Why build a bond ladder?

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August 30 2018
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Bond laddering is a strategy that could potentially increase the returns from fixed-income investments while also minimising exposure to interest rate risk.

The bond ladder strategy involves investing in several bonds with varying maturities in an investor’s portfolio. By spreading out fixed-income assets along the interest rate curve, the strategy decreases the losses brought about by interest rate drops and surges due to market movements.

Advantages of bond laddering

The example above is only one example of the advantages of bond laddering.

Investors also favour bond laddering because of the following reasons:

The strategy tends to decrease exposure to interest rate risk.
It keeps a portion of their investment liquid due to the varying maturities of their selected bonds.

Decreases exposure to interest rate risk
The cyclical nature of the economy and investment market makes experiencing market swings inevitable. Interest rates can suddenly surge or drop, forcing bond issuers to call the bond or issue a new one with better rates.

Investors can thus lose the opportunity to earn more from a bond with better rates or end up without an investment if the bond is callable.

The laddering strategy ensures that even if the investor incurs loss from one bond, the stable bonds remain intact and they continue to receive regular income.

Retains liquidity to a portion of the bond portfolio
Because a long-term fixed-income investment is locked away, the only liquid portion of the investor’s money is in the form of interest payouts. Depending on the value of their principal investment, their coupon payments may not amount to much.

However, the bond laddering strategy periodically releases a larger portion of their principal investment with every bond that matures.

For instance, an investor may equally invest $4,000 in five different bonds that mature in one, three, five, 10 and 20 years – for a total of $20,000. With each bond that matures, the investor would gain access to $4,000 plus the interest payments.

Disadvantages of bond laddering

No strategy is completely flawless. There are some bond laddering strategy disadvantages that may prompt investors to reconsider executing the strategy on their own.

These disadvantages include, but are not limited to:

Unfavourable prices
Limited diversification
Limited liquidity
Increased impact in case of default

Unfavourable prices
Compared to institutional and high-net-worth investors, individual investors rarely have the financial capacity to purchase a significant number of bonds. Because of this, individuals don’t usually have access to more favourable or discounted bond prices.

Limited diversification
Some high-value bonds also require a larger sum of money to access. Having a smaller sum of money compared to institutional investors means independent investors have access to a limited number and types of bonds.

Limited liquidity
One of the selling points of the bond laddering strategy is better liquidity. However, investors still need to wait until each bond matures to access their principal investment or sell the bond at a loss if they have a great need for the money.

Increased impact in case of default
Since an individual investor’s bond ladder portfolio tends to be less diversified, a default from any of the included assets may have a bigger impact to their overall portfolio.

For instance, an investor may build a $20,000 bond portfolio composed of five different bonds valued at $4,000 each. If any of their bonds default, they effectively lose 20 per cent of their portfolio.

Consult a professional before executing an investment strategy

Independent investing can be empowering and exciting, but it is still best to consult a licensed professional before executing more advanced investment strategies.

About the author

Louise is a content producer for Momentum Media’s nestegg who likes keeping up-to-date with all the ways people can work towards financial stability in 2019. She also enjoys turning complex information into easy-to-digest, practical tips to help those who want to achieve financial independence.

About the author

Louise is a content producer for Momentum Media’s nestegg who likes keeping up-to-date with all the ways people can work towards financial stability in 2019. She also enjoys turning complex information into easy-to-digest, practical tips to help those who want to achieve financial independence.

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