Understanding a Bond Ladder Invest Strategy

Written by: John Landers

A bond ladder refers to an investment strategy that creates a mixed portfolio of bonds. Each security has an appreciably different maturity date from other securities in the portfolio.  The maturity date of each bond represents a rung on the ladder. The higher up the ladder, the further out the maturity date.

Buying a number of smaller bonds with various maturity dates, as compared to purchasing a single fixed-income security with one maturity date, enable investors to minimize the interest-rate risk and have more security.

How the Strategy Works

The bond ladder portfolio includes Treasury notes and bonds. It can also have high-quality municipal bonds and AAA corporate bonds. Investors should choose bonds that are actively traded and plan to hold each security until its maturity date and collect the interest payments. When a bond matures, many investors reinvest the principal and add rungs, which extend the ladder.

People who need liquidity should place the maturity dates of the instruments close together. Richard Carter, vice president of fixed-income securities in Fidelity’s brokerage division, recommends bond ladders as an excellent strategy for investors interested in “creating a predictable income stream.”

A bond ladder with five securities/maturities can have five rungs with maturity dates of two, four, six, eight, and 10 years. Every two years, the investor has to make a decision whether to reinvest the principal or continue the ladder open-ended.

Barbell Strategy

An investor who has concerns about the bond ladder strategy may be more comfortable with a variation of the approach called the “barbell strategy”. This strategy entails investing in both short-term and long-term securities—eliminating intermediate maturity dates. An investor selects long-term instruments with high interest rates. The short-term bonds have the near term maturity dates that provides flexibility in the strategy to divest from the bond market.

Investors in an environment of rising coupons can reinvest the principal to take advantage of the higher interest rates.  During a period of falling interest rates, the long-term holdings continue to earn a higher rate of interest.

Pros

  •  Compared to buying single bonds, the bond ladder provides protection against inflation. During inflationary times, and rising interest rates, the strategy provides investors to have regular increments of cash, as bonds mature, to reinvest in securities at higher interest rates. Historically, the inflation risk presents one of the greatest perils for investors because of the erosion of  income received from bond payouts.
  • The bond ladder can provide higher interest rates during the current environment when the monetary policies have place downward pressure on interest rates. Conversely, experts recommend shortening the ladder because of the record-low interest rate environment. Investors always have the option to extend rungs in the ladder as interest rates increase.

Cons

  •  One of the short-comings of a bond ladder is that its effectiveness depends on the discipline of the investor to commit to a buy-and-hold strategy. To receive a predictable cash flow and manage various risks—credit and interest rate— investors must keep the instruments until maturity. Prematurely sell a bond to cover an emergency or other expense may expose an investor to other risks.
  • There is always a possibility of a bond being “called” before its maturity date by the issuer. This will end interest payments. The investor receives the principal back, but may have to accept a lower interest rate when reinvesting the money.

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Understanding a Bond Ladder Invest Strategy

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