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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 interest rate and liquidity risk, many investors will employ a laddered bond strategy. By spreading their bond purchases across different maturity lengths, investors can provide themselves with short-term liquidity to help manage cash flow and also protect against fluctuations in interest rates.
» Learn more: Bonds vs. CDs
How do bond ladders counter risk?
Let’s say you purchase a $10,000 bond with 10 years to maturity and coupon rate of 3%. Each year, the bond issuer will pay you $300 (3% of the $10,000 face value = $300). When the bond matures in 10 years, the bond issuer will return your original $10,000 investment.
In this example, the bondholder is exposed to two types of risk:
Interest-rate risk. 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 up from 3% to 5% while you are holding the bond, you’d be stuck earning the lower interest rate of 3% until the bond matures.
Liquidity risk. You could try to sell this bond to another investor on the secondary market, but other investors won’t be willing to pay $10,000 to get 3% when they could purchase a new bond and get the higher 5% interest rate. Therefore, you’d probably have to sell your bond at a discounted price, so it’s not very likely that you’d be able to get your principal investment of $10,000 back unless you wait until the bond matures.
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Building a laddered bond strategy
To build a laddered bond portfolio that counters these risks, you’ll need to first determine the length of time you’d like to invest and how frequently you want access to cash (monthly, annually, etc.). Then, you’ll 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, you can either take the cash or “re-ladder” and purchase a new long-term bond.
Let’s say you had $50,000 to invest in a laddered bond strategy over a period of five years, and you wanted access to cash each year. Instead of buying one five-year bond for $50,000, you could spread your portfolio and purchase five $10,000 bonds that mature at increasing one-year intervals. Take a look at the example below:
Bond laddering example
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.
Bond ladders and interest rates
The previous example raises the question: In year one, if you can get 3% for a five-year bond, and only 2% for a one-year bond, why not just put all $50,000 into a five-year bond to get more interest? This goes back to 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 on the secondary market. Depending on interest rate movements, selling the bond could result in a loss on your investment. Here, by laddering the bonds, the investor 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
Credit risks in a bond ladder
Any bond purchase involves some level of risk. One of the key risk factors for bond investors is credit risk. 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 can meet its debt obligations to bondholders.
The highest rating these agencies offer is AAA, or “triple-A.” After that, the ratings can run all the way down to D, which indicates that an institution is at high risk of defaulting on its payments to bondholders. In between these two ends of the spectrum, bond ratings are broken down into two categories: investment grade and noninvestment grade. Investment-grade bonds are generally in good financial standing with a low risk of default, whereas noninvestment-grade bonds carry more risk. Due to the higher risk involved, noninvestment-grade bonds generally offer higher interest rates to compensate for the additional risk to investors.
When it comes to building a bond ladder, investment-grade bonds generally make for better materials. If you use high-risk bonds and one of them defaults, you’d be missing a rung of your ladder, and that throws a wrench into your fixed-income strategy.
If you're considering a laddered bond strategy, consult with a financial advisor to ensure you're making educated decisions about your portfolio.
» MORE: How to buy bonds