There are tons of investment strategies out there, all offering different ways to make the most of your hard-earned money.
However, every investor’s situation is unique, and you need a strategy that sets the best path to maximize your returns while prioritizing what’s most important to you.
If you’re looking to minimize your risks while maintaining a steady cash flow in the face of life’s unexpected twists and turns, then a bond ladder may be the perfect investment strategy for you.
Keep reading to learn all about bond ladders and how to get started building your own.
What is a Bond Ladder?
A bond ladder is not just one singular investment, but rather an investment strategy that focuses on diversifying your portfolio while minimizing risks and maximizing returns.
Some investors choose to pool their money into one large bond with a single maturity date, essentially placing all their eggs into one basket and hoping for the best returns.
A bond ladder expands upon the concept of investing with bonds by spacing out their maturity dates in order to make better use of them.
Bonds are fixed income tools that allow an investor to collect interest payments throughout the bond’s lifetime as well as a principal amount when the bond’s maturity date arrives.
Having just one large bond ensures that you will receive the principal amount in return when its maturity date arrives, but you will likely have to wait a long time to start seeing those returns.
If being locked into one bond for a long time sounds unappealing to you or if you need to adjust your income over time based on varying financial situations, then a bond ladder may be the best solution for you.
Essentially, a bond ladder is made up of a bunch of different bonds, all with various maturity dates.
These varying dates are what allow you to control your cash flow to fit your expected needs at a certain time and guarantee a steadier flow of cash as compared to investing in one large bond.
A bond ladder can span across several months or even years depending on your situation and how you want to customize your investment.
The maturity dates will usually be spaced out evenly, but if you are in need of easier access to your money at a given moment, you should try to keep your bonds’ maturity dates closer together to increase liquidity.
The Benefits of a Bond Ladder
By far the biggest benefit of utilizing a bond ladder is minimizing the risks that are most commonly associated with investing via bonds.
Bond prices are affected by fluctuations in interest rates.
As interest rates go up, bond prices go down.
Bonds with longer maturity dates are even more likely to experience fluctuation than ones that mature much sooner.
A bond ladder circumvents this risk by eliminating the need to funnel investments into one large bond with a later maturity date.
Instead, the portfolio is made up of smaller bonds with maturity dates that occur much sooner, lowering the risk of price fluctuations due to interest rate changes.
Investing in only one bond also opens you up to the possibility of credit quality decreases shattering your investment.
Since bonds are held by companies, their prices are determined by the credit of that particular company.
If the company or entity somehow sees a drop in their value, there is an equivalent drop in the price of the bond associated with them.
You can see how this may quickly become a problem if your investments are placed in one large bond.
Say the company holding the bond experiences financial issues, causing their credit value and the bond price to drop.
In that case, with your portfolio depending on that one bond, you’re left with few choices.
A bond ladder, on the other hand, spreads out the credit value across numerous bonds, meaning that a sudden decrease in one of the companies will still leave your portfolio largely intact.
As mentioned above, bond ladders also allow you to count on returns more frequently than single bonds.
With diverse maturity dates producing principal returns at various times, you can plan out your bond ladder to make sure you have enough cash to account for any unexpected financial needs or situations.
Even if you were to suddenly lose your job, the cash provided by your maturing bonds would be able to get you through while finding a new job.
This type of customization and security is extremely valuable when planning ahead for your future.
How to Build a Bond Ladder
The best way to understand a bond ladder is to picture it as an actual ladder.
The rungs represent the bonds themselves while the distance between each rung is equivalent to the time elapsed between the various maturity dates.
Remember that the bonds should be evenly spaced out, just like the rungs of a real ladder.
There are two major steps involved in building your personalized bond ladder.
The first step is determining the total number of rungs you’ll need.
You can figure out this number via a simple calculation.
Divide the amount of money you wish to invest by the number of years you plan to use your bond ladder, and ta-da! You have your number of rungs.
If you’re unsure of how long you want to use your bond ladder, it’s generally a good idea to extend it for as long as possible.
Anyone looking to diversify their portfolio and minimize credit risk should aim for a higher number of rungs.
The next step in building your bond ladder is spacing your rungs.
It’s important to keep your personal goal in mind when determining how far apart your bonds’ maturity dates will be.
As we explained, bonds with longer maturity dates have higher returns in the end compared to those with shorter ones.
However, long maturity date bonds also run higher risks of price fluctuation from credit value and interest rates.
So, if you want to create your bond ladder with risk minimization and greater access to your funds in mind, you should aim for a shorter distance between rungs, aka a smaller amount of time between bond maturity dates.
The final piece of the puzzle is your building materials.
You can utilize all kinds of different bonds to make up your individualized ladder, each one with its own benefits.
If you’re not sure what type of bond is right for you, consider aiming for higher-rated bonds, as they are generally more reliable than lower-rated bonds for controlling cash flow.
Sample Bond Ladder
Let’s take a quick look at an example of a bond ladder.
Say you wanted to invest $100,000 across 4 years.
You would set up your bond ladder so that each bond costs $25,000, with the maturity dates spacing out evenly.
As your bonds mature, you have the option to reinvest the returns into new bonds, thus extending your ladder as long as you wish.
In that case, you would take the returns from the first rung of your ladder and use them to fund another rung about two or three years later, depending on which bonds you choose and their maturity dates.
For anyone looking to avoid the hassle of guessing where the market is going or who simply wants to eliminate the stresses that come along with investment volatility, a bond ladder is a great investment strategy to choose.