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Here's one way to use bonds and CDs to climb toward your investing goals.
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Have you heard of fixed-income laddering? It’s an advanced strategy that structures your investments in fixed-income securities to resemble a ladder with a series of maturity dates for the “rungs.” If you commit to fixed-income laddering by continually reinvesting, then a fixed-income ladder can become like a financial staircase.
Let’s explore what fixed-income laddering is and how it works, including the benefits and risks of this sophisticated investment strategy.
- Fixed-income laddering is an advanced yet low-risk investing strategy.
- Investors can create a series of bond maturity dates tailored to their financial goals.
- Fixed-income ladders typically require continual reinvestment.
What is fixed-income laddering?
Fixed-income laddering is an investment strategy that uses staggered maturity dates of fixed-income securities—like noncallable bonds and certificates of deposit—to create predictable investment cash flow. Fixed-income ladders are typically built and extended by reinvesting the proceeds as securities mature.
Fixed-income laddering is based on the premise that the longer your money is invested, the higher the return—at least in typical economic conditions. A bond or CD that matures soon represents the lowest rung on the ladder, while the securities with the longest maturities represent the topmost rungs. Typically (when the yield curve is in a “normal,” or upward-sloping configuration, per the blue line in figure 1) near-term securities have the lowest interest rate, while the later maturities have higher interest rates.
Fixed-income laddering normally involves reinvesting the near-term proceeds into new fixed-income securities at the top of the ladder. These new securities typically have the highest interest rates because they’re the furthest from maturity.
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Figure 1: BUILDING A LADDER? CHECK THE YIELD CURVE. Upward-sloping is normal, flat is cause for caution, and inverted typically spells trouble.
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How fixed-income laddering works
Ready to build a ladder? Bond laddering is most successful when investors make a sustained commitment over time to this portfolio strategy. Here are the basic steps to build and maintain a fixed-income ladder tailored to your needs:
- Design your fixed-income ladder. How often would you like to receive fixed-income distributions? For how many years? Start by evaluating your financial goals.
- Buy your first security. With your ladder structure planned out, you can begin to execute the investment strategy by purchasing your first fixed-income security. Make sure to do your own research on any bond or CD before making the decision to purchase.
- Add rungs to the ladder. Purchase fixed-income securities with many different maturity dates to build your ladder. You can add rungs to the ladder slowly or quickly, depending on your financial resources and goals.
- Reinvest matured securities. You can preserve and extend the length of your fixed-income ladder by continually reinvesting some or all of the proceeds.
Pros and cons of laddering your fixed income
Does a fixed-income ladder sound intriguing? Before you commit to this investment method, it’s important to understand the pros and cons.
Pros. There’s a lot to love about fixed-income laddering. You can:
- Customize your ladder to your financial goals. The ability to match bond maturity dates to your liquidity needs is a key benefit. Bonds and certificates of deposit can have many different term lengths.
- Capture rising interest rates. Reinvesting some or all of your bond yields into new fixed-income securities with long maturities is a way to boost the average interest rate that you’re earning on your portfolio.
- Receive predictable cash flow. Fixed-income securities provide exactly that—income that is fixed (with few exceptions). The predictability of cash flow from this investing strategy is another key feature.
Cons. Understand the risks before building your bond ladder:
- Interest rate fluctuations. Interest rates don’t always increase, which can mean returns from your fixed-income ladder could be lower than expected. Fluctuating interest rates can make it more challenging to execute a fixed-income laddering strategy.
- Reinvestment risk. Repeat investors in any security aren’t guaranteed to receive the same (or any) investment return. Continually reinvesting the proceeds of a security creates the risk that the yield on the next investment may be less than what you’ve already earned.
- Diversification risk. Concentrating your portfolio in fixed-income securities can reduce its diversification. Investors with limited financial resources may be challenged to create a robust fixed-income ladder in the context of a fully diversified portfolio.
- Opportunity cost. A fixed-income laddering strategy has limited potential for capital growth. Consider the opportunity cost—that is, the difference between the expected return from a fixed-income ladder and the expected return from pursuing a riskier investing strategy.
The bottom line
Instead of depositing and withdrawing money whenever you wish, a CD is a “timed” account.
Encyclopædia Britannica, Inc.
Fixed-income laddering isn’t the sexiest or most exciting way to invest, but it’s a solid option for investors with a low tolerance for risk. Building a bond ladder is a long-term investing activity that requires commitment, in contrast to some other trading and investing approaches. Learning how fixed-income ladders work is a great first step toward using laddering to reach new financial heights.
References
- Bonds and the Yield Curve | rba.gov.au
- How to Earn Steady Income with Bonds | fidelity.com
- Bond Ladders | schwab.com
