When portfolio managers talk about strategies for success, they will often refer to risk diversification and money management. These strategies separate those investors who are successful because of knowledge and skill from those who are merely lucky. Now, don't be mistaken, luck isn't a bad thing to have, but possessing foundational skills will ultimately lead to success. In this article we'll discuss the bond ladder, a bond investing strategy that is based on a relatively simple concept that many investors (and professionals) fail to use or even understand. (If you aren't too familiar with bonds, check out the Bond Basics tutorial before reading further.)

A bond ladder is a strategy that attempts to minimize risks associated with fixed-income securities while managing cash flows for the individual investor. Specifically, a bond ladder, which attempts to match cash flows with the demand for cash, is a multi-maturity investment strategy that diversifies bond holdings within a portfolio. 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, ensuring a steady stream of cash flows throughout the year.

In simpler terms, a bond ladder is the name given to a portfolio of bonds with different maturities. Suppose you had $50,000 to invest in bonds. By using the bond ladder approach, you could buy five different bonds each with a face value of $10,000 or even 10 different bonds each a with face value of $5,000. Each bond, however, would have a different maturity. One bond might mature in one year, another in three years and the remaining bonds might mature in five-plus years - each bond would represent a different rung on the ladder.

Why Use A Bond Ladder?
There are two main reasons to use the ladder approach. First, by staggering the maturity dates, you won't be locked into one particular bond for a long duration. A big problem with locking yourself into a bond for a long period of time is that you can't protect yourself from bull and bear bond markets. If you invested the full $50,000 into one single bond with a yield of 5% for a term of 10 years, you wouldn't be able to capitalize on increasing or decreasing interest rates.

For example, if interest rates hit a bottom five years (at maturity) after purchasing the bond, then your $50,000 would be stuck with a low interest rate if you wanted to buy another bond. By using a bond ladder, you smooth out the fluctuations in the market because you have a bond maturing every year (or thereabouts).

The second reason for using a bond ladder is that it provides investors with the ability to adjust cash flows according to their financial situation. For instance, going back to the $50,000 investment, you can guarantee a monthly income based upon the coupon payments from the laddered bonds by picking ones with different coupon dates. This is more important for retired individuals because they depend on the cash flows from investments as a source of income. If you are not dependent on the income, by having steadily maturing bonds, you will have access to relatively liquid money. If you suddenly lose your job or unexpected expenses arise, then you will have a steady source of funds to use as required.

How To Create A Bond Ladder
The ladder itself is very simple to create - just picture an actual ladder:

  • Rungs - By taking the total dollar amount that you are planning 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.
  • 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 - each having different strengths and weaknesses - are all different products that you can use to make the ladder. One important thing to remember is that the products in your ladder should not be redeemable (or callable) by the issuer. This would be the equivalent to owning a ladder with collapsible rungs.

Conclusion
It's been said that a bond ladder shouldn't be attempted if investors do not have enough money to fully diversify their portfolio by investing in both stocks and bonds. The money needed to start a ladder that would have at least five rungs is usually between $10,000-$20,000. If you don't have this recommended amount, purchasing products such as bond funds might be more prudent, as the charges related to the product will be offset by the benefits of diversity that they provide. In either case, make sure that all your eggs aren't in one basket, so that you can control risk exposure, have greater access to emergency funds and have the opportunity to capitalize on ever-changing market conditions.

Related Articles
  1. Investing Basics

    Explaining Financial Assets

    A financial asset is intangible property that represents a claim on ownership of an entity or contractual rights to future payments.
  2. Mutual Funds & ETFs

    ETF Analysis: Guggenheim Enhanced Short Dur

    Find out about the Guggenheim Enhanced Short Duration ETF, and learn detailed information about this fund that focuses on fixed-income securities.
  3. Mutual Funds & ETFs

    ETF Analysis: iShares Agency Bond

    Find out about the iShares Agency Bond exchange-traded fund, and explore detailed analysis of the ETF that tracks U.S. government agency securities.
  4. Mutual Funds & ETFs

    ETF Analysis: Guggenheim BulletShrs 2018 HY CorpBd

    Find out about the Guggenheim BulletShares 2018 High Yield Corporate Bond ETF, and get information about this ETF that focuses on high-yield corporate bonds.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  6. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  7. Mutual Funds & ETFs

    ETF Analysis: First Trust Tactical High Yield

    Find out more about the First Trust Tactical High Yield fund, a debt security-focused ETF designed to produce high income.
  8. Mutual Funds & ETFs

    ETF Analysis: SPDR Barclays Short Term Hi Yld Bd

    Find out about the SPDR Barclays Short Term High Yield Bond ETF, and explore detailed analysis of the fund that tracks short-term, high-yield corporate bonds.
  9. Mutual Funds & ETFs

    ETF Analysis: Vanguard Intermediate-Term Bond

    Find out about the Vanguard Intermediate-Term Bond ETF, and delve into detailed analysis of this fund that invests in investment-grade intermediate-term bonds.
  10. Mutual Funds & ETFs

    ETF Analysis: SPDR Barclays Short Term Corp Bd

    Learn about the SPDR Barclays Short-Term Corporate Bond ETF, and explore detailed analysis of the exchange-traded fund tracking U.S. short-term corporate bonds.
RELATED TERMS
  1. Security

    A financial instrument that represents an ownership position ...
  2. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  3. Credit Rating

    An assessment of the credit worthiness of a borrower in general ...
  4. Long-Term Debt

    Long-term debt consists of loans and financial obligations lasting ...
  5. Accelerated Return Note (ARN)

    A short- to medium-term debt instrument that offers a potentially ...
  6. Coupon Rate

    The yield paid by a fixed income security. A fixed income security's ...
RELATED FAQS
  1. What are the maximum Social Security disability benefits?

    The maximum Social Security disability benefit amount for a single eligible person in 2015 is $1,165 per month, but you can ... Read Full Answer >>
  2. What is the relationship between the current yield and risk?

    The general relationship between current yield and risk is that they increase in correlation to one another. A higher current ... Read Full Answer >>
  3. How does the bond market react to changes in the Federal Funds Rate?

    The bond market is highly sensitive to changes in the federal funds rate. When the Federal Reserve increases the federal ... Read Full Answer >>
  4. How do I use the holding period return yield to evaluate my bond portfolio?

    The holding period return yield formula can be used to compare the yields of different bonds in your portfolio over a given ... Read Full Answer >>
  5. What is the relationship between current yield and yield to maturity (YTM)?

    Both the current yield and yield to maturity (YTM) formulas are methods of calculating the yield of a bond. However, these ... Read Full Answer >>
  6. What is a 'busted' convertible bond?

    In finance, a convertible bond represents a hybrid security that offers debt and equity features and risks. While a convertible ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!