Lecture 26-Bond and CD Laddering - YouTube

>> Richard Ghidella: Good afternoon.

Today we're going to go over a concept called laddering, l-a-d-d-e-r-i-n-g.

Laddering is a concept of how to spread out investments over time in fixed term instruments

such as certificates of deposit and bonds.

And the problem comes about, let's say you had 50,000 dollars to invest and just

as an example here we're going to say that we're

between five investments we're trying to make the decision.

One year, two year, three year, four year and five year CDs.

[ Writing on whiteboard ]

Now, banks are in the business to make money.

Banks want your money for longer periods of time instead of shorter periods of time.

So, they'd rather have money for five years than

for one year, because they can make more plans

if they have your money for five years.

They can make more auto loans, more home loans, just a capital structure is more stable.

And so, banks the longer you put the money in

the higher the interest and just for an example,

we're going to say that a one year CD pays 1 percent, two year 2 percent,

three year 3 percent, four year 4 percent and five year, 5 percent.

Obviously, they're not spread out this exact same way.

If I take my entire 50,000 dollars and invest it at one year, the biggest advantage is

that I get my money back in year.

The biggest disadvantage is a really horrible interest rate.

If I lock my money up for five years, the biggest disadvantage there is its locked

up for five years, but the biggest advantage is I get a much higher interest rate.

And so the concept of laddering basically says let's spread out this money over time

and we create kind of a ladder of maturities.

So, for each of these what we're going to do is we're going to deposit 10,000 dollars.

And this really helps our flexibility and we

end up with an average yield of 3 percent.

But the true beauty of laddering comes about as the ladder ages over time.

So, one year from now my one year CD one year from now comes due.

So, I have this 10,000 dollars back in my pocket.

My two year CD that is a year old acts the exact same way as a one year certificate.

Because the two year certificate, its one year old, it has one year to go to maturity

so its going to act the same as a one year certificate.

These interest rates when you first establish them are fixed,

99 percent of the time they're fixed.

There are some CDs out there that have some flexible interest and stuff

like that, but predominantly not.

But this two year CD that has one year to go now yields 2 percent.

My three year CD that's a year old has two years to go.

It adds basically the exact same as a two year CD, but its yielding 3 percent.

My four year CD has three years to go, that yields 4 percent.

My five year CD that's a year old has four years to go and it yields 5 percent.

Now what I'm going to do to keep my ladder intact is I'm going to take my 10,000 dollars

that I got back, my one year and I'm going to reinvest it and I am going

to buy another 10,000 dollar five year CD and I'll get a rate of return of 5 percent.

So, as you can see my interest rates now start going up.

I still got the same flexibility, however,

my average interest rate here went up almost a full percent.

As time continues, right when we're in our second year and we're going to pause

for a second and shift our camera.

Okay, so we're in our second year now.

Our two year CD that pays 2 percent has now matured and I get my 10,000 dollars back.

My three year CD that is 2 years old has one year to go,

so it's going to act the exact same way as a

one year CD except my yield here is 3 percent.

And my next CD and basically just everything shifts up.

I've got my five year CD that is two years old.

It has three years to go, but it's earning 5 percent.

My CD that I purchased here a year ago, when my one year money matured

and it was only earning 1 percent, I reinvested it for five years.

Now this one is only one year old and it makes 5 percent,

so it acts the same way as a four year CD would.

I'm now going to take my 10,000 dollars.

I'm going to reinvest it in a new CD that earns 5 percent.

And obviously, if we take this another two years

then what we're going to have is we're going

to maximize our rate of return and we are going at the same be incredibly flexible.

One other concept, and here are two of the concepts: One's called shortening the ladder,

the other is called extending your ladder.

So, extending your ladder is kind of obvious.

It's just I'm going to make this ladder longer.

So, in year three we get our 10,000 dollars back, all of these shift up.

So, now we have one earning 4 percent, this one earns 5, 5, 5 percent.

Now we have our 10,000 dollars back here in year 3.

Extending our ladder basically is we stretch it out.

Let's say there's a great year, a great offer for a seven year CD paying 8 percent.

So, I'm going to pull this 10,000 dollars and extend the ladder,

maybe I'll come down here eight years because it

pays 7.5 percent and I think that's a good deal.

Or maybe I'm going to shorten my ladder because I know I need my money back sooner.

And the reason I need my money back sooner is

I know I need to put a new roof on my house.

I have to buy new plant equipment.

There's a lot of things that I could be doing at this point.

So, instead of extending out here to eight years

what I'm going to do is shorten it and I'm going

to buy a new one year CD that pays 1 percent.

And the reason I'm doing this, I don't necessarily enjoy the fact

that I'm getting only a 1 percent rate of return, but I know I have demand

for my money coming up, so I am going to select a shorter period of time, alright.

Now, if we had carried this out without shortening or extending, when we got out here

to year five what we would have had is our one year, two year, three year, four year,

five year all paying 5 percent and we will have maximized our yield under this situation.

One caveat that I want to mention here is obviously interest rates change all the time.

Interest rates change daily, they change weekly, and so when we look

down at this realistically they're all not going to be 5 percent.

That's not going to happen.

Because interest rates change, what we might end up with is something

like this first one, maybe it's 4.8, 5.2, 5.1.

