Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Bond Ladder

What it is:

A bond ladder is an investing strategy whereby the investor staggers the maturity of ("ladders") the bonds in his portfolio so that the bond proceeds can be reinvested at regular intervals.

How it works (Example):

For example, say you have $75,000 to invest. To create a laddered portfolio, you could invest $25,000 in a one-year bond at 6%, $25,000 in a two-year bond at 6.25%, and $25,000 in a three-year bond at 6.50%. Each year is considered a "rung" on the ladder.

In this example, as each bond matures, you would reinvest the proceeds into another three-year bond. When the one-year bond matures, you would reinvest the proceeds in a three-year bond. At the end of the second year, you would put the proceeds from the matured two-year bond into a three-year bond, and so on. Here is how the bond ladder, using sample data, looks visually:

 

Let's look at the difference between simply rolling a $75,000 one-year bond over every year and using the laddering method.

Because the laddered portfolio was able to take advantage of the higher yields offered by longer-term bonds, the laddered portfolio earns 4.49% more income ($19,999 vs. $20,898) during a four-year period even though much of the investor's capital was never more than one year from maturity.

Why it Matters:

There are several advantages to bond ladders, and bond-fund investors should take care to read their fund prospectuses as many fund managers use this strategy. The first advantage is that it can minimize the investor's exposure to interest-rate fluctuations because the investor is able to reinvest a portion of his or her capital each year at market rates. Second, the diversification inherent in laddering can help stabilize the investor's income stream. Third, bond ladders give the investor constant liquidity because a portion of the portfolio is never more than a year away from maturity. It enables the investor to enjoy liquidity while taking advantage of the higher yields offered by longer-term bonds. Fourth, the diversification mitigates some of the investor's call risk, minimizing the chance that the entire portfolio would be called away (the issuer would force a buy-back).

There are some drawbacks to bond ladders, however. First, the transaction costs of purchasing several bonds may be higher than purchasing one large bond. Second, the constant maturing does present some reinvestment risk to the investor in a falling interest rate environment.