How To Build A Bond Ladder (Or CD Ladder) To Boost Returns While Reducing Risk

2012 November 27
by Kyle Bumpus
from → Investing And Investments

Bonds are essential tools in any investor’s portfolio toolbox, but as with everything there are trade-offs. A few of the characteristics that make owning them so advantageous, such as a steady, guaranteed stream of interest payments ending with the return of your principle at a pre-determined future date, are also disadvantageous in the context of a portfolio. For example, say you buy a bond from XYZ Corporation with a maturity date 5 years in the future. You are earning 4% interest on that bond, which is pretty good in today’s low-interest rate environment, so you’re pretty proud of yourself. Now fast forward 12 months. Prevailing interest rates are now over 5% and you have a problem: your bond is still paying that same 4% interest. Sure, you could sell your bond on the secondary market and use the proceeds to buy a new 5% bond, but in order to do so you’d have to take a capital loss on the sale, giving you less capital to re-invest at a higher rate. Bummer.

Note: CD laddering works in exactly the same way as bond laddering, if that’s your drug of choice.

There are two common solutions to the above problem:

  1. Buy a bond mutual fund – Since bond funds have no maturity date, they are constantly re-investing interest payments and principle from maturing bonds at prevailing interest rates. When interest rates rise, yes, the bond fund’s price will drop by an amount commensurate with its average duration, but it will also be continuously re-investing in higher-yielding bonds. In the long run, you’ll come out ahead.
  2. Build a bond ladder – Some people prefer to know exactly how much money they’ll have at a specific future date. Bond funds aren’t an appropriate vehicle for that kind of thing, so you’re stuck with individual bonds. If you just bought a bond with a 5 year maturity you’d be exposed to the interest rate risk we mentioned above. A bond ladder strategy allows you to mitigate this risk to a large degree while still guaranteeing full return of principle at whatever future date you choose.

How To Build A Bond Ladder

What is bond laddering? At its base, a bond ladder is when you invest in multiple bonds with significantly different maturities at the same time in order to maximize the returns of your bond portfolio without sacrificing liquidity or exposing yourself to too much inflation or interest rate risk. You might by a 1 year bond at a certain interest rate, then a 2 year bond at a slightly higher interest rate, a 3 year bond at an even higher interest rate, etc until you reach whatever is the longest maturity you are comfortable owning (I would recommend going up to 5 or 10 years). You can ladder your bonds using any interval you want, for example 6 months or even 18 months instead of 12 months.

