A bond ladder is an investment strategy used to diversify a portfolio of fixed income securities by purchasing bonds with staggered maturities.
How does a bond ladder work?
Suppose on January 1, 2019, you purchase five bonds with the following maturity dates. The average maturity of this portfolio is three years, and the average yield will be comparable to the three-year yield on January 1, 2019.
By replacing the matured bond with a new five-year bond, the ladder remains intact and you can continue to expect an annual principal payoff. Eventually, the ladder will contain only five-year bonds, thus increasing your average yield while maintaining the average maturity.
Why use a bond ladder?
One of the most important benefits of a bond ladder is that it delivers predictable returns (assuming no defaults occur). Because bonds pay interest and principal according to a predetermined schedule, you can calculate exactly how much money you can expect to receive during the life of the ladder.
Suppose all of the above bonds pay coupons on January 1 and July 1. You can easily calculate your income on those two dates by adding up all of your expected cash flows for each bond. Likewise, you know exactly how much money you should receive in principal payments each time a bond matures.
This predictability is quite different from the behavior of a bond fund, which is inherently uncertain. The dividend payments float as the bonds in the fund change, and the value of the share price changes daily.
Another key benefit of bond ladders is that they are a great way to manage the two major risks facing fixed income investors.
- Interest rate risk
When you buy an individual bond and hold it to maturity, the coupon payment you receive is constant during the life of the bond. Naturally, this is beneficial when rates are stable or falling but problematic when rates are increasing.
With a bond ladder, you can control the amount of exposure you have to changing rates. If you think rates are likely to rise, you can create a short-term ladder with frequent maturity dates. Conversely, if you think rates are near a peak, you can build a long-term ladder with infrequent maturity dates. If you don’t have a strong opinion, you can compromise by creating a medium-term ladder.
The above example demonstrates how a short-term (five-year) ladder with annual maturity allows you to take advantage of expected rate increases. Since a rung of this hypothetical ladder will mature each year for the next five years, you will receive principal to reinvest annually. As rates begin to increase, you will be in an excellent position to purchase new bonds with higher coupons (and longer maturities, depending on your investment horizon). If rates stay low, you can simply purchase another five-year bond and wait until next year.
- Credit risk
Buying individual bonds exposes investors to credit risk, the possibility that a bond issuer will default on their debt (i.e., that they won’t pay back the lender).
Bond ladders help reduce the impact of defaults because they increase your portfolio's diversification. Rather than buying a single bond with 100% of your capital, a ladder distributes your investment across multiple bonds (as shown above).
Let’s go back to January 9, 2019. You have $5,000 to invest, and you want to keep the average maturity of your investment to no more than three years.
Your first alternative could be to buy five bonds, each maturing in three years. If the yield for three-year bonds at that time was 3%, then you would expect to receive interest payments totaling $450 over three years and a lump sum principal payment of $5,000 at the end of three years: