A ladder is a portfolio usually of fixed income securities which mature at regular intervals. The investments are most often bonds, but can be any investment with a fixed maturity date. That can include FDIC insured CD's, municipal bonds, TIPS, or even Treasury bills. As each bond in the ladder matures it is replaced with another bond of the longest maturity.
A bond ladder is a conservative investment strategy that provides steady interest income. The bonds may be purchased at any bond rating. Investment grade ladders are usually preferred, but junk bond ladders are possible for those willing to accept the risks.
A typical five year bond ladder would consist of 5 bonds with one maturing each year for five years. A ten year ladder consisting of 5 bonds maturing at two year intervals is also possible. Or multiple bonds can be included maturing more frequently. The bonds may also cover a range of investment grades. As most bonds pay interest at 6 mo. intervals, the bonds can be selected to pay interest at convenient intervals, at least quarterly, or with six or more bonds, every month.
The major advantages of a bond ladder are--
1. You hold the bonds to maturity when you expect to receive full face value of your bonds (provided they are of adequate quality, i.e. investment grade bond rating). You are little affected by changes in market interest rates except when you buy another bond to maintain the ladder.
2. Your interest income is steady and changes only gradually as the average of interest rates over the period.
3. By buying longer bonds, you receive higher interest than you would from short bonds.
Bond investors should keep in mind the need to sell bonds from time to time. Usually the sale must be made to a bond trader, who may make whatever offer he pleases. To make them saleable, bonds usually must be sold in lots of at least $5000. Hence, $25K is the practical minimum for a bond ladder. Larger sums give an investor more options.
Bond ladder investors should also consider possible probate needs. Holding the portfolio in a trust can be preferred, but keeping the holdings marketable can facilitate generation of cash to cover probate costs, pay taxes, and otherwise settle an estate. Some brokerage accounts offer POD or TOD provisions. Some bonds have death benefits that allow them to be cashed at face value prior to their maturity date on the death of the owner. If held in an IRA account, will the beneficiary have sufficient cash to make required distributions without the need to cash in the bonds at firesale prices?
When setting up a bond ladder, investors need to buy short bonds to fill out the ladder. These bonds are often expensive and may pay low interest rates. One solution is to buy the longer bonds first and then accumulate additional longer bonds at intervals to fill out the ladder over a period of time.
As pointed out by David Braze, any broker's office can quote on a bond ladder. You need to specify a bond rating and a maturity. Most investors are satisfied with a bond rating of A or better. Lower ratings, down to BBB, are still investment grade, but you risk an occasional downgrade taking your bonds into junk bond ratings. Higher rated bonds are available, but higher than necessary reduces yield and limits selection.
Bond ladders are usually created with a maturity of at least five years. Longer maturities offer higher yields, but increase risk. Bonds are available with maturities as long as 50 years, but those over about 15 years are considered too risky for individual investors. It's a good bet that industry leading companies will continue to be leaders for the next seven years, but 30 years is too far in the future. Thirty years ago, who would have guessed that one day General Motors would go bankrupt? You could end up investing in buggy whips or street car companies.
A broker will usually quote a ladder based on bonds in the brokerage inventory. Often they are new issue bonds, sold to you with no commission charged. Fees are paid by the issuing company. Your quote should specify the bonds to be included, their bond rating, maturity dates, and the portfolio yield. You will want to compare the individual bonds as including lower rated or longer maturity bonds is a common device to increase yield at somewhat higher risk.
Although bond ladders offer steady income, they can also be used for other purposes. A collection of zero coupon bonds can be timed to fund the education of your children or to purchase your dream (yacht? ranch? southsea island?) in retirement. Laddering is a versatile concept.
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