Bond Ladder

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 bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually.read more 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 bondsCallable BondsA callable bond is a fixed-rate bond in which the issuing company has the right to repay the face value of the security at a pre-agreed-upon value prior to the bond's maturity. This right is exercised when the market interest rate falls.read more 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 riskReinvestment RiskReinvestment risk refers to the possibility of failing to induce the profits earned or cash flows into the same scheme, financial product or investment. It even states the uncertainty of not getting the similar returns when such funds are invested in a new investment opportunity.read more. 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.

Bond-Ladder

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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:

Bond Ladder Example

Difference Between Bond Ladder and Bond ETF

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 institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more 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 toleranceRisk ToleranceRisk tolerance is the investors' potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor's age, income, investment objective, responsibilities and financial condition.read more, 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

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This has been a guide to What is a Bond Ladder & its Definition. Here we discuss how to create a bond ladder strategy and the difference between the bond ladder and bond ETF along with examples, benefits & limitations. You can learn more about from the following articles –