How a Bond Ladder Can Offer Stability in Any Market Condition
- Bond ladders offer investors stable income using a strategy that minimizes interest-rate risk.
- Fees for bond ladder portfolios tend to be lower than for actively managed portfolios.
- Ladders can still carry credit risk, and investors could face losses if they need to sell bonds before they mature.
- With today's ultra-low rates, bond ladders may prove to be an especially effective approach to stable income if rates rise in coming years.
What Is a Bond Ladder Investment Strategy?
A bond ladder is a portfolio of individual bonds whose maturity dates are staggered over a set number of years. As one bond matures, it is replaced with a new bond at the maximum maturity for the strategy. For example, a laddered portfolio might hold five bonds that mature on each of the next five years; as each bond matures, the proceeds are reinvested into a new five-year bond, maintaining the five-year ladder. The ladder can be made of U.S. government bonds, corporate bonds, a mix of both, or tax-exempt municipal bonds.
The strategy is designed to provide a predictable income stream while minimizing exposure to interest-rate fluctuations. With bonds maturing every year (or twice a year, depending on how the ladder is structured), an investor will receive regular coupon payments throughout the life of the bond, and at each maturity date, receive the bond principal in full.
Why Might Someone Hold a Bond Ladder?
For investors looking to manage cash flows by receiving a predictable amount on a fixed schedule, a bond ladder strategy can be an appealing option. A bond ladder can preserve capital in a rising-rate environment by holding bonds to maturity. This differs from a traditional bond portfolio (such as a passive mutual fund that tracks the Bloomberg Barclays U.S. Aggregate Bond Index), which will typically fall in value as interest rates rise. Because a ladder uses a buy-and-hold approach, price fluctuations for individual bonds do not become realized gains or losses, so long as the bond is held until maturity as intended.
Another appealing characteristic of a bond ladder is that fees tend to be relatively low. Compared with an actively managed bond fund, fees associated with the management of a laddered bond strategy are typically a fraction of the cost. In today’s environment when yields are at historically low levels and future return expectations muted, keeping more of the portfolio’s gains in your pocket by way of lower fees can make a difference.
Other Risks to Consider
While laddered bond portfolios help mitigate interest-rate risk and help lower fees for the investor, there are other risks to consider when investing in a bond ladder. For example, corporate bond ladders still carry default risk, or the possibility of a company being unable to pay back its debt. Traditional bond portfolios that hold corporate bonds also carry default risk, and in both cases hiring a professional investment manager who specializes in bond portfolios can help mitigate this risk. These managers select corporate bonds based on their assessment of credit quality, monitor the creditworthiness of portfolio positions through time, and make any changes should the risk of default arise. They may also seek to weed out riskier issuers so investors can avoid potential cash flow impacts associated with credit risk. Anyone building a bond ladder should ensure it is designed with ample diversification across individual bond issuers to provide this predictable stream of income.
This table summarizes the potential pros and cons of each approach.
How Might Ladders Fare Given the Current Rate Environment?
Given the historically low rate environment, mitigating the risk of rising rates may be top of mind for some bond investors today. Moreover, there’s potentially less risk of having to reinvest maturing bonds at lower interest rates and reducing income potential compared with prior periods, given there’s (arguably) not much lower that rates may be able to move from here.
Moreover, if interest rates rise, an investor will have the opportunity to reinvest proceeds from maturing bonds and coupon payments at higher yields as they continue to build their ladder, and effectively increase the average yield on their portfolio of bonds. As a result, rising rates can be a good thing for the laddered bond investor’s ability to generate additional income.
If you are interested in investing in a bond ladder strategy, visit our Select Fixed-Income Portfolios. We have a range of corporate and municipal bond ladder strategies to help meet your client's needs.
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