What Is a Bond Ladder?
A bond ladder is a portfolio of fixed-income securities in which each security has a significantly different maturity date. The purpose of purchasing several smaller bonds with varying dates of maturity rather than one large bond with a single maturity date is to minimize interest-rate risk, increase liquidity, and diversify credit risk.
Key Takeaways
- A bond ladder is a portfolio of fixed-income securities in which each security has a significantly different maturity date.
- In a bond ladder, the bonds' maturity dates are evenly spaced across several months or several years so that the proceeds are reinvested at regular intervals as the bonds mature.
- The purpose of purchasing several smaller bonds with varying dates of maturity rather than one large bond with a single maturity date is to minimize interest-rate risk, increase liquidity, and diversify credit risk.
- In order to build an ETF bond ladder, an investor simply needs to put an equal amount of money in a number of different ETFs; all with a different defined maturity date.
- Since callable bonds can be redeemed by the issuer before maturity, they're not ideal when building a bond ladder.
Understanding Bond Ladders
In a bond ladder, the bonds' maturity dates are evenly spaced across several months or several years so that the proceeds are reinvested at regular intervals as the bonds mature. The more liquidity an investor needs, the closer together their bond maturities should be.
A bond ladder works by structuring an investment portfolio with bonds that have varying maturity dates. The investor buys bonds with staggered maturity dates, such as one bond maturing each year over a five- or ten-year period. This staggered approach ensures that a portion of the portfolio matures regularly, providing opportunities to reinvest at prevailing interest rates or access cash as needed.
When a bond in the ladder matures, the principal amount is returned to the investor. The investor can then choose to reinvest this principal in a new bond at the end of the ladder, thus extending the ladder’s duration, or use the funds for other purposes. Reinvesting in new bonds helps maintain the ladder’s structure and ensures continued income generation and interest rate management.
Benefits of a Bond Ladder
Investors who purchase bonds usually buy them as a conservative way to produce income. However, investors looking for a higher yield, without reducing the credit quality, usually need to purchase a bond with a longer maturity. Doing so exposes the investor to three types of risk: interest rate risk, credit risk, and liquidity risk.
When interest rates increase, bond prices react inversely. This especially holds true the longer the maturity date is on a bond. A bond that matures in 10 years fluctuates less in price than a bond that matures in 30 years. If the investor needs some funds before the bond’s maturity, the rise in interest rates causes a lower price for the bond on the open market.
When interest rates rise, the demand for lower interest-paying bonds decreases. This leaves the bond with less liquidity since bond buyers can find similar maturity bonds with higher interest payments. The only way to get a more favorable price in this scenario is to wait for interest rates to go down, which causes the bond to go back up in price.
Buying a large position in one bond could also leave the investor exposed to credit risk.
Similar to owning only one stock in a portfolio, a bond’s price is dependent on the credit of the underlying company or institution. If anything lowers the credit quality of the bonds, the price is negatively impacted immediately.
For example, Puerto Rico bonds were once very popular, but when the province had financial issues, the bond prices immediately plummeted.
Using a bond ladder satisfies these issues. Since there are several bonds with a staggered maturity, bonds are constantly maturing and being reinvested in the current interest rate environment.
If the investor needs liquidity, selling the shorter maturity bonds offers the most favorable pricing. Since there are several different bond issues, the credit risk is spread across the portfolio and properly diversified. If one of the bonds has a downgrade in credit quality, only a portion of the entire ladder is affected.
Generally speaking, you should aim to have at least 10 "rungs" in your bond ladder. All things equal, the more rungs in the ladder, the higher the diversification, liquidity, and yield stability.
Types of Bonds to Use in a Bond Ladder
A bond ladder can incorporate various types of bonds, each serving different investment objectives. Government bonds such as U.S. Treasury securities are a popular choice due to their low credit risk and stable returns. Treasury bonds, notes, and bills can all be used in a bond ladder, providing a mix of short-, medium-, and long-term maturities.
Municipal bonds are another option for a bond ladder, especially for investors seeking tax advantages. These bonds are issued by state and local governments and often offer interest income that is exempt from federal, and sometimes state and local, taxes. Municipal bonds can be particularly attractive for investors in higher tax brackets.
Corporate bonds can also be part of a bond ladder, offering potentially higher yields compared to government or municipal bonds. Corporate bonds are issued by corporations and come with varying levels of credit risk. Investors should consider the credit rating of the corporate bonds they include in their ladder, as higher-rated bonds generally offer lower yields but come with lower default risk.
