Bond Ladder: Pros and Cons
October 8, 2020
By Rahul Iyer
If you have been tuned in to what is happening in the world of investing, you would have heard the terms “Bond Ladder”, “Bond Laddering” or “Laddering” before. In this article, we will explain what a bond ladder is and discuss its pros and cons.
This refers to the process of storing cash equivalent or income-yielding assets with different maturity periods in a portfolio. This is done to create a predictable stream of cash flow. Ladders are typically built with certificates of deposit, bonds and any other instrument that features a fixed payment amount. The securities in the portfolio are then held until their maturity date. In the process, you pocket whatever income you get from the investment and receive your initial investment (principal).
Bond Laddering: The Pros
There are two major benefits of bond laddering. By implementing the principles of bond laddering, you will be unphased by the current interest-rate environment. This is so because, at the point of maturity, you will get the bond’s face value back.
You are also protected from capital losses when you do bond laddering. Since you will be holding the bond up until its maturity date, you will not face the reality of having to sell your bond for a discount in a rising-rate environment.
Bond Laddering: The Cons
While bond laddering has its pros, it also has a number of cons that must be clearly considered. You face default risk when you build a portfolio with bonds. In light of this, you must choose bonds that are high-quality, stable and noncallable. Bond laddering also includes a complex level of research.
Those who manage funds professionally have more expertise than the average investor. To be successful, you will need to do a lot of research.
When setting up a portfolio that is founded on bond laddering, you will face a challenge when trying to diversify your portfolio. This is so because the typical face value of bonds is $1,000. To diversify, you will end up spending a lot of money. Failure to diversify then exposes you to the risk of losing your money.
Bond laddering can be a successful investment strategy; however, there is some amount of caution that must be taken. To leverage the benefits of this strategy, an investor must have the requisite knowledge and expertise to select bonds that will not default and will actually make it to the stipulated maturity date. Bond laddering may be best for individuals who have tons of money to invest due to the cost involved in purchasing bonds.