Climbing a Bond Ladder: A Universal Investment Tool
Bond ladders are a universal tool available for use with a variety of fixed-income investments.
There is usually more than one way to travel from point A to point B. When planning a trip, a person can look at a map or use the Internet to identify a variety of routes leading to a desired destination. So it is with fixed-income investing: There are a variety of investment products and structuring techniques that can help deliver targeted results. A bond ladder is one such fixed-income structuring technique.
Simply stated, a bond ladder is a bond portfolio containing a collection of individual bonds with successively longer maturities. As the shortest bond matures, the investor uses the proceeds of the maturing bond to purchase a new bond at a longer maturity date at a possible higher interest rate.
The primary goals of a bond ladder are to (1) generate more predictable investment income, (2) manage interest rate risk, (3) provide cash flow flexibility and (4) protect principal.
Predictable Investment Income
A bond ladder helps an investor organize and manage her cash flow. Since many bonds pay interest twice a year, an investor can structure interest payments to generally occur on either the first or 15th day of the month with coupon payments in different months of each year. With six or more bonds in a portfolio, it is possible to purchase a collection of bonds that could generate a predictable, monthly income stream.
Interest Rate Risk
The bond ladder investor generally plans to hold each bond to maturity, which eliminates the potential loss of principal due to an increase in interest rates. By staggering maturities within a bond ladder, an investor does not get locked into a single maturity date or a single interest rate. As the shortest bond matures, an investor manages interest rate risk by reinvesting the maturing principal in longer maturities, thus potentially capturing the long end of the yield curve and raising the yield on the overall portfolio.
Cash Flow Flexibility
Because bonds are scheduled to mature each year, an investor must decide whether to spend or reinvest the maturing principal. As bonds mature, an investor has flexibility to meet unexpected spending needs or to satisfy scheduled cash flow requirements. Maturing bonds also allow an investor to periodically revisit the stock/bond allocation and make new investments accordingly.
If an investor doesn’t utilize a bond ladder and attempts to capture higher yield by investing in mutual funds invested in long bonds, a potential loss of principal is introduced if interest rates have increased at the time shares are sold. This occurs because bond funds have no identifiable maturity date due to the fact that bonds are constantly being bought and sold. On the other hand, if the individual bonds in a bond ladder are held to maturity the principal will be repaid (except in the case of a credit default) regardless of price fluctuations prior to maturity.
Bond ladders are a universal tool available for use with a variety of fixed-income investments. For example, a bond ladder may be structured using either FDIC insured certificates of deposit, United States Treasury securities, municipal bonds or corporate bonds.
Originally featured in the July/August 2011 issue of Zions Bank’s Community® magazine.
David Hemingway is executive vice president and chief investment officer of Zions Bancorporation, the holding company for Zions Bank. Larry Denham, senior vice president and business development officer for Zions Bank, also contributed to this article.
Please note: The preceding article is offered for informational purposes only. Investment products and services are available through Zions Direct, member of FINRA/SIPC, a nonbank subsidiary of Zions Bank. Investment products are not FDIC insured, are not guaranteed by Zions Bank and may lose value.