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.

What Is a Bond Ladder?

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 — helping to ensure 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 a year, another in three years and the remaining bonds might mature in five or more years. These bonds would each represent a different rung on the ladder.

Why Use a Bond Ladder Strategy?

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 bullish and bearish bond markets. If you invested the full $50,000 into one single bond with a yield of five percent 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 even 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 so.

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. Even if you are not dependent on the income, you will still have access to relatively liquid money by having steadily maturing bonds. If you suddenly lose your job or unexpected expenses arise, then you will have a steady source of funds to use as needed.

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.
  • 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 are all different products that you can use to make the ladder. Each of them have different strengths and weaknesses. 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.

    The Bottom Line

    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 at least $10,000. If you don't have this recommended amount, purchasing products such as bond funds might be more sensible, 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 limit risk exposure, have greater access to emergency funds and have the opportunity to capitalize on ever-changing market conditions..