilized strategy in my books for investors to create meaningful wealth long-term while safeguarding their capital.
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