Not everyone can become a crypto-millionaire overnight. The rest of us play the game and climb the (bond) ladder.
We treat bonds like car rental insurance plans: We don’t think they’re necessary until there comes a moment—like when your tech-heavy portfolio is in the gutter or you forget to brake on the highway, oops—that makes you realize that it’s actually pretty important.
What is bond laddering?
Bond laddering is one way to create a diversified fixed-income portfolio. Essentially, you’re investing roughly equal amounts into bonds with maturities at regular intervals.
The reason we want to have a wide spread of maturities in our bond portfolio is to give ourselves a chance to benefit despite any market conditions. The yield curve can contort itself in many ways: It can move up, down, steepen, flatten, twist, shift, curve (dizzy yet?), and everything in between, depending on the market environment. Bond laddering can give you a whack at finding returns no matter what happens.
So how do position a bond portfolio based on our market views? There are three broad ways to structure a bond portfolio:
- Laddered: The most diversified method of structuring a bond portfolio, with roughly equal par amounts purchased at intervaled maturities.
- Bullet: Bond holdings are concentrated in middle-duration bonds.
- Barbell: Bond holdings are concentrated in shorter and long-duration bonds.
In other words, you have the choice of putting more money in bonds with maturities at different parts of your ladder. Think of it as spreading your eggs into different baskets based on your market assumptions.
Components of a bond ladder
When you think of a ladder, each rung is evenly spaced and maintains an even weight distribution. Each bond in your portfolio is like one rung on the ladder.
If the rungs—or bonds—aren’t evenly spaced and weighted, the ladder will fall over more easily and will be more difficult to climb, not to mention it sounds like a worker’s comp lawsuit waiting to happen.
In the context of bond investing, your portfolio will not be as well diversified if the bonds purchased aren’t evenly spaced and weighted.
Distance between rungs
The space between each rung can vary anywhere between a few months or a few years between bonds, but make sure they’re evenly spaced out. Your friend’s bond ladder might be a year, but yours could be shorter, and there should be no judgment about it. 👀
The height of a ladder can vary depending on its use. Similarly, a bond ladder can have a longer or shorter overall duration depending on the investor’s appetite for overall sensitivity to interest rates. A taller ladder means a bond portfolio that has more bonds spaced out over a greater total period of time.
What is a ladder made of? It could be steel, iron, or Play-Doh (not recommended). A bond ladder can be made up of treasuries, certificates of deposit (CDs), or other fixed-income securities. Whether we are looking at a bond ladder vs. a CD ladder, the overall structure is the same; the only difference is the type of security used.
What are the benefits of a bond ladder?
Since bond holdings are spread across different maturities, you’re never too far from a bond’s maturity (they grow up so fast!), which increases the overall portfolio’s liquidity. There is less need to sell bonds early to meet cash flow requirements, which reduces the risk of giving into the “buy high, sell low” fantasy (we never know when prices are at their peak or trough).
Cash flows are spread out across time and the yield curve, leading to less exposure to yield curve twists at certain points on the yield curve.
This is better than sinking all investments into one maturity, like $100,000 invested in 10-year maturity bonds. When you do that, you’re running the risk of 10-year treasury yields soaring and having to cry yourself to sleep (I’m not coming over).
Balance between price and reinvestment risk
With bonds maturing each year, some proceeds will be reinvested at higher rates, and some reinvested at lower rates, which creates a form of dollar-cost averaging in the fixed income market.
Using a bond ladder will result in having more convexity than a bullet portfolio, but less convexity than a barbell portfolio. In other words, bond ladders provide a more balanced exposure to convexity for investors who aren’t sure how volatile rates will be in the future. Better to be safe than sorry!
Using a bond ladder tool to build the “safest-safe” portfolio
While not the sexiest, bonds are seen as one of the least volatile asset classes, and a portfolio
with a high proportion of bonds is generally viewed as “safe.” Bond laddering is one of the most balanced and well diversified ways to set up a bond portfolio.