A bond ladder is a catchall phrase for a strategy to manage fixed-income (or interest-paying) investments. The term "fixed income" means the security will pay a set rate of interest, established when the instrument was first sold, so the annual income or earnings is the same (or fixed) throughout the life of that security.
Fixed-income securities have maturity dates. When they mature, we get our original investment back, which is used to purchase new securities. If all our money is invested in securities that mature in the same year, then at maturity we must reinvest at whatever interest rate prevails at that time. If interest rates have fallen since our original purchase, then on reinvestment we must either accept less interest income or invest in another security that has a greater risk. That's called reinvestment risk. In general, securities with longer maturities pay a higher interest rate than those with earlier maturity dates. But, the higher the interest rate paid, the greater the potential risk of loss.
A bond ladder lessens the effect of reinvestment risk. The strategy requires us to invest an equal amount of money in securities that mature on different dates. As an example, my strategy would be to invest the first fifth of my fixed-income money in a security that matures one year from now, the second fifth in a security that matures in two years, the third fifth in something that matures in three years, the fourth fifth in a vehicle that matures in four years, and the last fifth in a security that matures in five years. Each maturity date represents a rung on my bond ladder.
The bond ladder produces a much more stable return because only a portion of the portfolio will mature at any one time. If interest rates decline, only a small part of our total fixed-income investment is subjected to the lower return. The remainder of our portfolio continues to earn a higher income due to earlier purchases of securities with a higher interest rate. Conversely, if interest rates rise, then part of our portfolio will always mature at a regular interval, which allows us to take advantage of those higher rates with that part of our investment. In doing so, we are able to increase the yield of that portfolio.
Just as we are unable to predict the direction of stock market prices, we are unable to predict the direction of interest rates. A bond ladder allows us to avoid committing all of our resources to a single rate of return. Instead, it allows us to average those rates over time and provides for a steady stream of principal that we may reinvest at prevailing interest rates as our securities mature. By using the ladder, we avoid the reinvestment risk of committing to a single lower rate of return over the total period of our bond ladder.
If you use a relatively short ladder, as I do, then one way to construct it is by using CDs. Those instruments can be purchased without fee at many banking institutions with maturities as low as six months to as high as five years. Alternatively, for a slightly higher rate of return and a minimum investment of $1,000, you can use Treasury bills that mature in three-, six-, or 12-month intervals, or Treasury notes that mature in two, three, five, or 10 years.
In addition to using CDs and Treasuries, any broker can construct a bond ladder of any length using government and corporate securities purchased at original issue or in the secondary market. Note, though, that the brokerage option will almost certainly be the most expensive way to establish your ladder.
For more on fixed-income investments and other short-term options, visit our Savings Center. And for specific investment ideas, check out Motley Fool Income Investor.
