During a volatile economy, investors need to balance risk and return. Using a technique called bond laddering, you can help your clients diversify their portfolios by buying a carefully selected group of bonds with a variety of maturities.
A bond ladder can consist of fixed income investments, such as certificates of deposit (CDs), U.S. Treasury notes and bonds, municipal bonds, corporate bonds, and zero- coupon bonds. The benefits of a ladder include: preservation of principal, a predictable income stream, protection against reinvestment risk, and diversification.
How Does Bond Laddering Work?
Suppose an investor buys a bond portfolio with bonds maturing in two, five, and ten years, each maturity being viewed as a step on a ladder. When the first bond on the ladder matures in two years, the money is reinvested in another bond at the long end of the ladder, such as the bond with the ten-year maturity.
It is impractical and unnecessary to predict the direction of interest rates. Instead, by “laddering” the maturities of bonds in a portfolio, an investor can manage interest rate risk. If interest rates increase, maturing principal can be reinvested into longer-term, typically higher-yielding securities. This will increase the portfolio’s overall return while maintaining liquidity through the shorter-term securities already in the portfolio. If interest rates decrease, higher yields are already locked in through the longer-term investments. Maturing principal can either be reinvested in longer-term securities to capture higher rates, or shorter-term securities to protect liquidity in anticipation of future rate increases.
Bonds selected for the laddering technique mature on a regular basis. Investors can reinvest the principal or use the funds for another purpose. Additionally, should there be a need to access these funds prior to the maturity of the bond, liquidating the shorter maturities would have minimal impact on the portfolio’s overall yield.
When Might a Bond Ladder Make Sense?
- <!–[if !supportLists]–> <!–[endif]–>If an investor depends on investments for income
- <!–[if !supportLists]–> If an investor is planning to help pay for a child’s or grandchild’s education, or some other (scheduled future expense).
- <!–[if !supportLists]–> <!–[endif]–>If an investor is saving for retirement.
How To Build a Bond Ladder
Bond ladders can be constructed with a variety of fixed income securities. Each security has varying levels of risk including: credit risk, interest rate risk, and liquidity risk. A bond ladder strategy may not be appropriate for all investors.
Pershing’s online, fixed income trading platform, BondCentral®, offers ladder-building functionality. With a few quick clicks of the mouse, you can create a laddered portfolio customized with your name and the name of your firm.
BondCentral is a complimentary service available through NetX360®. Please contact your financial organization for additional information to get started with BondCentral.
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The information contained in these materials is believed accurate at the time of writing but is not guaranteed. Delta accepts no responsibility for its use whether in whole or part.