A client reached out this week asking about using a bond ladder as part of their fixed income allocation. I thought this topic may be of broader interest so let’s take a look!

What is a bond ladder?

A bond ladder is a portfolio of individual fixed income instruments (such as bank CDs or individual bonds) that have varying maturity dates. The maturity dates are staggered (or laddered) – with each “rung” representing an individual bond that matures at a set time interval. As those rungs mature over time, you reinvest the proceeds by creating another rung at the end of the ladder – and continue that on and on with each maturity.

This fixed income investment approach is designed to provide current income, while minimizing exposure to interest rate fluctuations. By owning fixed income instruments with varying maturity dates, investors aren’t relying on rates at one single point in time but rather, they will be reinvesting at various points in time which should help smooth out interest rate fluctuations.

This strategy also relies on holding fixed income securities to maturity. By doing so, provided the issuer doesn’t default, the investor will receive repayment of principal plus interest at maturity (regardless of how rates move during the time in between).

What are the objectives?

Typically there are two main objectives to a bond ladder.

First, a bond ladder is designed to provide current income and cash flow. As a reminder, a fixed income instruments (ex: a bank CD, US Treasury Bond, Corporate bond, etc. ) are contractual promises to repay a set amount of borrowed funds. These promises to repay also include contractual interest payments over the borrowing term, payable on fixed dates (annually or semi-annually are most common intervals). With a bond ladder, you can schedule out the interest payments to match your cash flow needs and timing.

Second, a bond ladder helps manage interest rate risk. Interest rates offered on fixed income instruments are dictated by the yield curve (the market interest rates across various maturities at a given point in time). The yield curve moves minute to minute, driven by a variety of factors (Federal Reserve (short end), economic growth (long end), supply and demand forces, geopolitical factors, etc). As with all elements of investing, predicting interest rates is impossible. A bond ladder helps fixed income investors “spread their bets.” Instead of having all your fixed income holdings mature on a single day (and being confronted with reinvesting all of your funds at the prevailing rate on that single day if you want income generation to continue), you ladder our maturities so you will be reinvesting a fraction of your portfolio at a variety of future dates. Certain reinvestments may work in your favor (ie: available rates will be higher) and others may work against you (ie: available rates will be lower) but either way, you are diversifying out that reinvestment risk which is a positive over time

How do you build a bond ladder?

A good starting point is to decide the total principal you wish to deploy in this strategy and your targeted time frame. Knowing those two items will help you set the amount and number of “rungs” in your ladder. If you prefer recurring income, using at least 6 rungs a year may be a better approach (as that will allow payment each month using all semi-annual paying bonds).

You then need to decide on your spacing between rungs- which is the time between the various maturities. This will be driven by your overall timeframe. Historically, stretching out a bond ladder was advantageous as rates at the longer end of the curve were materially higher than those at the short end. Today, the yield curve is relatively flat – meaning short rates and long rates are rather comparable. That is likely to change – eventually – but be sure to take the current rate curve into account as you set your spacing

Lastly, you will need to decide what materials to use for your ladder – ie: what specific fixed income instruments to invest in. As noted above, there are lots of options to consider including bank CDs, US Treasuries, Corporate Bonds, Municipal bonds, etc. As is always the case, a careful review of the underlying issuer and confidence in their credit quality and ability to repay should be top of mind.

Happy (fixed income) investing!