Definition:'Bond Laddering' is a fixed income investment strategy where the investor buys individual bond securities of various maturities. Similar to CD laddering a primary goal of the investor isto reduce interest rate risk and to increase liquidity.
How to Build a Bond Ladder
Bonds can be purchased in a brokerage account at firms such as Vanguard, Fidelity or Charles Schwab. The idea is to achieve liquidity by having bond issues that mature at close intervals. To do this, an investor can build a portfolio of several bonds with short-term (1 year or less) to intermediate-term maturities (1 to 5 years).
The short-term bonds will normally have lower yields than the intermediate-term bonds so the bond investor will need to balance their need for liquidity with their need for yield. For example, if liquidity is the primary goal, the bond investor can buy several bonds with maturities of one year or less. This strategy would be similar to CD laddering, where the investor would buy one bond per month for several months or longer. This way, there will be one bond maturing per month by the end of the laddering period.
If the bond investor's primary goal is higher interest rates (yield), they may consider including some bonds with longer maturities, such as 5-year or 10-year bonds, in their fixed income portfolio. Investors who don't mind taking on extra risk in exchange for higher rates of interest can consider using high-yield (junk) bonds.
When to Use (and When Not to Use) Bond Laddering
Investors use bond laddering for two primary reasons: 1)they want access to cash if needed and/or 2) They expect interest rates to rise and they want to periodically buy into higher yielding bonds as the investor continues ("climbs up") the ladder.
Therefore the best time to use bond laddering is when interest rates are low and are expected to rise in the near future. For example, a bond investor will not want to tie up all of their savings in one low-yielding bond for too long. If interest rates are expected to rise the bond investor will be able to purchase higher yielding bonds as each individual bond in the 'ladder' matures.
Equal and opposite, if interest rates are high and expected to fall, a bond ladder may not be the best option for the fixed income investor. They may want to consider buying longer maturities, such as 5-year, 10-year or even 30-year bonds to "lock in" higher yields.
It is important to note that bond investors take on a price risk that is not associated with CD laddering. For example, as interest rates rise, bond prices generally fall. So if the bond investor needs to sell their bond prior to its maturity date, they may not receive all of their initial investment amount (principal) back if prices have fallen since purchasing the bond. If the bond investor needs access to cash, it is wise use liquid investments, such as money market funds.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.