What is a Bond Ladder?
A bond ladder is an investment strategy that involves constructing a portfolio in which bonds or other fixed income securities mature continuously at equally spaced intervals. As the bonds closest to maturity expire, the investments are rolled over to the end. This keeps the investor’s position of holding bonds with equally spaced maturities. This strategy is used to attain higher average yields while reducing liquidity and interest rate risk.
Quick Summary of Points
- A bond ladder is an investment strategy that involves constructing a portfolio in which bonds mature continuously at equally spaced intervals
- This investment strategy can be used to retain liquidity while also taking advantage of generally higher yield, long-term bonds
- Laddering also increases portfolio diversification while reducing interest rate risk
How Does a Bond Ladder Work?
The bond ladder strategy can be constructed with various fixed income instruments. For example, they can be created using corporate bonds, certificates of deposits, treasury notes, etc. A single bond ladder may use various securities at a time to meet its purpose.
To create this portfolio strategy an investor must decide how much they can invest, how far into the future they will invest, and how far apart to space the maturities. The more liquidity an investor wants the closer the maturities should be to each other. This will ensure steady streams of cash from the maturing bonds but also means the investor may not take advantage of higher yields from longer maturities.
Once the investor has made this decision, they will split their investable money into equal portions and buy fixed income securities that mature at equally spaced intervals. For example, let us take an investor who has $40,000 to invest and wants the maturities to be one year apart over a 4 year period. They will buy $10,000 worth of fixed income securities one year apart from each other.
When the 1-year bonds mature, they will roll the investment over into bonds with a 4-year maturity. This will keep the investor’s ladder position. At year two, the bonds with a 2-year maturity will expire. These again will be rolled over into bonds with a 4-year maturity. This is repeated each year until the investor is holding a portfolio of all 4-year maturity bonds that expire regularly one year apart. To better visualize this strategy the below graphic illustrates this process.
Above you can see that the bonds being held with maturities one year apart make up the rungs of the ladder. At any point in time, the investor will be holding a portfolio of 4 x $10,000 = $40,000 in bonds that will mature equally one year apart. As time goes on and the bonds mature, the investments will be rolled over. After four years, the investor will be holding all 4-year maturity bonds that will expire one year apart. This process can be repeated indefinitely.
What is the Purpose of a Bond Ladder Strategy?
This strategy is used for a number of reasons. The main advantage of laddering is that an investor will take advantage of fixed income securities with longer maturities and in most cases higher yields. However, instead of locking into a long-term fixed income instrument and losing liquidity, the bond ladder ensures some liquidity since bonds will always be reaching maturity no later than the spaced intervals of the ladder.
Another advantage of using bond laddering is the reduction of interest rate risk. Longer-term bonds are more susceptible to a changing interest rate. With a ladder strategy, you constantly have bonds maturing, so if interest rates were to rise these bonds can be rolled over and reinvested at the new market rate.
This strategy is also good because it adds diversity to the investor’s portfolio. Not only does this strategy involve staggering maturities, but it can also incorporate different types of fixed incomes with different ratings. For example, some of the bonds may be highly rated, while some can be lower rated with higher yields.
What are the Cons of Using a Bond Ladder?
Although there are many advantages of using a bond ladder, there are also potential downsides. One being that you may be forced to invest in lower interest rates depending on how interest rates move at the time of your bonds expiring.
This strategy is meant to retain a reasonable amount of liquidity however some liquidity is lost and if immediate funds are necessary, parts of an investor’s portfolio may need to be sold off. If interest rates are rising, this would mean a loss for the investor.
Bond laddering also involves multiple transactions. If these transactions are set up through a broker, the fees of entering into all these contracts can add up.
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