How to Build Stability in Fixed Income Earnings with a Bond Ladder
Smooth out your interest earnings and mitigate common risks of fixed income investing
The fixed income market is going crazy right now. The second- and third-largest bank failures in US history have taken place this month so people are questioning the safety of bank deposits. In addition, we’re seeing historic changes in interest rates as last week saw the third-largest decrease in 2-year treasury rates in 40 years. With all this volatility, how do you ensure safety and stability in earnings from what should be a safe, income-generating part of your portfolio: fixed-income?
Today’s post is about one tool to build stable and smooth earnings from fixed income: bond ladders.
What is a bond ladder?
A bond ladder is a combination of fixed income securities such as bonds or CDs which have different maturity dates. These maturity dates are ideally evenly spread out so that there is an ongoing cadence at which these securities mature and pay out to you. As securities mature, you reinvest the proceeds in additional securities to build on the bond ladder and take advantage of higher average interest rates from interest-rate roll.
For those of you who have followed my posts, I recently wrote one titled How to Maximize Your After-tax Returns on Cash with Short-term Treasury Bills which talked about the ability to earn strong, 4–5% interest rates on safe, liquid and tax-advantaged US government treasury bills. In that article, I mentioned that I was building a bond ladder of short-term bills so I thought I’d use my holdings as an example for this post. Here are my short-term holdings, which I’ve been building up through purchasing 6-month and 1-year bills. As longer-term interest rates have risen, I’ve recently been adding 2-year notes as well:
As you can see in my holdings, I’ve set up my ladder to have weekly maturities of these securities. Most bond ladders have much longer intervals between maturities, but the example I’ve shared above is my short-term bond portfolio, thus the short intervals. To keep building on the bond ladder, I take the funds from a week’s expired security and reinvest half each in a 6-month and 1-year bill. As interest rates have been rising over the last year, this strategy has helped me increase the average interest rate of my fixed income holdings. I’ve also started layering on 2-year notes when I had any extra money to save to take advantage of increasing longer-term interest rates.
Investopedia has a great article on bond ladders that I recommend you read to learn more about the strategy: Bond Ladder: Overview, Benefits, FAQ and Examples. For those of you who don’t have time to read that full article, here are the key pros and cons in my view.
What are the benefits of a bond ladder?
Bond ladders help with four key aspects of investing in fixed income securities:
- Interest-rate risk: Interest rates change all the time — we’ve seen that happen this week with historic decreases in 2-year treasury bills. When interest rates change, the value of bonds change in the opposite direction — if interest rates increase, bond values decrease and vice versa. The rate of change in values is directly correlated with the amount of time to a bond’s maturity. The longer to a bond’s maturity, the higher the impact of a given change in interest rates on that bond’s value. A bond ladder helps with interest-rate risk because of its diversification. Having a range of maturities leads to different impacts on the bonds’ values from any changes in interest rates. If interest rates increase, the ladder has short-term bonds whose value don’t go down that much to balance the higher impact on the longer-term bonds held. Conversely, if interest rates decrease, ladders have long-term bonds which will increase more than the short-term bonds
- Interest-rate roll: Normally, the longer the term of a bond, the higher the interest rate that you’ll receive. By reinvesting the proceeds of the shorter-term bonds that are maturing in your portfolio into longer-term bonds to keep your ladder going, you should be able to increase the weighted-average interest rate of your ladder. Please note that this isn’t always the case as we see today with an “inverted curve” where short-term rates are higher than long term
- Liquidity risk: Liquidity is just a fancy way of saying that you have cash (liquid funds) when needed. Because bond ladders have a range of maturities, there should be a bond maturing in the near term in case you have an immediate need for money. Even if there isn’t a bond maturing right when you need the money, there should be a near-term bond available to sell whose value won’t be that impacted because the time remaining to its maturity is limited. I use US Treasury securities for my bond ladder to further mitigate liquidity risk because there’s always a market for US government securities. For people who use corporate bonds, there is the additional liquidity risk of limited interest in buyers to whom you can sell such a bond if you need immediate cash
- Credit risk: This really isn’t a risk with government securities because the government has always honored its debts. For those whose bond ladders include corporate bonds, there is always a risk that a bond issuer will default. By having many bonds in your ladder, you reduce the risk that any individual bond is defaulted upon
What are the downsides of a bond ladder?
While I am a strong believer in bond ladders, there are downsides to this strategy as well:
- Inability to time the interest rate cycle and interest rate rolls which makes it likely that you will only earn average interest rates: One of the benefits I shared above of bond ladders is that you typically get a higher average rate from interest rate rolls. However, in times like today where there is an inverted interest rate curve, reinvesting in longer-term bonds may actually lead to a lower average interest rate. In addition, you won’t be able to “time the market” by investing all of your funds when rates reach highs. Timing the market is pretty hard to do so I don’t think this is actually a big downside, but it is something you should recognize
- Time and effort to build and maintain the ladder: As you saw above in my short-term bond ladder, I have securities maturing every week. It takes time each week to reinvest those monies into new bonds. One way of reducing this is to lengthen the interval between securities, but even then, maintaining a bond ladder will still require your time and effort
- Minimum amount of money needed to build a bond ladder: To build a bond ladder, you need to have a minimum number of securities with different maturities — I’ve read recommendations that it be at least 10 different maturities. Many securities have minimum investment amounts so you need to multiply that number by at least 10
Where do I build a bond ladder?
Most brokerages offer the ability to buy bonds cost-free through their platforms. You can also buy government bonds directly at treasurydirect.gov. If you prefer having CDs instead of bonds, you can invest in CDs through your bank or also through brokerage firms. I personally prefer buying government bonds using a combination of my brokerage and directly through treasurydirect.gov.
This completes today’s post on how to build stability in fixed income earnings with a bond ladder. The practical steps you can start taking from today’s post are:
- Update the fixed income part of your portfolio to build a bond ladder: Build a smoother and more liquid stream of income for the safe, fixed income portion of your portfolio
- Use high-quality government securities for your bond ladder: This portion of your portfolio is meant to be the safe ballast that gives you a smoother flow of current income. As I described in the article, the size of government debt markets further reduces liquidity risk. In addition to safety, government securities also provide tax benefits
- Make your updates slowly: As with any other part of managing your finances, slow and steady is the best way to approach building your bond ladder. Incremental changes to your portfolio that increase alignment with your long-term plan reduces the likelihood of making a mistake
Thank you for joining me on my journey to build financial literacy for young adults and their families. Please share any comments or questions that you have in the comments section. If you are interested in reading more of my posts, please access my author page (https://vocal.media/authors/sudhir-sahay) where you can see all the posts I’ve published. Also, if there are any topics you’re interested in my broaching in future posts, please let me know. In addition to the comments section, I can be reached at [email protected]
About the Creator
Sudhir Sahay is a Sales and Marketing executive and a father of two young men. Sudhir hopes to share his journey building basic financial literacy for his children and providing savings and investing advice to their friends and peers.
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