Maybe this year had a horrible year for interest rates, 3.9 and 4.7.

So, even though we're investing because interest rates go up and down it's not going

to be even 5 percent all the way across the board, okay, because those change.

The other thing that I'd like to mention is that a lot of people get very,

very upset at the possibility that they're going to pay what's called an interest penalty.

So, interest penalties are I invest my money in

a CD for a long period of time, say five years,

I need that money back and so I have to pay a penalty to get my money back.

I pay an interest penalty.

If we have 50,000 dollars if we want to keep everything incredibly flexible we invest it

all

at 1 percent, 50,000 times 1 percent is 500 bucks.

If we do the laddering and we spread this ladder out over time

and the ladder builds then we're going to end

up with our 50,000 dollars yearly in an average

of 5 percent, which means we're going to get 2500 dollars.

So, by doing this we're going to make an extra 2000 dollars each year.

Certainly every once in a while some disaster's going to happen,

some emergency's going to happen.

We're going to lose a job temporarily.

We're going to have a combination of one of our kids knocks out their front teeth,

the car breaks down and the water heater breaks all in the same week.

And so, we're going to need to access some of the deposits at four or five years.

Typically what you're charged is in a long-term CD is about six months' worth of interest.

So, if we're going to break one our CDs we're going to break a 10,000 dollar CD

and let's say it's a five year CD that's yielding 5 percent,

which means it pays 500 dollars a year.

Typically we're going to be charged a six month

interest penalty, so we're going to divide this

by 2 and we're going to get an interest penalty of 250 dollars.

Certainly 250 dollar interest penalty is nothing to sneeze at and it certainly is real money.

However, an awful lot of people get so fixated that they never want to pay a bank penalty.

They never want to pay an early withdrawal penalty that they don't spread out their money

over time and they end up with incredibly low yields.

And so, they end-- so people end up very,

very short sided because what would you rather do every year.

Would you rather make 500 dollars a year or would you rather make 2500 dollars a year

and pay a 250 dollar interest penalty every couple years that you run into an emergency?

By far your best option here is to pay the penalty every two or three years.

Shoot, under this system you could pay a penalty every single year

and you're still 1750 bucks ahead of the game.

And so, do not get all caught up on paying a penalty now and then.

In the long run you'll be way ahead.

There's a very similar analogy.

One of my really good friends during one of the gas spikes decided hey,

he's going to sell his truck and buy a car that gets much, much better gas mileage.

And so, he traded in his truck.

He bought another car and that car saved him about 250 dollars a month in gas.

The problem was his car payment was 450 dollars a month

and because it was a new vehicle his insurance went up about 100 dollars per month.

So while he was so fixated on saving a few hundred dollars in gas, which he did,

in the end when you included the car payment and the additional insurance he lost out.

And so, therefore the same as you've got to look at the overall cost

of a vehicle maybe you can buy a car for 10,000 less that gets slightly worse gas mileage.

Overall, the car with worse gas mileage might be a heck of a lot cheaper.

The same thing here, we want to spread this out and take advantage

of high interest rates whenever we can.

Even if we pay a penalty now and then we're going to be way, way ahead of the game.

So, this laddering also is not done only in CDs and only done by individuals.

Big corporations do laddering in their cash accounts.

And so, we'll end up with a company like say Home Depot, Intel, General Electric and sitting

in their cash account is maybe 300,000,000 dollars.

And they can't take this money and invest it

for six months or nine months or two years

because they have to make payroll.

There are seasonal adjustments that take place.

Obviously, Home Depot right before Christmas they put an awful lot of money

out to buy an awful lot of things and then the cash all starts coming in after Christmas.

Same with most retail, especially toy stores.

And so, we can take this 300,000,000 dollars and do laddering within a cash account

and what we're going to do is buy and sell what is called commercial paper.

Commercial paper is kind of like these short-term borrowing bond type instruments

between big corporations.

So, when we look at yields maybe just sitting here in cash

that I can access right now pays me 01 percent.

Interest rates certainly are horrible right now.

But, I can also invest then for seven days and maybe I'll get a half of 1 percent.

And there's 14 day paper, 21 day paper, 30 day paper and 45 day paper, okay.

These are some of the common denominations.

In fact, there's also a lot of 10 day paper.

But, we're going to take advantage of almost the exact same yield.

And so, maybe 14 days pays .6, 21 pays .7, 30 pays .8

and maybe at 45 days I can get 1 percent.

And so, if I can spread this money out over time,

because you know maybe I'll put a whole bunch of money here at 14 days,

because I know I have the big payroll to meet.

And I know I have some extra money, so I can drop 100,000,000 dollars down here at 1 percent

and I'm going to spread out the other 100,000,000 depending on whatever my demand

is.

So, instead of getting a measly .01 percent on my 300,000,000 maybe

within this system I can actually make a half a percent per year.

And a half percent doesn't necessarily sound like a heck of a lot money,

but if I'm going to get a half a percent of 300,000,000 dollars, right, 10 percent's 30,

1 percent is 3, so a half a percent is 1.5 million dollars.

So, therefore by using a laddering concept within a cash account, even if I'm just going

to nip an extra half a percent, if there's a lot

of money in there, 1.5 million dollars a year,

that's a very easy way to pull that off, alright.

And that's the end of our concept for laddering.