Bond laddering is a fancy term for diversifying your bond portfolio by maturity. Buy one bond that matures in two years, another that matures in five, and a third that matures in ten, and — presto! — you have just constructed a bond ladder.
Why bother? Why not simply buy one big, fat bond that matures in 30 years and will kick out regular, predictable coupon payments between now and then? Laddering makes more sense for a few reasons.
Laddering protects you from interest rate flux
The first rationale behind laddering is to temper interest rate risk. If you buy a 30-year bond right now that pays 4.5 percent, and if interest rates climb over the next year to 6.5 percent and stay there, you’re going to be eating stewed crow for 29 more years with your relatively paltry interest payments of 4.5 percent.
Obviously, you don’t want that. (You could always sell your 30-year bond paying 4.5 percent, but if interest rates pop to 6.5 percent, the price you would get for your bond is not going to make you jump for joy.)
Of course, you don’t have to buy a 30-year bond right now. You could buy a big, fat two-year bond. The problem with doing that is twofold:
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You won’t get as much interest on the two-year bond as you would on the 30-year bond.
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You are subjecting yourself to reinvestment risk: If interest rates fall over the next two years, you may not be able to reinvest your principal in two years for as much as you are getting today.
If you ladder your bonds, you shield yourself to a certain degree from interest rates rising and falling. If you’re going to invest in individual bonds, laddering is really the only option. Do it. Do it!
Laddering allows you to tinker with your time frame
Note that as each bond in your ladder matures, you would typically replace it with a bond equal to the longest maturity in your portfolio. For example, if you have a two-year, a five-year, and a ten-year bond, when the two-year bond matures, you replace it with a ten-year bond.
Why? Because your five-year and ten-year bonds are now two years closer to maturity, so the average weighted maturity of the portfolio will remain the same: 5.6 years.
Of course, over the course of two years, your economic circumstances may change, so you may want to tinker with the average weighted maturity. That depends on your need for return and your tolerance for risk.
A perfectly acceptable (and often preferable) alternative to bond laddering is to buy a bond mutual fund or exchange-traded fund. But whether you ladder your bonds or you buy a bond fund, use caution when relying only on fixed income to fund your retirement – it is probably not the wisest path. You should have a bond ladder or bond funds and other investments (stocks, real estate, perhaps commodities) as well.
