Bond Ladder

A bond ladder is a 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 with changes in interest rates, liquidity requirements, and diversification benefits.

Here, the investor doesn't invest in bonds of only one type of maturity but rather in a portfolio of bonds that have different maturities so that when he feels that there are better avenues of investment available, he may avail of such options by reinvesting the money from the bonds maturing at that time or shortly into these better avenues. It is a method of constantly reshuffling the portfolio to invest the funds better and gain the desired risk-reward ratio.

Bond ladder strategy refers to an investment strategy in which there is the process of buying a portfolio of bonds that have different dates of maturity. The bonds are spread across these dates. As each bond reaches the maturity period, the investor can invest it into a fresh bond at the longer end of the ladder.

The diversification benefit in this process is very significant in the sense that since the bonds have different maturity dates, the investor’s exposure to fluctuations in the interest rate is limited.

However, the investor continues to get a steady income in the form of interest from bond ladder portfolio which is a predictable cash flow. The investment also allows control and flexibility because the investor can select the best bonds that meet their investment goals and criteria as per the credit quality, maturity dates and yields.

Finally, we know that laddering has pros and cons, and the investor 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 can set aside some funds for this approach, it lowers the risk of the portfolio and can be a useful way to save for a retirement account.

Investors aware of the economic environment should take up this strategy or take the help of an asset manager for the same and do 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.

The investor may 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

The issuer can call callable bonds as per the call schedule. 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 can reissue the debt at a lower cost. 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 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 in. The higher the coupon, the greater the risk associated with the bond. 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. Therefore the investment goal should be clear because the invested money may bear returns after continuing the bond ladder strategy for a long period. So keeping sufficient funds separate should be a possibility for the investor.

Suppose an investor has $100,000 to invest, and due to his awareness of the bond ladder portfolio 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 rates due to greater interest rate risk
• Once any of the bonds mature, they are reinvested for a different maturity 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.

Some of the advantages of the concept are detailed below:

#1 - Manage Interest Rate Risk

• Interest rate risk occurs when the bond cash flows are still pending and has two components; 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 provide higher interest rates. 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 bonds of various maturities are available in the portfolio. 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. The investor can redeem some maturing then or shortly and invest them in a higher-paying bond.

#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 other needs. For this purpose, the investor may desire that short-term bonds be liquidated at the time of such needs without having to pay the penalty on the same. Therefore building a bond ladder 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, with lower risk tolerance, an investor might still have invested in low-reward 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 corporate bond ladder approach allows the investor to do so without bearing the penalty for premature bond termination.

Let us look at some of the disadvantages of the financial concept.

#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; therefore, building a bond ladder approach may backfire at times.

#3 - Transaction Costs

As laddering requires frequent buying and selling, the transaction costs are higher compared to the non-laddering approach. However, it is a trade-off and part and parcel of the investment.

Both the terms given above are two different concepts used in the financial market. However, some differences between them are as follows:

• Nature of Diversification: In a Bond ETF, there can be various kinds of securities varying based on 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 corporate bond ladder is an approach to a homemade Bond ETF; however, the ETF is more transparent and provides greater flexibility in terms of liquidity.