Bond laddering is a powerful investment strategy especially for investors who depend on their investments for income on a regular basis. This applies to investments in various fixed income instruments such as Certificates of Deposits (CDs), US Treasury Notes, Municipal Bonds, Corporate Bonds, as well as zero-coupon bonds.
The key principle behind the bond laddering strategy is to diverse your investments by the maturity of the bonds. You take the amount you want to invest and distribute it evenly in different Certificates of Deposits and bonds that will matury at regular intervals such as every 1 year.
Let’s take an example to understand this. Let’s say you have $500,000 to invest in fixed income. You divide this into 5 investments of $100,000 each and invest it in different bonds maturing in 1, 2, 3, 4 and 5 years respectively. The following graph shows your investments.
Starting today, every one year an investment of $100,000 will mature and will be available to you for reinvestment. When the first investment matures, you take that money and reinvest it in the bond at the longest end of the ladder. The investment which was two years away is now one year away and the original investment that was 5 years away is now 4 years away. And you have now taken your $100,000 and invested in bonds with maturity 5 years away. The ladder is intact as shown below:
This process of diversifying by maturity and reinvesting will continue year after year as long you don’t change your investment goals.
Advantages of Bond Laddering
Bond laddering offers many advantages for bond investors:
- Bond laddering strategy can offer higher average yields because generally, the bonds with higher maturity offer higher yields. Since the strategy helps you invest in both long-term and short-term bonds, you benefit from higher yields of long-term bonds and liquidity of short-term bonds.
- You can structure a bond ladder as per your financial situation. This is particularly useful if you depend on the income from your investment.
- Your investment is also protected to some extent from changes in interest rates and you tend to receive a more consistent yield on your investment.
- Bond laddering can reduce reinvestment risk.
- It adds diversification to your portfolio as you invest in bonds with different maturities and with different issuers having different ratings.
- It also provides you liquidity as you have investments maturing at regular intervals.
Disadvantages of Bond Laddering
Bond laddering also has some disadvantages:
- Since you hold the bonds up to maturity, you may be deprived of any capital gains if the interest rates fall.
- In a bond ladder, you may end up reinvesting your money at lower interest rates.
- For ladders, you must only invest in high-quality bonds to avoid default risk.
- Since you always plan to hold the bond until maturity, it can leave you unprepared for emergencies and you may have to sell bonds at a loss even if the interest rates are rising.
- If you work with a broker to set up a bond ladder, the laddering may become expensive due to commissions, i.e., the transaction cost of purchasing multiple bonds compared to one large bond.
Overall, bond laddering can be a great strategy and can help you boost your returns but requires consistent monitoring and effort to keep the ladder going.