When investors refer to a bond ladder, 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. This is particularly valuable in uncertain markets as it allows you to avoid locking assets entirely in either low-yielding, short-term bonds or higher-yielding bonds that will decline in value as rates continue rising.
For example, if you wanted to create a bond ladder today, you could buy bonds maturing in 2023, 2024 and 2025. When your 2023 bond matures, you would invest the proceeds in a 2026 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 continue heading higher (which seems all but inevitable), 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 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 and work in a rising rate environment 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 both investment-grade and high-yield versions, with maturity dates from 2022 to 2031.
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 rates are rising, it will grow over time.
Do you consider bonds a cornerstone of your portfolio in today’s interest rate environment?
*This post has been updated from a previously published version.