Discover how bond ladders can help you secure the predictable income of bonds with the flexibility to reinvest if rates go up.
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A bond ladder in action
I sometimes hear from people who want to invest in bonds, but aren't sure if they should jump in now or wait for interest rates to rise. Unfortunately, it's extremely difficult to predict when interest rates will rise or fall, and staying on the sidelines can mean you miss the benefit of current yields. That's where a bond ladder can help.
A bond ladder is a portfolio of individual bonds that mature on different dates.
For example, you might be able to build a ten year bond ladder with a bond maturing every year. As the bonds at the lower end of the ladder mature, the proceeds can be reinvested at the long end, in new long-term bonds.
If interest rates have risen, you'll be able to take advantage of higher yields relatively quickly.
And if rates have fallen, you'll still have higher-yielding bonds in your ladder.
This can help smooth out the effects of market volatility on your portfolio.
You can also use a bond ladder to help manage cash flows.
Because many bonds pay interest twice a year, on dates that generally coincide with their maturity date, investors can structure monthly bond income by creating a ladder with a mix of short- and long-term bonds that generate income every month.
It would take a large portfolio to meet all of an investor's income needs with a bond ladder alone. But over time, a bond ladder can help ensure that your eggs aren't all in one basket, and can help you manage in a changing interest rate environment.
A bond ladder is a portfolio of individual CDs or bonds that mature on different dates. This strategy is designed to provide current income while minimizing exposure to interest rate fluctuations. Instead of buying bonds that are scheduled to mature during the same year, you purchase CDs or bonds that mature at staggered future dates. Spreading out maturity dates can help prevent investors from trying to time the market. Staying disciplined and reinvesting the proceeds from maturing bonds can help investors to ride out interest rate fluctuations.
What are the primary goals of a bond ladder?
There are two primary goals a bond ladder can help investors achieve.
How is a bond ladder created?
The bond ladder itself is fairly straightforward to create. The overall length of time, spacing between maturities, and types of securities are primary considerations when building a bond ladder. Even in a low or rising interest rate environment, bond ladders can help to balance the need for income while managing interest rate risk.
Take the total amount that you plan to invest, with the goal of extending the ladder as long as possible. For example, $100,000 to buy individual bonds could be invested with 10 rungs of $10,000 each.
An additional benefit to having at least six rungs is that an investor can create a ladder structured to generate income every month of the year.
The distance between rungs is determined by the span of time between the maturities of the respective bonds, which can range from months to years. Generally, the spacing should be roughly equal.
Bonds with longer maturities tend to offer higher yields, though shortening the bond maturities generally reduces income and interest rate risk.
Just like a real ladder, investors can build their ladders with different materials; in other words, different types of bonds or CDs. Moreover, investors can also utilize the potential tax advantages of municipal bonds, the credit guarantee of U.S. Treasuries, or the generally higher yields of investment-grade corporate bonds.
At Schwab, we generally prefer investors to focus on higher-rated bonds when building a bond ladder. Lower-rated bonds, like high-yield bonds, have a greater likelihood of default, and could negatively impact the goal of steady income and predictable value at maturity.
How does a bond ladder work?
With bond laddering, you invest in multiple bonds with different maturities. As each bond or CD matures, you can reinvest the principal in new bonds with the longest term you originally chose for your ladder.
If interest rates move higher, you can reinvest at higher rates. If rates fall, you’ll still have some bonds locked in for the longer term at higher yields.
Here’s an example of how a ladder works and is for illustrative purposes only.
In this example, you buy four bonds with staggered maturities. Your combined average annual yield is 2.125%.
Ladder two years from today
In two years, when Bond A matures, you can reinvest the proceeds in a new bond, extending your ladder. You can continue to do this as bonds mature in the future.
This hypothetical example is for illustrative purposes only. It cannot predict or project the return of any specific investments.
While predictable, bond income is not guaranteed and is subject to call risk as well as possible default on principal and interest (which increases with lower-rated securities).
Schwab suggests purchasing a minimum of 10 securities for diversification.
Keep in mind, while the minimums for buying corporate and municipal bonds may be relatively low, there are typically benefits to investing larger amounts into individual bonds, such as greater liquidity. For relatively small investments, fixed income mutual funds or exchange-traded funds (ETFs) may make more sense.
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