Last, investors may include Treasury Inflation-Protected Securities (TIPS) in their bond ladder to hedge against inflation. TIPS are government securities that adjust their principal value with inflation, ensuring that interest payments and the principal returned at maturity increase with the cost of living. Again, these are government-issued and considered low-risk.
Downsides to Bond Ladders
One significant downside to bond ladders is the potential for lower returns compared to other investment options like equities. Bonds, particularly high-quality ones like government securities, typically offer lower yields than equities or other higher-risk investments. This means that, while bond ladders provide stability and regular income, they might not generate the same level of returns as more aggressive investment strategies.
Another downside is the impact of inflation on fixed-income investments. Bond ladders generally consist of bonds with fixed interest payments, which can lose purchasing power over time due to inflation. Though a bond ladder could hold TIPS, they would be more susceptible to the impact of inflation if they do not.
Bond ladders require ongoing management and reinvestment. As bonds mature, investors need to decide how to reinvest the proceeds to maintain the ladder’s structure and continue benefiting from the strategy. Additionally, if interest rates are unfavorable when reinvestment opportunities arise, the investor might face lower yields on new bonds. Though some of these bonds may be auto-rolled into new funds, bond ladders simply take more administrative effort compared to simple buy-and-hold investments.
Finally, bond ladders may not provide the same level of diversification as other investment vehicles. While they offer diversification across different maturities, they still concentrate investments within fixed-income securities. This lack of diversification can expose investors to risks related to interest rate changes, credit quality, or economic conditions specific to the bond market.
Example of a Bond Ladder
Here's an example of a simple bond ladder that retail investors can create. To construct a 10-year Treasury bond ladder, an investor could have bought the following 10 ETFs in equal amounts:
- The iShares iBonds Dec 2023 Term Treasury ETF (IBTD)
- The iShares iBonds Dec 2024 Term Treasury ETF (IBTE)
- The iShares iBonds Dec 2025 Term Treasury ETF (IBTF)
- The iShares iBonds Dec 2026 Term Treasury ETF (IBTG)
- The iShares iBonds Dec 2027 Term Treasury ETF (IBTH)
- The iShares iBonds Dec 2028 Term Treasury ETF (IBTI)
- The iShares iBonds Dec 2029 Term Treasury ETF (IBTJ)
- The iShares iBonds Dec 2030 Term Treasury ETF (IBTK)
- The iShares iBonds Dec 2031 Term Treasury ETF (IBTL)
- The iShares iBonds Dec 2032 Term Treasury ETF (IBTM)
As one ETF matures, the investor could roll those funds into the subsequent fund holding the next year. For example, as the fund holding the bond with a 2023 maturity date matures, those funds could be rolled over to an ETF with a term of 2033. This means that at every moment, the investor is holding 10 ETFs of ranging terms.
What Is a Bond Ladder?
A bond ladder is an investment strategy that involves purchasing bonds with staggered maturity dates so that portions of the portfolio mature at regular intervals, such as every year or every few years.
Should You Build a Bond Ladder With Callable Bonds?
No. Since callable bonds can be redeemed by the issuer before maturity, they're not ideal when building a bond ladder.
How Do You Build an ETF Bond Ladder?
In order to build an ETF bond ladder, an investor simply needs to put an equal amount of money in a number of different ETFs; all with a different defined maturity date.
What Are Alternatives to a Bond Ladder?
Instead of building a bond ladder, an investor can purchase an ETF that holds a diversified portfolio of bonds of varying durations. Popular all-duration ETFs include the iShares Core U.S. Aggregate Bond ETF (ASG), the Vanguard Total Bond Market ETF (BND), the Vanguard Total International Bond ETF (BNDX), and the iShares TIPS Bond ETF.
What Is the Ideal Number of Bonds in a Ladder?
The ideal number of bonds in a ladder depends on the size of the investment and the desired level of diversification. A basic bond ladder might include five to ten bonds with staggered maturities, but larger portfolios could benefit from more bonds to further spread risk.
The Bottom Line
A bond ladder is an investment strategy that involves purchasing bonds with staggered maturity dates, providing a steady income stream while managing interest rate risk. By reinvesting matured bonds into new ones, investors maintain liquidity and can adapt to changing interest rates, therefore reducing overall risk.
