Ask Money

A bond ladder

Chris Farrell May 11, 2009

Question: I am 42 and have never ventured beyond CD’s so obviously my tolerance for risk is very low; I don’t like anything I don’t understand – compound interest is something I do understand! I have a 90K CD that just matured at one of the national big banks on “shaky ground” and I plan on transferring it to a local bank for my own peace of mind. I will put 5K in the “rainy day” fund, and then have 85K left. The only way I can get a rate of 3% or higher is to go for a CD of 50 months or longer. Our circumstances right now are such that I need to use this money as a “monthly income generator;” I have the monthly interest transferred into a checking account and use it for expenses (so I don’t ever get the full APY, just the interest rate). Our son has autism and I need to be home with him in order to take him to a special preschool and get him the therapies that he needs. If I was working, I would let the interest accrue. Are there any safe alternatives to CD’s where I could get a monthly payment at 3 to 4% or higher on my 85K without committing to 4 or 5 years???…. Thanks in advance for your reply and I’m grateful for your advice! Cheryl, Akron, OH

Answer: First of all, you’re right to steer clear of anything you don’t understand. Secondly, you are risk averse and you have good reason to be cautious with the money. It’s an axiom of finance that you can’t get a higher yield without taking on more risk, and right now safe securities pay a paltry rate of interest. Third, I am worried about tying up money in a CD for four or more years. What if rates jump higher next year if the economy recovers, inflation rears its head–or both?

How about creating a laddered portfolio out of FDIC-insured CDs or U.S. Treasuries? It’s both a savvy and safe way to invest. The basic idea behind a ladder is that you buy some 3-month, 6-month, 1-year, 2-year, 3-year and 5 year securities. If rates go up you reinvest your short-term securities when they mature at the higher rate. If rates stay where they are you still get the higher yield from the 4 to 5 year securities. You’ll get the average yield of all securities you buy, and as long as you hold it until the CD or Treasuries mature, you can’t use lose money.

By the way, it’s the after-tax yield that matters. So, I would compare the after-tax yield on CDs to the after-tax yield on Treasuries (you don’t pay state and local taxes on the latter). You can buy Treasuries without commission–in other words, for free–from the U.S. government at www.treasurydirect.gov. The website www.analyzenow.com has a web-based program for monitoring bond ladders. Just go to the free programs section and click on the “investment Manager” program. Smart Money has a nice article on bond ladders here.

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