What is a bond ladder?
When investors refer to a bond ladder strategy, they are referring to a way of creating your own adjustable-rate income stream, by buying a series of bonds or bond funds with staggered maturity dates. Then, as each security matures, you reinvest the proceeds in a new security at the top of ladder, which becomes your new longest-dated security.
If interest rates are rising, the new investments will have higher coupon rates than the investments rolling off the bottom of the ladder, and your yield will gradually rise.
For example, if you wanted to create a bond ladder strategy today, you could buy bonds maturing in 2021, 2022 and 2023. When your 2021 bond matures, you would invest the proceeds in a 2024 bond, which will most likely be offering a higher interest rate than currently-available bonds.
While longer-term bonds yield more, shorter-duration fixed income investments carry less interest rate risk. In other words, if you expect rates to go up soon, you’ll want your longest-dated bond to still mature fairly soon (probably within five years) so you’re not stuck holding a bunch of very low-yield fixed income investments for a long time.
In an interview we did with value investor and former longtime Cabot Wealth Network analyst J. Royden Ward, he described a bond ladder strategy this way:
“A bond ladder is a portfolio of bonds, which have varying terms to maturity. Ben Graham advocated holding at least 25% of your investments in bonds, which I think is good advice.
“Investing in several bonds with different maturity rates—and dates—rather than in one bond with a single maturity date will minimize your interest rate risk and increase your liquidity and diversification.
“To create a five-year bond ladder, for instance, you would buy a bond that matures in one year, another bond that matures in two years, then one in three years, four years, and finally five years.”
Preserve Your Capital
The most important part of creating a bond ladder strategy that will preserve your capital and work in a rising rate environment is that you only buy individual bonds or defined maturity bond funds, using ETFs.
Unlike standard bond funds, bond funds with maturity dates preserve the principal guarantee you get with individual bonds, or the promise that you’ll get your original investment back when the security matures. For most investors, Guggenheim’s BulletShares ETFs are the simplest way to construct a bond ladder.
The ETFs come in both investment-grade and high-yield versions, with maturity dates from 2020 to 2027.
The BulletShares ETFs mature on the last trading day of the year in the name of the fund, at which time Guggenheim distributes the NAV of the fund to shareholders.
Whichever funds you choose, when the first maturity in your ladder arrives, you can keep your bond ladder intact by reinvesting the redemption value into a new security at the top of the ladder. This will maintain your income stream—and if rates are rising, it will grow over time.
For more information about using the bond ladder strategy, read these two interviews with J. Royden Ward: Five Steps to a Bond Income Ladder and Roy Ward on Bond Ladders for Rising Income.