When the first bond matures, the principal is reinvested in another bond at the long end of the ladder. This process is continued year after year, as long as the investor’s goals remain the same.
As you can see, the fundamental idea behind a bond ladder is diversification by maturity. Diversification is one of the cornerstones of sound investment management.
The bond ladder strategy offers you many benefits:
Higher Average Yields
Generally, the longer a bond’s maturity, the higher the yield. A bond ladder combines the higher yields of longer-term bonds with the liquidity of shorter-term bonds.
More Consistent Returns
If interest rates rise, newly purchased bonds take advantage of improved rates. If interest rates fall, your prior laddered holdings will most likely produce more income than could be achieved at the current levels. The result may be a more consistent yield.
Less Reinvestment Risk
With a bond ladder, you lessen reinvestment risk-the risk that all income assets mature when yields are low, forcing you to accept less income or choose riskier, higher-yielding investments. A bond ladder strategy can reduce the impact of this risk. However, this requires an ongoing commitment to the program.
In addition to diversifying your principal in bonds with different maturities, you can also build your bond ladder with different issuers and credit ratings. By doing so, you have potential to benefit from the additional diversification.
With a bond ladder, you have one or more bonds maturing on a regular basis. You can choose to reinvest your principal in another bond or redirect the funds for another purpose. Should you need extra cash, liquidating your shorter maturities should have minimal impact on your portfolios overall yield.
Every investment involves a risk/reward trade-off. The less risk you are willing to assume, the lower the yield or return you can typically expect from an investment. Generally speaking, bond investors demand higher yields for shouldering market risk and credit risk.
Market risk is simply another way of describing the inverse relationship between bond prices and interest rates. If interest rates are rising and you dont want much fluctuation in your bond portfolio, stay short-term. Although rising interest rates push all bond prices down, in general, the longer a bonds time to maturity the greater its price sensitivity. By concentrating on short-term bonds, you may be less exposed to market risk a comfortable posture for many.
On the other hand, if interest rates are falling from currently high yields, income-oriented investors may want to purchase longer-term securities. This strategy enables you to own an attractive yield that may not be available in the future. Because interest rates are difficult to predict with accuracy, you may want to own short- or intermediate-term bonds (up to 10 years) and simply hold them to maturity. Bond ladders can be structured with short-, intermediate-, or long-term bonds. The bond ladder concept is a strategy many investors to follow with a goal to minimize market risk. Credit risk is the risk that the issuer wont make timely interest or principal payments. If you are concerned about default, construct your bond ladder with Treasury securities, high-quality or insured municipal bonds, or corporate bonds. Although you may sacrifice some yield, you’ll have peace of mind knowing you own high-quality securities.
In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks. Any fixed income security sold or redeemed prior to maturity may be subject to substantial gain or loss.
The bonds are subject to availability.
Bonds are subject to interest rate, market, inflation and credit risks. Bonds that are rated by Moody’s at Ba or below are considered to have speculative elements and the repayment ability of the issuer is not assured.
Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.