There are three basic components of any bond ladder

  1. How many rungs do you want? – The number or rungs in your bond ladder represents, for lack of a better word, how much time diversification you want. In normal markets, longer-term bonds yield more than intermediate-term bonds which in turn yield more than shorter-term bonds in a continuum. You would always expect a bond with a longer maturity to yield more than a bond of equivalent default risk with a shorter maturity (ignoring an inverted yield curve, which sometimes happens in the early stages of a recession). An effective, well-diversified bond ladder would have adequate exposure to a variety of maturities from the very short up to the intermediate or even long term. To calculate how much money to invest in each rung, simply divide the amount of money you have to invest by the number of rungs you’d like to own.  Remember, more rungs equals more time diversification, but you don’t want to go overboard.  At some point the amount of additional diversification you’re getting just isn’t worth the extra hassle. I recommend 5 rungs as a good compromise between diversification and simplicity, but nothing is set in stone. Say you have $10,000 to invest in bonds and you want a 5-rung bond ladder. You would simply divide $10,000 by 5 rungs to arrive at $2,000, which is the amount you would invest in each rung of your ladder.
  2. How high do you want your ladder to go? – This is just how long a maturity you want for the top run of your ladder. Do you want your longest-term bond to mature in 5 years? 10 years? 18 months? Remember that longer-yielding bonds tend to yield more than shorter-term bonds but are also subject to more inflation and interest rate risk. While bond laddering can mitigate these risks significantly, it can’t eliminate them. In general, the longer your investment horizon, the higher you can afford to build your bond ladder. Investors retiring in 30 years may choose a 10 or even 15 year bond for their top rung whereas somebody saving for a down-payment on a house within the next 5 years certainly wouldn’t want to go over 5 years. To decide what maturity interval to invest in, simply divide the height of your ladder by the number of rungs it will have as determined in step one. For example, a bond ladder with a height of 10 years and 5 rungs would invest in bonds maturing at 10 years /5 rungs = 2 year intervals (meaning a 2 year bond, 4 year bond, 6 year bond, 8 year bond, and 10 year bond). Similarly, a bond ladder with a height of 5 years and 5 rungs would invest at 1 year intervals while a ladder with a height 3 years (36 months) and 6 rungs would invest at 36 months / 6 rungs = 6 month intervals (meaning a 6 month bond, a 12 month bond, an 18 month bond, etc all the way up to 36 months).
  3. What type of bond would you like to invest in? – In order to be effective, all rungs of a bond ladder should invest in the same type of bond. For instance, if you choose to build a Treasury ladder then all rungs of your ladder should consist of Treasury bonds. You shouldn’t mix in corporate bonds, TIPS, municipal bonds, or CDs. Ladders are meant to diversify across time to mitigate inflation and interest rate risk, not default risk. If you wish to hold different types of bonds (or CDs) you should create a separate ladder for each type. I do not recommend trying to ladder corporate bonds, however, because the default risk is just too high. I would only use Treasury bonds, TIPS, or Certificates of Deposit.
Here’s the most important part: when the earliest-maturing bond in your ladder matures, take that money and reinvest it into a brand new bond with the highest maturity possible that is less than or equal to your goal. So if your goal is 4 years away, you wouldn’t reinvest your proceeds into any bond with a maturity greater than 4 years, no matter how high your bond ladder originally was. On the other hand, if your goal is still 10 years away and the top run of your ladder is only 5 years, you would reinvest the proceeds into a brand new 5 year bond. In this way, you continually rebuild your ladder’s rungs, maintaining constant duration and exposure to inflation and interest rate risks until you near your goal. Once your goal is nearer than the top rung of your ladder, you begin to reign in risk until your goal is met.

Bond Ladder Example

Sound confusing? A bond ladder example should help clear things up.

An investor has $20,000 to invest and is saving up for a new car in 4 years. Since her goal is so close at hand, she wants to keep the height of her ladder relatively low. In this case, let’s just set the height at 4 years. To keep things simple, she will only build a ladder with 4 rungs. Thus, our investor would invest $5,000 each in a 1 year bond, a 2 year bond, a 3 year bond, and a 4 year bond to start off. Here’s what her ladder would look like at the beginning of year 1.

Beginning of Year 1: 4 year bond, 3 year bond, 2 year bond, 1 year bond.

At the end of the first year, the investor’s 1 year bond matures, leaving her with $5,000 to reinvest. Since her goal is now only 3 years away, she can’t reinvest it back into a 4 year bond like she ordinarily would. Instead, she invests that money into a new 3 year bond, which is the longest maturity on her ladder that is still less than or equal to her goal. Notice that the maturities of the other bonds she bought last year will have drawn one year closer, leaving her with bonds maturing at 1 year, 2 years, and 3 years. Add the brand-new 3 year bond she just purchased to this and we get the following…

Beginning of Year 2: 3 year bond, 3 year bond, 2 year bond, 1 year bond

Another year, another maturing bond. This time, our investor reinvests the proceeds into a 2 year bond (since the goal is now only 2 years away), leaving her with…

Beginning of Year 3: 2 year bond, 2 year bond, 2 year bond, 1 year bond

Now the investor only one year away from her goal, so she reinvests our proceeds accordingly, leaving her with a collection of 1 year bonds…

Beginning of Year 4: 1 year bond, 1 year bond, 1 year bond, 1 year bond

Finally, our investor has reached her goal! Conveniently, all her bonds mature at exactly the same time, leaving our subject with plenty of cash to buy her new car. Enjoy!

 

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One Response
  1. 2012 November 28

    Great article. If one is going to invest in bonds, a ladder is key. Rates will go up in the next decade, and investors need the flexibility to adjust as rates change. I create bond ladders with all my bond holding clients.

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