If you invest in bonds, you earn a regular payout from the interest rate you agreed to when you purchased the bonds. The interest rate follows the market rate at the time of the purchase. But if you think the interest rate may rise further, you prefer to wait before locking the interest. But at the same time, you are unsure it will keep rising and want to take advantage of the current relatively high-interest rate. Well, let’s not try to time the market. You can use the Bond Laddering Strategy.
Bond laddering can help you secure a regular income with the flexibility of reinvesting into higher rates should it keeps rising.
What is Bond Laddering?
Bond laddering is a strategy of building a portfolio of fixed incomes (such as bonds or fixed deposits) that mature on staggered future dates. By staggering the maturity dates, you can minimize the exposure to interest rate fluctuation by reinvesting the matured bonds with the new interest rate at regular intervals.
In principle, this bond laddering is similar to the dollar-cost averaging strategy but applied to fixed-income investments.
Minimize interest rate risk
One of the primary benefits of bond laddering is allowing investors not to get locked into a single interest rate. By staggering the maturity date, investors will have bonds maturing at regular intervals (ex: every quarter) and be able to reinvest them at the prevailing interest rate. If the interest rate has risen, investors can enjoy the higher rate when reinvesting the matured bonds. However, if the interest rate has dropped, investors will have to reinvest at a lower rate. But, their previous bonds that were reinvested before should have locked in at a higher rate. This effectively smoothes out the interest rate fluctuation.
Regular cash flow
By staggering the maturity date, investors will enjoy receiving regular cash flow. Many fixed-income products usually pay interest at maturity. Thus, by staggering them, investors can structure the maturity of the bond such that they can enjoy the interest payout at regular intervals.
How to build a bond laddering strategy?
In short: you invest in multiple bonds of different maturities and stagger them. As each bond matures, you reinvest the capital into a new bond at that time and enjoy the prevailing interest rate. There are some terminologies you need to know with bond laddering:
Rungs
The total amount of money you want to invest can be divided equally by the total number of years (or months, quarters, etc.) you wish to have on your ladder. This is the number of rungs on your ladder. The greater the number of rungs, the better it is because it provides more diversification and can generate more regular income.
Spacing
The distance between rungs is determined by the duration of time between bond maturities. This spacing can be in months or years, but it is better to have roughly equal spacing between all rungs. Higher spacing allows you to enjoy higher returns because longer-duration bonds usually return higher interest. But at the same time, you absorb higher reinvestment and liquidity risks. Shorter spacing lowers your interest return, but you enjoy lower risk and higher liquidity.
Materials
Your bond ladder doesn’t have to consist of one type of bond. You can mix different fixed-income products to create your bond ladder, such as government bonds, corporate bonds, fixed deposits, treasuries, etc.
Example of Bond Laddering
Let’s say you have $100,000 to invest in bonds. Instead of investing $100,000 in a single bond, you can divide them into five equal rungs. You buy five different bonds with different maturity dates. In this case, we spend:
- $20,000 on a 1-year bond (Bond A)
- $20,000 on a 2-year bond (Bond B)
- $20,000 on a 3-year bond (Bond C)
- $20,000 on a 4-year bond (Bond D)
- $20,000 on a 5-year bond (Bond E)
In year 2, bond A matures, and we reinvest the proceeds from bond A into a new bond of 5-year maturity called bond F. So now your bond ladder will be something like this:
- $20,000 maturing in 1 year (Bond B)
- $20,000 maturing in 2 years (Bond C)
- $20,000 maturing in 3 years (Bond D)
- $20,000 maturing in 4 years (Bond E)
- $20,000 maturing in 5 years (Bond F)
In year 3, bond B matures, and you can reinvest into bond G having 5-year maturity.
- $20,000 maturing in 1 year (Bond C)
- $20,000 maturing in 2 years (Bond D)
- $20,000 maturing in 3 years (Bond E)
- $20,000 maturing in 4 years (Bond F)
- $20,000 maturing in 5 years (Bond G)
Rinse and repeat. You can keep doing this every year and enjoy the regular payout. Congratulations! You just build a bond portfolio with a regular payout without worrying about trying to time the market.
By using the bond laddering strategy, investors can minimize the interest rate volatility while benefiting from the regular payout. Bond laddering can make investors avoid the temptation of trying to time the market and be more disciplined with their investment approach.
