A bond ladder is a strategy for balancing risk and return within the fixed income portion of your investment or retirement portfolio.
The concept of laddering involves constructing a portfolio of bonds with staggered maturities so that a portion of the portfolio matures each year or number of years. The interval chosen (say two years) becomes the spacing between the rungs of the ladder and serves as a selection criteria for the bonds to be purchased for the portfolio. Spacing between rungs should be generally equal. The number of rungs in the ladder should be at least five and not more than 10.
The longer the ladder, the higher the income and associated interest-rate risk or bond duration, which is defined as the sensitivity of a bond’s price to changes in interest rates. Shortening the spacing between rungs generally reduces income and interest-rate risk and provides a greater ability to reinvest principal from maturing bonds should interest rates rise. Over time, a laddered bond portfolio will include bonds purchased in periods of both high and low interest rates.
Ladders can be built with several different types of bonds or certificates of deposit, but most investors choose between U.S. Treasuries (for safety), investment-grade U.S. Corporate bonds (for higher yields) or the tax advantages offered by municipal bonds. A bond ladder helps smooth out the effect of fluctuations in interest rates because there are bonds maturing at regular intervals. When a bond matures, you can reinvest the principal in a new longer-term bond at the end of the ladder to capture higher rates.
As you build a bond ladder, keep in mind any particular cash flow needs you may have and structure the expected receipt of bond coupon payments accordingly. The cash flow or income stream of a bond ladder will stay relatively constant as only a small portion of the portfolio will mature and be replaced each year. The consistent returns offered by a bond ladder give investors the advantage of knowing that any time is a good time to build or buy into a laddered bond portfolio.