Income Ladder and Bond
Ladder Terminology and Definitions
Principal - This is the
original amount of capital invested.
Interest - This is the
payment offered in exchange for lending capital.
- A fixed-rate investment is one where there is a promise to pay a known
amount of interest and principal on a known date or dates.
- This is another name for fixed-rate investments.
Term - The length
of time before the invested principal can be withdrawn without penalty.
- This is
another name for the term.
Interest Rate - This is
the interest earned divided by the principal invested expressed as a
percentage. For example if $1000 is invested and earns $50 of
interest after one year, the annual interest rate is $50/$1000 = 0.05 or
Yield Rate - The
yield rate is the annual total return of an investment expressed as a
percentage. The difference between yield rate and interest rate is
best explained with an example. Assume that $1000 is invested at an
interest rate of 5%, but also assume that interest is compounded
semi-annually. After one-half year, the investment earns 2.5%
interest, or half of the 5% annual interest. Now the total investment
value is $1025. During the second half of the year, the investment
earns the second 2.5%, but this is now 2.5% of $1025 or $25.63. The
interest is higher during the second half of the year because there is a
small amount of interest earned on the interest that was earned during the
first half of the year. At the end of the year the investment is
worth $1025+$25.63 or $1050.63. The yield rate is then $50.63/$1000
or 5.063%. Sometimes interest is compounded monthly or daily and
this further increases the yield. With bank certificates of deposit
it is common to see yield rates that are slightly higher than the interest
rates due to compounded interest.
However there is another
reason why a yield rate can be different than the interest rate.
Assume that the above $1000 investment is not a newly issues bank CD but
rather a bond that was issued in the past. Now assume that it can be
purchased at a discount for $970, and that the bond matures in one
year. The interest earned is still $50.63. But there is an
additional $30 gain upon maturity. The total yield is therefore ($50.63
+ $30)/$970 or 8.31%. The yield rate in this example is higher
because the bond was purchased at a discount to its maturity value.
Note that the income ladder calculator should not be used for investments
that are purchased at a discount or premium to their maturity value.
Yield To Maturity -
This is the yield rate or total return that will be achieved if an
investment is held to maturity.
Yield Curve - A graph
of yield rates vs. maturities for a particular type of investment is
called a yield curve.
Inverted Yield Curve -
Yield curves often slope up to the right, indicating higher yields for
longer maturities. However occasionally investments with shorter
maturities offer higher yields than investments with longer
maturities. In this situation the yield curve is said to be
Bank Certificates of Deposit
(CDs) - Fixed-rate investments offered by banks and insured by the
FDIC (Federal Deposit Insurance Corporation).
US Treasuries -
Fixed-rate investments offered by the US government.
Bonds - Fixed-rate
investments offered by companies or governments.
Bond Funds - A bond
fund is similar to a stock mutual fund whereby investors pool their
capital and employ a fund manager to invest in multiple bonds or other fixed-rate
investments. It might be tempting to think that a bond fund can
serve the same purpose as an income ladder. But in fact bond funds
are variable investments. The value of a bond fund rises and falls,
there is no promise to pay a known amount on a known date, and the fund
never matures. Therefore bund funds do not offer the same degree of
certainty as individual bonds or fixed-rate investments held to maturity.
Par Value - This is the
maturity value or the face value of a bond. When a bond is
sold for a price that equals its face value, it said to be sold at par.
Coupon - The interest
payment for a bond is often referred to as the coupon.
Bond Ladder - A series
of bonds (or other fixed-rate investments) with staggered maturities is
called a bond ladder. For example assume 5 bonds with staggered
maturities are purchased as follows:
When the 1-year bond matures,
its principal and interest can be used to purchase a new bond with a
5-year maturity to replace the original 5-year bond that now matures in 4
years. After the 2-year bond matures, its principal and interest
can be used to purchase another new 5-year bond, and the cycle can repeat
indefinitely. Since yield rates are always changing, the strategy
tends to smooth out the ups and downs of the market over time. The
strategy also offers the advantage that eventually all of the bonds in the
ladder will have been purchased with longer maturities which usually (but
not always) offer higher yields.
Income Ladder - An
income ladder is similar to a bond ladder except that interest and matured
principal are used to support income rather than to purchase new bonds or
other fixed-rate investments. When the fixed-rate investments are
insured or guaranteed, such as with bank CDs and US Treasuries, an income
ladder is one of the most reliable ways to achieve a predetermined stream
of investment income.
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