What Is Bond Laddering?
Bond laddering is an investment strategy that involves buying bonds with different maturity dates so that the investor can respond relatively quickly to changes in interest rates.
- Bond laddering involves buying bonds with differing maturities.
- The idea is to spread the risk along the interest rate curve.
- The strategy is employed by risk-averse investors looking for income over growth.
How Bond Laddering Works
A bond investor might purchase both short-term and long-term bonds in order to disperse the risk along the interest rate curve. That is, if the short-term bonds mature at a time when interest rates are rising, the principal can be re-invested in higher-yield bonds.
Generally, a short-term bond matures in less than three years.
If interest rates have hit a low point, the investor will get a lower yield on the reinvestment. However, the investor still holds those long-term bonds that are earning a more favorable rate.
Essentially, bond laddering is a strategy to reduce risk or increase the opportunity of making money on an upward swing in interest rates. In times of historically low interest rates, this strategy helps an investor avoid locking in a poor return for a long period of time.
Other Benefits of Bond Laddering
Bond laddering offers steady income in the form of those regularly occurring interest payments on short-term bonds. It also helps lower risk, as the portfolio is diversified because of the various maturation rates of the bonds it contains.
Bond laddering should ideally be used to reduce the risk of a fixed income portfolio.
In effect, laddering also adds an element of liquidity to a bond portfolio. Bonds by their nature are not liquid investments. That is, they can't be cashed in at any time without penalty. By buying a series of bonds with different dates of maturity, the investor guarantees that some cash is available within a reasonably short time frame.
Bond laddering rarely leads to out-sized returns compared to a relevant index. Therefore, it is usually used by investors who value the safety of principal and income above portfolio growth.
Variations on Bond Laddering
In theory, an investor's bond ladder could consist of any number of types of bonds. Municipal and government bonds, U.S. Treasuries, and certificates of deposit are among the variations, and each will have its own date of maturity. A less complicated approach is to buy shares in a bond fund and let a professional do all the legwork.