Bond laddering is a fixed income investment strategy that allows investors to decrease their exposure to interest rate risk over the long term.
Investors and fund managers usually employ the bond laddering strategy to spread out their risk when interest rates fluctuate, or simply as a defensive measure in case some of their selected bonds present a higher risk of defaulting.
Some investors also favour the bond laddering strategy because it retains the liquidity they tend to lock away when investing in long-term bonds.
The steady progression of maturing bonds during the portfolio’s time horizon allows investors to reinvest or spend the income they regularly receive from the bonds.
How bond ladders work
Unlike the bond barbell strategy, which forces a bond portfolio to be heavily weighed on both sides by investing only in short and long-term bonds, bond ladders ensure that the investor will earn income throughout the portfolio’s life.
For example, Phil sets aside $50,000 to build his 20-year bond portfolio. Phil can either buy $50,000 worth of 20-year bonds or employ the bond laddering strategy by purchasing a variety of bonds with different maturities.
If Phil uses the bond laddering strategy, he could divide his principal investment into five equal portions to invest in five different bonds. When the first bond matures, Phil could keep his earnings or reinvest it either in the next maturing bond or in a new bond with a different maturity. He can continue this process until his 20-year time horizon is up and his last bond matures.
The table below illustrates Phil’s portfolio, according to these three assumptions:
- Phil purchases bonds with annual payouts and holds them to maturity;
- Bond maturities are spread out over one, three, five, 10 and 20 years; and
- He redeems coupon payments instead of reinvesting them.
| Principal = $10,000 | 1-year bond | 3-year bond | 5-year bond | 10-year bond | 20-year bond |
| Coupon rate | 2% | 3% | 4% | 5% | 6% |
| Annual coupon payment | $200 | $300 | $400 | $500 | $600 |
| Investment value upon maturity |
$10,200 |
$10,900 |
$12,000 |
$15,000 |
$22,000 |
From coupon payments alone, the laddering strategy would give Phil an income of $20,100 over a period of 20 years from his five different bonds. If Phil simply invested the full $50,000 in the 20-year bond, he would have earned only $12,000 ($600 x 20) when the bond matures after 20 years – an $8,100 difference!
Bond laddering isn’t for everyone
As shown above, the bond laddering strategy seems more beneficial than simply holding a long-term bond to maturity. However, interest rate movements can make the situation complicated.
Ladders could also end in a loss or smaller income for any investor, especially those who aren’t well versed in the investment market. Hiring a professional to manage the bond ladder, on the other hand, triggers management fees that could make their gains smaller or negligible.
It’s best that investors speak to a licensed professional before applying any investment strategy to ensure that the strategy matches their objectives and risk appetite. Likewise, searching for alternative strategies for fixed income investments is also recommended.
Note: The figures in the examples above are for illustration purposes only and does not consider fees and taxes that may apply when investing in bonds.
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