What is a bond ladder?

Q: What is a bond ladder?

A:A bond ladder is a portfolio of individual bonds that have different maturities. For example, a bond ladder could be constructed with equal numbers of bonds with maturities across 1–10 years, or it could consist of bonds that mature in 2–7 years. Since buying small lots of individual bonds will increase costs, the number of bonds and the number of maturities used in a ladder might be influenced by the dollars available to invest. The threshold we follow is $500,000 for tax-deferred accounts and $1 million for taxable accounts.

A ladder can help minimize risk. At least three types of risk are related to fixed income investing:

1) price risk, 2) reinvestment risk and 3) credit risk. Creating a bond ladder can minimize price and reinvestment risk. The longer the maturity of an instrument (and the greater its duration), the greater the price risk will be. Reinvestmentrisk is the risk that a bond will mature when interest rates are lower than when the bond was purchased. Thus, when an investor reinvests the proceeds from the maturing instrument, he or she could receive a lower rate of return. Minimizing price risk comes at the cost of accepting reinvestment risk, and vice versa. It is possible to reduce credit risk by purchasing bonds with higher credit quality such as U.S. government debt and upper investment-grade instruments, as well as municipal bonds rated AAA and AA from low-default sectors.

Advantages and disadvantages of ladders. Investors can match maturities to known/desired cash flow needs while avoiding the expense of a mutual fund or an active separate account manager. Tax-loss harvesting can be performed in taxable accounts. Investors can control which bonds they own, which is not possible with a bond fund. For example, investors can allocate a portion of the ladder to state-specific bonds or those with alternate-minimum tax restrictions. One thing to be aware of when building a bond ladder is the need to adhere to a buy-and-hold strategy. Selling securities before the final maturity date can have a negative impact on the desired performance of the bond ladder.

Considerations when designing bond ladders. An investor’s time horizon can be a factor when deciding the length of the ladder. If invested properly, the length will be dependent on whether the market is compensating for an extension. Also, consider risk tolerance and liquidity/income needs, which can be a factor when deciding how many bonds (rungs) to include on the ladder (for example, some investors who need a large stream of income might wish to develop a ladder that seeks to earn a specific expected yield).

Every bond ladder should be based on an investor’s specific financial objectives. Taxes should also be considered when determining the type of ladder. Federal tax brackets will dictate whether tax-free or certain taxable bonds make more sense for the client. Taxes should also be considered for certain residents who live where the state tax is high. At the same time, national diversification would help minimize credit risk. We believe state exposure should be capped at 35 percent.

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