The bond ladder is a method to generate expected income by purchasing bonds that mature at regular intervals over a period of time. A bond ladder is also a way to manage interest rate risk. A bond ladder can be created using individual bonds as well as exchange-traded funds and mutual funds.
How does a bond ladder work?
A bond ladder is a method to produce a predictable income stream while reducing interest rate risk. The ladder consists of bonds (or bond funds or ETFs) with different maturities. When initially building the ladder, the lower rung bonds with closer maturity dates generally have lower yields in the portfolio. The higher rung bonds with longer maturity dates typically have higher yields in the portfolio.
When the lower rung bonds on the ladder mature, you have the option to reinvest them into the higher rung bonds on the ladder or move your investment out of the ladder entirely. When reinvesting the bonds, the yields may be higher or lower depending on the interest rates at the time you invest (reinvestment risk). If interest rates are higher, you can reinvest at a higher rate and improve your return. If interest rates are lower, your principal may not return as much as it could, but you still have bonds at the top of the ladder with higher rates.
Note: The bond ladder also provides protection against bond price fluctuations. As interest rates rise, bond prices decrease. However, the ladder is designed to hold the bonds until maturity, so changes in the portfolio’s value do not impact the strategy.
This strategy can be particularly beneficial for retirees, as explained by Michael Finke, Professor of Wealth Management at the American College of Financial Services, to The Balance via email. “The key benefit of a bond ladder is greater certainty about the cash value of future payments. For example, if a retiree has a specific goal for next year’s inflexible spending, they can secure that amount by creating a ladder of bonds that mature in the coming years.”
Examples of a bond ladder
Suppose that in retirement, you want to create a $250,000 ladder to mature over a 10-year period.
| Investor | Years to Maturity | Yield | Annual Income |
|---|---|---|---|
| $50,000 | 2 Years | 2% | $1,000 |
| $50,000 | 4 Years | 3% | $1,500 |
| $50,000 | 6 Years | 3.5% | $1,750 |
| $50,000 | 8 Years | 3.75% | $1,875 |
| $50,000 | 10 Years | 4% | $2,000 |
| Total Annual Income | $8,125 |
When the first bond matures in two years, it is reinvested in a 10-year maturity. The rest of the bonds continue to move down the ladder. The bond that originally matured in four years now matures in two years, and so on.
Types of bond ladders
A bond ladder can be created using individual bonds or bond funds and ETFs.
Individual bonds provide flexibility. You can choose the maturity period or “height of the ladder,” as well as the number of rungs or the timing of maturities. However, it may be difficult to manage credit risk, or the risk that the issuer will fail to pay interest or return principal at maturity.
A bond ladder can also be created using bond ETFs that have a maturity feature, such as BlackRock’s iShares iBonds or Invesco BulletShares. These ETFs contain a portfolio of bonds that mature at the same time. Upon maturity, the proceeds are distributed to shareholders, which can be reinvested. Bond ETFs can provide diversification in the portfolio with lower investment minimums. They are also generally more liquid than individual bonds since ETFs are traded on stock exchanges.
What
What does that mean for individual investors?
Like all investments, a bond ladder carries risks. “Bond ladders often have a long duration, meaning their value may drop significantly if interest rates rise,” said Vinky. However, market value fluctuations may not matter if investors stick to the plan and hold the bonds until maturity.
A bond ladder is a long-term investment strategy designed to generate income and preserve capital. If you are nearing retirement, or have other reasons to generate expected investment income, a bond ladder may be suitable for you.
Frequently Asked Questions (FAQs)
How much money do I need to build a bond ladder?
If you are building a bond ladder using individual corporate bonds, you will need to buy enough bonds to diversify the portfolio. Since corporate bonds are typically issued in denominations of $1,000 or $5,000, you will likely need at least $350,000. If you use exchange-traded bond funds, you can build a bond ladder with a relatively small amount to invest.
How much can I expect from bond ladder income?
The amount of income will depend on prevailing interest rates, the type of bonds, and the years to maturity in the ladder. Corporate bonds usually generate higher income but also come with a higher level of risk. U.S. government bonds are considered the safest, but they will have lower returns than corporate bonds.
Was this page helpful?
Thank you for your feedback! Let us know why!
Sources:
Charles Schwab. “Bond Ladders.”
Fidelity. “How and Why To Build a Bond Ladder.”
BlackRock. “What Are iBonds ETFs?”
Invesco. “BulletShares Fixed Income ETFs.”
Source: https://www.thebalancemoney.com/what-is-a-bond-ladder-6822666
Leave a Reply