Rick Welch: Dollars and $ense
What is a bond ladder?
A bond ladder is a strategy for balancing risk and return within the fixed income portion of your investment or retirement portfolio. The concept of laddering involves constructing a portfolio of bonds with staggered maturities so that a portion of the portfolio matures each year or number of years. The interval chosen (say 2 years) becomes the spacing between the rungs of the ladder and serves as a selection criteria for the bonds to be purchased for the portfolio. Spacing between rungs should be generally equal. The number of rungs in the ladder should be at least 5 and not more than 10. The longer the ladder, the higher the income and associated interest-rate risk or bond duration, which is defined as the sensitivity of a bond’s price to changes in interest rates. Shortening the spacing between rungs generally reduces income and interest-rate risk and provides a greater ability to reinvest principal from maturing bonds should interest rates rise. Over time, a laddered bond portfolio will include bonds purchased in periods of both high and low interest rates.
Ladders can be built with several different types of bonds or certificates of deposit, but, most investors choose between US Treasuries (for safety), investment-grade US Corporate bonds (for higher yields) or the tax advantages offered by municipal bonds. A bond ladder helps smooth out the effect of fluctuations in interest rates because there are bonds maturing at regular intervals. When a bond matures, you can reinvest the principal in a new longer-term bond at the end of the ladder to capture higher rates. As you build a bond ladder, keep in mind any particular cash flow needs you may have and structure the expected receipt of bond coupon payments accordingly. The cash flow or income stream of a bond ladder will stay relatively constant as only a small portion of the portfolio will mature and be replaced each year. The consistent returns offered by a bond ladder give investors the advantage of knowing that any time is a good time to build or buy into a laddered bond portfolio.
The question you should now be asking is how do bond ladders work in different type of interest rate (rising or falling) environments? With rising rates, bond values will initially drop, but will recover as they move toward maturity at par. Short-term bonds provide liquidity and ready cash to reinvest in new, higher-yielding bonds. As proceeds from maturing bonds are reinvested in higher-yielding bonds at the far end of the ladder, the portfolio’s yield gradually increases. This increase in yield and accompanying rising income stream will compensate the investor for some of the lost value that occurred throughout the ladder as interest rates rose. When rates fall, the portfolio’s return rises as bond prices climb. Ultimately, as short-term bonds mature and proceeds are reinvested in lower-yielding longer-term bonds, the portfolio’s return and income stream will decrease. Over long periods of time, a bond ladder may perform better than other popular bond investment or duration management strategies like the barbell or bullet strategies. With the barbell strategy (picture a barbell with weights on each end), only short-term (1-3 years) and longer dated (8-12 years) bonds are purchased. The bullet strategy involves the purchase of only intermediate term bonds (6-8 years).