Bond Laddering: How it Works, Benefits, Variations

What Is Bond Laddering?

Bond laddering is an investment strategy that involves buying bonds with different maturity dates so that the investor can respond relatively quickly to changes in interest rates.

It reduces the reinvestment risk associated with rolling over maturing bonds into similar fixed income products all at once. It also helps manage the flow of money, helping to ensure a steady stream of cash flows throughout the year.

How Bond Laddering Works

A bond investor might purchase both short-term and long-term bonds in order to disperse the risk along the interest rate curve. That is, if the short-term bonds mature at a time when interest rates are rising, the principal can be re-invested in higher-yield bonds.

If interest rates have hit a low point, the investor will get a lower yield on the reinvestment. However, the investor still holds those long-term bonds that are earning a more favorable rate.

Essentially, bond laddering is a strategy to reduce risk or increase the opportunity of making money on an upward swing in interest rates. In times of historically low interest rates, this strategy helps an investor avoid locking in a poor return for a long period of time.

Rungs

By taking the total dollar amount you plan to invest and dividing it equally by the total number of years for which you wish to have a ladder, you will arrive at the number of bonds for this portfolio or the number of rungs on your ladder. The greater the number of rungs, the more diversified your portfolio will be and the better protected you will be from any one company defaulting on bond payments.

Height of the Ladder

The distance between the rungs is determined by the duration between the maturity of the respective bonds. This can range anywhere from every few months to a few years. Obviously, the longer you make your ladder, the higher the average return should be in your portfolio since bond yields generally increase with time. However, this higher return is offset by reinvestment risk and the lack of access to the funds. Making the distance between the rungs very small reduces the average return on the ladder, but you have better access to the money.

Building Materials

Just like real ladders, bond ladders can be made of different materials. One straightforward approach to reducing exposure to risk is investing in different companies. But investments in products other than bonds are sometimes more advantageous depending on your needs. Debentures, government bonds, municipal bonds, Treasuries, and certificates of deposit (CDs) can all be used to make the ladder. Each of them has different strengths and weaknesses. One important thing to remember is that the products that make up your ladder should not be redeemable by the issuer. This would be the equivalent of owning a ladder with collapsible rungs.

Other Benefits of Bond Laddering

Bond laddering offers steady income in the form of those regularly occurring interest payments on short-term bonds. It also helps lower risk, as the portfolio is diversified because of the various maturation rates of the bonds it contains.

In effect, laddering also adds an element of liquidity to a bond portfolio. Bonds by their nature are not liquid investments. That is, they can't be cashed in at any time without penalty. By buying a series of bonds with different dates of maturity, the investor guarantees that some cash is available within a reasonably short time frame.

Bond laddering rarely leads to outsized returns compared to a relevant index. Therefore, it is usually used by investors who value the safety of principal and income above portfolio growth.

Variations on Bond Laddering

In theory, an investor's bond ladder could consist of any number of types of bonds. Municipal and government bonds, U.S. Treasuries, and certificates of deposit are among the variations, and each will have its own date of maturity. A less complicated approach is to buy shares in a bond fund and let a professional do all the legwork.