Bond Ladder Strategy 101 - Constructing the Bond Ladder
By Bill Addiss | Updated: Aug 5, 2019
Traditionally, bonds have been a haven for an investor’s “safe” assets. Even the most aggressive trader would recognize the need for bonds in their personal asset mix, whether it be for retirement planning in growth accounts (like a 401k or IRA), or for personal income.
Yet bonds remain a mystery to many investors. For institutional as well as retail investors, one of the most common and easily adopted strategies is called a bond ladder. Once understood, this income generating strategy can be implemented by the individual investor without needing to pay any management or advisory fees.
What is Bond Laddering?
A bond ladder is simply a portfolio of individual bonds which when bundled together in a portfolio offer a variety of benefits. Most importantly, this bond portfolio will be constructed of bonds with different and increasing maturities, thereby creating a ladder of increasing maturity bonds.
This is a “passive” strategy, meaning once the ladder has been constructed and the appropriate bonds purchased, it requires very little ongoing maintenance. Since this portfolio of bonds can be constructed by the individual investor, there would be no ongoing management fees or brokerage charges.
How to Build a Bond Ladder
Rather than just investing in one block of bonds to generate income, this strategy involves buying a series of bonds with varying and sequential maturities. In other words, rather than just investing in bonds with a 10 year maturity, the investor would instead buy a series of bonds with staggering maturities up to 10 years. For example, one could invest 20% in bonds maturing every 2 years for the next 10 years.
Bond Ladder Example – Initial 10 Year Setup
The Benefits of Investing with Bond Ladder Strategies:
Constant stream of income: A bond ladder could give the investor a constant stream of income which can be reinvested at prevailing rates upon maturity of the bond, (referred to as “reinvestment risk”). So, should interest rates rise, the investor has the opportunity to reinvest their coupon/income at the increased rate. However, should rates fall, the investor has “locked-in” some of their income at the higher rate.
Regular principal payments to reinvest: When the bond matures, the investor receives the $1000 par value of the bond, (assuming the issuer has not defaulted) to reinvest back into a longer maturity bond. By creating this ladder of sequential maturities, the investor is able to reinvest their principal back into bonds with longer maturities, continuing to create this portfolio of “rolling” investments. This is called “rollover risk” in the world of bond investing.
Balancing Risk & Reward with Bond Laddering
A bond basically represents a loan to the issuer of that bond in denominations of $1000 (called the par or face value). When the bond matures, the investor receives back the par value they had lent to the issuer. The more speculative the borrower is, the greater the rate of interest they have to pay to borrow money, hence the higher the coupon of the bond. Investors can adjust the rate of return on their bond ladder based on the creditworthiness of the bond they invest in and the credit risk they are willing to take. Here are some generalities:
|T’Bills, T’Notes, T’Bonds
||These instruments are backed by the full faith and credit of the US Government. They are considered to be some of the most secure, low risk investments in the world. However, in return for this safety they offer the lowest returns.
|Certificates of Deposit (CDs)
||Although not technically bonds, CDs are loans to banks. Traditionally, banks offer these instruments with maturities as short as 1 month to as long as 10 years, making them very applicable for the bond ladder strategy. These instruments are backed by a US Agency, The FDIC, up to a specified dollar limit, so they too are considered safe and secure, but traditionally yielding only slightly more than Treasury securities.
||A wide variety of corporations issue bonds to borrow money from investors. Based on their rating assigned from a credit agency such as Moody’s S&P or Fitch’s, corporate bonds are divided into two main categories: High Grade (also called Investment Grade) and High Yield (also called Non-Investment Grade, or “Junk” Bonds). The lower the credit quality of the issuer, the higher the interest they will offer to pay the investor to borrow the money, therefore the greater the interest to the bond buyer.
||States, Cities, Municipal Entities
||Like corporations and governments, municipalities often need to borrow money and will therefore issue bonds. Once again, the bond buyer is lending money to the issuer and taking on the credit risk of that municipality. Rating agencies rate municipal bonds like they do corporate bonds, and the more risk the investor is willing to take, (i.e. the lower the rating), the more income they earn. Municipal bonds also have tax advantages to many investors and traditionally are not used in bond ladders constructed in a tax deferred account like an IRA or a 401K account.
The bond ladder strategy described here is not intended to “hit a home run”. Quite the contrary, it is intended to provide consistent, reliable income in a variety of interest rate scenarios, either rising or declining rates. It is intended to immunize investors from the risk of interest rate changes. Just as importantly, it is a strategy that can be easily implemented by the investor seeking to avoid management or advisory fees.
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