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Laddered Bond Portfolio

An investment portfolio strategy that is composed of fixed income securities with different maturity dates

What is a Laddered Bond Portfolio?

A laddered bond portfolio is an investment portfolio strategy that is composed of fixed income securities with different maturity dates. It is also referred to as a “bond ladder” portfolio.

 

Laddered Bond Portfolio

 

 

Summary:

  • A laddered bond portfolio is an investment portfolio strategy that is composed of fixed income securities with different maturity dates.
  • A laddered bond portfolio involves several fixed income securities with significantly different maturity dates to minimize risk through a diversified portfolio.
  • It is commonly referred to as the “bond ladder” portfolio in the investment world.

 

Why use a Bond Ladder?

A bond ladder allows an investor to mitigate risks through diversification. It comes with several fixed income securities with significantly different maturity dates to minimize risk through a diversified portfolio. It also helps to achieve increased liquidity of the portfolio.

 

How does a Laddered Bond Portfolio Work?

A laddered bond investment strategy requires the portfolio to be diversified with fixed income securities ranging from short-term to long-term bonds. The strategy works by diversifying the investment portfolio maturity date-wise to mitigate risk along the interest rate curve.

A laddered bond portfolio simply works by dispersing risk in a ladder-like fashion. If the short-term bonds or lower-rung bonds are maturing at a time when market conditions are unfavorable with rising interest rates, the principal amount can be reinvested in the higher-rung bonds. It mitigates interest rate risk, reinvestment risk, credit risk, and liquidity risk.

 

Bond Ladder Portfolio – Features

 

1. Multi-maturity investment strategy

The laddered bond portfolio is a multi-maturity investment strategy since it contains several fixed income bond investments with different maturity dates. The portfolio is diversified from short-term to long-term bonds and in a “ladder-like” fashion, that’s why it is also referred to as a laddered bond investment portfolio.

 

2. Diversification

The laddered bond portfolio includes several small fixed income securities with a range of maturity dates. It allows diversification to minimize risk.

 

3. Risk mitigation

The bond ladder portfolio strategy focuses on four different kinds of risk mitigation: interest-rate risk, credit risk, reinvestment risk, and liquidity risk. The diversification of the portfolio helps to achieve the purpose of mitigating any type of risk.

 

4. Flexibility with cash flow position

Since a laddered bond portfolio involves fixed income securities with a range of maturity dates spaced out from one another, the investor isn’t locked into one investment position until the maturity of the security. It provides some level of flexibility to adjust one’s cash flow position according to the prevailing market conditions.

 

5. Steady stream of income

The laddered bond portfolio also provides a steady stream of income, given the flexibility it offers to adjust one’s cash flow position based on market conditions.

 

Why are Callable Bonds Avoided while Building a Laddered Bond Portfolio?

Callable bonds are essentially avoided while building a laddered bond portfolio since the essence of a laddered bond investment strategy is to diversify the portfolio with different fixed income securities with specified maturity dates. However, callable bonds forfeit this purpose because:

  • They are callable prior to maturity.
  • When they are called prior to maturity, the interest payments are no longer received and the principal amount is returned as of the call date.

 

Illustrative Example

An investor decides to invest $90,000 using the bond ladder investment strategy. He creates an investment portfolio with a one-year bond of $15,000 at 4.25%, a two-year bond of $22,000 at 6%, a three-year bond of $25,000 at 6.25%, and a four-year bond of $28,000 at $6.50%.

When the one-year bond matures, the investor reinvests the principal in the bond at the higher rung, similarly following the same practice for the succeeding mature bonds, and so on. It is the bond ladder investment strategy.

 

Related Readings

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

  • Risk
  • Callable Bond
  • Liquidity Event
  • Non-Callable Bond

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