What are bond ladders?
Learn about bond ladders and how they can support a cash management strategy.
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1 minute
February 21, 2024
Bond ladders are a popular tool many corporate cash managers use.
This post will help define the concept, cover advantages and potential risks, and how to use them as part of your company’s investment strategy.
Let’s dive in.
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A bond ladder is a portfolio of bank CDs or bonds that mature at different times in the future. The strategy focuses on providing income while reducing risk from changes in interest rates.
Buying bank CDs or bonds (a type of fixed-income security) with different maturity dates forces you to stick to a plan, keeping you disciplined instead of trying to time the market. It also lets you know when and how much you will get paid via principal and coupon payments.
You can create a near-perpetual revenue stream if you continue reinvesting the cash from each maturing bond.
Remember that with bond ladders, you invest in multiple bank certificates of deposits (CDs) or bonds with different maturities. As each bond matures, you reinvest in a new bond with the longest maturity you picked for the ladder.
If interest rates rise, you buy a new bond with a higher rate. If interest rates fall or stay the same, old bonds are locked in at a higher rate.
In the illustration below, we picked eight years for ladder length with two-year rungs.
Two years in the future, Bond 1 matures, and it's time for you to reinvest that money in a new bond at the maximum maturity. In this example, rates rose. You would continue this process for as long as you wanted the ladder in place.
If used correctly, a bond ladder can create cash flow and income to pay expenses, fund business objectives, pad emergency funds, and extend the life of your business.
Create & Manage Cash Flow Since bonds can pay you monthly, semiannually, or at maturity. You can design and structure your bond ladder in any way you want or need.
Manage Interest Rate Risk Interest rates change often and sometimes dramatically. When you build a bond ladder with different maturity dates, you avoid locking in any single rate for a long time. The staggered maturity dates may smooth out the volatility in a changing interest rate environment.
Each time a bond matures, you go to the market and purchase a new bond with a maturity date in the future. If rates have risen, you lock in a new lower bond price for that portion of the ladder. If rates have fallen, you will, unfortunately, buy a lower rate. However, bonds in the ladder will have previously locked in higher rates.
This structuring helps to reduce reinvestment risk. The allure of utilizing a bond ladder stems from its ease of use, consistent returns if put into practice properly, and potential for automation.
While bond ladders can be an effective strategy for income investments, they are not without potential risks that can substantially impact your pool of investment.
These risks can largely be categorized by changes in market conditions and the risk of loss of the principal amount. Understanding these risks may require investment advice to align them with your investment objectives and risk tolerance.
Volatile market conditions: Market changes are a fundamental challenge that can potentially result in fewer returns.
For instance, when bonds mature and the proceeds are reinvested in a declining interest rate environment, they might be at lower rates than initially planned.
Conversely, in a rising interest rate environment, the value of bonds can decrease.
Careful consideration of these typical 1-2 market conditions-related risks is crucial, particularly in highly volatile economies.
Loss of Principal: If you need to sell a bond before it matures, the bond could sell for less than its purchase price, hence, a loss of the principal.
Bond ladders are straightforward to create. Building them has three main pieces: rungs, spacing, and investments.
Rungs of the Ladder: Deciding how much you plan to invest in a bond ladder will determine how many rungs it will have. This also decides how far in the future the ladder can be and how often you get paid.
For illustrative purposes, $1,000,000 for your bond ladder strategy could give you 10 $100,000 rungs. Each $100,000 rung would purchase an individual bank CD or bond
Rung Spacing: Rung spacing is the time between the maturities of each bond. It is ideal to try to keep the time between maturities near equal and in regular intervals.
Longer maturities will generally pay you more. But they also increase your interest rate risk.
You can reduce interest rate risk by shortening the bond maturities of the bond ladder.
Investments: A bond ladder can be built with various fixed-income instruments. Each flavor has a different benefit, but here are the most common in the bond market: Bank CDs, US Treasuries, Municipal Bonds, Investment-Grade Corporate Bonds, and High-Yield Bonds.
Tip: It is best to build a ladder out of higher-rated bonds. A high-yield bond can offer you increased yield but comes with an increased risk of default. Defaults can affect the goal of consistent income and whether you get your entire investment back.
There are many investment strategies and diversification tools to earn, with bond ladders on the more conservative end. You build a bond ladder strategy fixed-incomefor your needs, with various fixed income assets and maturity dates helping you customize while letting you manage cash flow and reduce your interest rate risk.
And you have reasonable expectations of the benefits – if you value cash flow and income, you may want to consider one for your business.
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Bonds are debt securities that provide regular income to those who purchase them (referred to as bondholders). Bonds can come in several varieties based on the bond issuer distributing them, maturity dates, and other factors.
Examples include:
Let's dig a bit deeper. For illustrative purposes, when you invest in individual bonds, you essentially act as a lender to the issuer. In exchange, you receive scheduled payments over a specified period, and the bond’s face value returns when it reaches maturity.
Bonds can range in credit quality; some are classified as investment-grade and others are classified as high-yield (also referred to as "junk bonds"), which offer higher yields to compensate for the higher risk associated with bonds of lower credit quality.
A common practice mentioned previously in this post is to diversify your portfolio. Investors can do so by investing in various different bonds that vary in terms of issuer, maturity date, yield, and credit rating.
Before investing in any bonds, it’s critical that you spend some time reviewing the prospectus, which gives detailed information about the security, including its credit quality, maturity date, yield, and the reputability of the issuer.
Finally, the Securities Investor Protection Corporation (SIPC) protects against the loss of cash and securities – such as stocks and bonds – in case the broker fails. However, it does not protect against market loss.
Bond Exchange-Traded Funds (ETFs), much like bond funds and mutual funds, offer a straightforward way to achieve diversification, and their shares can be traded through a brokerage.
However, it’s worth noting that you own shares of the ETF rather than the underlying bonds represented, which are held with fidelity by the ETF provider or fund manager.
This structure introduces a level of risk, as the health of your investment becomes tied to the performance and stability of the fund manager.
Thus, while bond ETFs provide the convenience of mutual and bond funds, their unique structure also adds an unpredictable element to your investment strategy.