If you're buying bonds, consider constructing a "ladder."
A laddered portfolio, mixing bonds of differing durations, provides a steady stream of interest income and helps protect you from sharp changes in interest rates, which may cut into your total return.
Let's say you have $100,000. Instead of buying one monster bond at $100,000, split the total into equal amounts, such as five units of $20,000 each, and buy bonds with different maturity periods.
Say you want to buy US Treasury issues. You might start your ladder by buying securities with durations of two, four, six, eight, and ten years.
Then, every two years as a note comes due, you would generally buy a new 10-year note. Your total interest income from this portfolio will gradually rise or fall, depending on which direction interest rates move.
But unlike with mutual funds, you're guaranteed to get your principal - the initial amount you invested - back.
Some people might want something coming due every year, going out as far as 30 years.
This conventional ladder approach, spreading the money evenly over your chosen maturity periods, contrasts with another bond-buying strategy, known as the "barbell." Here, you buy only short-term and long-term bonds. Some bond dealers argue that the current "flat" yield curve, with yields fairly close between short and intermediate term bonds, makes intermediates unappealing.
Barbells, however, "are for more sophisticated investors," says Cadmus Hicks, director of research at John Nuveen & Co. in Chicago. He suggests holding a ladder in the short to intermediate range, going out about 15 years.
Whatever maturity you choose, each year or so you have fresh cash to reinvest.
Several types of bonds can be used. You can buy Treasuries directly from Uncle Sam, without having to pay a broker commission (call 202-874-4000). You could also use a mix of Treasuries and municipal bonds, or even some corporate issues. And if you don't have enough money for bonds, you could set up a ladder using bank certificates of deposit - again spread out over various maturity periods.
In buying a bond, look for its rating and any possible call provision.
Typically, say bond mavens, buy bonds graded AA or higher. Also, look for bonds with no "call" provision. That's an escape hatch by bond issuers that lets them pay back your principal early and then issue new bonds at a lower interest rate. You get stuck hunting for a new bond in a lower-rate environment.