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A bond ladder is an investment strategy where you buy several bonds with different maturity dates. The goal is to generate a reliable stream of income while reducing interest rate risk -- which, as we'll explain shortly, is a big risk for bond investors. In this article, we'll explain how a bond ladder works, the pros and cons, and who should use this strategy.
A bond ladder is a portfolio of multiple bonds with different maturity dates. Investors commonly use this strategy to manage interest rate risk, diversify their portfolio, and improve liquidity.
Interest rate risk is the risk that fluctuations in a bond portfolio will reduce its value. Bond prices and interest rates have an inverse relationship, i.e., when interest rates rise, bond prices fall, and vice versa. The reason? A big appeal of investing is bonds is the annual interest payments, frequently referred to as bond coupons.
If interest rates spike, demand for existing bonds will drop. Investors can get a better yield by buying new bonds instead of purchasing existing ones. But if interest rates drop, you face reinvestment risk, or the risk you'll have to put your money in lower-yielding investments when your bonds mature.
As a simplified illustration, imagine you invested $10,000 in a single bond issue with a 10-year maturity date that pays a 4% annual coupon. But interest rates rise, and investors can earn 6% annually on similar bonds. So if you try to sell your bonds on the secondary market, you'd probably have to sell them for less than their face value because investors can earn more with newer bonds.
But let's say you opted for a bond ladder instead and invested $2,000 in five different bond issues with one-, two-, three-, four, and five-year maturities that paid rates ranging from 3% (for the one-year bond) to 5% (for the five-year bonds).
If interest rates rise when the first bond matures after one year, you can reinvest your $2,000 and take advantage of those higher yields. But if interest rates have fallen, you'll still have money invested in bonds earning a higher rate.
As with any investment strategy, there are several pros and cons associated with a bond ladder.
Here's an example of what a bond ladder could look like if you invested $10,000 each in the following bonds:
By the time Bond A matures, you'd have received $10,300 between the principal and interest. You'd then take that money and reinvest it in a five-year bond at current interest rates, which means you'd always have a portfolio of bonds with maturity dates ranging from one to five years.
