What Is Laddering?
In finance, the term laddering is used in a variety of ways depending on the industry. Its two most common usages relate to retirement planning and the underwriting of new securities issues.
Generally, laddering is used to describe different investing strategies that aim to produce steady cash flow by deliberately planning investments, creating an influx of liquidity at a predetermined time, and/or matching a desired risk profile.
Although these strategies can vary substantially in their execution, what they have in common is the practice of carefully combining a series of investments to produce a desired outcome.
For fixed income investors, laddering can help manage interest rate risk and reinvestment risk.
- Laddering is a financial term used in various ways depending on the industry.
- It's commonly used in retirement planning where it refers to a method for reducing interest rate and reinvestment risk.
- Laddering is also used in the securities underwriting market to describe an illegal practice that benefits insiders at the expense of regular investors.
- A bond ladder is a series of bonds with particular maturities that are each held to maturity and whose proceeds are reinvested in a new, longer-term bond to maintain the ladder's length.
- Bond ladders are used to generate fixed income cash flow and manage certain risks.
How Laddering Works
Fixed Income Laddering
The most common usage of the term laddering is found in retirement planning. There, it refers to buying multiple fixed income financial products of the same type—such as bonds or certificates of deposit (CDs)—each with different maturity dates. By spreading their investment across various maturities, investors obtain ongoing cash flow as they manage their interest rate and reinvestment risks.
In addition to managing those two risks, an investor's purpose in creating, for example, a bond ladder is to obtain a total return—no matter the interest rate rate environment—similar to the total return of a long-term bond.
To build a bond ladder, investors purchase a series of individual bonds, each of which matures in a different year. For example, you could buy five bonds that mature in 1, 2, 3, 4, and 5 years. As the first bond matures, investors reinvest the proceeds in a new five-year bond. This process repeats itself with each maturity. Thus, the maturity length of the ladder is maintained.
The practice of laddering can help investors manage reinvestment risk because, as mentioned, as the shortest-term bond on the ladder matures, the cash is reinvested in a longer-term bond on the ladder. Longer-term bonds tend to have higher interest rates.
Similarly, the practice of bond laddering can also reduce interest rate risk (if one has to sell) due to the variety of maturities. Shorter-term bond prices fluctuate less than longer-term bond prices due to years to maturity and the effects of duration.
Importantly, the whole idea behind the ladder is to hold the bonds to maturity rather than to sell them. Therefore, the current price of their bonds due to any change in interest rates isn't an issue. Investors' capital is preserved.
Reinvestment risk is the risk that investors won't be able to reinvest bond income payments and the principal they receive upon maturity at the same rate as that of the maturing bond. Interest rate, or market price, risk is the risk that the price of a bond will change as interest rates change.
Laddering as a term is also used in the context of the underwriting of initial public offerings (IPOs). Here, it refers to an illegal practice in which underwriters offer a below-market price to investors prior to the IPO if those same investors agree to buy shares at a higher price after the IPO is completed. This practice can provide unfair advantages to insiders at the expense of regular investors, and is therefore prohibited under U.S. securities law.
Example of Laddering
Michaela is a diligent investor who is saving for her retirement. At 55 years of age, she has saved approximately $800,000 in combined retirement assets. She is gradually shifting those assets toward less volatile investments.
Michaela decides to invest $500,000 in various bonds, which she has carefully combined—or laddered—to reduce her reinvestment and interest rate risks. Specifically, Michaela’s bond portfolio consists of the following investments:
- $100,000 in a bond maturing in 1 year
- $100,000 in a bond maturing in 2 years
- $100,000 in a bond maturing in 3 years
- $100,000 in a bond maturing in 4 years
- $100,000 in a bond maturing in 5 years
Each year, Michaela takes the money from the bond that matures and reinvests it in a new bond that matures in five years. By doing so, she effectively ensures that she is exposed to interest rate risk only when she has to buy the new bond. Plus, she manages a potentially lower reinvestment rate by buying the longer-term, higher interest rate bond.
By contrast, if she had invested $500,000 in a single five-year bond, she would have risked a greater opportunity cost if interest rates had ended up rising during those five years.
What Is Interest Rate Risk?
Interest rate risk is also known as market price risk. It is the risk that the price of a fixed income investment will change as interest rates change. For example, in a rising rate environment, bond prices fall. When rates fall, prices rise. So, if your circumstances force you to sell bonds as rates rise, you may receive less for them than you paid. However, if you hold bonds to maturity and aren't worried about selling them, interest rate risk won't affect those bonds.
Why Do Investors Ladder Bonds?
One reason investors ladder bonds, or buy individual bonds of different maturities and reinvest in new bonds as each matures, is to take advantage of the fixed income cash flows they offer when held to maturity. Laddering protects against market price risk (the risk that their price will drop as interest rates rise) since an investor doesn't plan to sell the bonds. It also helps manage reinvestment risk since the investor reinvests proceeds from each maturity back into the longer-term bond (higher-yield) end of the ladder.
Is a Shorter-Term Bond Ladder Better Than a Longer-Term One?
That depends on what an investor seeks. Generally speaking, in a typical yield environment, long-term bonds offer higher yields than short-term bonds. So a longer ladder can increase the yields an investor can obtain as they reinvest. However, longer-term bonds are more volatile than shorter-term bonds, so changing prices could be an issue. Inflation would be, too. Shorter ladders tend to have lower yields and have less volatile price fluctuations. They can be less susceptible to inflation. That could mean investors end up reinvesting a greater proportion of total capital.