Why use a ladder?
Bond laddering works by spreading investment dollars among bonds that will mature at various times between one and twenty years from now.
In a normal interest rate environment, shorter maturities will yield less than longer maturities. Think of individual bonds as rungs on your ladder. As each individual bond matures, your principal is made available for reinvestment as current interest rates.
The value of a ladder is the ability to reinvest the principal from the maturing bond into a new bond with a higher yield. The new bond will then become a new rung on your ladder.
An additional advantage of using the ladder strategy is having the ability to customize your ladder to suit your individual investment objectives, such as future funding needs or specefic income requirements. Investment selection will also take into account such things as your tax liabilities, quality considerations and anticipated future changes in your financial situation.
It is a strategy for all interest rate environments.
Since a bond ladder enables you to reinvest your assets periodically over time, your portfolio will be less affected by interest rates volatility. This concept is similar to dollar cost averaging in stocks. As bonds come due, you are able to reinvest your principal into bonds of intermediate or long term maturities, where the yields are higher.
Interest rate changes will affect you less with a bond ladder. Here is why:
If interest rates go down over the next few years, you will already have locked in higher rates- and the current market value of your fixed income portfolio will be rising.
If interest rates stay the same, you will be earning longer term yields, so your return should exceed what you would be earning if you left your investment short term.
If interest rates go up, the current market value of your fixed income portfolio will be falling. However, as each rung on the ladder matures, you will have money to invest at higher rates.
Ladders are typically built using a variety of the following types of fixed income securities: U.S. Treasury and government agency securities, tax-exempt municipal bonds, corporate bonds, zero-coupon bonds.
Benefits of using a Ladder Strategy
With a bond ladder, bonds will be maturing regularly. Proceeds can then be reinvested in the ladder or taken out in cash if needed.
The ladder approach allows you to be invested in a variety of bonds to provide diversification, reducing both credit risk and reinvestment risk. In addition to selecting a number of different maturities, you can select a variety of investment types of quality ratings.
Many investors have an aversion to buying long term bonds. However, given a normal interest rate environment, intermediate and long term securities offer higher returns than short term securities. The liquidity and diversification provided by a well-structured ladder will enable you to include longer, higher-yielding securities to potentially increase the overall return of your portfolio.
Investors should be aware of the call features on their bonds and how they could negatively affect the structure of a laddered portfolio. Callable bonds offer higher rates of return than comparable non-callable bonds, yet you need to diversify carefully. If all your bonds become callable at a time when rates happened to be lower, you would have to reinvest at those lower rates. We structure your portfolio to include non-callable bonds or stagger the call dates to help protect you from reinvestment risk.
You are in the driver's seat with your bond laddering strategy. Your bond ladder can be designed today to help meet your current financial needs, whether for saving or income generation. Laddering a portfolio is a dynamic process that gives you the opportunity to restructure as your needs and objectives change in the future.
Because you have a ladder with diversification, you can afford to vary the quality of your portfolio, in attempt to increase your yield. Remember, the overall quality of your bond ladder should be decided by your individual risk tolerance.
In periods of rising interest rates, a bond ladder offers greater protection from declining market value than a portfolio consisting solely of long term bonds. In periods of declining rates, your ladder rises in value - and you still have the higher rates already purchased.