Overview
When compared to equity investments, investing in bonds are considered comparatively safer. For, bond investments offer steady, stable and often predictable returns unlike uncertainties that exist in equity investments. If one needs a regular income stream, then bonds, which generally have a ‘low-risk’ tag, come in handy. Though bonds typically offer a tad higher return, through their coupon rates, than savings accounts or fixed/recurring deposits in banks or post offices, bonds are prone to fluctuations with interest rate changes.
One of the ideal strategies to manage returns and risks associated with your bond portfolio is bond-laddering. Financial experts also call this as fixed-income laddering. Technically, both are same; if you use the laddering technique for bonds, it is bond-laddering and if the same is used for all fixed-income instruments together, it is known as fixed-income laddering.
With this approach, investors can reinvest the maturity amount of each bond and stagger the risk, returns and liquidity too. Some of the advantages of the bond-laddering strategy are regular flow of income, reduction in interest rate risk, increased liquidity, and the ‘potential’ to reinvest at higher interest rates.
Not just individuals, even corporate companies, or the institutional investors, also do bond-laddering to gain an optimum benefit from the bonds or other fixed-income investments. Though bond-laddering has some advantages, this strategy is well suited for conservative investors who have an aversion to risk and who need a steady income stream. So, before jumping to create a bond-ladder, it’s crucial to find out if the strategy is in perfect alignment with your investment objectives.Let’s dive into the mechanics, benefits and drawbacks of the bond-laddering strategy.
What is bond-laddering?
Bond-laddering is nothing but accumulating bonds in your portfolio in such a way that the dates of maturity are staggered over a period of several years or a decade. The idea behind purchasing more bonds with different maturity periods is to create a steady income stream and to manage interest rate risk.
It is an advanced strategy in which all your bond investments, put together, are structured enough in such a way that they resemble a ladder with a string of maturity dates (staggered) to form a “rung” of the ladder.
In this strategic investment approach, you buy more bonds with staggered maturity periods and stack each and every bond as a step in a ladder. In this ladder, each step denotes a bond that matures at a different period. You can keep extending your ladder, by reinvesting the maturity amount into a new bond, so on and so forth.
In simple words, you are building a financial staircase for you to climb the ladder of financial freedom, in your retirement life. However, for this to happen, you need to be patient, disciplined and committed to reinvest the maturity amount continuously.
Objective
The main idea behind the bond-laddering strategy is to gain a steady stream of income through receiving interest payments at different time periods in the year. Further, one of the main objectives of this strategy is to mitigate interest rate risk by avoiding investing all funds in bonds with the same coupon rate or that fetch the same yield. You are rolling over your bonds’ interest payments and principal amount by continuously reinvesting it in new bonds.
‘Time-diversification’ strategy
It wouldn’t be wrong if we say that bond-laddering is a time-diversification strategy. Instead of purchasing more bonds with the same maturity period, you are diversifying the bonds with different maturity periods.
This method of spreading bond purchases, based on different maturity dates, helps you manage interest rate changes in a better way. Further, this helps you in earning a steady, stable, and consistent return over the years. There is no hard-and-fast rule for devising this strategy. It could be customised and tailor-made depending upon your financial goals, be it short-term goal or long-term retirement goal.
How does a bond ladder work?
To create a bond ladder, you are diversifying your funds to invest in several bonds that have different maturity dates. When one bond from your portfolio reaches the maturity period, the maturity proceeds are reinvested into a new bond that has a longer maturity period, say a few years or a decade. However, before proceeding to build a bond-ladder, be sure with your investment horizon, know your risk profile, check the credit ratings of the new bonds you are planning to add to your portfolio and stagger the maturity dates accordingly.
In short, as each bond matures, the maturity proceeds are reinvested into a new bond at the farthest end of the ladder, that is the bond with the longest maturity period. This helps in creating a continuous flow of income stream, which is ideal for retirees or those who need a regular income.
Helps in managing interest rate risk
In the bond-laddering strategy, you are staggering the maturity dates of all the bonds you hold in your portfolio. Therefore, you are not locking your funds in a single coupon rate or in a single interest rate/yield bond. By building a ladder with different maturity periods, you are easing out the effect of interest rate fluctuations. For, you have bonds maturing every year or every quarter, based on the number of rungs in the ladder.
Once an older bond in your kitty has matured, you can reinvest the maturity proceeds in a new bond with a longer time horizon, at the end of a ladder. If the interest rates have increased in the market, you could benefit from it. But at the same time, if the interest rates have fallen, the maturity amount of the older bond would have to be reinvested at lower rates, which is unavoidable in the market. Still, you have already built a rung with higher-yield bonds at the end of the ladder.
Benefits of bond laddering
Bond-ladder strategy spreads/staggers the risk of interest rate fluctuations across multiple bonds with different maturity period
If interest rates rise, the matured bonds can be reinvested at the new interest rate, which might offer higher yield than your old bond. That is, you can reinvest the principal amount at different interest rates as and when the older bond matures
Bond-laddering gives you confidence that you have created a predictable regular income stream. Unlike dividends from equity, income received from bonds by way of interest payments is predictable. Further, you have already created a ladder of bonds that would mature at a different period, so your income flow is continuous
Once your old bond matures, you can reinvest the maturity amount in purchasing a different type of bond according to your new goal or new risk-taking ability.
Your liquidity position could be improved by way of laddering your bonds. For instance, your bonds would be maturing periodically in such a way that you have access to the principal amount and that you need not have to sell bonds in the secondary market
By way of laddering your bonds, you are mitigating the risks such as default risks, interest rate risks etc., associated with the bonds. Further, you are also diversifying your portfolio instead of giving more weightage to equities which are highly risky. By adding different types of bonds, with varied risk levels and yields, you are enhancing the strength of your portfolio and also ensuring a steady flow of income.
Drawbacks of bond laddering
There are chances that an investor ends up reinvesting at lower interest rates when bonds mature. When interest rates fall in the market, the yield of new bonds will be low
Bonds are always associated with the default risk by an issuer of a bond. If any one of the bonds in the rung is defaulted or disturbed, the chain of money flow would be disturbed. Therefore, investors must be careful in choosing the bond type and it is important to check the credit ratings of the bonds you are purchasing
If funds are needed during the tenure of the bond, you would be forced to sell a bond but if interest rates rise, the price of your old bond would fall, leading to loss
Of course, all these drawbacks are meant for bond investments and not just bond-laddering.
Though a bond ladder helps you in managing interest rate fluctuations, helps you in creating a consistent income stream, provides stability and liquidity, gives you a chance to invest in higher-yield bonds through reinvestment, it’s crucial to choose only those bonds that are in perfect alignment with your financial goals and risk-taking ability.
Disclaimer: Investments in debt securities (bonds) are subject to risks including delay and/or default in either interest component or principal amount or both. Read all the offer-related documents carefully.