When I was a financial advisor, I wrote many articles about investment and tax advice. And I thought I would eventually write an article about the bond ladder strategy, when the market turned south.
But having gone through an 11 year bull market after the Great Recession, I wasn’t quite sure when that was going to happen. However, the coronavirus pandemic convinced me that it was time.
This article will walk you through:
- Elements of a bond ladder strategy
- Why you may consider buying individual bonds and certificates of deposit (CDs) over bond mutual funds or bond ETFs
- 5 points to consider when making your own decision about fixed income securities
Let’s begin with a client story.
In January 2020, one of our more conservative clients had asked me about why her accounts had ‘so much cash and bonds.’ I gently explained that it was part of our agreed-upon asset allocation.
I reminded her why we had set up a bond ladder strategy for her and her husband. Given the potential big events in her life, we wanted to make sure that she had available cash to take care of her needs. She reluctantly let go of the issue, but I knew she wasn’t happy that she felt like she was missing out on a stock market run.
In March, the coronavirus sell-off shaved over 35% from the stock market’s all time highs in a one-month period. That same client sent me an email thanking me for holding my ground and keeping her investments where they were.
But it wasn’t only her. During the coronavirus pandemic, we reached out to each of our clients, to make sure they were safe. When the topic eventually moved to their finances, many of them thanked us for having them partially invested in a bond ladder.
That’s when I knew it was time to write this article.
When I originally wrote this article, we were talking about the stock market decline from the coronavirus pandemic. Then, the stock market went on a furious rally throughout 2020 and 2021. As of this writing, market conditions have deteriorated, leading to a rising interest rate environment.
Truthfully, this approach has worked for many portfolios during the Great Recession of 2008-2009, the ‘lost decade’ of the early 2000s, and countless other periods when stocks didn’t perform as well as investors would have liked.
There are many technical aspects of building a bond ladder. However, this article focuses on the things that my financial planning clients, all individual investors, appreciated about the bond ladders in their portfolios.
I know this because many of them told me. But first, what exactly is a bond ladder?
What is a bond ladder?
A bond ladder is a portfolio of individual bonds that are purchased as part of an overall investment strategy. Instead of buying one (or more) bonds with the same maturity dates, a bond ladder might have staggered maturity dates.
For example, if Joe had $100,000 to invest, and wanted to create a bond ladder over 5 years, he might buy the following:
- 1 year bond at $20,000
- 2 year bond at $20,000
- 3 year bond at $20,000
- 4 year bond at $20,000
- 5 year bond at $20,000
Having 5 different bonds with 5 different maturity dates would give Joe the opportunity to reinvest at regular intervals. Let’s fast forward a year.
Without including interest payments, the bond ladder looks like this:
- $20,000 in cash (bond just matured)
- 1 year bond at $20,000
- 2 year bond at $20,000
- 3 year bond at $20,000
- 4 year bond at $20,000
Now Joe has options with that $20,000. He could use it for:
- Predetermined needs. This might be something that Joe had planned for in advance
- Emergent needs. Perhaps something unanticipated came up. Fortunately, this bond matured just in time.
- Reinvestment. If Joe doesn’t need the cash, he can simply buy another bond or CD at the prevailing interest rates.
The concept is relatively simple. You can use different types of bonds or CDs to create a bond ladder. This might include:
- Treasury bonds
- Municipal bonds (state & local government bonds)
- High quality corporate bonds
Your portfolio of bonds will be based upon your preferences for bond yields, safety, and time to maturity. The intention of a bond ladder is to hold bonds until they mature. Then, the maturing bonds are simply replaced with new bonds.
Let’s look at the types of risk associated with bonds, and how a prudent investor might mitigate that risk.
Purpose of a bond ladder
The purpose of a bond ladder is not solely to provide a steady income. The purpose of a bond ladder is three-fold:
- To stabilize a portfolio consisting of fixed-income and equities.
- To protect against risks associated with holding bond mutual funds and ETFs
- Protect against liquidity risk.
Let’s look at each of these a little more closely.
In a typical bond (fixed-income) and stock (equities) portfolio, an investment adviser might recommend 60% stocks and 40% bonds. Or 50%/50%. Or whatever they deem suitable, based upon your risk assessment.
Aggressive investors will be more invested in stocks, while conservative investors will hold more bonds, CDs and cash. Within the bond side of the portfolio, there are still ways to aggressively invest for income.
But that depends on your appetite for risk with fixed income investments.
The yield curve is a fancy way of describing the expected yield for the amount of credit risk a particular bond is expected to take. Credit risk is simply the risk that a bond issuer will not be able to make its required payments.
For example, a U.S. bond, like a Treasury bond, is almost ‘risk-free.’ There is no such thing, but Treasuries are as close as you can get. So it’s on one end of the yield curve.
On the other end would be very low-quality bonds. But how do you know how risky each bond is? That’s where independent credit rating services, like Moody’s, come in.
An agency like Moody’s rates each bond, and assigns it a grade. Higher quality bonds are assigned higher ratings. Lower quality bonds are assigned lower ratings.
