- Laddering bonds with a variety of maturities can help provide you with a source of predictable income.
- Ladders should be built with high-quality, noncallable bonds.
- Fidelity's Bond Ladder Tool can help self-directed investors build ladders.
Income-seeking investors can get exposure to bonds through mutual funds, exchange-traded funds (ETFs), and—for those with sufficient assets—individual bonds. A popular way to hold individual bonds is by building a ladder or portfolio of bonds with various maturities. Many investors build bond ladders to help create predictable streams of income and manage some potential risks from changing interest rates.
How ladders may help when rates are falling
Interest payments from bonds can provide you with income until they mature or are called by the issuer. When that time comes, there’s no guarantee you’ll find new bonds paying similar interest because rates and yields change frequently.
Laddering bonds that mature at different times lets you potentially diversify this risk across a number of bonds. Though a bond in your ladder might mature while yields were falling, your other bonds would continue generating income at the higher older rates.
How ladders may help when rates are rising
A ladder may also be useful when yields and interest rates increase because it regularly frees up part of your portfolio so you can take advantage of new, higher rates. If all your money is invested in bonds with a single maturity date, you might be able to reinvest at higher yields, but your bonds might also mature before rates rise. Ladders can also offer some protection from the possibility that rising rates might cause bond prices to fall.
"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 in how you invest in different credit and interest rate environments," says Richard Carter, Fidelity vice president of fixed income products and services.
Bond ladder considerations
Before building a bond ladder, consider these 6 guidelines.
1. Know your limitations
Ask yourself—or your advisor—whether you have enough assets to spread across a range of bonds while also maintaining adequate diversification within your portfolio. Bonds are often sold in minimum amounts of $1,000 or $5,000, so you may need a substantial investment to achieve diversification. It may make sense to have at least $350,000 toward the bond portion of your investment mix if you're going to invest in individual bonds containing credit risk such as corporate or municipal bonds.*
Make sure that you also have enough money to pay for your needs and for emergencies. Also consider whether you have the time, willingness, and investment acumen to research and manage a ladder or if you would be better off with a bond mutual fund or separately managed account.
2. Hold bonds until they reach maturity
You should have a temperament that will allow you to ride out the market’s ups and downs. That’s because you need to hold the bonds in your ladder until they mature to maximize the benefits of regular income and risk management. If you sell early, you will risk losing income and may also incur transaction fees. If you can't hold bonds to maturity, you may experience interest-rate risk similar to a comparable-duration bond fund, which you may want to consider instead.
3. Use high-quality bonds
Ladders are intended to provide predictable income over time, so using riskier lower-quality bonds makes little sense. To find higher-quality bonds, you can use ratings as a starting point. For instance, select only bonds rated "A" or better. But ratings can change, so you should do additional research to ensure you are comfortable investing in a bond you may potentially hold for years. If you are investing in corporate bonds, particularly lower-quality ones, you need more issuers to diversify your ladder. This table suggests how many issuers you may need.
How do bond ratings work?
Moody's and Standard & Poor's are independent credit rating services that analyze the financial health of bond issuers. The ratings they assign help investors assess how likely an issuer is to be able to make principal and interest payments to bondholders.
4. Avoid the highest-yielding bonds
An unusually high yield relative to similar bonds often indicates the market is anticipating a downgrade or perceives that bond to have more risk than others and has traded its price down and increased its yield. One potential exception is municipal bonds, where buyers often pay a premium for familiar bonds and bonds from smaller—but still creditworthy—issuers that may have higher yields.
5. Keep callable bonds out of your ladder
Part of the appeal of a ladder is knowing when you get paid interest, when your bonds mature, and how much you need to reinvest. But when a bond is called prior to maturity, its interest payments cease and the principal is returned to you, possibly before you want that to happen.
6. Think about time and frequency
Another feature of a ladder is the length of time it covers and how often the bonds mature and return principal. A ladder with more bonds will require a larger investment but will provide a greater range of maturities. If you choose to reinvest, you will have more opportunities to gain exposure to future interest rate environments.
How to build a bond ladder
Here’s an example of how you can build a ladder using Fidelity's Bond Ladder tool. Mike wants to invest $400,000 to produce income for about 10 years. He starts with his investment amount—though he could also have chosen a level of income. He sets his timeline and asks for a ladder with 21 rungs (that is, 21 different bonds with different maturities) with approximately $20,000 in each rung. Then he chooses bond types. In order to be broadly diversified, each rung contains a range of bonds and FDIC-insured CDs with various investment grade credit ratings.
Mike lets the tool suggest bonds for each rung. On the next screen, the tool suggests bonds and shows a summary of the ladder, including the expected yield and annual interest payments. (Note: The screenshot below is incomplete and only shows 2 of the rungs in order to highlight the summary calculations, such as the Average Yield, at the top of the page.)
Another view shows Mike the schedule of interest payments and return of principal he could expect if he purchases the ladder.
Mike's expected cash flow appears to decrease as bonds mature, but he may be able to extend his income by reinvesting the principal.
While a well-diversified bond ladder does not guarantee that you will avoid a loss, it can help protect you the way that any diversified portfolio does, by helping to limit the amount invested in any single investment. Also, a bond ladder leverages the cash flow features of bonds in terms of their coupons and principal repayments: this gives it the potential to be an efficient and flexible vehicle with which to create an income stream tailored to the time period, with a payment frequency to meet your needs.