It's a common financial planning conundrum: Your clients need retirement income—secure, steady retirement income that won't fluctuate. A pension is a nice way to get it, but who has one of those any more? And putting money into fixed income has its own perils, from puny yields on ultrasafe Treasuries to mounting defaults in what had once been sterling credits.

A bond ladder is one way to temper some of these concerns. A tried-and-true technique, bond ladders are regaining popularity in this difficult market environment as a way of providing predictable income, especially for those in retirement, along with direct ownership of bonds.

"Bond ladders can be an excellent way to manage cash flows for those in retirement," says Timothy Johnson, chief investment strategist with Lincoln Financial in Nashville, Tenn. "The beauty of this strategy is that an individual bond will provide a stream of income through the coupon payment and the return of principal at maturity."

Some adherents believe that all investors can benefit from a bond ladder. "A bond ladder is really an investment strategy for all seasons," explains Stan Richelson, president of the Scarsdale Investment Group in Philadelphia and author of Bonds: The Unbeaten Path to Secure Investment Growth. "It's always good and has nothing to do with what kind of market we're in."

Other proponents, however, stick to the idea that today's steeper yield curve serves the goals of bond laddering best. "In a flattening yield curve, there are other strategies that would outperform the bond ladder," says George Strickland, managing director and portfolio manager with Thornburg Investment Management in Santa Fe, N.M.

How It Works

Bond laddering is pretty straightforward to implement. You populate the rungs of the ladder with issues all along the yield curve.

For example, if you have a $1 million ladder to build, you might purchase 10 rungs of $100,000 in each of 10 years, starting with one-year certificates of deposit and one bond in each of the next nine years. As one issue comes due each year, you purchase a new 10-year note, in this example. Of course, it is possible to build the ladder with bonds of different maturities or to emphasize the short end or the long end, depending on the client's needs or your interest rate forecast.

The ladder achieves several goals. First, it provides a predictable income source. Second, it gives a bond portfolio a shorter average maturity, but with almost the same yield as a longer maturity one. In the above example, the average maturity of the portfolio would be five years.

That mismatch between maturity and yield helps to mitigate both interest rate risk and reinvestment risk. Bond ladder investors are not tied into lower yielding fare for long should yields rise, nor are they forced to purchase an entire portfolio of crummy coupons should rates fall. "Over time, you are able to pick up the yield of a 10-year bond with the volatility and risk of a five-year bond," Strickland says.

Construction Ahead

Speak with a few money managers, and you'll see that the number of bond ladder strategies is as varied as the number of managers. Some advisors prefer to use Treasuries, others like munis and still others might sprinkle in a few corporate bonds for added yield.

Bert Whitehead, founder of Cambridge Advisors and author of Why Smart People Do Stupid Things with Money, designs his ladders going out 15 years using Treasury separate trading of registered interest and principal securities, better known as STRIPS. Bondholders purchase the bonds at a steep discount because the bonds mature at par.

At maturity, Whitehead uses the proceeds for client income, rather than reinvesting in a new bond. He buys new bonds for the ladder with money from clients' stock portfolios. This way, he says, clients are assured of income for 15 years. "We rebuild the bond ladder during times of prosperity," he says.

When times aren't as good, like right now, clients' cash flows aren't affected because it comes from the ladder. "Cash flow is always cash flow," he says.

The bond ladder represents about 40% to 50% of a client's investable assets, with roughly 50% in stocks and the remainder in cash. The dependable income from the bond ladder allows Whitehead's clients to take more risk in their equity portfolios than they normally would be able to tolerate in retirement.

Whitehead begins building the retirement bond ladder when clients are still in their forties and fifties. "We dollar cost average into interest rates," he says. It takes that long for the maturing bonds to become available as income, as well.

Then there are advisors like Johnson, who says he can "usually implement a good ladder over a number of days." Johnson uses the more conventional approach of reinvesting maturing bonds in long-dated bonds. And he uses straight Treasuries and Treasury Inflation Protected Securities, or TIPS.

In the middle are advisors like Shane Merritt, a financial advisor with Merritt Capital Management in Gloucester, Mass., who takes six months to pick and choose the types of bonds he wants to build into clients' bond ladders. Merritt, whose firm offers advisory services through Raymond James Financial Services, even includes corporate bonds on his ladder rungs.

Yet most advisors agree that ladders with small dollar amounts—less than $250,000—won't give clients proper diversification. Most bonds sell in minimum lots of $10,000, so a portfolio of 25 issues can diversify the bond ladder along issuers, structures and interest rates.

What's in There?

What types of bonds belong in a bond ladder? Again, there are as many answers to that question as there are advisors, and it all depends on the client's individual situation.