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Ladders, barbells and bullets: Choose your savings tool

Laddering CDs for maximum efficiencyWhen you're building your investment portfolio, it can be easy to focus too much attention -- and too many resources -- on the stock portion and give short shrift to the other two members of the investing trinity: fixed income and cash.

Fixed income can look timid and wasteful, especially if the stock market is doing well. But, when it's tanking, fixed income can be a welcome port in the storm.

For many people, fixed-income investments focus on certificates of deposit, corporate and municipal bonds and Treasuries.

For this report we're going to look at five-year strategies for maximizing profit. Because of the five-year time frame, we'll be talking mainly about CDs and Treasury bills and notes. You could, however, add some short-term corporate notes to the mix.

Barry Vosler of LPL Financial Services in DeWitt, Iowa, and Stephen Barnes of Barnes Investment Advisory in Phoenix are certified financial planners who are sharing their knowledge and advice for this report.

Building your ladder
Both agree you should have at least $25,000 for this type of five-year fixed investment plan, but Vosler says don't let that stop you from trying it with less money. The approach costs $5,000 for each year of the five years of the plan, but you could try it with as little as $1,000 for each year.

Here's how laddering CDs works:

You go to the bank with $25,000, buy a $5,000 one-year CD, a $5,000 two-year CD and so on until your last $5,000 buys you a five-year CD. Each year is a rung on the ladder. When the one-year CD matures you can take the $5,000 and roll it over to buy another five-year CD because by that time your current five-year CD will have four years left before it matures. As each year's CD comes due, you roll it into a five-year CD until you have five of the five-year CDs in a rotation that means one expires each year.

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It is roughly the equivalent of dollar-cost averaging when you buy stocks or mutual funds.

A benefit of this type of laddering is you're never more than a year away from at least some of your money. That can give some peace of mind to investors who think two- to five-year maturities are too long.

The five-year plan with one-year rungs we're developing is simply an example. Barnes says there really isn't an optimal term to focus on when laddering.

"It depends on each individual's requirements for the money. If you don't have any need for the money for a while, that would indicate a different allocation. If you have needs, you'll bring it in shorter.

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Barnes says his firm ladders bonds at six-month intervals.

Vosler has four reasons for laddering a portion of your fixed-income investments:

• "Typically for longer term investments you'll get a higher yield than with shorter term investments."
• "Structured investment plans, like laddering, keep investors true to their goals. It helps avoid all the buzz from the Internet that confuses people."
• "It helps eliminate guessing about the direction of future interest rates. It's difficult if not impossible to predict and this makes it irrelevant."
• "A properly structured ladder will reduce interest rate risk, marketing risk and reinvestment risk."

Barnes says CD laddering is not only a way to maximize yields, but a second layer of risk control -- the first being adding CDs to a portfolio to offset stock market risk.

Where Barnes and Vosler differ is that Barnes doesn't believe in varying strategies in a laddering plan in a changing interest rate climate.

"We don't want to get into the game of guessing rates," he says. "The Fed will lower rates -- take a number and get in line -- everybody knows that. It's already figured into securities now. Don't try to guess the direction of interest rates. This strategy is a defacto ignorance of where rates may be headed."

Vosler agrees laddering is designed to eliminate interest rate guesswork, but thinks there's some merit to having different laddering plans depending on whether interest rates are rising or falling.

When rates head down
"If rates are trending down, like now, line up the short end of the ladder in CDs and the longer end in Treasuries. Banks tend to be more reactionary in their pricing of CDs than the bond market and banks are usually behind the curve -- so as rates trend down you'll find the higher rates at the banks."

"On the longer term of the ladder, if given the choice between CDs and Treasuries at the same rate, I'd want Treasuries on the long end with rates coming down because it could give us some appreciation in value as rates come down."

"The trade off between rates and principal is they move in opposite directions. If rates go lower, bond prices go higher. We'd want that possibility of price appreciation."

"If rates were going up I'd want to flip that around and have Treasuries on the short end of the maturity cycle and CDs on the long end. Same reason on the short end -- banks will probably be behind the curve and not offering rates that are as attractive. The reason banks are usually behind the curve is they're reacting to their customers and the need for funding loans at that time," says Vosler.

Bullets and barbells
Barnes says that while he'd build a ladder without regard to the interest rate environment, the way he'd take advantage of changing interest rate climates is by mixing in "bullet" and "barbell" strategies with the ladder:

"With a bullet, you put all your money in one particular maturity. If you believe interest rates are going to rise significantly down the line, you'd buy all six-month securities now," says Barnes. "In the barbell strategy you believe the best rates are in the short term and the long term -- the middle isn't rewarding you sufficiently. So, you want money market funds and 30-year treasuries. It's a bet on rates coming down."

Some planners consider bullets and barbells too sophisticated for the average investor, so if these strategies interest you, be sure to do plenty of research and consider talking to a professional.

Vosler cautions against using callable CDs in a laddering plan -- if interest rates drop, the whole ladder, or a significant portion of it, could be called.


-- Posted: Jan. 19, 2001

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See Also
CD Rate Trend Index
How to play the CD market
10 great financial moves you can make with $50
More savings stories

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