Bond laddering is a technique designed to help investors navigate unpredictable market conditions or, more specifically, the changing interest rates of the bond market. This strategy can be achieved through staggering bond maturity dates.
The typical life of a bond dictates that an investor will purchase a bond, thereby investing money in a loan to the issuing organization, and the organization will make periodic interest payments to the investor until the bond reaches its specified end date, also known as the bond's maturity date. At the maturity date, the investor's initial investment, or principal, will be paid back in full. For more information, see Bond Basics.
The three primary objectives of purchasing multiple bonds and staggering their respective maturity dates include:
- Managing Interest Rates - Investing money into multiple bonds with different dates of maturity can potentially help protect investors from interest rate volatility and provide additional reinvestment opportunities. When one bond matures and the investor is ready to reinvest, he or she is bound by the prevailing interest rate at that time. But with multiple bonds maturing at different times, the investor may increase the likelihood of reinvesting at interest rates that are favorable. However, it is equally likely that interest rates will be unfavorable, and investors should be prepared to take that risk.
- Meeting Investment Opportunities at the Right Time - Investing in just one bond ties up all the investor's purchasing capital until that bond's maturity date. Investing in numerous bonds provides investors with multiple maturity dates and can potentially provide more financial flexibility for investors. Bond Laddering Theory suggests that higher levels of flexibility will afford investors greater potential to capitalize on (or protect themselves from) bull and bear markets, although there is no guarantee that this is the case with any investment strategy.
- Reaping the Rewards in a Timely Fashion - Bond laddering can also affect the investor in a more immediate way. Staggering bond maturity dates spreads out the interest payments received by the investor. Rather than receiving the total interest payment for a single bond on one day every six months (most bonds pay interest semiannually), the investor can arrange a staggered bond portfolio to receive interest payments in regular installments made every few weeks or months.
Bond laddering is commonly used by investors who are heavily reliant on their investments for income, but can have advantages and disadvantages for any investor. For more information about the risks specific to bond investing, see Bond Risks.
How to Ladder Your Bond Portfolio
Bond laddering is an investment technique achieved through staggering bond maturity dates. To stagger your bonds:
- Have a Price in Mind - Start by deciding the amount of money you want to invest in bonds.
- Build Your Ladder - Determine the numbers of bonds, or 'rungs', you want to purchase for your investment portfolio. Your future interest payments will depend on the number of bonds used to build your ladder and how you choose to arrange the distance between their respective maturity dates and interest payment schedules.
- Extend Your Ladder to Meet Your Personal Needs - The further away the maturity dates for the bonds you hold are, the longer your bond ladder will be. The length of your bond ladder can range anywhere from a few years to a decade or more. Because bond yields typically increase over time, longer bond ladders have a higher expectation of generating more income. As with any aspect of investing, however, longer ladders and the chance for higher yields are accompanied by higher risks and less liquidity of funds.
- Determine Your Interest Payment Needs - Analyze your current and future income needs to set up a regular interest payment schedule that works for you.
- Choose Your Bonds - Research and select bonds that match your personal investment goals and fit into your bond ladder. To find bonds that fit your investment strategy, use the Bond Finder tool in your account. Simply click the Trade tab, choose CDs & Bonds from the left menu, mouse over the Bonds tab and left-click on Bond Finder. Enter the criteria of your choice, and the Bond Finder will screen for bonds that match your requests.
Bonds involve risks including, but not limited to interest rate risk, reinvestment risk, inflation risk, call risk, liquidity risk, credit risk, market risk, default risk, event risk and a risk of loss of principal. New issue offerings are sold by prospectus or offering circular available at www.scottrade.com. Investors should read these carefully.