Bond laddering is a common strategy designed to ensure a consistent stream of income and mitigate interest rate risks. The idea is to invest in diverse, high-quality non-callable bonds with differing maturity dates. Municipal bond ladders are even more compelling for some individuals given their unique tax advantages and safe-haven status. These bonds have been solid performers over the past couple of years in the low interest rate environment.
Below, MunicipalBonds.com takes a look at some important considerations in determining if bond ladders are right for you.
Why Use Ladders?
Bond ladders are a great way to build consistent income and diversify away interest rate risk. When interest rates rise, bond yields increase and bond prices fall, which reduces the value of an investor’s bond portfolio. This is a significant risk if they don’t hold the bond to maturity.
To illustrate these benefits, suppose that an investor puts $5,000 into a single T-bond and another investor puts $1,000 into five notes with different maturity dates.
In a period of rising interest rates, the first investor would be stuck holding their relatively low-yielding bond, which could lead to significant opportunity costs. The second investor would be able to reinvest the proceeds from the first bond at the newly higher rates and mitigate some of those losses for the entire laddered bond portfolio. If the market moves in the other direction, the second investor still only needs to turn over a fraction of their overall portfolio.
Risks to Consider
Bond ladders may seem like a safe strategy to build a steady stream of income and reduce interest rate risk factors, but there are still some important risks to keep in mind in order to avoid adding new risks in place of the reduced interest rate risk.
Most investors build bond ladders using individual bonds rather than bond funds, which introduces a number of different risk factors.
The first drawback is the higher costs associated with buying individual bonds compared to larger and more liquid bond funds. Since there’s very little liquidity in these individual bonds, investors may also find that they cannot sell their bonds at a fair price during a rising interest rate environment. Finally, the lack of diversification could lead to a higher risk of default – especially in cases where the investor purchased higher-yield bonds.
Muni Bond Funds
The best way to mitigate these concerns for individual investors without millions of dollars to invest is to purchase bond funds. Over the past several years, many issuers have introduced new bond funds targeting specific maturity dates, which makes it easy to build a ladder.
There are a number of different municipal bond funds with targeted maturity dates, including the popular iBond® series by iShares. Using these funds, investors can create a ladder that theoretically benefits them in the same way as individual bonds. Short-term funds would have less interest rate risk than long-term funds, and the muni issues should benefit from the same tax advantages as long as they are classified as AMT-free funds.
The downside is that many of these laddered bond funds include callable bonds, which could eliminate some of the benefits of bond ladders. Bond issuers can call these bonds if the price exceeds a certain level, which tends to happen when interest rates are falling. The fund must then replace the bond with lower-yielding alternatives, which might create uneven cash flows for investors who were hoping for stable income streams.
The Bottom Line
Bond laddering is a common technique that’s used to generate a consistent stream of income for retirement and mitigate many interest rate risk factors. While they seem pretty straightforward to implement, there are a number of other risk factors that investors should carefully consider before putting them to use in their own portfolios.