If you believe interest rates are going to continue on an upward trajectory, a bond ladder is one way for you to manage the risk. While I have personally preferred the historically greater returns by investing in equities, bonds and CDs offer returns with less volatility and a stable return until they mature.
Like other investments, when you invest in bonds, you face the risk that you might lose money. Interest rate risk is the risk that changes in interest rates will affect the market value of the bond you hold. If interest rates rise after you buy bonds, you’re not only missing out on potentially higher yields, but the market value of your bond will likely go down. The cardinal rule of bonds is that when interest rates fall, bond prices rise, and when interest rates rise, bond prices fall. To mitigate this interest rate risk, you may opt to buy bonds with staggered maturity dates using a strategy called “bond laddering.”
A bond is essentially a loan to a corporation or a government agency. Investors can purchase corporate or government debt, which entitles them to interest payments and the return of their initial investment, or principal, at maturity as defined by the bond’s purchase agreement.
A bond’s interest rate is often called its “coupon rate.” The coupon rate of fixed-rate bonds is largely influenced by the interest rates set by the Federal Reserve. But the bond’s length of maturity also makes a difference: In general, bonds that mature over a longer period of time pay a higher coupon rate to compensate investors for the greater level of interest rate risk they’re taking on.
How Do Bond Ladders Work?
A bond ladder strategy can help smooth out the effects of interest rate risk while allowing investors to take advantage of higher coupon rates offered by longer-term bonds.
For example, an investor may set up a bond ladder by investing an equal amount of money into bonds that mature in two, four, six, eight, and 10 years.
The investor holds each set of bonds until maturity. After two years, the first bonds mature and the investor receives their principal back, in addition to the interest they’ve accrued along the way. At this point, they have two choices: They can cash out, or they can continue the bond ladder by reinvesting the principal in new bonds that mature in 10 years—adding a rung to their existing ladder. After two more years, when the next set of bonds matures, the investor adds another 10-year bond to the ladder. Continuing in this way, they’ll eventually have a continuous ladder of five 10-year bonds staggered to mature at two-year intervals.
Because the individual bonds in a bond ladder are eventually all 10-year bonds, the investor takes advantage of the higher coupon rates of long-term bonds.
As interest rates change over time, a bond ladder strategy can help protect investors from varying rates over the years. By reinvesting principal as interest rates rise, investors can benefit from those rising rates in the longer term. When interest rates fall, bonds with higher rates already part of the ladder can help offset any interest rate reductions.
What Kind of Bonds are Best in a Bond Ladder?
Bonds are rated by the creditworthiness of the issuer, or a measurement of how likely they are to repay the bond on schedule. The highest-rated bonds, such as those issued by the U.S. Treasury, are rated “AAA.” Generally speaking, it’s best to invest in bonds rated “A” or higher. Study bond ratings carefully before adding the security to your ladder. Be especially wary of high-yield bonds, which typically offer a higher rate of return, but are also at higher risk of default.
Callable bonds are another risky prospect when attempting to create a bond ladder. Callable bonds can be “called” back by the borrower at any time before the maturity date if they find it advantageous to do so. Investors may want to avoid these bonds so rung from their ladder isn’t removed unexpectedly.
By creating a bond ladder and paying attention to the kinds of bonds they include in them, investors may be able to achieve a steadier investment stream over time from their bond letter.