What Is Laddering?
The term laddering has different definitions in the financial world. The first refers to a scheme to manipulate prices during an initial public offering (IPO). With this type of laddering, underwriters offer IPO shares to clients at an artificially low offering price. In turn, those clients must agree to buy more IPO shares later at higher prices. This increases the demand for the IPO and drives up prices. It is an illegal practice.
In portfolio management, laddering refers to an investment strategy that involves buying multiple financial products of the same type—such as bonds or certificates of deposit (CDs)—with different maturity dates. This technique is often used to help diversify an investor's portfolio and is considered a key part of retirement planning.
- Laddering may refer to a scheme to artificially manipulate prices during an initial public offering.
- In financial planning, laddering involved buying multiple financial products of the same type but with different maturities.
- Laddering is a key component in retirement planning where investors buy assets of various maturities, based on when they will be liquidated.
How Laddering Works
With IPOs, laddering happens when underwriters tie IPO allocations to after-listing purchases. The underwriter promotes the issue price by artificially inflating an IPO's share price. Investors can buy shares at a certain—often lower—price if they agree to buy more shares at a higher price after the IPO is completed. This sends share prices higher.
By agreeing to allocate additional shares to choice clients, the underwriter and clients are able to make big gains on the IPO shares. Once the price increases to a certain level, insiders can then sell their shares and take their profits.
The process of laddering in IPOs is illegal.
Laddering also refers to a strategy used in financial planning. In this case, laddering involves dividing the amount of money to be invested across multiple financial products of the same type—usually bonds or CDs—but with different maturities.
For example, instead of buying a single $100,000 CD, an investor could build a CD ladder by putting:
- $20,000 in a 1-year CD
- $20,000 in a 2-year CD
- $20,000 in a 3-year CD
- $20,000 in a 4-year CD
- $20,000 in a 5-year CD
This example shows a five-year ladder with five rungs. As each CD matures, the investor would put the money into a new 5-year CD. Each year, a different CD would be replaced as it matures.
The strategy decreases interest rate risk as well as reinvestment risk. For instance, it can decrease interest rate risk because an investor can hold both short-term and long-term bonds. As one bond matures in the bond ladder, the funds can be reinvested into higher yield bonds if rates rise.
The practice of laddering can also help investors manage reinvestment risk because as one bond on the ladder matures, the cash is reinvested. Even if prevailing rates at the time of reinvestment are lower than the previous bond's returns, the smaller amount of reinvestment dollars mitigates the risk of investing a lot of cash at a low return.
In retirement planning, laddering can be used to separate certificates of deposit (CDs), cash, bonds, annuities, and others onto different ladder rungs, or in buckets or baskets depending on when the asset will be liquidated to fund the retirement revenue stream.
Steady Cash Flows
There are other uses for laddering in financial planning. This strategy can help investors maintain steady cash flows as investments periodically mature. This can encourage regular saving for investors looking for an income-producing portfolio.
Low-risk assets are used at the start of retirement. They usually have an expected lower rate of return, due to lacking a risk premium. Higher-risk assets would be placed in a ladder or basket that is used at the end of retirement.
Laddering and Capital
Laddering can be used to free up capital. For example, a person may buy a shorter-term bond if they need the capital soon to fund a child's tuition. A person might buy longer-term bonds with more favorable rates as a retirement investment, assuming the economy is experiencing a normal yield curve.
Consequences of IPO Laddering
The process of laddering during an IPO is illegal. Firms that are accused of manipulating IPO share prices may be flagged by the Securities and Exchange Commission (SEC) for investigation. If found guilty, they could face charges of fraud and market manipulation and may face penalties.