When portfolio managers talk about strategies for success, they often refer to risk diversification and money management. These strategies separate 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 having the foundational skills will ultimately lead to success.
In this article, we'll discuss the bond ladder, a bond investment strategy that is based on a relatively simple concept that many investors and professionals fail to use or even understand.
- A bond ladder is a multi-maturity investment strategy that diversifies bond holdings within a portfolio.
- By staggering maturity dates, you won't be locked into one bond for a long duration.
- Bond ladders allow investors to adjust cash flows according to their financial situation.
- When building your ladder, consider the rungs, the height of the ladder, and the building materials.
- Have enough money for your ladder, bypass callable bonds, don't redeem your investments early, and look for high-quality bonds.
What Is a Bond Ladder?
A bond ladder is a strategy that attempts to minimize the 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 with a face value of $5,000. Each bond, however, would have a different maturity. One bond may mature in a year, another in three years, while the remaining bonds may 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 in a 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 relatively 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. Picture an actual ladder, rungs and all. The analogy of a real ladder applies to the bond ladder strategy.
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.
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 to owning a ladder with collapsible rungs.
If you're going to use the bond ladder strategy, there are a few things you need to consider if it's going to be a success. Because the bonds that have greater rewards often come in higher denominations, you should have enough money to diversify your investments.
As mentioned above, invest in bonds that cannot be redeemed by the bond issuer. Callable bonds are investment vehicles that are redeemed before maturity by the issuer, which means interest payments would stop.
Bond ladders don't work well with callable bonds because interest payments can stop before they hit maturity.
Be patient, even in times of need. Resist the temptation to cash in your bonds before they mature. There's really no point in using a strategy like this if you're going to redeem your bonds early. Doing so also puts a bigger distance between rungs. You may also put yourself in a position where you're taking on more risk if you cash any of the investments in your bond ladder strategy too early, namely the risks of loss or a drop in yields.
Finally, look for high-quality investments to put into your bond ladder. Bonds with A-grade or higher ratings should be on your radar. Many of these provide great income potential for long-term investors, especially if they use bond ladder-style strategies.
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 may be more sensible, as the charges related to the product will be offset by the benefits of diversification they provide.
In either case, make sure all your eggs aren't in one basket so you can limit risk exposure, have greater access to emergency funds, and have the opportunity to capitalize on ever-changing market conditions.