Loading the player...

What is a 'Bond Ladder'

A bond ladder is a portfolio of fixed-income securities in which each security has a significantly different maturity date. The purpose of purchasing several smaller bonds with different maturity dates rather than one large bond with a single maturity date is to minimize interest-rate risk, increase liquidity and diversify credit risk.

BREAKING DOWN 'Bond Ladder'

In a bond ladder, the bonds' maturity dates are evenly spaced across several months or several years so that the proceeds are reinvested at regular intervals as the bonds mature. The more liquidity an investor needs, the closer together his bond maturities should be.

Why Use a Bond Ladder?

Investors who purchase bonds usually buy them as a conservative way to produce income. However, investors looking for a higher yield, without reducing the credit quality, usually need to purchase a bond with a longer maturity. Doing so exposes the investor to three types of risk: interest rate risk, credit risk and liquidity risk.

When interest rates increase, bond prices react inversely. This especially holds true the longer the maturity date is on a bond. A bond that matures in 10 years fluctuates less in price than a bond that matures in 30 years. If the investor needs some funds before the bond’s maturity, the rise in interest rates causes a lower price for the bond on the open market.

When interest rates rise, the demand for lower interest-paying bonds decreases. This leaves the bond with less liquidity, since bond buyers can find similar maturity bonds with higher interest payments. The only way to get a more favorable price in this scenario is to wait for interest rates to go down, which causes the bond to go back up in price.

Buying a large position in one bond could also leave the investor exposed to credit risk. Similar to owning only one stock in a portfolio, a bond’s price is dependent on the credit of the underlying company or institution. If anything lowers the credit quality of the bonds, the price is negatively impacted immediately. For example, Puerto Rico bonds were once very popular, but when the province had financial issues, the bond prices immediately plummeted.

Using a bond ladder satisfies these issues. Since there are several bonds with a staggered maturity, bonds are constantly maturing and being reinvested in the current interest rate environment. If the investor needs liquidity, selling the shorter maturity bonds offers the most favorable pricing. Since there are several different bond issues, the credit risk is spread across the portfolio and properly diversified. If one of the bonds has a downgrade in credit quality, only a portion of the entire ladder is affected.

RELATED TERMS
  1. Current Maturity

    The interval between the present date and the maturity date of ...
  2. Bond

    A debt investment in which an investor loans money to an entity ...
  3. Average Effective Maturity

    For a single bond, it is a measure of maturity that takes into ...
  4. Term Bond

    Bonds from the same issue that share the same maturity dates. ...
  5. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  6. Bond Laddering

    A portfolio management strategy and model for investing in fixed ...
Related Articles
  1. Investing

    How To Evaluate Bond Performance

    Learn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk.
  2. Investing

    Key Strategies To Avoid Negative Bond Returns

    It is difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses.
  3. Investing

    Top 6 Uses For Bonds

    We break down the stodgy stereotype to see what these investments can do for you.
  4. Investing

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  5. Investing

    An Introduction to Individual Bonds

    Individual bonds are better than bond funds and can be a key component to one’s investment strategy.
  6. Investing

    How To Choose The Right Bond For You

    Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
  7. Investing

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
RELATED FAQS
  1. What happens to the price of a premium bond as it approaches maturity?

    Learn how bonds trade in regard to premiums and discounts, and how bond prices shift closer to par value as bonds approach ... Read Answer >>
  2. Why is my bond worth less than face value?

    Find out how bonds can be issued or traded for less than their listed face values, and learn what causes bond prices to fluctuate ... Read Answer >>
  3. Which factors most influence fixed income securities?

    Learn about the main factors that impact the price of fixed income securities, and understand the various types of risk associated ... Read Answer >>
Hot Definitions
  1. Free Cash Flow - FCF

    A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents ...
  2. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to ...
  3. Two And Twenty

    A type of compensation structure that hedge fund managers typically employ in which part of compensation is performance based. ...
  4. Market Capitalization

    The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying ...
  5. Expense Ratio

    A measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual ...
  6. Mezzanine Financing

    A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. Mezzanine financing ...
Trading Center