A bond ladder is a bond investing strategy. It is a relatively simple concept that attempts to minimize the risks associated with fixed income securities. It also tries to match cash flows with the demand for cash. The bond ladder is a multi-maturity investment strategy, a collection or portfolio of bonds, all with different maturity rates.
By using the bond ladder strategy, you could invest 50,000 US dollars (USD) in five different bonds. Each of these bonds would have a face value of 10,000 USD, and each would have a different maturity, the end date when they give out the cash. One bond might mature in five years, and another in three years. Each of these bonds represents a different rung on the ladder.
There are two basic reasons for using the bond ladder strategy. By staggering the bond maturity dates, your money is not locked in to one bond for a particular length of time. By locking your 50,000 USD into one bond, you cannot protect your money from decreasing interest rates or capitalize on increasing rates. If interest rates were to hit bottom at the maturity date your single bond, you would be stuck with a low interest rate if you wanted to buy another bond. A bond ladder smooths out these fluctuations because you have a bond maturing every year or thereabouts.
The other reason for investing in a bond ladder is that it enables the investor to control and adjust cash flow as needed. With your initial investment, you can have a monthly income from the coupon payments of the laddered bonds by picking bonds with different coupon dates. This is important for people who depend on cash flow from their investments. If you were to have a sudden financial expense, then the funds would be steady enough to use as a source of income.
Creating a bond ladder is very simple. Just like with a real ladder, you must take into account the different rungs, height and the material of the ladder. Taking your initial outlay and dividing it by the number of bonds you wish to invest in gives you the number of rungs your ladder will have. The greater the number of rungs, the more diverse your portfolio of bonds will be, and the better protected your money will be.
Bond ladders can be made of different materials. This simply means the diversification of investment types you place your money in. You can invest in municipal bonds, government bonds, treasuries or debentures. Each investment type has its own strengths and weaknesses. Remember that whatever you invest in must be redeemable by the issuer.
Finally, the height of the bond ladder will be determined by the amount of time each bond takes to mature. Maturity can range from a few months to a few years. The higher you make your ladder, the greater your return should be, as longer maturity dates means higher financial yields. However, this type of high return may be an investment risk with less ready access to funds. Making maturity dates shorter means less financial yield in the long run, but better access to your money.