You are likely familiar with bonds—a common security in which an investor loans money to a company or government entity for a set time (by purchasing a bond). The borrowing party pays interest on the money and repays the principal in full by the end of the period.
While bonds are considered low-risk investments, they are not entirely risk-free. There are two types of risk associated with them:
- Credit risk refers to the chance that the issuing party will fail to make interest payments and default on repaying the principal.
- Interest rate risk is the possibility of a loss resulting from a change in interest rates. If an investor buys a 10-year bond paying 3%, for example, and interest rates rise to 5%, the bond declines in value. The investor could hold the bond until it reaches maturity (when they will regain the principal), but they would miss out on investing at the higher interest rate.
One strategy for mitigating these risks is called a bond ladder: The investor purchases several bonds with different maturities, issued by various companies and/or government entities. Each bond is a rung on the ladder. The time between each maturity is the space between each rung.
This strategy allows our clients to store portfolio gains during a rise in the market; these gains can then be reinvested in stocks when the market is down. A bond ladder can also provide a better return on liquidity than a savings account or money market. By having bonds maturing at regular intervals, our clients have less money held in low-interest accounts.
Mitigating Credit Risk
To lower the credit risk to our clients, we only consider high-quality bonds. There are several rating agencies, such as S&P, Moody’s, and Fitch, that grade bonds based on how likely the issuer is to default. The ratings for bonds can be grouped into two categories: investment grade and non-investment grade (or junk). S&P’s investment-grade ratings are labeled as AAA, AA, A, and BBB, with BBB- being the lowest rating still considered investment-grade. Our advisers purchase bonds with an A rating or better for our clients.
A bond ladder could also lower credit risk by including a variety of issuers, from government to municipal and corporate bonds. Municipal bonds are diversified by considering the state of issue, the municipality, and whether a taxing authority or project revenue provides backing. Corporate bonds are diversified by issuer and industry. Our bond ladders also use certificates of deposit, which can offer further stability.
Mitigating Interest Rate Risk
Our investment strategy calls for bond ladders to be built out across five years. The goal is to have one fifth of the bond portfolio mature every 12 months.
When a bond is held to maturity, the investor regains the face value of the bond plus interest set at a fixed rate. Since bond prices go up as interest rates go down (and vice versa), a bond’s current market value may be more or less than the face value of the bond at any time before maturity. However, the bond will mature to face value regardless of current interest rates.
A steady stream of bonds reaching maturity provides liquidity. The principal from maturing bonds can be used to:
- invest in new bonds at current interest rates
- rebalance a portfolio by investing in stocks during market corrections
- provide cash for client spending
The five-year ladder helps when interest rates are falling because all the rates in the bond portfolio are locked in until maturity. Even though some bonds might mature as yields are falling, other bonds continue generating income at the higher, older rates.
The ladder is also practical when interest rates increase because it regularly frees up part of the portfolio to take advantage of new, higher rates.
The Importance of Monitoring
A bond ladder is not a strategy that can be established and left on autopilot. We monitor our bond ladders regularly by reviewing changes in price and credit rating for individual bonds. (An unusual price change could signal a problem that has not shown up in the credit rating yet.) While we generally intend to hold each bond until maturity, sometimes a bond is sold early to avoid a default.
A well-diversified bond ladder does not guarantee against loss, but it can minimize risk the way any diversified portfolio does. We use bond ladders in our clients’ portfolios to leverage the cash flow features of bonds—both their interest payments and the principal repayment at maturity. A bond ladder has the potential to be an efficient and flexible vehicle to smooth out the ups and downs of the market.
- Two types of risk come with owning bonds—credit risk and interest rate risk. A bond ladder is a strategy of holding a range of bonds to help mitigate these risks.
- Ratings for bonds are grouped into investment grade and non-investment grade. We recommend only purchasing bonds with an A rating or better.
- The investor receives back the face value of the bond at maturity, plus interest that has been set at a fixed rate.