The content has been provided by a third party not affiliated with E*TRADE. The material is for educational purposes only.
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, 2009 you purchase 5 bonds with the following maturity dates. The average maturity of this portfolio is 3 years and the average yield will be comparable to the 3 year yield on January 1, 2009.
On January 1, 2010 you will receive a lump sum principal payment for the first maturing bond. In order to maintain a 5-year ladder you need to use the proceeds to buy a new 5-year bond.
By replacing the matured bond with a new 5-year bond the ladder remains intact and you can continue to expect an annual principal payoff. Eventually the ladder will contain only 5-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 caluclate exactly how much money you expect to receive during the life of the ladder. Suppose that 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 than 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 (5-year) ladder with annual maturity allows you to take advantage of expected rate increases. 2009 interest rates are near historic lows. Since 20% of this hypothetical ladder will mature each year for the next 5-years, you will have a substantial amount of money to reinvest each year. 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 5-year bond and wait till 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, 2009. You have $5,000 to invest and you want to keep the average maturity of your investment to no more than 3 years.
Your first alternative could be to buy 5 bonds each maturing in 3 years. If the yield for 3 year bonds at that time was 2.0% then you would expect to receive interest payments totaling $300 over 3 years and a lump sum principal payment of $5,000 at the end of 3 years:
Another alternative might be to build a bond ladder with an average maturity of 3 years by purchasing 5 bonds, staggering maturities of each by one year so that the first bond matures on 1/1/2010 and the last on 1/1/2014. If the yield for each bond changed by 0.5% for each year, then you would expect to receive interest payments totaling $350 over 5 years and a lump sum principal payment of $1,000 at the end of each year:
If, however, you do not need the principal payments, you could re-invest the principal each year in a new 5-year bond yielding 3.0%. By the 5th your ladder would have 5 bonds each yielding 3.0%. You would still receive a lump sum principal payment of $1,000 at the end of each year, and your portfolio would still have an average maturity of 3 years, but now you would expect to receive interest payments totaling $650 over the 5 years.
As illustrated above, bond ladders work best when the yield on the bonds to be bought in the future years is higher than the current yield.
1 “The text of this strategy note, with the exception of the “Example” and the “Summary”, was created by Tradeweb Markets LLC and has been reprinted here with Tradeweb Direct's permission. Copyright © 2016 Tradeweb Markets LLC. All Rights Reserved.”
Copyright © 2018 Tradeweb Markets LLC. All Rights Reserved.