Bond Ladder Tips
Consider building your ladder with at least $100,000 for diversification purposes ($200,000 if investing in corporate bonds).
While there is no required minimum investment for the Bond Ladder tool, we suggest that a minimum of $100,000 invested across multiple issuers, sectors, and maturities can help achieve a diversified bond portfolio. Diversification has two specific meanings in the context of a bond ladder:
- Interest rate diversification: A reasonable spread of bonds at different maturities on the yield curve can help to reduce reinvestment risk (the risk that when a bond matures, the proceeds may be reinvested at a lower interest rate).
- Credit risk diversification: The lower the credit ratings of the bonds held in the ladder, the greater the number of bonds that are necessary to diversify against the risk of default. (See the table on the Build a Bond Ladder page for data on the probability of default for bonds of all investment-grade ratings.
The table below suggests a minimum number of issuers to consider for bond ladders of differing credit quality.
Credit Rating Number of Issuers AAA U.S. Treasury 1 AAA–AA Municipals 5 - 7 AAA-AA 15-20 A 30 - 40 BAA/BBB 60+
Consider building your ladder with a credit quality of "A" or better ("AAA" or insured, when investing in municipal bonds) to reduce default risk.
Because a bond ladder is intended to be a long-term investment, we suggest you use bonds of the highest credit quality.
A bond ladder is fundamentally a buy and hold strategy, so investors may be less sensitive to the risk of downgrade than default risk. However, investors in ladders that hold bonds with an expected lifespan of more than five years should be aware that a bond may have more than one downgrade in succession and at each stage, increasing the probability of default. It is also important to note that default and downgrade probabilities vary over time. Default probabilities are generally higher than average during periods of economic weakness.
The lower a ladder's minimum bond rating, the more bonds are necessary to reduce the potential loss from default risk.
Studies have shown that portfolios of lower quality bonds require more issuers than portfolios of higher quality bonds to achieve proper credit diversification.
- For ladders composed of U.S. Treasury bonds, a single issuer (in this case the U.S. Government) might be sufficient because of the low credit and default risk involved.
- For agency ladders, investors should consider diversifying among several issuers as most agency bonds are sponsored but not guaranteed by the federal government.
- For CD ladders, investors should consider diversifying among several issuers to reduce the likelihood that any one CD exceeds FDIC protection thresholds.
- For AAA- to AA-rated municipal ladders, only a few different issuers may be required to diversify the risk of credit events.
- Corporate bond ladders may require a large number of bonds (10 to 50) for diversification, depending on the underlying issuers.
Note: A portfolio of only a few high quality bonds would still be subject to reinvestment risk.
Excluding callable bonds may help reduce cash flow risk and yield risk.
The Bond Ladder tool provides the option of including or excluding callable bonds, with the default setting to exclude callable bonds. If you decide not to take advantage of call protection, there is a risk that bonds will be called by the issuer prior to maturity. When a bond is called, its interest payments cease and the principal is returned as of the call date. If you seek to reinvest this principal in a similar bond, you will likely have to accept a lower yield (and lower interest payments).
One of the key goals of a bond ladder is to mitigate reinvestment risk by scheduling bonds to mature at regular intervals. This allows bond ladder investors to reinvest principal further out along the yield curve, usually at higher yields. A called bond can alter both your cash flow schedule and the schedule of principal coming due. It is also likely that several bonds might be called within short succession of each other because market conditions that cause one bond to be called might cause other bonds to be called as well.
Keep in mind that with callable bonds, the yield quoted will be the lower of Yield to Call or Yield to Maturity.
When building a municipal bond ladder, consider using either general obligation bonds or essential service and insured revenue bonds.
Municipal bonds are generally backed by one of two primary sources: the full taxing authority of a governmental entity (for general obligation bonds), and revenues from a project (for revenue bonds).
Revenue bonds are generally considered more risky than general obligation bonds, and therefore tend to offer higher interest rates. Investors should consider how essential the service behind the revenue stream is. For example, a facility that delivers fundamental services, such as water and sewer, may be more likely to have dependable revenues through multiple economic cycles.
States will sometimes hire a third party insurance provider to insure the income stream from revenue bonds. This guarantee usually helps raise the credit quality (and reduce the yield) of these insured bonds. However, in recent years, many bond insurers have become significantly weaker in their claims-paying abilities. Investors should consider the credit rating of the insurer as well as the credit rating of the issuer when investing in insured revenue bonds.