- Staggering bond maturities can help to create a predictable stream of bond income.
- The rungs help to manage interest rate and reinvestment risk.
- Build with diverse, high-quality, noncallable bonds.
Investors looking for steady income have plenty of options, from a simple CD to different flavors of annuities, individual bonds, separately managed accounts, or professionally managed mutual funds. One other option is the bond ladder.
Like all these options, bond ladders have their advantages and disadvantages, but many investors decide to build a bond ladder because it can help to customize a stream of income and manage some of the risks of changing interest rates.
Interest rate risk is the potential for rising rates to cause the prices of bonds to fall. While many investors can live with rate risk in exchange for the benefits bonds can provide a diversified portfolio, uncertainty about rates can be unnerving, especially for investors who look to bonds to create a stream of income. Bond ladders may help to manage these concerns by creating a predictable stream of income.
"Laddering bonds may be appealing because it may help you to manage interest rate risk, and to make ongoing reinvestment decisions over time, giving you the flexibility to invest in different credit and interest rate environments," says Richard Carter, Fidelity vice president of fixed income products and services.
It's worth noting however, that bond ladders don't completely eliminate rate risk, the price of bonds in the ladder continues to fluctuate as rates change, and an investor will still face periodic reinvestment risk for some portion of the portfolio.
Managing reinvestment risk
Interest payments from the bonds in a ladder can provide scheduled cash flows. In addition, the ladder can help you manage reinvestment risk. What is reinvestment risk? Say you invest in an individual bond. That bond eventually would mature, the issuer would return your principal, and you'd have to purchase a new bond if you wanted to continue generating income or maintain your portfolio's asset allocation mix. But if interest rates and bond yields had decreased in the meantime, you wouldn’t be able to generate as much income as before with the same amount invested in a similar quality bond. That’s a predicament some investors who rely on investment income won't want to find themselves in.
Building a bond ladder has the potential to diversify this reinvestment risk across a number of bonds that mature at different intervals. Imagine that yields fall as one rung in your ladder approaches maturity. If you choose to reinvest, you will have to invest only a fraction of your bond portfolio at the lower rate. Meanwhile, the other bonds in the portfolio will continue generating income at the relatively higher older rates. So the impact of falling rates may be smaller with a ladder than with a bullet strategy that targets a single maturity date or than with an investment in a small number of bonds.
What if yields and interest rates increase? A bond ladder regularly frees up a slice of your portfolio, so you can take advantage of the new, higher rates. If you have all your money invested in a "bullet" strategy, with a single maturity date, you might be able to reinvest at higher yields. But what if your bonds didn't reach maturity while rates are higher? If none of your holdings mature during the time of higher rates—you might miss out.
"A bond ladder gives you a framework in which to balance the reinvestment opportunities of short-term bonds with the potentially higher yields that longer-term bonds typically offer," says Carter.
Having a well-diversified bond ladder does not guarantee that you will avoid a loss, but it can help protect you the way that any diversified portfolio does, by helping to manage the risk of any single investment.
Bond ladder considerations
While building a bond ladder may help you manage interest rate and reinvestment risk to some extent, there are 6 important guidelines to consider to make sure you are diversified and to attempt to protect yourself from undue credit risk.
1. Hold bonds until they reach maturity
It's important that you have enough money set aside to meet your short-term needs and deal with emergencies. You should also have a temperament that will allow you to ride out the ups and downs of the market. That’s because many of the benefits of bond ladders—such as an income plan and managing interest rate and credit risk—are based on the idea that you keep your bonds in your portfolio until they mature. If you sell early—either because you need cash or you change your investment plans—you will be exposed to additional risks, including the risks of loss or decreased yield from your ladder. In fact, if you don't hold bonds to maturity, you may experience similar interest-rate risk as a comparable-duration bond fund. So, if you don't know how long you can hold the bonds, you may want to consider a shorter ladder, or a bond mutual fund.
2. Make sure you have enough money invested to diversify*
Because bonds are often sold in minimum denominations of $1,000 or $5,000, it can take a substantial investment to achieve diversification. It may make sense to have at least $500,000 in bond investments in your long-term investment mix.
If you are investing in corporate bonds, particularly lower-quality corporate bonds, the number of issuers needed to diversify a ladder across sectors and issuers becomes even greater.
The table to the right offers some illustration of how many different issuers may be required to help achieve diversification at different credit ratings.
3. Build your ladder with high-credit-quality bonds
Because the purpose of a bond ladder is to provide predictable income over a long period of time, taking excessive amounts of credit risk probably doesn't make sense. So you may want to consider only higher-quality bonds. You can use ratings as a starting point to find those bonds. For instance, select only bonds rated "A" or better. But even ratings have limits; they could change or be outdated, so you should do additional research to ensure you are comfortable investing in a security you are intending to hold for potentially many years.
How do bond ratings work?
Two of the major independent credit rating services are Moody's and Standard & Poor's. They research the financial health of each bond issuer (including issuers of municipal bonds) and assign ratings to the bonds being offered. A bond's rating helps you assess that bond's credit quality compared with other bonds.
The bonds in a ladder are intended to be held until maturity, so price declines caused by rating downgrades generally won't affect the income stream, though it will impact the underlying value of the ladder. Higher-quality bonds offer another advantage as well: These investments typically come with lower transaction costs, which can help manage the expenses associated with this strategy.
4. Avoid the highest-yielding bonds at any given credit rating
You may feel tempted to choose the highest-yielding bonds for whatever credit rating or maturity you have chosen, figuring they represent a bargain—more yield for the same amount of risk.
Resist that temptation. You need to understand why a bond is offering a higher yield. An unusually high yield relative to similar bonds is often an indication that the market is anticipating a downgrade or perceives that bond to have more risk than the others and therefore has traded the bond’s price down (thereby increasing its yield). That can happen in advance of an official downgrade and may be too risky for your ladder. One potential exception is that in the municipal bond market, buyers often pay a premium for the most familiar issuers, meaning that higher yields may be available from smaller issuers.
5. Keep callable bonds out of your ladder
Part of the beauty of a bond ladder is the scheduled cash flow; you know when the bonds will mature and you know how much you will need to reinvest. But when a bond is called prior to maturity, its interest payments cease and the principal is returned as of the call date—altering both your cash flow schedule and the schedule of principal coming due. You may want to select bonds that can’t be called away early.
6. Think about time and frequency
Another important feature of a bond ladder is the total length of time the ladder will cover and the number of rungs, or how often the bonds in the ladder are scheduled to mature, returning your principal. A ladder with more rungs will require a larger investment but will provide a greater range of maturities, and if you choose to reinvest, this means you will have more opportunities to gain exposure to future interest rate environments.