Bond ladders allow you to manage interest rate risk by spreading out bonds that will mature over an established period. They also offer regular income streams while protecting investment capital.
Ladders can be constructed using Treasury bills, high-grade corporate bonds, certificates of deposit, or any other fixed income investments.
How Laddering Can Help You Manage Interest Rate Risk
Bonds can offer steady income streams and help diversify your portfolio, yet are subject to interest rate risk. Many investors use a laddering strategy in order to reduce this risk and maximize investment potential.
Laddering is a financial technique in which bonds with different maturity dates are mixed into a portfolio and distributed at regular intervals to form the structure of a ladder. When one matures, its principal is reinvested into another bond with longer maturity dates in order to keep its integrity.
This approach can help protect you against fluctuations in interest rates and lock in higher yields over time if rates rise in the future. But it’s essential that you fully understand its risks, consulting a financial professional to see if this strategy might fit with your portfolio.
Investing in Ladders
Bond ladders can help manage interest rate risk in your bond portfolio by investing in bonds with staggered maturities–known as “rungs.” When one matures, you reinvest the proceeds to extend the ladder.
Utilizing a ladder investment strategy can provide protection from rising rates by diversifying across multiple bonds with various maturities dates, potentially yielding higher yields than investing in only one bond. Furthermore, should any one rung of your ladder suffer credit degradation it only impacts that portion of your portfolio and won’t cause complete ruin to all your investment portfolio.
When building your ladder, take into account your investment horizon and income needs as well as any interest rate fluctuations or credit risks you might be exposed to. Your tolerance should also be taken into consideration – an inflation-protected security such as Treasury inflation-protected securities may help mitigate against rising inflation while bonds should be chosen carefully to diversify and consider your tax status when selecting bonds for inclusion on your ladder.
Reinvesting
Reinvesting interest and principal as bonds mature and expire can help you take advantage of lower yields while potentially mitigating interest rate risk. Wealthfront’s Automated Bond Ladder tool makes reinvesting ladder proceeds easy!
When choosing bonds, take into account your investment horizon, income needs and risk tolerance before selecting any particular issuers. Also take tax into consideration as municipal and corporate bonds have taxable interest while Treasuries don’t. Inflation risk can have an adverse effect on fixed income investments by raising prices while yields decline; to counter this threat consider including Treasury inflation-protected securities (TIPS) among your bonds ladder and diversify across multiple issuers to manage risk of default.
Selling Ladders
Bond ladders with staggered maturities help minimize the risk that one of your bonds might be called before its maturity date. Bonds called prior to maturity cease paying interest and their principal returns back to you, typically with reduced yield compared to what was promised initially.
Bond ladders differ from individual bonds in that their maturing bonds’ proceeds are automatically reinvested at higher yields into subsequent rungs of the ladder – much like dollar cost averaging for stocks – providing an even stream of income while protecting from price depreciation as rates increase and creating an ongoing income source.
advisors often consider laddered fixed-income portfolios a “lock in” of current rates, since you know exactly what returns can be expected if held until maturity (assuming there is no default from issuer). But laddering should also be carefully considered before making a definitive decision; so speaking to an experienced financial professional prior to making any final decisions should also be a top priority.
