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Bond laddering is a bond investment strategy where you purchase bonds with different maturity dates to have predictable income in the future. As each bond matures, you can reinvest it as the next "rung" on your bond ladder to create a chain of investments.
The goal of bond laddering is to reduce investment risk by spreading it across bonds that mature at a variety of times. This way you can know when to expect an almost-guaranteed payment as each bond matures.
How Bond Laddering Works
A bond is a type of investment where you essentially lend money to a company or government agency with the understanding that you will be repaid at a later date (with interest) when the bond matures. Bonds tend to be lower-risk investments that can help balance out a portfolio against high-risk investments, such as stocks.
But bonds can tie money up for a long time and cause investors to miss out on gains if they have distant maturity dates. That's why savvy investors may turn to bond laddering, where they build a progressive ladder of bonds with different maturity dates to have a constant stream of income.
To illustrate how bond laddering works, let's say an investor purchases five bonds:
| Bond Ladder at Time of Creation | ||
|---|---|---|
| Bond Term | Time to Maturity | |
| Bond A | Two years | Two years |
| Bond B | Four years | Four years |
| Bond C | Six years | Six years |
| Bond D | Eight years | Eight years |
| Bond E | 10 years | 10 Years |
When Bond A matures after two years, the investor uses the money and profits to purchase another 10-year bond (Bond F), transforming the ladder to:
| Bond Ladder After Two Years | ||
|---|---|---|
| Bond Term | Time to Maturity | |
| Bond A | Two years | Matured and reinvested |
| Bond B | Four years | Two years |
| Bond C | Six years | Four years |
| Bond D | Eight years | Six years |
| Bond E | 10 years | Eight Years |
| Bond F (New) | 10 years | 10 years |
The more rungs you have, the more dates of maturity your bond ladder permits. This means you may have more options over time to invest at better and better rates as the bonds in your portfolio mature.
Bond ladders may protect you when interest rates change soon after a purchase. If interest rates rise soon after you purchase several 10-year bonds, for instance, you may lose out if the bond's rate doesn't outpace inflation. However, if you purchase a bond that will mature in two years, you can reinvest those funds at the higher interest rates sooner.
Of course, the inverse is true. If rates fall by the time your short-term bond matures, you may have to buy the next "rung" of your ladder at a lower rate.
Pros and Cons of Bond Laddering
As an investment, strategy bond laddering has both pros and cons. Its appeal to the individual investor often depends on their financial situation. Bond ladder investors are typically looking for a conservative investment that provides consistent income.
Pros
- Laddering protects you from fluctuations in interest rates. When interest rates rise, you have the opportunity to buy again at a more favorable rate. With long-term maturity bonds, you would be stuck earning a lower interest rate until the date of maturity, which is potentially years in the future.
- Investments provide more liquidity. Short-term bonds make premiums available sooner, meaning investors have access to their cash regularly if needed.
Cons
- It may require a high startup cost. Bond investors pay a bond's face value when buying it. That means a $5,000 bond you expect to provide returns over time will cost $5,000 upfront.
- If interest rates fall, you may lose out. When rates fall, your next rung may have to be purchased at a lower rate.
How to Build a Bond Ladder
You can build a bond ladder yourself or work with an investment professional to take the following steps:
1. Start With a Set Number of Rungs
The number of rungs on your bond ladder may be dictated by how many bonds you can afford to purchase all at once.
2. Use Noncallable Bonds With High Grades
The bonds you choose should not be callable. Callable bonds may be "called" before their projected maturity date, meaning you get your initial investment back but lose out on the interest associated with the longevity of the maturation period.
The grade of a bond can also affect its risk. When building a conservative bond ladder investment, stick to high-quality bonds, such as those with AAA ratings. These may have lower yields but are less risky. The three main companies that rate the creditworthiness of bonds are Moody's, Standard & Poor's and Fitch.
3. Purchase Bonds of Varying Maturities
Your bonds should have varying maturities, such as staggered one- to two-year intervals between maturity dates. Plot them out at the rate at which you need to receive income.
The Bottom Line
Bond laddering is a strategic, conservative investment, but you still should be sure you can manage your other expenses before investing. You know it's probably the right time to start investing when your monthly expenses are easily covered, your debt is paid off and you have built up an emergency fund and retirement savings.
Only start bond laddering when you can afford to tie up cash for the length of time it takes for the bonds to mature. Once you reach this point, bonds can be a great way to make a steady, reliable income, particularly in retirement.