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A bond ladder is a combination of fixed income securities, such as bonds and notes, with varying maturity dates.
The maturity dates of these bonds occur at regular periods over time, which creates a laddered structure.
On-screen text: Disclosure: Investments in bonds and fixed income products are subject to various risks and special tax liabilities. You should discuss any/all implications of investing in such products with your broker and/or tax advisor.
In this video, we'll examine how bond ladders work and learn how they can generate regular income and reduce risk in a fixed income portfolio.
One of the main risks that fixed income investors face is interest rate risk. This is the risk that interest rates will rise, which may cause bond prices to fall.
Not all bonds have the same level of exposure to this risk. Bonds with short maturities, such as six months or one year, reach maturity relatively quickly. Because any change in interest rates would affect the bond owner for a comparatively limited time, these investments are less exposed to interest rate risk. Generally, because of the lower risk involved, these bonds pay lower interest.
Conversely, bonds with long maturities, like five or 10 years, are more exposed to interest rate risk. Because of the increased interest rate risk, these investments typically pay higher interest.
If an investor had to choose between these two investments, she would have to decide between a bond with more risk and a higher interest rate or a bond with less risk and a lower interest rate.
On-screen text: Disclosure: Bond funds contain interest rate risk (as interest rates rise, bond prices usually fall); the risk of issuer default; and inflation risk.
Bond ladders propose an alternative. With a bond ladder, an investor purchases both bonds, plus one or more others with different maturities, which allows her to earn a favorable yield but also reduce interest rate risk. This is because portions of her fixed income portfolio will reach maturity at regularly scheduled intervals. So, should interest rates rise, she'll have access to a portion of her funds sooner, which she can reinvest in new, higher-interest bonds.
To better understand how bond ladders work, let's look at an example.
On-screen text: Disclosure: For illustrative purposes only. Not a recommendation of any security or strategy.
Suppose an investor has $30,000 to invest in fixed income. She has a low risk tolerance and a short time horizon.
She finds the following securities that meet her investment criteria: a Treasury bill with a 1-year maturity and a quarter-percent yield, a Treasury note with a 3-year maturity and a .85% yield, and another Treasury note with a 5-year maturity and a 1.15% yield.
By spreading her funds across these three securities, she creates a bond ladder that earns an average yield of 0.75%. Additionally, part of her portfolio will mature every two years.
Therefore, if interest rates were to rise, say by one percentage point, the investor can reinvest the principal from the matured bond in a new bond or CD with a higher rate. So, with a bond ladder, our investor is able to receive regular income payments and reduce interest rate risk.
These benefits are what make bond ladders a widely used strategy among fixed income investors.
Bond ladders can minimize the risk of rising interest rates, while maximizing the income from a fixed income portfolio. But like all other investments, bond ladders carry risks and may not be appropriate for all investors. To learn more about bond ladders, you can go online or contact a fixed income specialist.
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