Bond Laddering

by Scott A. Williams

(Author’s Note: Consider the bond yields used as examples and try to guess this article’s original date of publication, shown at the end. SAW)

Bonds often make sense as part of a long-term investment portfolio. For investors who also own common stocks, bonds add an element of diversification and greater price stability—two factors that can help moderate overall risk. One way to produce a relatively stable stream of income, while simultaneously reducing the impact of fluctuating interest rates and moderating the price volatility associated with bonds, is to use a technique called laddering.

How does laddering work? 

To ladder bonds, you buy several bonds at once, spreading your assets equally among bonds maturing at evenly spaced intervals, usually one a year. (Think of each maturity level as a rung on a ladder.) A 10-year ladder is fairly typical, although investors often construct ladders with more than 10 or as few as five bonds. Ladders are frequently built using U.S. Treasury issues because their credit risk is so low. Corporate and municipal bonds are also used to construct ladders, although investing in such issues can introduce substantially higher credit risk and liquidity concerns.

To help you understand laddering basics, let’s consider a simple example using ten $5,000 U.S. Treasury issues for a total principal investment of $50,000. You could purchase these bonds conveniently on the secondary market, or, assuming your need coincides with the date of the next appropriate Treasury auction, you could save the $25 commission per bond and buy some of your bonds directly at auction. Either way, your sample investment is split equally among ten individual securities with maturities laddered from one to 10 years. Each year, as one bond matures, you reinvest the principal in a new 10-year bond to keep the ladder going.

The table below shows how such a portfolio might perform, using hypothetical yield rates and our sample $5,000 investment per bond.

Maturity         Current Yield            Income
1 year              5.60%                          $280.00
2 years            6.05%                          $302.50
3 years            6.25%                          $312.50
4 years            6.36%                          $318.00
5 years            6.47%                          $323.50
6 years            6.53%                          $326.50
7 years            6.58%                          $329.00
8 years            6.64%                          $331.90
9 years            6.69%                          $334.50
10 years          6.75%                          $337.50
Total Investment: $50,000
Average Maturity: 5.5 years
Average Yield: 6.39%
Total Annual Income: $3,197

How does the laddering strategy compare to investing the whole $50,000 in a single bond? Using the hypothetical 5-year yield from the previous table, here’s the result:

Maturity         Annual Yield             Income
5 years            6.47%                          $3,235

In this hypothetical comparison, income from the two approaches is similar. But with only 10% of the laddered portfolio maturing every year, the laddered bonds are better insulated from interest-rate fluctuations. The single issue would be extremely vulnerable to income risk; if interest rates are lower when the bond matures, your principal will be reinvested at lower rates and income will decline. Of course, if interest rates are higher at maturity, your reinvested principal would earn higher income. If you needed to sell the individual bond before maturity, you’d also be vulnerable to price risk, since the market price of bonds fluctuates with changes in interest rates and the outlook of investors.

Some Pros and Cons

The key advantage of laddering bonds is a relatively stable income stream with only moderate risk to principal from price fluctuations. It is a strategy that requires discipline—or forces it. Transaction costs are high in the first year because ten bonds are purchased. In subsequent years, however, only one bond is purchased so annual expenses are reduced to 10% of the first year.

Laddering may be best suited for investors with sufficient assets—$50,000 in our example—to establish and maintain the ladder. Since bonds are generally just one component of a balanced portfolio, investors with smaller portfolios may not have sufficient funds to invest in a bond ladder as well as other investments.

The laddered strategy has its drawbacks as well. For example, over time you may earn a lower return from a bond ladder than you would from holding only long-term bonds, i.e., bonds that mature in 10 or more years. Concentrating on long-term bonds exposes you to a higher risk of price fluctuations, but if you have the luxury of time, the higher yields on long-term bonds probably will outpace your return on a laddered arrangement, such as our example, with an average maturity of only 5.5 years.

In addition, liquidity suffers under a laddered arrangement. Getting access to a portion of your principal requires selling a bond, or not reinvesting one that happens to mature when you need the money. But if you don’t immediately reinvest a mature bond, you will break the ladder, shortening your portfolio’s average maturity and reducing the income it generates.

Because it is an income strategy, laddering is not considered appropriate for retirement savings. A ladder of individual issues has no mechanism for reinvestment of coupons, so you would be unable to enjoy the powerful advantages of compound interest and tax-sheltered growth.

Finally, record keeping and tax reporting are somewhat more burdensome with laddering. With our example, come tax season you will have paperwork to complete for ten individual bonds.

(NOTE: Instead of laddering, some investors divide their bond assets between short-term and long-term issues, skipping those with intermediate maturities. This strategy is called barbelling.)

Laddering vs. Bond Funds

You can achieve virtually the same effect of laddering individual issues by laddering short-, intermediate- and long-term bond funds. (Strictly speaking, bond funds do not mature so there is no principal to reinvest in a ladder at maturity. However, the moderating effect of owning short-, intermediate- and long-term bond funds simultaneously is similar to a true ladder.)

One significant advantage of bond funds over laddering individual bonds is that the strategy works with less money—as little as $7500 assuming three funds (short-, intermediate- and long-term), each with a $2500 minimum initial investment. If you have less than $7500 to invest in bonds you have another option. A bond market index fund can provide, in a single mutual fund, returns that closely follow the broad bond market.

Laddering bond funds provides yields comparable to laddering individual issues but with much greater liquidity. Many bond funds (including all Vanguard bond funds) let shareholders write a check to withdraw a portion of invested funds. That can be especially advantageous if you have known future expenses, such as buying a house or paying for college, that will require dipping into principal.

If you want to include bonds as part of your retirement portfolio, laddering bond funds lets you reinvest income distributions in additional shares. If the bond funds are part of a tax-advantaged retirement plan, such as a 401(k) or IRA, your investment and reinvested distributions can grow tax free until you begin taking payments after retirement.

If you are able to invest sufficient principal in a true bond ladder (many investment advisers suggest $50,000 or more), you may enjoy a lower expense ratio than many actively managed bond funds. The lower a fund’s expense ratio, the lower your break-even point. However, many investors find additional value in bond funds because expenses are used, in part, to pay for professional portfolio management; investors who ladder individual issues must manage their own investment.

Conclusion

Whether you choose single issues, ladders, or one or more bond funds, it is possible to moderate risk by diversifying your portfolio to include bonds. Many investment professionals believe that laddering bonds can add balance to your portfolio, provided you have sufficient principal to invest in many individual bonds. If you have less available to invest in bonds, need flexible access to principal for known expenses (such as buying a house or paying for college) or do not wish to manage your own investments, consider the benefits of investing in a bond fund or a ladder of bond funds.

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This article originally appeared in Trade Winds (Summer 1997), a publication of The Vanguard Group. Republished with permission.
Copyright © by Scott A. Williams. All rights reserved.