What it is:
How it works/Example:
For example, say you have $75,000 to invest. To incorporate bond laddering into your portfolio, you could invest $25,000 in a one-year bond at 6.25% and $25,000 in a three-year bond at 6.50%. The "rungs" on the ladder correspond to each year.
Now, 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 strategy looks using our example:
Why it matters:
There are many advantages to bond laddering. Bond-fund investors should read their funds' prospectuses, because many fund managers use the strategy. The first advantage of bond laddering is that it allows investors to gain from interest rate increases since the investor is able to reinvest some of his or her capital each year at market rates. Second, the inherent diversification in bond laddering can help an investor create a steady income stream. Third, laddering gives the investor regular liquidity because a portion of the portfolio is never more than a year away from maturity. Bond laddering enables investors to have liquidity while, at the same time, taking advantage of the higher yields offered by longer-term bonds. Fourth, the diversification also suppresses some of the investor's call risk, reducing the chance that the entire portfolio would be called away.
However, there are some drawbacks to bond laddering. First, the transaction costs of purchasing several bonds are often higher than purchasing one large bond. Second, the constant maturing does present some reinvestment risk to the investor if interest rates are falling.