As the bonds on the lowest rung of the ladder mature, you have the choice of either reinvesting in bonds on the highest rung of the ladder or moving your investment out of the ladder altogether. As the bonds are reinvested, the yields may be higher or lower depending on interest rates at the time you reinvest (reinvestment risk). If interest rates are higher, you can reinvest at the higher rate and improve your return. If interest rates are lower, your principal won’t return as much as it might, but you will still have bonds in the upper end of the ladder that are at the higher rates. The strategy can be especially useful for retirees, Michael Finke, professor of Wealth Management at The American College of Financial Services, told The Balance via email. “The primary advantage of a bond ladder is greater certainty about the dollar value of future payouts. For example, if a retiree has a specific future inflexible annual spending goal, they can lock in this amount by creating a ladder of bonds that mature in future years.”
Example of a Bond Ladder
Suppose at retirement you wanted to create a ladder with $250,000 to mature over a 10-year period.
Types of Bond Ladders
Bond ladders can be created using individual bonds, or bond funds and ETFs. Individual bonds offer flexibility. You can select the length of maturity, or “height of the ladder,” as well as the number of rungs, or timing of maturity. However, managing credit risk, or the risk that the bond issuer will fail to make its coupon payments or return the principal at maturity, can be difficult. Bond ladders can also be created using bond ETFs that have a maturity feature, such as iShares iBonds from Black Rock, or Invesco Bulletshares. These ETFs have a portfolio of bonds that mature at the same time. At maturity, the proceeds are distributed to the shareholders, which can then be reinvested. Bond ETFs can provide portfolio diversification for low minimum investments. They are also generally more liquid than individual bonds because ETFs are traded on the stock exchanges.
What It Means for Individual Investors
Like all investments, bond ladders have risk. “Bond ladders often have a long duration, meaning that their value could fall significantly if interest rates rise,” Finke said. But fluctuations in market value may not matter if investors stick with the plan and hold bonds to maturity. Bond ladders are a long-term investment strategy designed for income and capital preservation. If you are approaching retirement, or have other reasons for generating predictable investment income, a bond ladder may make sense for you.
