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22 Dec 2014

BOND LADDER

If you haven't already read about the basics of savings bonds and how to invest in SA retail bonds, give them a go by clicking on those links and read them. As promised, today we will be looking at how one can ladder their savings bond investments.

A bond ladder is simply used to take advantage of the high interest rate periods and reduce the impact of the low interest rate periods for a fixed rate bond investor. An amount of money that should be invested is divided into smaller lump-sum pieces that mature at different times. If for instance one has R300,000 to invest, they may divide it into three pieces that mature in 2, 3 and 5 years.
Remember that your bond ties the interest rates to the value they were at the time of registration. If the interest rates are 7% for 5 years savings bonds and one invests R300,000; 7% is what they get regardless of the change in the interest rates during the investment period. To try and combat this, an investor staggers that same R300,000 into three R100,000 pieces like this:
Year 2014 December
R100,000 for 2 Year Fixed Rate bond at 7.25% maturing in 2016 December
R100,000 for 3 Year Fixed Rate bond at 7.25% maturing in 2017 December
R100,000 for 5 Year Fixed Rate bond at 8.25% maturing in 2019 December
     
What the laddering does is to release the first R100,000 in 2016 in order for one to reinvest it at higher interest rates if the interest rates have gone up between the investment time and maturity of that bond. If the interest rates go up sometime in 2015 and/or 2016, one will have an opportunity to reinvest their R100,000 (plus interest) after maturity at that higher interest rate. The same happens in 2017 with the second bond and in 2019. You now have three different bonds which diversifies your risk over a period of five years or longer.

The other attractive way to do this is investing the R300,000 at various times. This is what appeals more to me. Lets try an example:
With our R300,000 broken into into 3 pieces invested at different years from 2014.
R100,000 for a 2 Year Fixed Rate bond at 7.25% invested in 2014 and maturing in 2016 December
R100,000 for a 2 Year Fixed Rate bond at 7.25% invested in 2015 and maturing in 2017 December
R100,000 for a 2 Year Fixed Rate bond at 7.25% invested in 2016 and maturing in 2018 December
I will not do the three years fixed rate bond as I find it pointless since both the 2  and  3 years fixed rate bonds earns the same rate. The shorter the period the better in that case.
OR
R100,000 for a 5 Year Fixed Rate bond at 8.25% invested in 2014 and maturing in 2019 December
R100,000 for a 5 Year Fixed Rate bond at 8.25% invested in 2015 and maturing in 2020 December
R100,000 for a 5 Year Fixed Rate bond at 8.25% invested in 2016 and maturing in 2021 December
etc.
With this process you get to have the bonds maturing every year after the initial five years of investment. This does not have to be done annually. It may be every 6 months or any other number of months for that matter. To complicate it a bit one can take bonds that mature at various periods at different years. I know it can spin one's head thinking about this but the point is that one should be collecting interest every year. 

I personally want to invest a set amount every year. For practicality's sake, I will make an example of R100,000 per year over 5 years with all the interest reinvested. This makes my capital R500,000.
R100,000 for a 5 Year Fixed Rate bond at 8.25% invested in 2014 and maturing in 2019 December with R150,845.88
R100,000 for a 5 Year Fixed Rate bond at 8.75% invested in 2015 and maturing in 2020 December with R154,637.37
R100,000 for a 5 Year Fixed Rate bond at 9.25% invested in 2016 and maturing in 2021 December with R160,500.95
R100,000 for a 5 Year Fixed Rate bond at 9% invested in 2017 and maturing in 2022 December with R156,568.10
R100,000 for a 5 Year Fixed Rate bond at 8.25% invested in 2018 and maturing in 2023 December with R150,845.88

I tried to change the interest rates throughout the initial 5 years of investing. You see how one ends up having their bonds mature every single year. I hope it clarifies the point of laddering your investments instead of investing your R500,000 at once. Investing the smaller amounts gives you some power and control as the interest rates change. You also get to have your income every year. Remember that the R100,000 could be R1M for some people. After a five year period that would give you about R500,000 or more in interest annually. The pensioners can opt to get their interest monthly, which makes for a nice monthly passive income.

Something we should all remember is that savings bonds are not high return investments. They are less risky compared to other investments.  If you are thinking of balancing your portfolio, consider building up your own bond ladder. This is very important as one gets older. A secure savings account with a government guarantee is not too shaby. 

Finally, it's a holiday week. I will write another article or two this week because I promised a reader one on earning interest on a credit card.

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