A bond ladder offers a way to build a level of financial stability into your portfolio, according to Charles Schwab. Individual bonds and CDs held to maturity provide a steady, planned series of maturities with predictable returns.
For investors who can hold these bonds and CDs to maturity, a bond ladder is part of a sound retirement strategy.
How does a bond ladder work?
A bond ladder is built using individual bonds of various types as well as CDs. These fixed income vehicles will generally mature at varying intervals. If held to maturity, the bonds and CDs offer investors their par value plus any interest paid during the holding period.
In the case of CDs, the interest often stays inside the CD and compounds. This means the owner receives the face amount of the CD and any interest earned at maturity.
In the case of zero-coupon bonds, the owner receives the bond’s face value at maturity, with the “interest” being the difference between the discounted purchase price and the full value at maturity.
Key considerations for building your bond ladder
The following tips can help when building a bond ladder as part of your portfolio.
- Keep in mind the timingof the fixed-income maturities. Some investors prefer bonds that mature at regular intervals, such as quarterly, semi-annually, or annually. The maturities’ intervals do not need to be uniform, however.
- Make a plan based onhow long you want the ladder to run. As an example, an investor might have bonds and other fixed-income holdings maturing every six months over a five-, seven-, or 10-year period. This period can be defined by the investor and tailored to fit their specific needs and goals.
- Plan on holdingeach bond or other fixed-income holding to maturity. Generally, holding the bonds to maturity allows investors to benefit from predictable cash flows while reducing interest-rate risk and transaction costs.
Exceptions can arise, however. Bonds in the ladder can be sold prior to maturity if your circumstances change and you need to raise cash. Or, in the event of a significant decline in interest rates, it may make sense to sell some of the bond holdings to realize profits.
Benefits of bond ladders
The bond ladder approach can offer several benefits to an investor.
- Stability and predictability. If the bonds in the ladder are held to maturity, your cash flow and returns from the ladder should be very predictable. Upon maturity, you receive the face value of the bonds or other fixed-income holdings. During the holding period of each bond, you receive any periodic interest payments.
When building a bond ladder, it is best to use non-callable bonds. If bonds are called during the period of the bond ladder, this could leave gaps in your cash flow.
- Minimizing interest rate risk. While interest rates will rise or fall over time, holding the bonds that comprise the ladder until maturity minimizes the price risk associated with a rise in rates.
- Cash flow predictability. Thanks to regular periodic interest payments and the value of maturing bonds over time, a bond ladder gives investors predictable cash flows they can deploy back into their portfolio or use for other needs dictated by their situation.
Morningstar outlines both pros and cons of bond ladders.
Downsides of bond ladders
There can also be several downsides to a bond ladder.
- Choosing bonds: As with any type of individual security, the components of a bond ladder must be selected by the investor. This means that unless they have bond expertise or are working with an advisor who does, they need to do the research and choose the appropriate holdings for the ladder.
- Inflation: During periods of inflation, the real value of the bonds and the interest payments in the ladder can come under pressure. The exception is certain inflation-protected bonds.
- Diversification: Although there are different types of bonds investors can choose from, bonds in general do not provide much diversification. Bond prices are largely dependent on interest rates.
Using bond ladder proceeds
Investors can use cash coming in from the components of the bond ladder in a variety of ways to meet their specific needs. For example, periodic interest payments can be invested or directed to pay off specific debt or obligations.
The payments received upon the maturity of the various holdings can be reinvested in extending the bond ladder or elsewhere in the investor’s portfolio. The funds can also be directed elsewhere, again, depending on the investor’s needs.
Bond funds vs. ETFs
As an alternative to a bond ladder composed of a series of individual bonds, investors might consider using bond ETFs or mutual funds.
While there are no maturities, investors can build a portfolio of bond ETFs and funds that offer a variety of bond types and maturities.
Related: Rising inflation just made this overlooked bond shine
