What is a bond ladder?
A bond ladder is an investing strategy in which the investor buys multiple bonds with different maturity dates in order to create a diversified source of fixed income that mitigates interest rate risk and liquidity risk.
When investors purchase a bond, they are effectively lending money to the issuer for a fixed length of time in exchange for annual interest payments at a rate determined at the beginning of the term. But over the course of three years, 10 years or especially longer, the interest rate environment and other factors can shift and negatively affect a bond's value.
To offset some of these risks, many investors use bond ladders. By spreading their bond purchases across different maturity lengths, investors can get short-term liquidity to help manage cash flow and protect against fluctuations in interest rates.
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How bond ladders work
Here are the basic steps to building a bond laddering strategy.
- Determine the length of time you’d like to invest and how frequently you want access to cash (monthly, annually, etc.).
- Select bonds that sequentially increase in their maturity date, with each bond considered a rung of the ladder.
- As bonds mature and you receive your principal back, either take the cash or use it to purchase a new long-term bond (“re-ladder”).
Bond laddering example
Let’s say you have $50,000 to invest over five years, and you want access to cash each year. Instead of buying one five-year bond for $50,000, you could diversify your portfolio by purchasing five $10,000 bonds that mature at one-year intervals. Take a look at the example below.
The investor purchased five bonds that each mature one year apart, beginning with Bond A, a one-year bond with a coupon rate of 1%. Generally speaking, coupon rates are higher for bonds with longer maturity dates, which is why Bond E — a five-year bond — has a coupon rate of 3.5%.
In year two, Bond A has matured and the principal investment of $10,000 has been returned to the investor. Meanwhile, interest rates for five-year bonds have gone up to 4%, so the investor decided to re-ladder and use the proceeds from Bond A to purchase Bond F with five years to maturity. Bond F becomes the new top rung of the ladder, and each year as the next bond matures the investor can either keep the proceeds or reinvest in a new five-year bond.
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Risks of a bond ladder
Two fundamental risks of a bond ladder are interest rate risk and liquidity risk.
Interest-rate risk is the risk that market interest rates will rise, causing the bond to become relatively less attractive to (and thus less valuable than)competing bonds that have a higher coupon rate. Bond prices and interest rates have an inverse relationship, meaning that when interest rates rise, bond prices fall. So if interest rates for 10-year bonds go from 3% to 5% while you are holding the bond, you may be stuck earning the relatively low interest rate of 3% until the bond matures.
Liquidity risk is the risk that you can’t sell your bond for a profit. For example, you could try to sell your bond to another investor, but other investors may not be willing to pay $10,000 to get 3% when they could purchase a new bond and get 5%. You may have to sell your bond at a discount, meaning you may not get your principal investment of $10,000 back unless you wait until the bond matures.
Institutions that issue bonds must undergo a review from a credit rating agency. The three major agencies are Standard & Poor’s, Moody’s and Fitch. These agencies take a close look at each institution’s financial standing and provide a rating based on how likely it is that the institution will meet its debt obligations to bondholders.
The highest rating these agencies offer is AAA, or “triple-A.” The lowest rating is D, which indicates that an institution is at high risk of defaulting on its payments to bondholders.
Between these two ends of the spectrum, bond ratings fall into two categories: investment grade and noninvestment grade.
- Investment-grade bonds are generally from issuers in good financial standing with a low risk of default.
- Noninvestment-grade bonds (also called high-yield bonds) are generally from issuers with a high risk of default. To attract investors, noninvestment-grade bonds generally offer higher interest rates to compensate for the additional risk.
Investment-grade bonds generally make for better bond ladders. If one of your bonds defaults, you’ll be missing a rung of your ladder, and that throws a wrench into your fixed-income strategy.
Investment-grade bond ratings | |||
Moody's | Standard & Poor's | Fitch | What the grade means |
Aaa. | AAA. | AAA. | Highest quality, minimal risk. |
Aa. | AA. | AA. | High quality, very low risk. |
A. | A. | A. | High/Medium quality, low credit risk. |
Baa. | BBB. | BBB. | Medium grade, moderate credit risk. |
Non-investment-grade bond ratings | |||
Moody's | Standard & Poor's | Fitch | What the grade means |
Ba. | BB. | BB. | Substantial credit risk. |
B. | B. | B. | High credit risk. |
Caa. | CCC. | CCC. | Low quality, very high credit risk. |
Ca. | CC. | CC. | In or near default, some prospect of recovery. |
C. | C. | C. | Moody's lowest rating, typically in default with little prospect of recovery. |
C. | D. | D. | In default, also used when bankruptcy has been filed. |
Bond ladders and interest rates
The previous example raises the question: In year one, if you can get 3% for a five-year bond but only 2% for a one-year bond, why not just put all $50,000 into a five-year bond to get more interest?
The answer is liquidity and interest rate risk. If you invest all $50,000 in a five-year bond, you’re tying up that money for five years (unless you sell the bond). Depending on interest rate movements, selling could result in a loss. By laddering the bonds, the investor in this example was able to take advantage of the higher interest rate of 4% over five years when they purchased Bond F.
On the flip side, say interest rates for five-year bonds had fallen to 1%. In this case, the investor might decide to keep the proceeds when Bond A matures or invest in something else that could yield a higher return.
» Interested in giving a bond as a gift? Read all about savings bonds
Bond laddering is complex
Bond laddering can be complicated, and it requires a firm grasp of the bond markets, as well as the risks involved. If you're considering a laddered bond strategy, be sure to consult with a financial advisor to ensure you're making educated decisions about your portfolio.
