How to Build a Bond Ladder in Your Portfolio
Fixed-income investors need predictable income, and one of the classic ways to receive continual cash flow from investments is to set up a bond ladder.
Just like a step ladder has ever-higher rungs, an investor or a financial advisor creates a bond ladder by buying several bonds with consecutive maturity points that span a certain time frame. This allows the investor to create a predictable stream of bond income, says Marc Pfeffer, chief investment strategist at CLS Investments.
[Read: The Ultimate Guide to Bonds.]
Here are three things to know about setting up a bond ladder:
-- What is a bond ladder?
-- How do you build a bond ladder?
-- Why you should buy a bond ladder?
What Is a Bond Ladder?
Ladders can be short term, such as holding bonds that mature in three, six, nine and 12 months, or ladders can be longer term, holding bonds that mature in yearly increments. Some ladders may extend out one to five years, others can go out to 10 years. The length of a bond ladder depends on the investor's income needs.
Jason Bloom, senior director of global macro ETF strategy at Invesco, says bond ladders address the two different income needs for investors. The first is to align cash flow and the return on the principal investment with the investor's future liability, which is to ensure an investment matures in time to pay a known debt.
People sometimes use bond ladders to pay college tuition bills, for example, having the bonds mature just before school bills are due.
Bond ladders also reduce interest-rate investment risk and reinvestment risk, Pfeffer says. By staggering when certain bonds mature, investors have interest rates locked in for the life of the ladder.
Typically interest rates rise as the calendar extends to reward the investor to take extra risk, which is why short-term bonds are supposed to have lower interest rates than long-term bonds.
To keep the ladder going, when a bond matures, the investor can take those proceeds and buy the longest-dated bond in their series. For example, if someone has a five-rung bond ladder with maturities that stretch from one year to five years out when the one-year bond matures, the investor takes the proceeds and reinvests in a five-year bond.
"From an investment-portfolio construction standpoint, it is the sort of timeless strategy to manage interest-rate risk," Bloom says.
How Do You Build a Bond Ladder?
Bond ladders can also help with diversification and portfolio stability, says Jody Lurie, director of fixed income strategy and research at Janney Montgomery Scott.
Not only are investors buying at different maturities, they often are buying from different issuers. Because investors have locked in their investments and reinvest at predictable increments, this action can lower volatility and still allow investors to participate in the markets.
However, it means that investors can't necessarily take advantage of price swings because their position is set. Bond ladders help protect an investor's downside risk, but they also limit upside potential.
"That's the point of diversification," Lurie says. "The point is not to have these wide swings. It's to create kind of a band to hedge your risk. So if you're reducing your downside, then you're also reducing your upside. There are sacrifices to be made for that."
[See: 7 of the Best Bond ETFs to Buy Now.]
Lurie says bond ladders can be used for an entire fixed-income portfolio to mitigate price swings from the equity side, or they can be used for a small amount of money.
She gave an example of how to build a bond ladder for the short term for a small amount of money. If someone expects to receive a windfall but doesn't like the equity market's volatility or may need the money sooner than later, this person can use a very safe investment like a certificate of deposit staggered over six months or a year.
"Having a short-term CD ladder could make sense as an alternative to having the money sit in cash and do nothing. That's not to say that the CD ladder doesn't have its own risks, but if it's FDIC-insured and you keep it within the FDIC limits, in theory it should be better than having it sit in cash," Lurie says, referring to the Federal Deposit Insurance Corp guarantees.
Investors can build bond ladders using individual bonds, CDs and exchange-traded funds designed for laddering, such as Invesco's BulletShares ETFs and iShares iBonds, which have fixed maturity dates.
However, Jennifer Ellison, principal at Bingham, Osborn & Scarborough, says it's difficult and can be costly for retail investors to buy individual bonds, so she recommends individuals use a bond manager because of the complexity of buying individual bonds.
Why You Should Buy a Bond Ladder?
Ellison says bond ladders are a conservative investment and are for investors who are generally focused on earning income rather than growth. But that can mean that investors lose out on a bond's total return, which has been significant in the current interest rate environment, she says.
Total return takes into account both price appreciation and yield, and total return was a significant part of last year's strong fixed-income market returns.
Because of the current interest rate environment where the yield curve is flattening, which means longer-dated bonds have a similar yield to short-term bonds, investors who want to create a bond ladder should stick to using shorter-term CDs, she says.
[See: Why Bonds Beat Expectations.]
Pfeffer says bond ladders remain worthwhile for those who want predictable income. To make a bond ladder successful, he says investors need to hold their bonds to their maturity as selling early messes up the income flow.
Investors need to make sure the bonds are not callable, meaning that the issuer has the option to pay off the bond before the maturity date. That also can wreak havoc on a bond ladder because the bond will no longer earn interest.
Finally, bond ladders still have credit risk and won't protect the holder from defaults, he says, so it's imporant to know the issuer's credit rating.
Generally, Bloom says, bond ladders are good for investors who want stability.
"You get concrete visibility over those over the life of the bond ladder," he says. "You know what your total return is going to be as long as the bond doesn't default. Visibility in this investment landscape is something pretty rare."
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