Complete Guide to Bond Ladders

Investing in fixed-income securities such as bonds is a lower-risk way to earn a stable, passive income. While the returns may not be massive, you can sleep better knowing that your investments are not likely to disappear overnight. 

Bond ladders are strategic implementations of fixed-income investments that can reduce your risk and simultaneously offer you a steady stream of income. Take a look at bond ladders, how they work and how you can leverage them to further your financial goals.

What is a Bond Ladder?

A bond ladder is an investment portfolio made up of multiple bonds with each having a different maturity date. Compared to simply putting all your eggs in one basket with a single maturity date, splitting your investment across different bonds with varying maturity dates increases liquidity, minimizes interest rate risk and diversifies your credit risks. 

A bond is a loan that investors provide to a company (corporate bond) or government (Treasury bills) with a maturity date when the principal is repaid. The bond’s coupon rate determines the interest to be paid at regular intervals to the investor.

How to Build a Bond Ladder?

A bond ladder comprises several bonds (rungs of the ladder) with maturity dates evenly spaced across months or years to allow proceeds to be reinvested at regular intervals upon each bond’s maturity. 

Here are the steps to build a bond ladder: 

Step 1: Find and purchase high-quality bonds with different maturity dates. Your selections should align with your financial objectives and preferred investment horizons.

Step 2. Wait for each bond to reach maturity while earning interest periodically. 

Step 3. Upon maturity, you can either choose to reinvest the proceeds in another bond ladder or cash out for some other purposes.

If you desire more liquidity, which provides better access to your funds, you may have to choose bonds with maturity dates aligned with when you need cash.

Bond Ladder Terminology

The simple steps above will help you get started with bond laddering in no time. But here are some concepts you must understand to properly grasp the bond ladder strategy:

• Rungs: The individual bonds are the rungs that make up the bond ladder. The more rungs or bonds in the ladder, the greater your diversification and the lower your risk could be. You can determine the number of rungs in your ladder by dividing the total amount you want to invest by the time frame you want each bond to last. 

• Spacing: Spacing refers to the period between the maturity dates of your bonds or rungs. Experts recommend using equal spacing, which can be anywhere from every few months to several years. Shorter spacing results in lower average bond returns but slashes investment risks and boosts liquidity. Longer spacing tends to generate higher income because the coupon rates are typically higher. You may want to design your ladder with smaller spacing if you think you may want to access your funds in the short term. 

• Materials: The materials are the building block of the ladder (i.e, the bonds). You must research extensively before picking a bond that suits your financial goals. High-quality bonds tend to be stable and less likely to be called away (repaid prematurely) by the issuer. You should be familiar with the different types of bonds and their comparative strengths. Corporate bonds tend to have higher yields, municipal bonds offer tax advantages with low default risks, and Treasury bonds are guaranteed by the government. The more bonds you add to the ladder, the more diversified your portfolio.

Benefits of a Bond Ladder

The primary aim of the bond ladder strategy is to help investors manage cash flow while minimizing risks. Here are three reasons you may want to try out a bond ladder:

• Mitigate interest rate risk: The staggered maturity dates of bonds in bond ladders ensure investors aren't locked into a single interest rate for long periods, especially when it's unfavorable. Because bonds are maturing at different intervals, the ladder helps balance out the effects of interest rate fluctuations. You can reinvest a matured bond in a new bond with a longer term to benefit from an increase in interest rate. But if the interest rates drop, the maturing bonds will have to be reinvested at lower rates. Still, the bonds already in the ladder have locked in higher rates. 

• Cash-flow management: Bonds usually pay interest twice a year, typically on their maturity dates. Based on the predictability of the coupon payments, investors can better plan based on expected income from the bonds with different maturity dates. 

• Flexibility: Because the maturity dates of bonds in a bond ladder are staggered, you have the flexibility of reinvesting the principal into a new bond or, if the interest rates are lower, investing the funds in different instruments. You can also choose to use the funds for other financial exigencies without fear of penalty for early termination.

Drawbacks of a Bond Ladder

The bond ladder strategy may offer a low-risk, consistent income-generating investment, but it’s not without drawbacks. Here are some disadvantages to note: 

• High barrier to entry: Bonds are mostly issued in denominations of $1,000, and building an effective ladder requires you to buy many bonds simultaneously. You might need a substantial amount of money to be able to spread your investments across several maturities. 

Investing with a relatively small amount will water down the effectiveness of the strategy because the rungs will be too spaced out, and your ladder is shorter. Investing in more bonds reduces default risks because of diversification, especially when dealing with corporate bonds.

• Not entirely risk-free: Bonds aren't entirely risk-free because they depend on the creditworthiness of the issuing company and as such may default. Some can also be called prematurely, which means your principal will be returned without future interest payments. An early recall can disrupt your predictable ladder schedule and potentially limit your earnings. 

Compare Bond Brokers

To set up a bond ladder, you’ll need a bond broker. With so many brokers to choose from, it can be tough to decide which one is best for you. Benzinga has saved you the trouble and compiled reviews and insights on the best bond brokers in the market.

Frequently Asked Questions