Lower-rated bonds have higher yields than high quality bonds, because of the additional risk. So it’s possible to build a bond ladder for income. But it’s not feasible to expect a steady stream of income without taking on additional risk.
Of course, you could invest in bond funds & ETFs. The advantage of bond funds is that a fund manager does all the work for you. But there are risks in that approach, too.
Bond ladder vs bond funds/ETFs
It is possible to invest in one or several mutual funds or ETFs that buy fixed income securities. And some of these funds invest in very specific areas, like:
- Duration focused bonds: For example, only long-term bonds or short-term bonds
- Country-specific bonds: Like only U.S. bonds
- Credit quality: Only high-quality bonds
The primary challenge in this is interest rate risk. Bond fund managers actively buy and sell bonds within the fund portfolio.
A manager may buy bonds when cash needs to be invested. Conversely, that manager might sell bonds when investors want to redeem shares, or if there is opportunity to make a profit.
So here’s where interest rate risk comes in.
Interest rate risk
Interest rate risk is the risk that changing interest rates will impact the value of a fixed-income security. In a bond ladder, interest rate risk isn’t a focus item because bonds and CDs are held to maturity.
When a bond is held to maturity, it will always be redeemed at the par value. This is priced into the bond when it’s purchased, and the investor knows exactly what payments to expect over that bond’s life. As long as it’s held to maturity, there is no interest rate risk within a bond ladder.
But in a bond fund, you suffer the fortunes of the interest rate environment. When interest rates fall, a bond is more valuable than it was before.
And bond fund managers can make lots of money by selling individual bonds in in the bond market at a profit. From the early 1980s through the early 2020s, bond fund managers went through a record bull market.
Conversely, when interest rates go up, bond prices go down. And bond fund performance declines as well. That extra percent of yield isn’t much consolation when your bond portfolio is down 10%.
With a bond ladder, you don’t focus on the market price. Your focus is on the par value of the portfolio. And with predictable maturities, you mitigate liquidity risk.
In the investment world, liquidity risk is the risk that a company does not have enough cash flow to meet its short term obligations.
For an individual investor, we can use this term as the risk that you might incur for emergent issues. Most people address liquidity risk by having an emergency fund.
A bond ladder can help mitigate liquidity risk. From a risk management perspective, you can keep less money in your emergency fund. Because you know, with certainty, that a single bond will likely take care of most emergent issues.
And within a bond ladder, you know the total dollar amount invested at any given time. Based on the number of rungs in the ladder, you know the number of bonds that will mature. And you know the time period over which those bonds mature.
How to construct a bond ladder
Since each type of bond ladder is different, it’s worth discussing how we would construct bond ladders for our investment management clients. Since we’re relatively conservative, our primary goal is funds preservation, not investment results.
Our firm’s focus
Nothing is guaranteed. And by law an investment advisor cannot guarantee the safety of any investment. However, at my financial planning firm, we would invest our fixed income portfolios on securities backed by federal and state governments.
Here are some of the criteria we would look for:
- In IRAs, would look primarily at CDs or Treasury bonds, whichever was higher-yielding for the timeframe we invested in. If we bought CDs, we would buy up to the FDIC limit only.
- No corporate bonds of ANY rating.
- In taxable accounts, we would look for highly-rated municipal bonds (Moodys AA3 or S&P AA or better).
- Sometimes, we would look for insured bonds for additional protection for conservative investors. We would also screen against certain states and municipalities we feel might not be able to meet their future obligations.
- While interest rates were low, our bond ladders might not go out further than 2 years.
- Market rates: When our clients asked us to buy a bond or CD, we wouldn’t sit and wait for the best price. We would simply shop for the best rates we can get at the time of purchase, and buy. But we would wait for bonds that met our strict criteria for safe investing.
- Finally, and most importantly, we would hold all bonds and CDs until maturity.
Let’s talk about five factors you might consider when building your own bond ladder.
Bond Ladder Benefit #1: Safety, Not Yield
Not every bond ladder is constructed with safety in mind. In fact, when you research bond ladders, you might see articles that discuss how a bond ladder might generate income. At my old firm, we saw things a little differently.
If you have $500,000 in a bond ladder, yielding 1%, that’s $5,000 per year. While that could be considered income, most of our clients would not consider it income that they could count on.
Perhaps we could have found riskier assets that yielded 4%. Our clients probably would not have appreciated stretching that far, just to get $15,000 per year.
Instead, if we invested $500,000 in a bond ladder in March 2022, it might look like this hypothetical example:
|Bond/CD Name||Maturity Date||Face Amount||Interest|
|Bond – Des Moines IA||6/1/2022||$ 30,000||$ 1,500.00|
|CD – Morgan Stanley||7/10/2022||$ 60,000||$ 1,650.00|
|Bond – Fort Band TX||9/1/2022||$ 30,000||$ 900.00|
|Bond – Cincinnati OH||12/1/2022||$ 50,000||$ 2,625.00|
|CD – Wells Fargo||12/14/2022||$ 42,000||$ 1,302.00|
|CD – Wells Fargo||12/14/2022||$ 54,000||$ 1,674.00|
|CD – John Marshall||12/18/2022||$ 45,000||$ 720.00|
|CD – John Marshall||1/11/2023||$ 34,000||$ 544.00|
|CD – Wells Fargo||3/8/2023||$ 60,000||$ 1,740.00|
|CD – Morgan Stanley||6/18/2023||$ 31,000||$ 837.00|
|CD – Morgan Stanley||9/30/2023||$ 30,000||$ 526.00|
|CD – Morgan Stanley||12/13/2023||$ 34,000||$ 595.00|
Sample bond ladder in a client portfolio
While you might normally focus on the amount of interest, we would not. Our focus was on maturity dates. On this table, you could see that from the date of investment, 3 bonds are available within the next 6 months:
- $30,000 becomes available in the trust account on 6/1/2022
- $60,000 becomes available in the IRA on 7/10/2022
- $30,000 becomes available in the trust account on 9/1/2022
And so on.
