With rates at historically low levels, does it make sense to invest in long-term bonds? On the other hand, interest rates on short-term bonds are so low that you might not be able to keep ahead of inflation with them. What should a bond investor do in this interest rate environment? Consider using a bond ladder. Once implemented, this strategy will eliminate the need to think about the future direction of interest rates.

A bond ladder is a portfolio of bonds of similar amounts that mature in several different years. For instance, a $100,000 portfolio might consist of 10 different bonds of $10,000 each, maturing in 10 consecutive years. When a bond matures, the principal is reinvested in another bond at the bond ladder's longest maturity date (10 years in this example).

By spreading out the maturity dates, you lessen the impact of interest rate changes. You hold the bonds until maturity, so changing interest rates won't result in a gain or loss when you sell the bond. Since your bonds mature every year or so, your principal is reinvested over a period of time instead of in one lump sum. If interest rates rise, you have principal coming due every year or so to reinvest at the higher rates. In a declining interest rate environment, you have some funds in longer-term bonds with higher interest rates. A bond ladder keeps your bond portfolio invested in a range of maturity dates, evening out your interest income over time.

But the main advantage is that you don't continue to hold short-term bonds waiting to decide where interest rates are headed. Just as predicting where the stock market is headed is difficult, it is also difficult to predict where interest rates are headed. Who would have thought a couple of years ago that interest rates would remain so low for so long?

When designing a bond ladder, decide on an average maturity date, which could be five, 10, or even 20 years, depending on your financial needs. There should be enough "rungs" in the ladder so principal is maturing every year or two. If the rungs mature in longer than two-year increments, you might miss interest rate changes. Consistently follow your plan by automatically reinvesting principal at the longest maturity date.

You can also set maturity dates in your ladder to coincide with a specific financial need. For instance, a bond ladder might mature in each of four consecutive years while your child is in college, allowing you to pay college costs with maturing principal.

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