How laddering works
A laddered bond portfolio is one in which bonds come to maturity at regular intervals. When principal is returned with interest at maturity, the money can either be used as income or it can be reinvested at future interest rates.
Example: Someone who knows she needs $20,000 in income every six months for the next six years can buy a series of twelve bonds with maturity dates spaced six months apart for the next ten years: One maturing in six months, one in a year, one in eighteen months, and so forth. Laddering is often used with Treasuries, but it can also be applied to municipal and corporate bond portfolios alike.
Ultimately, the goal of the bond ladder investor is to match up future cash flows with expected income needs.
Because a bond ladder contains short-term, intermediate-term, and – if time horizons permit – long-term bonds, a properly laddered portfolio is not overexposed to interest rate fluctuations. If long-term interest rates should fall, the long-term portion of the portfolio will benefit, since interest rates and bond prices move inversely to one another.
On the other hand, if interest rates should rise, depressing bond prices, the bonds on the lowest rung of the ladder – the next bonds to mature – can be reinvested at the new, higher interest rates, unless needed for income in the interim.
Know the risks
A bond ladder does not guarantee low volatility or a higher investment return. And bonds are subject to a variety of risks:
Ã¢Â?Â¢ Inflation risk: The risk that inflation may outpace effective yields on bonds, eroding purchasing power. TIPS, or Treasury Inflation-Protected Securities, are indexed to inflation, and can help you hedge against the erosion of the purchasing power of the dollar.
Ã¢Â?Â¢ Credit risk – The risk that a bond issuer may default on its obligations to pay principal and interest. Various bond rating agencies, such as Moody’s Investors Service, Fitch Ratings, and Standard and Poor’s, analyze company financial statements and business prospects and attempt to assess their financial soundness – and the possibility that they may default if business conditions go sour. Bond ratings generally start at Aa1, AAA, or Aaa, indicating exceptionally strong credit quality and the highest degree of safety of principal in the markets, and go down to “D”, indicating the bond issuer is defaulting. The only way to reduce risk essentially to zero is to invest solely in U.S. treasuries, or to invest only in FDIC-insured savings accounts, subject to FDIC insurance limits.
Ã¢Â?Â¢ Interest rate risk – The risk that interest rates may fluctuate, causing uncertainty in bond prices. Interest rate risk can’t hurt you, though, if you plan on holding the bond to maturity. As long as the bond issuer doesn’t go bankrupt or default, you will still get the full coupon payments, and the full face value of the bond back at maturity. Note: Bond ratings only attempt to measure credit risk, not interest rate risk. Just because a bond is rated AAA doesn’t mean the bond price can’t go down when interest rates rise.
Ã¢Â?Â¢ Reinvestment risk – The risk that proceeds from maturing bonds must be reinvested at lower interest rates in the future. Short-term bonds have little interest rate risk, but are subject to a good deal of reinvestment risk.
A bond laddering strategy helps to mitigate reinvestment risk, because with a bond ladder, only a small portion of your bonds will mature – and become available for reinvestment – at any given time. Therefore, if interest rates take a short-term nosedive immediately before the maturity date, only a portion of your bond portfolio will have to be invested at the new lower rates. The remainder of your laddered portfolio will continue chugging along, having locked in the higher yields that were available back when you bought the bonds in the first place.
Conversely, if all your bonds are slated to mature at exactly the same time – a strategy known as the “bullet,” you would take on a good deal of reinvestment risk: If interest rates decline before your bonds mature, you would be forced to reinvest your entire portfolio at depressed yields.
The bond fund alternative: Building a solid bond ladder takes some money up front. Most bonds don’t come in denominations of less than $1,000 face value (though some U.S. Savings Bonds are available for less). And even though you generally buy bonds at a discount to their face value, you will still need enough money to buy several issues and pay a commission to a broker. If you don’t have the money up front, you may wish to consider a bond mutual fund as an alternative. Bond funds have the advantage of instant diversification, and no-load funds are available without paying a sales commission. The disadvantage is that unlike most bonds, a bond fund has an underlying expense ratio (typically 0.10% to 1.00% per annum, depending on the type of bonds in the fund). Further, a bond fund has a less predictable income stream than that generated by a bond ladder.