Bond Ladder

What is a Bond Ladder?

A bond ladder is an investment strategy that involves constructing a portfolio in which bondsBondsBonds are fixed-income securities that are issued by corporations and governments to raise capital. The bond issuer borrows capital from the bondholder and makes fixed payments to them at a fixed (or variable) interest rate for a specified period. or other fixed income securitiesFixed Income SecuritiesFixed income securities are a type of debt instrument that provides returns in the form of regular, or fixed, interest payments and repayments of the 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 yieldsYieldYield is defined as an income-only return on investment (it excludes capital gains) calculated by taking dividends, coupons, or net income and dividing them by the value of the investment. Expressed as an annual percentage, the yield tells investors how much income they will earn each year relative to the cost of their investment. while reducing liquidityLiquidityIn financial markets, liquidity refers to how quickly an investment can be sold without negatively impacting its price. The more liquid an investment is, the more quickly it can be sold (and vice versa), and the easier it is to sell it for fair value. All else being equal, more liquid assets trade at a premium and illiquid assets trade at a discount. and interest rate riskInterest Rate RiskInterest rate risk is the probability of a decline in the value of an asset resulting from unexpected fluctuations in interest rates. Interest rate risk is mostly associated with fixed-income assets (e.g., bonds) rather than with equity investments..

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 bondsCorporate BondsCorporate bonds are issued by corporations and usually mature within 1 to 30 years. They usually offer a higher yield than government bonds but carry more risk., certificates of deposits, treasury notes10-Year US Treasury NoteThe 10-year US Treasury Note is a debt obligation that is issued by the US Treasury Department and comes with a maturity of 10 years., 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 liquidityLiquidityIn financial markets, liquidity refers to how quickly an investment can be sold without negatively impacting its price. The more liquid an investment is, the more quickly it can be sold (and vice versa), and the easier it is to sell it for fair value. All else being equal, more liquid assets trade at a premium and illiquid assets trade at a discount. an investor wants the closer the maturities should be to each other. This will ensure steady streams of cash from the maturing bondsBondsBonds are fixed-income securities that are issued by corporations and governments to raise capital. The bond issuer borrows capital from the bondholder and makes fixed payments to them at a fixed (or variable) interest rate for a specified period. but also means the investor may not take advantage of higher yieldsYieldYield is defined as an income-only return on investment (it excludes capital gains) calculated by taking dividends, coupons, or net income and dividing them by the value of the investment. Expressed as an annual percentage, the yield tells investors how much income they will earn each year relative to the cost of their investment. from longer maturities.

Once the investor has made this decision, they will split their investable money into equal portions and buy fixed income securitiesFixed Income SecuritiesFixed income securities are a type of debt instrument that provides returns in the form of regular, or fixed, interest payments and repayments of the 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 maturityHeld to Maturity SecuritiesHeld to maturity securities are securities that companies purchase and intend to hold until they mature. They are unlike trading securities or available for sale securities 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 bondsBondsBonds are fixed-income securities that are issued by corporations and governments to raise capital. The bond issuer borrows capital from the bondholder and makes fixed payments to them at a fixed (or variable) interest rate for a specified period. 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 investorInvestorAn investor is an individual that puts money into an entity such as a business for a financial return. The main goal of any investor is to minimize risk and will take advantage of fixed income securitiesFixed Income SecuritiesFixed income securities are a type of debt instrument that provides returns in the form of regular, or fixed, interest payments and repayments of the with longer maturities and in most cases higher yields. However, instead of locking into a long-term fixed income instrument and losing liquidityLiquidityIn financial markets, liquidity refers to how quickly an investment can be sold without negatively impacting its price. The more liquid an investment is, the more quickly it can be sold (and vice versa), and the easier it is to sell it for fair value. All else being equal, more liquid assets trade at a premium and illiquid assets trade at a discount., 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 riskInterest Rate RiskInterest rate risk is the probability of a decline in the value of an asset resulting from unexpected fluctuations in interest rates. Interest rate risk is mostly associated with fixed-income assets (e.g., bonds) rather than with equity investments.. Longer-term bonds are more susceptible to a changing interest rateInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal.. 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 diversityDiversificationDiversification is a technique of allocating portfolio resources or capital to a variety of investments.The goal of diversification is to mitigate losses 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 ratesInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. depending on how interest rates move at the time of your bonds expiring.

This strategy is meant to retain a reasonable amount of liquidityLiquidityIn financial markets, liquidity refers to how quickly an investment can be sold without negatively impacting its price. The more liquid an investment is, the more quickly it can be sold (and vice versa), and the easier it is to sell it for fair value. All else being equal, more liquid assets trade at a premium and illiquid assets trade at a discount. 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.

Additional Resources

Thank you for reading CFI’s article on the bond ladder strategy. To learn about related concepts check out CFI’s other resources:

• Barbell StrategyBarbell StrategyThe barbell strategy involves investors purchasing short term and long term bonds, but not intermediate term bonds. This particular distribution on the two extreme ends of the maturity timeline creates a barbell shape. This strategy offers investors exposure to high yielding bonds with limited risk.
• Fixed Income RisksFixed Income RisksFixed income risks occur based on the volatility of the bond market environment. Risks impact the market value of the security when it is sold, cash flow from the security while it is held, and additional income made by reinvesting cash flows.
• Fixed Income Interest Rate RiskFixed Income Interest Rate RiskFixed income interest rate risk is the risk of a fixed income asset losing value due to a change in interest rates. Since bonds and interest rates have an inverse relationship, as interest rates rise, the value/price of bonds falls. Interest rate risk can be measured by the full valuation approach or the duration/convexity approach.
• DiversificationDiversificationDiversification is a technique of allocating portfolio resources or capital to a variety of investments.The goal of diversification is to mitigate losses