Bond investing is much like a game of musical chair in which bond prices move to the tune of interest rates. Sometimes you might feel that you have no control over what happens to your bond portfolio with the future movements in interest rates.
But familiarity with ‘bond laddering’, an investment strategy, could help deal with what is called reinvestment risk.
How Bond Laddering Works
- ~ A bond investor might purchase both short-term and long-term bonds in order to disperse the risk along the interest rate curve. That is, if the short-term bonds mature at a time when interest rates are rising, the principal can be re-invested in higher-yield bonds.
- ~ If interest rates have hit a low point, the investor will get a lower yield on the reinvestment. However, the investor still holds those long-term bonds that are earning a more favourable rate.
- ~ Essentially, bond laddering is a strategy to reduce risk or increase the opportunity of making money on an upward swing in interest rates. In times of historically low interest rates, this strategy helps an investor avoid locking in a poor return for a long period of time.
- ~ The face value of each bond might be same.
- ~ For example, a bond portfolio of Rs10 lakh may have 10 different bonds of Rs1 lakh each maturing after one year, two years, three years and so on.
- ~ In such a situation, your bond portfolio would actually look like a ladder in which every year some of your bonds would be maturing, generating a steady cash flow.
- ~ This cash flow, if you so like, can be reinvested again to create another rung of a bond ladder.
This kind of strategy ensures that your entire bond portfolio does not mature on the same date.
By taking the total amount you plan to invest and dividing it equally by the total number of years for which you wish to have a ladder, you will arrive at the number of bonds for this portfolio or the number of rungs on your ladder. The greater the number of rungs, the more diversified your portfolio will be and the better protected you will be from any one company defaulting on bond payments.
Height of the Ladder
The distance between the rungs is determined by the duration between the maturity of the respective bonds. This can range anywhere from every few months to a few years. Obviously, the longer you make your ladder, the higher the average return should be in your portfolio since bond yields generally increase with time. However, this higher return is offset by reinvestment risk and the lack of access to the funds. Making the distance between the rungs very small reduces the average return on the ladder, but you have better access to the money. Well, reinvestment risk of a bond is something that arises due to future movements in interest rates.
Other Benefits of Bond Laddering
Bond laddering offers steady income in the form of those regularly occurring interest payments on short-term bonds. It also helps lower risk, as the portfolio is diversified because of the various maturation rates of the bonds it contains.
In effect, laddering also adds an element of liquidity to a bond portfolio. Bonds by their nature are not liquid investments. That is, they can’t be cashed in at any time without penalty. By buying a series of bonds with different dates of maturity, the investor guarantees that some cash is available within a reasonably short time frame.
Bond laddering rarely leads to outsized returns compared to a relevant index. Therefore, it is usually used by investors who value the safety of principal and income above portfolio growth.
It is a lot like ‘not putting all your eggs in the same basket’. Likewise, your entire bond portfolio should not mature on the same date.
To Sum Up
What: Bond laddering is an investment strategy that tries to minimize the risk associated with the future movement in interest rates.
How: A bond portfolio using laddering would consist of bonds having same face value maturing on different dates at a regular interval.
Why: Bond laddering strategy is useful because it helps in minimizing the reinvestment risk.