If you are interested in fixed income securities, for either current income
or growth, but are wary of “locking in” the relatively low interest rates in
today’s market, you may want to consider an investment strategy known as a
“bond ladder.” Laddering helps investors position themselves to react to
changes in interest rates.
What is a Bond Ladder?
A bond ladder is made up of equal blocks of bonds with staggered maturities.
For example, a $50,000 bond ladder would consist of 50 bonds, with 10 bonds
($10,000 face value) maturing in one year, two years, three years, four
years and five years. Each $10,000 block would effectively serve as a “rung”
on the ladder. By diversifying the maturities in the portfolio, the investor
will have funds available for reinvestment at regular intervals. As each
bond matures, the investor purchases a new $10,000 “rung” with a five-year
maturity, thereby keeping the maturities evenly spaced and the ladder
This regular reinvestment offers the opportunity to average the rate of
return on your portfolio over time as interest rates rise and fall, rather
than committing to a “one time” fixed return over the same period. The
staggered maturities provide the investor with funds to invest if interest
rates increase, and avoids the penalty of having all of your money maturing
in a low interest rate environment. Barring a default by the issuer, the
investor will receive the par value of the bonds as they mature each year.
This way, the investor can avoid selling their bonds in the secondary
market, which depending on the level of interest rates, could be at a price
higher or lower than their original investment.
Certificates of deposit (CDs) are often purchased using the same laddering
strategy. In a similar fashion, a block of CDs is purchased with staggered
maturities. CDs carry a fixed interest rate and maturity date. Short
maturities of 3-, 6-, 9- and 12- months generally pay interest at maturity,
while longer-term CDs usually pay interest semi-annually. FDIC-insured CDs
are fully-insured for up to $100,000 (principal and interest) should the
issuing bank fail.
Similar to dollar cost averaging in equity investments, laddering your fixed
income investments may not provide the highest return available over the
period. This “averaging” of interest rates means there is a potential for
lower returns. For example, if interest rates remain unchanged, or decline
when it’s time to reinvest, a laddered portfolio would generally yield less
than if the investor had instead locked in a longer-term rate. Historically,
averaging has produced better long-term results than timing the market.
Given the dynamic nature of interest rates, it is difficult to predict the
timing or direction of the market’s next move. While there is no way to
eliminate completely an investor’s exposure to interest rate fluctuations,
it is possible to minimize the effects by creating a bond ladder. As with
any investment strategy, you should consult with a qualified financial
professional to assess whether this technique is appropriate for you.
C. David Petrucci, CFP®, is an Associate Vice-President-Investments and
Wealth Management Specialist with Legg Mason Wood Walker, Inc., a
diversified securities brokerage and financial services firm that is a
member of the New York Stock Exchange, Inc. and SIPC.