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Education

Bonds 103: Understanding the Potential Benefits of Bond Ladders

Like any investment, bonds come with risks, including (but not limited to) interest rate risk and reinvestment risk. When investing in bonds, some investors like to use an investment strategy known as ‘laddering’ to help reduce their exposure to those risks.

What you will learn

  • Bond ladder strategies
  • Potential benefits of a laddered approach

What is a bond ladder and how does it work?

Investors who like the return characteristics of bonds may decide they want to buy bonds and simply hold them until they mature. While this strategy sounds straightforward, it can create challenges for investors as their bonds mature.

If a large number of the bonds mature at around the same time and the investor wants to reinvest them in new bonds, she will be reinvesting them into bonds offering similar yields. If interest rates have dropped since she last invested, she will be reinvesting her money into lower rates of return.

One popular strategy that investors can use for managing this problem is called a bond ladder.

A ladder is a portfolio of bonds that mature at regular intervals (often every year or every other year) across a chosen maturity range. As a bond matures, the principal is typically reinvested in the rung of the ladder that has the longest maturity (usually offering the highest yields). Similarly, coupon payments can be reinvested in the same way.

Climbing the Bond Ladder
The diagram shows the concept of a bond ladder, where a portfolio has various tenured bonds that mature at one-year intervals over a five-year period. To illustrate the concept, five columns show stacks of six boxes, with each box representing maturities one year apart. At the top of the column, a box is labeled “six-year,” with the five boxes below it labeled with shorter durations: five, four, three, two and one year. This first ladder of bonds on the left represents Year 1 of a five-year plan, where at the end of the year the maturing one-year bond is reinvested into a six-year bond for Year-two. An arrow points from the bottom box of the first column, to the top box of second column, representing the six-year bond. For each year, arrows point from the bottom of the column to the top of the column for the next year, representing reinvestment of the maturing bond into a six-year bond. Different shades of blue are used to show how each year the bonds lose a year of maturity, where a six-year bond becomes the five-year bond in the next year, and a five-year bond becomes a four-year bond, and so on.

In a laddered portfolio, maturing short-term bonds are reinvested in bonds at the ladder’s long end, which typically offers higher yields. That can be an advantage in a rising interest rate environment.

What are the potential benefits of bond ladders?

By investing and reinvesting in a range of bonds with different maturities, bond ladders seek to generate more predictable income streams for investors. Additionally, bond ladders reduce the risk of having to reinvest a significant portion of a bond portfolio into lower yielding bonds.

One of the other benefits of bond ladders is that they reduce the need to perfectly “time” investments to benefit from changing interest rates. The longer rungs of the ladder bring the average yield potential of the portfolio higher, while the shorter maturing bonds provide opportunities to capture higher yields if and when interest rates go up.

This is because the longer rungs of the ladder bring the average yield of the portfolio higher, while the shorter maturing bonds provide opportunities to capture higher yields if and when interest rates go up.

Bond ladders are particularly advantageous in rising rate environments. This may seem counter-intuitive given that bond prices fall when interest rates rise. However, the periodically maturing proceeds from a bond ladder portfolio can be reinvested in potentially higher rates.

Are bond ladder strategies always passive?

Traditionally, bond ladders were considered a passive buy-and-hold strategy. However, actively managed ladders are also available to investors.

For active strategies, managers will overlay their investment research, active management approach and outlook on rates to direct the portfolio strategy.

For example, the manager may skip rungs on the ladder offering very low yields in favor of higher yielding maturities.

Glossary of Key Investment Terms

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