Our focus was not on the $14,513 they might earn interest each year. That’s not the goal. It’s simply a reflection of the best coupon rate available at the time we purchased these instruments.
Our focus was on the fact that $500,000 is invested in high-quality, fixed income instruments. And that all maturities were within the next 2 years from investment.
The only thing left to do is…nothing. Literally. That leads us to our next benefit.
Bond Ladder Benefit #2: Predictable Liquidity
A quick Google search led me to believe that this phrase isn’t very commonplace. But it should be.
Predictable liquidity is simply knowing the schedule of when you’ll have access to cash without having to sell anything. This doesn’t have much of a benefit in a roaring bull market, it really hits home when the stock market just went down 30%.
Generally speaking, one of the worst things an investor can do is sell securities into a down market. But oftentimes, the conditions that create the down market are the ones that generate the need for cash.
For example, selling stocks during the 2008 recession could be considered foolish. But if you were one of those who lost their job, you probably didn’t have much of a choice.
A bond ladder allows you to see when that cash will be available. So you can make an informed decision.
Using the above example, you might be able to make it until June, when that first bond matures for $30,000. And that might be enough to get you through your emergency.
In that case, you probably don’t need to sell anything. And you might not need to have a huge savings account (earning hardly anything) if you have a bond ladder.
Bond Ladder Benefit #3: Smaller ‘Emergency Fund’ Requirements
When you can see the predictability of your bond ladder, how much money do you need to set aside in ‘cash?’ Probably not as much.
And that’s part of the point. Instead of an ‘all or none’ solution, where you’re faced with the choice of ‘being invested’ or ‘sitting in cash,’ a bond ladder allows you to do both.
And because more of your money is working for you, you can set aside less of it in a ‘rainy day’ fund. Which leads us to the next benefit—your portfolio is more stable.
Bond Ladder Benefit #4: Stability
No one really appreciates stability in their portfolio in an up market. Certainly, in 2019, when the S&P 500 returned over 28%, very few people wanted the ‘stability’ related to a municipal bond that returned 1%.
Someone invested in a 50% stocks/50% bonds portfolio would have seen something around 14% in that timeframe. Which isn’t a bad return.
When you see the market ‘outperforming’ your portfolio by such a drastic amount, it’s enough to make even the most patient investor question why they’re invested in bonds.
Of course, when the stock market is down 30%, then a client in a 50% stocks/50% is thinking, “Hey, I’ve only lost half as much as the rest of the market.” Which is the exact point.
Many of our clients were retired or approaching retirement. While every portfolio could use the 28% returns (who wouldn’t want one of those years), very few of our clients would feel okay if their portfolio got cut by a third overnight.
So you can’t have it both ways. If you’re going to take steps to reduce the risk in the down markets, then you’ve got to expect that the market will ‘outperform’ in the good years.
And when interest rates go up, that’s when you’ll see bond ladders outperform bond funds. Because of interest rate risk.
Bond Ladder Benefit #5: Protection Against Interest Rate Risk
So what happens if interest rates do go up? If you’re not in a position to reinvest at higher interest rates, you could be stuck with a bunch of low-interest paying bonds or CDs for the duration of your portfolio.
Moreover, since the prices of bonds goes down when interest rates go up, that part of your portfolio could be worth less. So how does a bond ladder help in this regard?
First, let’s revisit one of the key tenets of our bond ladders. We hold everything until maturity.
If your CD is backed by the federal government, or your bond is expected to mature, it doesn’t matter what the trading value is. As you get closer to the maturity date, the closer the value of your bond or CD will get to its maturity value.
In other words, a bond that has fallen in value will creep back up, and a bond that has risen in value will creep down.
Second, when that bond or CD matures, you can simply reinvest at the (now) higher interest rate.
Finally, we revisit benefit number 1: We care about safety, not yield.
In other words, rising interest rates means that the interest income might go up. That’s not the important part.
The important part is that the bond or CD is safe, either through federal backing (when available), or by holding out for very highly-rated municipal bonds.
When I was a financial planner, our clients truly appreciated bond ladders in the down markets because they represented relative safety. More importantly, our clients could manage their day-to-day lives because they know that money will be there to support their needs, when they need it. And they wouldn’t have to sell stocks in a down market to access it.
If you’re considering a bond ladder, you should discuss it with your financial advisor or investment manager before starting on your own.