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December 02, 2022 at 01:44 PM
What You Need to Know
- A bond ladder entails buying several bonds that mature at different points in time.
- A bond ladder is a good strategy to help mitigate interest rate risk.
- Bond ladders can be built with different types of bonds as well as some types of bond ETFs.
There are a number of ways that your clients can invest in bonds. These include bond mutual funds and ETFs, as well as individual bonds. A bond ladder using individual bonds can be a way to help build predictable income and reduce bond risk with all or a portion of your client’s fixed income portfolio allocation.
What Is a Bond Ladder Strategy?
A bond ladder entails buying several bonds that mature at various points in time, typically regular intervals. For example, your client might have a series of bonds that mature every six months over a three- or five-year period. They might have bonds that mature every year or every two years over a five- or 10-year period. The interval of bond maturities as well as the length of the overall period the ladder covers can vary based on your client’s needs and preferences.
Beyond just bonds, a ladder of CDs can also be created. It would work in the same way as a bond ladder, with a series of CDs that mature at predetermined intervals.
How Does a Bond Ladder Work?
Here is an example of how a bond ladder might work for your client. The ladder might consist of a series of five high-quality corporate bonds each maturing two years apart.
| Time to maturity | Par value | Coupon rate | Annual income | |
|---|---|---|---|---|
| Bond 1 | 2 years | $20,000 | 2.5% | $500 |
| Bond 2 | 4 years | $20,000 | 3.0% | $600 |
| Bond 3 | 6 years | $20,000 | 3.25% | $650 |
| Bond 4 | 8 years | $20,000 | 3.5% | $700 |
| Bond 5 | 10 years | $20,000 | 4.0% | $800 |
The annual income from the initial ladder is $3,250 or 3.25% on an investment of $100,000, assuming all of the bonds were purchased at their par value.
Once Bond 1 matures in two years, your client would replace it with a bond maturing in 10 years if they wanted to maintain the same ladder. The new ladder might look like this:
| Time to maturity | Par value | Coupon rate | Annual income | |
|---|---|---|---|---|
| Bond 2 | 2 years | $20,000 | 3.0% | $600 |
| Bond 3 | 4 years | $20,000 | 3.25% | $650 |
| Bond 4 | 6 years | $20,000 | 3.5% | $700 |
| Bond 5 | 8 years | $20,000 | 4.0% | $800 |
| Bond 1A | 10 years | $20,000 | 4.25% | $850 |
In this case, with the addition of the new 10-year bond (Bond 1A), the ladder’s annual income would be $3,600 with an annual yield of 3.6%.
An investor can have more than one bond ladder. For example they might have a ladder of Treasury maturing at intervals over a five-year period and a ladder of investment-grade corporates maturing over an eight-year period.
A bond ladder can be used as part of your client’s allocation to bonds. They might also hold bond mutual funds or ETFs focusing on certain types of bonds and bond durations.
What Are the Benefits of a Bond Ladder?
The main benefits of a bond ladder include the ability to manage interest rate risk and to manage cash flow.
Interest rate risk is a factor both when interest rates rise and when they fall. When interest rates rise, the value of the various bonds in the ladder will decrease. By holding the bonds until maturity, your client will receive the par value of the bond upon redemption instead of a lower value should they sell it when the price is depressed prior to maturity.
During a period of falling interest rates, the rates on new bonds that may be purchased at the long end of the ladder to replace maturing bonds will be lower than they had been. The higher rates on the remaining bonds in the ladder help to maintain a higher overall yield on the total ladder.
A bond ladder can also help your clients structure a predictable cash flow stream. Individual bonds generally make interest payments twice per year. By looking at the months that various bonds distribute their interest, your client can spread the payments out over various months during the year, helping to ensure a regular stream of income.
When Do Bond Ladders Make Sense for Investors?
A properly constructed bond ladder can provide interest income at regular intervals that clients can depend on. This income is generated while the bond ladder helps minimize interest rate risk by holding the underlying bonds until maturity.
A bond ladder makes sense in situations where your client has the liquidity outside of the bond ladder to keep the ladder in place without having to sell off some of the rungs on the bond ladder early. This can expose them to depressed prices for the bonds in a period of rising interest rates such as the one we are currently experiencing.
A laddered bond portfolio can make sense for retirement as an example. A retired client might benefit from the regular income, you can then work with them to strategize on the reinvestment or redeployment of funds as rungs on the ladder mature.
How Much Income Can You Generate From a Bond Ladder?
The amount of income that can be generated from a bond ladder will depend on two main factors:
- The total amount invested in the bond ladder
- The coupon rates of the bonds in the ladder
The annual income is a function of these factors. For example, if the total par value of the bonds in the ladder is $200,000 with an average interest rate of 3.0%, then the annual income from the bond ladder would be $6,000.
This may change over time if the total value of the bonds in the ladder changes and also based on the current interest rates for new bonds added to the long end of the ladder as some bonds mature.
Are There Pitfalls or Downsides to Using a Bond Laddering Strategy?
While a bond ladder can be a solid strategy for all or a portion of a client’s fixed income allocation, there can still be some risks to using a bond ladder.
