What is Bond Ladder?
Bond ladder is fixed income investment approach in which the portfolio is layered into bonds of varying maturities like the long, medium and short term bonds that help manage risk associated to change in interest rates, liquidity requirements and diversification benefits.
Here, the investor doesn’t invest in bonds of only one type of maturity rather in a portfolio of bonds which have different maturities so that when he feels that there are better avenues of investment available, he may avail such options by reinvesting the money from the bonds maturing at that time or in the near future into these better avenues. It is a method of constantly reshuffling the portfolio to better invest the funds and gain the desired risk-reward ratio.
How to Create a Bond Ladder Strategy?
The investor may simply buy bonds of various maturities to create the bond ladder. However, a few things that the investor should keep in mind are as follow:
#1 – Not use Callable Bonds
Callable bonds can be called by the issuer as per the call schedule, and therefore including the same in the portfolio may disturb the laddering schedule and lead to untimely reinvestment risk. The investor should know that the issuer will always call the bond when the interest rates fall because they will be able to re-issue the debt at a lower cost, and therefore the investor will be left in a low-interest-rate environment to reinvest his funds.
#2 – Choose Stable Bonds
The investor should take care of the credit rating of the bonds that he is putting in his portfolio, and always look up recent downgrades and upgrades issued by various rating agencies to understand whether the bond is worth investing or not. Further higher the coupon, the greater is the risk associated with the bond, and therefore the investor does his due diligence before investing so that he doesn’t take a higher risk than his tolerance level.
#3 – Invest for Long Term
Laddering is a long term strategy with frequent reinvestments, and therefore the investment goal should be clear because the invested money may bear returns after continuing the strategy for a long period of time. So keeping sufficient funds separate should be a possibility for the investor.
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Example
Suppose an investor has $100,000 to invest, and due to his awareness of the bond ladder approach, he has made the following investment regime:
- We assume that the bonds are selling at par, so the initial investment is $10,000 in each bond, and as it is a cash outflow, it is represented by a negative number
- All bonds give annual coupons and on the maturity dates repay the principal
- Bonds with longer maturity pay higher coupon rate due to greater interest rate risk
- Once any of the bonds mature, they are reinvested for a different maturity as per the current interest rate environment.
- The appearance of the portfolio above is like a ladder, and that is why this strategy is so named.
Difference Between Bond Ladder and Bond ETF
- Nature of Diversification: In a Bond ETF, there can be various kinds of securities varying on the basis of maturity, industry sector, issuer, and so on, while bond laddering is narrower as the variation is mostly in the form of maturity.
- Liquidity: Bond ETF trade all day long on the stock exchange and therefore have greater liquidity, the investor is not investing directly in the bonds, but in the ETF, and like a mutual fund, he may withdraw a portion of his wealth from the ETF anytime, however in laddering, the investor is invested in the bonds itself and therefore needs to wait for the maturity to reinvest his funds otherwise might have to sell at a lower price or might have to bear the penalty for selling before maturity.
We may say that laddering is an approach to homemade Bond ETF; however, the ETF is more transparent and provides greater flexibility in terms of liquidity.
Benefits
#1 – Manage Interest Rate Risk
- Interest rate risk occurs when the bond cash flows are still pending and has two components, as when the interest rates increase, the price of the bond decreases, therefore we can say that the bonds held by the investor have become less attractive, as other bonds are available in the market which provides higher interest rate. Therefore the current bond should be priced lower. This causes a loss of value of the bond.
- Further, the coupons are being reinvested at a lower rate than the market can provide through other bonds. So these risks are managed if there are bonds of various maturities available in the portfolio. The investor can redeem some which are maturing then or in the near future and invest it in a higher-paying bond. The longer maturity bonds may be kept intact because there might be a reversal phenomenon during the life of that bond, and it may become attractive again before maturity.
#2 – Manage Liquidity
At times the investor may require some degree of liquidity to be able to pay for his upcoming objectives such as a down payment for a home or child’s college education and such other needs. For this purpose, the investor may desire that short-term bonds can be liquidated at the time of such needs without having to pay the penalty on the same. Therefore laddering can be a good approach.
#3 – Diversification
At times bonds from one financial situation may be of a certain maturity while it might be different for another, therefore investing in various institutions may provide diversification benefits because each financial institution has different investment domains, such as some specialize in the housing sector, others are focused in the energy sector while yet others are sector agnostics. Therefore, having a certain level of diversification is always sought after.
#4 – Manage Return
At the time of initial investment, the available options might not have been highly favorable because the economy might have favored the equity sector more, and the bond returns might have been lower. However, having lower risk tolerance, an investor might have still invested in low yield bonds. However, after a change in the economic cycle, there could be a situation where the interest rates could be rising, and it would be a better time to reinvest to seek higher returns. Therefore the laddering approach allows the investor to do so without having to bear the penalty for premature termination of a bond.
Limitations
#1 – Greater monitoring
A constant observation needs to be made for the change in the interest rate environment because the investor needs to know what would be the better avenue for reinvesting his funds.
#2 – Reinvestment Risk
As some bonds mature, there needs to be a better or at least the same return investment available for reinvestment. However, that may not always be the case, and therefore, at times, the laddering approach may backfire.
#3 – Transaction Costs
As laddering requires frequent buying and selling, therefore the transaction costs are higher as compared to the non-laddering approach. However, it is a trade-off and part and parcel of the investment.
Conclusion
- Finally, we know that laddering has its pros and cons, and the investor who is willing to trade interest rate risk for reinvestment risk may use this approach. It requires a long term investment horizon to bear fruits, and if the investor is able to set aside some funds for this approach, it lowers the risk of the portfolio and can be a useful way for saving for a retirement account.
- Investors who are aware of the financial environment should take up this strategy or take the help of an asset manager for the same and do the complete due diligence of the asset manager’s past performance because this is a more active approach than other strategies within the fixed income domain.
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