Lets understand Bond Ladder Strategy - Meaning, Goal, Example, How & When to implement
Understand strategy to diversify portfolio to optimize return
If diversification is key to survive over longer period of time then you should follow specific strategy for debt return optimization. Let understand and discover how bond ladders strategy can help you secure the predictable income of bonds with the flexibility to reinvest if rates go up.
What is Bond Ladders Strategy ?
A bond ladder is a portfolio of individual corporate deposits 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 corporate deposits or bonds that mature at different 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.
Manage interest rate risk
By staggering maturity dates, investors avoid getting locked into a single interest rate. A ladder helps smooth out the effect of fluctuations in interest rates because there are bonds maturing every year, quarter, or month, depending on the number of rungs in the ladder. When a bond matures, an investor could reinvest that principal in a new longer-term bond at the end of a ladder. If interest rates have risen, they’ll benefit from a new, higher interest rate and keep the ladder going. If interest rates were to fall, unfortunately the maturing bonds would likely be reinvested at lower rates, but the bonds at the end of the ladder will have likely locked in higher yields already.
Manage cash flow
Since many bonds pay interest twice a year on dates that generally coincide with their maturity date, investors can structure predictable monthly bond income based on coupon payments with different maturity months as well as years.
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.
How does a bond ladder work?
With bond laddering, you invest in multiple bonds with different maturities. As each corporate deposits or bonds 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.
Lets take an example of how a ladder works
Take the total amount that you plan to invest, with the goal of extending the ladder as long as possible. For example, Rs. 10,00,000 to buy individual bonds could be invested with 10 bonds of Rs. 1,00,000 each.
Over span of 10 years, total Rs. 10,00,000 will be invested with 10 bonds of Rs. 1,00,000 each. The average yield of bond will be considered and every bond mature will be reinvested over next ladder to continue this cycle.
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).
How ladders may help when rates are falling
Interest payments from bonds can provide you with income until they mature or are called by the issuer. When that time comes, there’s no guarantee you’ll find new bonds paying similar interest because rates and yields change frequently.
Laddering bonds that mature at different times lets you potentially diversify this risk across a number of bonds. Though a bond in your ladder might mature while yields were falling, your other bonds would continue generating income at the higher older rates.
How ladders may help when rates are rising
A ladder may also be useful when yields and interest rates increase because it regularly frees up part of your portfolio so you can take advantage of new, higher rates. If all your money is invested in bonds with a single maturity date, you might be able to reinvest at higher yields, but your bonds might also mature before rates rise. Ladders can also offer some protection from the possibility that rising rates might cause bond prices to fall.
Bottomline
The Bond Ladder Strategy is effective way to diversify portfolio to optimize return over longer period of time by increasing overall interest yield cumulatively.