What is Laddering?
How Does Laddering Work?
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.
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, using sample data, looks visually:
Why Does Laddering Matter?
There are several advantages to laddering, and bond-fund investors should take care to read their funds' prospectuses as many fund managers use this strategy. The first advantage of laddering is that it can allow investors to gain from increases in interest rates since 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, laddering gives 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.
There are some drawbacks to laddering, 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.