The High and Low Points of the Bond Ladder

Question: In your article about the risks of individual bonds, you noted that one drawback is that you won't be able to take advantage of higher yields when they become available. But wouldn't a bond-laddering strategy help overcome that drawback?

Answer: We covered a lot of ground in our Better Bond Investing week, but we didn't discuss bond laddering, which, as you noted, can help mitigate some of the risks of investing in individual bonds.

Before we get into the benefits of bond laddering--as well as what to watch out for--let's first discuss exactly what a bond ladder is. In short, laddering a bond portfolio means that you buy bonds with varying maturity dates--for example, one bond maturing in a year, another in three years, and two others maturing five and 10 years from now, respectively. When the bonds mature, the investor can either spend the proceeds--which would necessitate matching the maturity dates of the bonds in the ladder to spending needs (for example, when college tuition comes due each year)--or reinvest in another bond that matures at a later date.

Laddering is, above all, a diversification strategy, enabling you to spread your assets across multiple credits with different characteristics, thereby mitigating the risk of sinking a lot of your assets into a single bond that defaults. And if you're reinvesting your proceeds when a bond matures, laddering helps you further diversify across multiple interest-rate environments.

For example, let's say you wanted to move money into the bond market right now. If you were willing to sink your money into a bond maturing in 10 years, you'd likely have to settle for a yield of 2% on a Treasury bond and less than 4% for an investment-grade corporate bond--quite low by historical standards. If bond yields went up before your bond matured--meaning that new bonds with higher yields became available--you'd have two choices, neither of them appealing. You could hold your bond until it matures in 10 years, thereby forgoing the ability to generate a higher income stream between now and then. Alternatively, you could sell your old bond and buy the new, higher-yielding one, but you wouldn't be able to sell it at face value. (No one would want your low-yield bond if they could buy one with a higher rate instead; they'd only take it off your hands if you were willing to lower your asking price.)

A laddered strategy, by contrast, could help you combat that risk. You could invest a slice of your bond portfolio in a bond that won't mature for 10 more years, but put the rest of your money into bonds with shorter terms--say, six months, two years, three years, five years, and 10 years. If interest rates trended up during the next decade, as in the example above, you'd come out ahead of the person who bought and held the 10-year bond because you'd be able to reinvest the proceeds from your shorter-term bonds into the newly available higher-yielding bonds. Many bond-fund managers employ a version of a laddered approach, investing across a spectrum of maturities to diversify the portfolio's interest-rate and reinvestment risks.

Watch Your Step
But as useful as laddering can be, it's not without a downside. As with any diversification strategy, laddering won't guarantee you the best return. Just as the person who bought  Apple (AAPL) stock 10 years ago is much wealthier than the one who held an S&P 500 index fund (or nearly any other fund), diversifying across multiple bond maturities has the potential to depress your return, too. If interest rates decline during the time you hold a laddered bond portfolio--as they have during the past few decades--you'd have to reinvest maturing bonds at ever-lower interest rates, thereby reducing your portfolio's aggregate yield over the time that you held it. Your return would have been higher if you had simply purchased a higher-yielding, long-maturity bond at the outset of your holding period and sat tight until maturity.

Incredible shrinking yields are the key reason why many folks who had been employing laddered strategies have abandoned them in recent years. At the same time, yields can't go down much further from here, so it's safe to say that the benefits of building a bond ladder today far outweigh the risks.

All that said, investors who ladder still face some of the same risks that any holders of individual bonds face, as I outlined in this article. It can be difficult to build a diversified portfolio without a lot of dough, and if you do manage to do so, you're likely to face exorbitant trading costs. Because laddered bondholders are investing smaller sums into more bonds on a regular basis, their trading costs are apt to be even higher than those of bond investors who take a concentrated, buy-and-hold approach. (This Investing Classroom unit discusses some of the transaction costs that can weigh on the returns of smaller bond investors.) A new crop of laddered-bond mutual funds, which Morningstar's Russ Kinnel discusses in this article, can help bond investors find the best of both worlds, employing laddered strategies while also obtaining the diversification benefits and trading efficiencies of mutual funds.