What is Bond Ladder?
The term “bond ladder” refers to the investment strategy in which an investor builds a portfolio of fixed income securities (primarily bonds) that mature at equally spaced regular intervals. As the bonds mature at the end of each interval, they are reinvested or rolled over for another round, and in this way, the investors maintain their holding position of bonds into equally spaced intervals.
Explanation of Bond Ladder
In the bond ladder strategy, the investors place their money in multiple bonds with staggered maturity periods. As each bond matures, the investors then reinvest the money in a new bond with a maturity period equivalent to the longest term of the ladder strategy. Effectively, if the interest rates go up, the investors can reinvest at the higher rates. On the other hand, if the interest rates fall, then the investors will have the existing bonds already invested at the higher yields.
Goals of Bond Ladder
The investors who chose to follow the bond laddering strategy intend to achieve the following two goals:
- To reduce the reinvestment risk associated with the rollover of the matured bonds all at once. By staggering the maturity periods, the investors avoid investing at any single interest rate.
- To manage the flow of money through a steady stream of cash flows in the form of coupon payments spread across the year.
How Does Bond Ladder Work?
In the bond ladder strategy, the investors initially purchase short-term and long-term bonds to spread the risk along the interest rate curve. Basically, when the interest rates are rising, the investors can reinvest the short-term bonds at a higher rate, while the long-term bonds will continue to generate lower returns until their maturity. On the other hand, when the interest rates plummet, the investors will earn a lower yield on the reinvested short-term bonds, but the long-term bonds will generate higher returns until their maturity. In this way, the bond laddering strategy helps in generating a higher average yield while reducing interest rate risk and liquidity risk.
Example of Bond Ladder
Let us look at an example to understand the strategy of the bond ladder. Let us assume that an investor has $20,000 to invest, and he intends to construct a bond portfolio that is spread across four years, and there is a maturity every year. So, the investor will invest $5,000 in four different bonds with maturity periods of one year, two years, three years and four years. Let us name them Bond 1, Bond 2, Bond 3 and Bond 4, respectively, for the sake of convenience.
So, at the end of one year, when Bond 1 matures, the investor will roll over it into a 4-year maturity bond. Similarly, the other three bonds will be rolled over into 4-year bonds at the end of two years, three years and four years. Eventually, after a period of 4 years, the investor’s ladder position will be created. So, it can be seen that in the above chart that the investor will have a maturity at the end of each year.
How to Build a Bond Ladder?
A bond laddering strategy is usually constructed with a mix of different types of bonds. The following are the various components of a typical bond ladder strategy:
- Rungs: The number of bonds in the portfolio can be derived by dividing the total dollar amount by the total number of years for which the ladder strategy has to be created. This resembles the number of rungs in a ladder. The thumb rule is that the higher the number of rungs, the more diversified is the portfolio and thus better protected against reinvestment risk. The number of rungs is 4 in the above example.
- Height: It is the distance between two consecutive rungs, which is the metaphorical representation of the duration between two consecutive maturities. The height of a bond ladder can vary from few months to a few years. The thumb rule is that the lower the height, the more safeguarded is the portfolio from reinvestment risk, but it results in a relatively lower average return. The height of the bond ladder is 1 year in the above example.
- Building materials: Bond ladders are also made up of different materials, just like real ladders. For instance, the investors may invest in different companies to reduce exposure to company-specific risks. The investors can also consider investing in other fixed securities, such as debentures, treasury bonds, municipal bonds, government bonds and certificates of deposit.
Some of the major advantages of the bond ladder are as follows:
- First, the investors can have the maturities at the end of a particular interval instead of getting caught in the lock-in period of a long-term fixed-income instrument. This ensures a better liquidity position.
- It significantly reduces the reinvestment risk due to changing interest rates, which is an issue with long-term bonds.
- The ability to incorporate different types of fixed income securities helps in the diversification of the investment portfolio.
Disadvantages of Bond Ladder
Some of the major disadvantages of the bond ladder are as follows:
- In a continuously declining interest rate market, the investors are forced to invest in lower yield bonds. So, the bond laddering strategy can backfire at times.
- This strategy involves frequent buying and selling of bonds. Now, if the investments are routed through a broker, then the broker fees eat away a certain portion of the bond yield.
So, it can be seen that the bond laddering strategy has its own set of advantages and limitations. It is best suited for investors who are willing to take the trade-off between interest rate risk and reinvestment risk. The investors should be able to set aside the fund for a relatively long period for the approach to be fruitful. The strategy can lower the portfolio risk and thus can be a very good option for saving for a retirement account.
This is a guide to Bond Ladder. Here we also discuss the definition and How Does Bond Ladder Work? Along with advantages and disadvantages. You may also have a look at the following articles to learn more –