Laddered Bond Portfolio
What is a Bond Ladder?
The fixed income investment strategy that involves building a portfolio of multiple bonds that have different maturity dates in called a “bond ladder”. It requires purchasing bonds with evenly spaced maturities (i.e. mature at regular intervals, for example one year) and aims to provide protection against interest rate changes and better management of cash flows along with regular interest payments through the life of the bond. The strategy is preferred by investors who wish to have an “all-weather” bond portfolio, meaning, an approach that works well in different market conditions.
Key Learning Points
- A bond ladder approach involves buying multiple bonds that mature at regular intervals – this would provide high level of diversification and the ability to better manage cash flows
- It also gives investors the option to adjust the level of liquidity they require by either shortening the maturity intervals (for higher liquidity) or increasing them (for lower liquidity)
- Bond ladders are also preferred by investors for their ability to offer protection against changes in interest rates
- As bonds typically distribute interest bi-annually (often on the same dates as their maturity date), a ladder strategy can be used to build a predictable regular income stream
How Does a Bond Ladder Work?
A bond ladder portfolio is invested across multiple bonds with different maturities thereby spreading the risk of being locked into a single interest rate. As each bond matures, the received principal gets reinvested in the longest maturity for the strategy. For example, if that is ten years and maturity intervals are set at one year, the proceeds of the one year bond that has matured would be reinvested into a new ten year bond (meanwhile the longest existing maturity in the portfolio would have moved to nine years).
Keeping in mind that when interest rates rise, bond prices decline, there are generally two possible scenarios that a ladder portfolio could encounter:
- If interest rates rise – this typically is a more favorable scenario for bond ladders as investors can lock in higher yields. As the short-term bonds mature, investors reallocate the principal to purchase longer-term bonds with higher yields and keep the ladder going by continuously capturing the prevailing rates.
- If interest rates fall – the maturing bonds would be reinvested at lower rates. However, the longer maturity bonds would have locked in higher yields already.
In addition, maintaining good levels of liquidity is facilitated through the bonds in the shorter-term end of the portfolio, which can be sold at most favourable prices. As a general rule, the higher liquidity investors require, the closer their maturity intervals should be.
The below chart shows the process of reinvesting the principal of a matured bond at the short-term end of the portfolio into a new bond with a higher yield.
How to Build a Bond Ladder?
Building a bond ladder is rather straightforward . There are three primary considerations investors need to pay attention to:
- Rungs – since diversification is key for this strategy, investors would typically look to spread their funds across as many rungs/holdings as possible (for example $100,000 could be equally allocated to 10 rungs each with c.10% weight or $10,000). Ideally, those that target regular income would look to invest in at least six rungs as that would generate payments every month (bonds typically pay interest twice a year).
- Spacing – technically, this describes the time period between the maturities of individual bonds/holdings and can range widely (from several months to years). Investors would generally space their rungs equally, which should provide a good balance between short-term bonds (that reduce the risk of interest rate changes) and long-term ones (which typically offer higher yields).
- Components – here investors would need to decide what type of bonds or CDs (Certificate of Deposit – fixed-term savings account that pays a fixed interest rate) they will use to build the laddered portfolio. Although Treasuries or high-quality corporate bonds are usually preferred for this approach, in some cases investors may choose to target higher yielding bonds (outside investment grade), which however carry a greater level of default risk.
Bond Ladder Example
In this example, we construct a bond ladder portfolio of ten rungs. Each holding is allocated equal amount (10% of the portfolio) and maturities are spaced at regular intervals of one year.
Individual rungs are comprised of ETFs – the iShares iBonds Corporate ETFs that seeks to track the investment results of an index composed of U.S. dollar-denominated, investment-grade corporate bonds with different maturities.
As one holding matures, the principal could be reinvested into the subsequent holding the next year. For example, as the 2024 bond matures, the proceeds can be put into a new holding with maturity date in 2033.
How to Build a Treasury Bond Ladder
Using the above example, the same approach can also be applied to Treasuries. In the table below, we show what a bond ladder invested in Treasury bonds that mature in 3-month intervals looks like.
Investors would also typically use the yield to maturity measure, which calculates the total return they should expect to earn on a bond if held until it maturity.
We show how to calculate this measure in the technical example below.
Conclusion
A bond ladder strategy can provide protection against interest rate risk due to its diversification feature, but can also leverage its cash flows (in the form of interest and principal payments) to offer more flexibility/liquidity and to create stable income stream.