What Is Bond Laddering?
Bond laddering is an investment strategy that involves buying bonds with different maturity dates so that the investor can respond relatively quickly to changes in interest rates.
It reduces the reinvestment risk associated with rolling over maturing bonds into similar fixed income products all at once. It also helps manage the flow of money, helping toensurea steady stream of cash flows throughout the year.
Key Takeaways
- Bond laddering involves buying bonds with differing maturities in the same portfolio.
- The idea is to diversify and spread the risk along the interest rate curve to hedge against any idiosyncratic moves in rates.
- By staggering maturity dates, you won't be locked into any particular bond for a long duration.
- The strategy is employed by risk-averse investors looking for income over growth.
How Bond Laddering Works
A bond investor might purchase both short-term and long-term bonds in order to disperse the risk along the interest rate curve. That is, if the short-term bonds mature at a time when interest rates are rising, the principal can be re-invested in higher-yield bonds.
Generally, a short-term bond matures in less than three years.
If interest rates have hit a low point, the investor will get a lower yield on the reinvestment. However, the investor still holds those long-term bonds that are earning a more favorable rate.
Essentially, bond laddering is a strategy to reduce risk or increase the opportunity of making money on an upward swing in interest rates. In times of historically low interest rates, this strategy helps an investor avoid locking in a poor return for a long period of time.
Rungs
By taking the total dollar amount you plan to invest and dividing it equally by the total number of years for which you wish to have a ladder, you will arrive at the number of bonds for this portfolio or the number of rungs on your ladder. The greater the number of rungs, the more diversified your portfolio will be and the better protected you will be from any one companydefaultingon bond payments.
Height of the Ladder
The distance between the rungs is determined by the duration between the maturity of the respective bonds. This can range anywhere from every few months to a few years. Obviously, the longer you make your ladder, the higher theaverage returnshould be in your portfolio sincebond yieldsgenerally increase with time. However, this higher return is offset by reinvestment risk and the lack of access to the funds. Making the distance between the rungs very small reduces the average return on the ladder, but you have better access to the money.
Building Materials
Just like real ladders, bond ladders can be made of different materials. One straightforward approach to reducing exposure to risk is investing in different companies. But investments in products other than bonds are sometimes more advantageous depending on your needs.Debentures, government bonds,municipal bonds, Treasuries, and certificates of deposit(CDs) can all be used to make the ladder. Each of them hasdifferent strengths and weaknesses.One important thing to remember is that the products that make up your ladder should not be redeemable by the issuer. This would be the equivalent of owning a ladder with collapsible rungs.
Other Benefits of Bond Laddering
Bond laddering offers steady income in the form of those regularly occurring interest payments on short-term bonds. It also helps lower risk, as the portfolio is diversified because of the various maturation rates of the bonds it contains.
Bond laddering should ideally be used to reduce the risk of a fixed income portfolio.
In effect, laddering also adds an element of liquidity to a bond portfolio. Bonds by their nature are not liquid investments. That is, they can't be cashed in at any time without penalty. By buying a series of bonds with different dates of maturity, the investor guarantees that some cash is available within a reasonably short time frame.
Bond laddering rarely leads to outsized returns compared to a relevant index. Therefore, it is usually used by investors who value the safety of principal and income above portfolio growth.
Variations on Bond Laddering
In theory, an investor's bond ladder could consist of any number of types of bonds. Municipal and government bonds, U.S. Treasuries, and certificates of deposit are among the variations, and each will have its own date of maturity. A less complicated approach is to buy shares in a bond fund and let a professional do all the legwork.
FAQs
Risk management: Bond ladders spread the risk of interest rate fluctuations across several bonds with different maturity dates. This reduces the impact of any single change in interest rates on the entire portfolio. Predictable income stream: As each bond within the ladder matures, it provides a known amount of income.
How does bond ladder strategy work? ›
With bond laddering, you invest in multiple bonds with different maturities. As each bond or CD matures, you can reinvest the principal in new bonds with the longest term you originally chose for your ladder. If interest rates move higher, you can reinvest at higher rates.
What is the downside of a bond ladder? ›
Downsides to Bond Ladders
One significant downside to bond ladders is the potential for lower returns compared to other investment options like equities. Bonds, particularly high-quality ones like government securities, typically offer lower yields than equities or other higher-risk investments.
Is now a good time to buy a bond ladder? ›
Even after two favorable monthly inflation reports, cash and bond yields remain high and steady. It continues to be a buyer's market.
What are the benefits of laddering? ›
Other Benefits of Bond Laddering
Bond laddering offers steady income in the form of those regularly occurring interest payments on short-term bonds. It also helps lower risk, as the portfolio is diversified because of the various maturation rates of the bonds it contains.
What is the main purpose of benefit laddering? ›
The theory goes that over time, the benefit ladder brings the customer closer to the brand and builds positive emotion by associating it with progressively deeper and more meaningful benefits. First off, a business needs to establish its product and its features.
Is a bond ladder better than a bond ETF? ›
Bond Ladders. The liquidity and transparency of an ETF offers advantages over a passively held bond ladder. Bond ETFs offer instant diversification and a constant duration, which means an investor needs to make only one trade to get a fixed-income portfolio up and running.
Is a bond ladder better than an annuity? ›
There's a lot less flexibility, whereas with the bond ladder, you can choose to make different decisions. On the flip side, if you live to 108, that annuity is paying out for all those years, as long as you're alive, but the bond ladder doesn't go out that far, typically speaking.
What is the tips bond ladder? ›
This strategy involves building a TIPS ladder, i.e., buying a number of individual inflation-protected US Treasury bonds that separately mature over the coming years. Locking in a stream of real income payments in retirement via a TIPS ladder can both safely cover your fixed spending and create a living standard floor.
What is the disadvantage of laddering? ›
CD Laddering
If you don't notify them of your intentions for the CD at maturity, your bank could roll over your funds into another CD that pays lower interest. If you're going to keep your money with that financial institution, make sure the new fund is paying the highest rate out there.
It all depends on you. A bond ladder is similar to a CD ladder but uses bonds instead, which typically have longer terms. Bonds also aren't as secure as CDs, and the return isn't guaranteed. That said, the potential return can be higher with bonds than with CDs.
Are treasury bond ladders a good idea? ›
Since long-term bonds are more sensitive to interest rates than short-term bonds, long-term bonds tend to rise the most when rates are falling. Thus, constructing a bond ladder that weighs long-term bonds more heavily when rates are falling might be a profitable strategy.
Will bonds make a comeback in 2024? ›
Investment-grade corporate bonds remain attractive given their lower risk and relatively high yields. Long-term investors who can handle volatility might consider high-yield bonds and preferred securities, but we wouldn't suggest large positions in either.
Do bonds lose money in a recession? ›
The short answer is bonds tend to be less volatile than stocks and often perform better during recessions than other financial assets. However, they also come with their own set of risks, including default risk and interest rate risk.
Should you sell bonds when interest rates rise? ›
Most bond investors are in it for the long haul, meaning for the term of the bond, but there are several good reasons for selling bonds before they mature. They include: Selling bonds because interest rates are about to increase, making your existing bonds less valuable.
Does laddering reduce market risk? ›
The laddering or stepping of maturities can result in not only reduced risk and improved returns, but also permits reinvestment flexibility, a predictable cash flow and a desired level of liquidity.
What are the advantages of a bond having collateral? ›
For bondholders, collateral trust bonds can offer a higher level of security compared to unsecured bonds, as the financial assets held in trust provide a source of repayment in case of default.
