A bond ladder is a fixed-income investment strategy that involves purchasing a series of bonds with staggered maturity dates. The goal is to generate predictable income while helping reduce interest rate risk.
Instead of putting all your money into bonds that mature at the same time, a bond ladder spreads investments across multiple maturity dates. This allows investors to maintain liquidity, reinvest periodically, and avoid locking their portfolio into a single interest-rate environment.
How Interest Rates Affect Bond Prices
Understanding how interest rates affect bonds helps explain why investors use a bond ladder strategy.
Bond prices and yields move in opposite directions.
- When interest rates rise, existing bonds typically lose market value because newly issued bonds offer higher yields.
- When interest rates fall, existing bonds generally gain market value, since their yields are higher than those offered by new bonds with similar maturity and credit quality.
Because of this relationship, bond investors face two key risks:
- They may need to sell bonds below face value if they need cash when interest rates are higher.
- Their bonds may pay lower yields than prevailing rates if rates rise after they purchase them.
How a Bond Ladder Strategy Works
A bond ladder strategy helps manage these risks by spreading fixed-income investments across different maturity dates.
For example, instead of investing entirely in five-year bonds, an investor might divide their investment across bonds maturing in three, four, and five years.
As each bond matures, the investor reinvests the proceeds into a new bond at the longest maturity of the ladder. This process maintains the ladder structure while allowing the portfolio to gradually adjust to changing interest rates.
Why Investors Use Bond Ladders
When interest rates rise, the new bonds added to the ladder typically offer higher coupon rates than the bonds that just matured. Over time, this allows the overall yield of the portfolio to increase.
If interest rates remain stable, longer-maturity bonds often provide higher yields than shorter-term bonds in a normal yield-curve environment. By continuously reinvesting at the long end of the ladder, investors can benefit from those higher yields.
A bond ladder can be particularly useful during uncertain market conditions because it prevents investors from committing their entire portfolio to either short-term, low-yield bonds or long-term bonds that could decline in value if interest rates rise.
Bond Ladder Example
To create a simple bond ladder, an investor might purchase bonds that mature in 2027, 2028, and 2029.
When the 2027 bond matures, the proceeds could then be reinvested in a 2030 bond, extending the ladder and maintaining the staggered maturity structure.
Over time, this reinvestment process helps investors maintain consistent income while adapting their portfolio to changing interest rates.
[text_ad]
While longer-term bonds yield more, shorter-duration fixed-income investments carry less interest rate risk.
In other words, if you expect rates to begin heading higher (say if the Fed signals that rates will remain high longer than the market expects or inflation rears its ugly head again), 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 low-yield fixed-income investments for a long time.
If your liquidity needs are not a concern and interest rates are holding steady, you can lengthen your ladder by incrementally buying later maturities (in the example above, using half of your proceeds to buy 2030 bonds and half to buy 2031 bonds).
This requires a little more active management but does help ensure that you’ve locked in more money while rates are high.
In an interview we did with value investor and former longtime Cabot analyst J. Royden Ward, he described a bond ladder as such:
The most important part of creating a bond ladder that will preserve your capital is that you only buy individual bonds or defined-maturity bond funds.
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, BulletShares ETFs are the simplest way to construct a bond ladder.
The ETFs come in investment-grade, municipal and high-yield versions, with maturity dates from 2026 to 2033 (there are 2034 and 2035 funds for the investment-grade and municipal bond ETFs as well).
The BulletShares ETFs mature on either December 15 or the last trading day of the year in the name of the fund, at which time the NAV of the fund is distributed 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 market rates begin rising, it will grow over time.
In the event you run into unexpected liquidity needs, the annual maturation of one-fifth (in a five-year ladder) of your bond holdings can help.
And, should rates fall, your portfolio holdings will grow in value because they’re paying above-market rates.
[author_ad]
*This post has been updated from a previously published version.
