Originally Posted On: https://aldeninvestmentgroup.com/nicole-sennett/bond-laddering/
The Bond Curve is No Longer Inverted—Learn if Your Bond Ladder is Ready with Nicole Sennett
There’s good news! The bond curve is no longer inverted. On September 6th, 2024, the 10-year Treasury bond yield surpassed the 2-year yield for the first time since June 2022. August’s weak job market data and the Federal Reserve’s predicted rate cuts spurred this shift.
Now that the bond curve inversion has reversed, many fixed-income investors feel more confident that the economy has successfully made a soft landing. As a result, bond laddering is becoming a more attractive investment strategy.
Below, we’ll explain bond laddering, how it works, and what benefits it provides. Then, we’ll explore why bond laddering may be a worthwhile fixed-income investment strategy in today’s market.
What is Bond Laddering and How Does it Work?
Bond laddering is the process of investing in a series of bonds with staggered maturity dates. To clarify, let’s break down its two components.
Bonds are debt securities issued to investors by a company or government agency. When you purchase a bond, you lend money to its issuer for a set period of time. In exchange, the issuer agrees to return your money by the bond’s maturity date, plus interest. Most bonds pay interest twice a year.
Laddering is an investment strategy where you distribute funds across multiple fixed-income assets or securities with staggered maturity dates. This strategy can reduce risk and enhance liquidity by ensuring that portions of your portfolio mature at regular intervals. The core elements of a bond ladder are as follows:
- Rungs—Just like real ladders, bond ladders are made up of rungs. Each rung is a bond with a unique maturity date.
- Spacing—While rungs are an essential part of ladders, the open space between them is also important. In bond laddering, this distance is the length of time between maturity dates, which can range from a few months to several years.
- Building materials—Ladders can be made of different materials, from wood to metal to plastic. Some of these materials are stronger than others. Likewise, bond ladders can employ a variety of fixed-interest securities, including corporate bonds, Treasury bonds, municipal bonds, and bond ETFs. Higher-rated bonds often produce stronger ladders, making them less likely to default.
- Height – The height of your ladder depends on the number of rungs you include. You can extend your ladder by reinvesting your funds as they mature.
The Role of Interest Rates in Bond Laddering
Bond interest rates are fixed at the time of issuance, so you’ll enjoy the same yield for their full duration of call or maturity.
Even so, interest rate fluctuations still play a crucial role in bond laddering:
- When interest rates rise, the value of your existing bonds typically decreases. This is because newer bonds offer higher yields. Bond laddering allows you to reinvest your maturing bonds’ proceeds into new, higher-yield bonds, offsetting your older, longer-term bonds’ decline in value.
- When interest rates fall, the value of your existing bonds increases because their yields are higher than those of newly issued bonds. Bond laddering allows you to enjoy higher yields on your long-term bonds while allocating your maturing bond proceeds elsewhere.
As you can see, bond ladders can help you optimize your returns in both scenarios.
Benefits of Bond Laddering
Now that you understand how bond laddering works, you may wonder what benefits it can provide. A well-constructed bond ladder can offer:
- A steady income stream – Thanks to their staggering maturity dates, bond ladders can generate a predictable income stream of bi-annual interest payments. If you purchase at least six bonds, you can receive monthly payments. This steady income stream may appeal to you if you’re nearing retirement or simply seeking dependable cash flow.
- Robust risk management and diversification—Bond laddering reduces your exposure to interest rate fluctuations by spreading your investment across multiple bonds with varying maturity dates. This diversification helps protect your portfolio from sudden shifts in interest rates and mitigates the risks associated with any single interest rate cycle. It also alleviates the stress of trying to time the market.
- Liquidity and flexibility – While individual bonds don’t offer high liquidity, laddering ensures that a portion of your portfolio is liquidated periodically. You’ll receive a predictable amount of cash at regular intervals through the scheduled maturation of bonds, which you can use to extend your bond ladder, address short-term financial needs, or try a different investment strategy.
Risks of Bond Laddering
Bonds may be considered a relatively safe investment, but bond laddering still has some downsides you should be aware of. Some potential disadvantages include:
- Default risk – If a bond issuer struggles to meet its financial obligations, it may default on your bond, losing your principal and future interest payments. To mitigate this risk, review issuers’ credit ratings beforehand.
- Recall risk – Callable bonds give issuers the right to pay off bonds before their maturity dates, leaving you without interest payments for the rest of their duration. Since these bonds can undermine the strength and structure of your bond ladder, you should avoid using them in its construction.
- Limited growth potential – Bond ladders prioritize steady income over capital growth. Thus, bond ladders often provide lower returns than stocks and other growth-oriented investments.
- Higher management demands – Bond ladders can be more complex to manage than buy-and-hold investments. Not only do you need to keep track of your bonds’ maturity dates, but you also need to monitor interest rates and determine the best reinvestment opportunities.
Fortunately, you may be able to mitigate or reduce most of these risks by working with a financial advisor who helps you select the best types of bonds and manages reinvestments on your behalf.
How to Create a Bond Ladder
If the advantages of bond laddering align with your financial goals, now may be the perfect time to create one. Here are the five steps involved in building a successful bond ladder:
Step #1: Clarify Your Bond Ladder Budget and Timeline
The first step is deciding how much money you want to invest in your bond ladder. Make sure you keep enough cash on hand for immediate expenses and emergencies. After that, you can determine your bond ladder’s initial duration: five years, ten years, twenty years, or more.
Step #2: Determine The Number of Rungs in Your Ladder
Next, you need to map out how you want to distribute your funds throughout your ladder. As discussed earlier, including at least six rungs in your bond ladder can provide you with a reliable monthly income, while adding additional rungs can enhance your diversification.
Step #3: Select Your Preferred Bond Type
Bond ladders can be built using a variety of bonds, including:
- Corporate bonds – Companies issue corporate bonds. They typically offer higher yields than government bonds to account for their increased risk of default. If you build your ladder using corporate bonds, carefully review the issuing company’s credit rating.
- Treasury bonds – Treasury bonds are considered one of the safest investments because they’re backed by the full faith and credit of the United States government. They often have lower yields than corporate bonds, but their security makes them an appealing option for conservative investors. Additionally, Treasury bond income is exempt from state and local taxes.
- Municipal bonds stand out for their tax advantages. Interest earned on municipal bonds is typically exempt from federal taxes and may also be exempt from state and local taxes. These tax advantages can make municipal bonds more attractive to high-income investors seeking tax-efficient returns.
- Bond ETFs – Bond exchange-traded funds (ETFs) allow you to build the rungs of your bond ladder using a basket of bonds. This added diversification can provide exposure to a wider range of bonds, spreading risk across various issuers and maturities.
- Certificates of Deposit – While not technically bonds, CDs are considered one of the most secure fixed-income investments because they’re insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per account. Their main risk is unintentional reinvestment – if you forget to withdraw your funds at the maturity date, your bank may automatically roll them over into a new CD, possibly at a lower interest rate.
Since each of these fixed-income investments offers different benefits and drawbacks, it is important to choose the one that best aligns with your financial goals, risk tolerance, and tax strategy.
Step #4: Determine Your Preferred Maturity Intervals
Your bond ladder’s rung spacing is based on its maturity intervals. The ideal intervals will depend on your cash flow requirements. Shorter intervals offer more consistent liquidity and frequent reinvestment opportunities, while longer intervals may provide higher yields.
Interest rates may also influence your decision. If rates are rising, shorter intervals may enable you to reinvest your maturing bonds at higher rates in the near future. If rates are falling, longer intervals may lock you into higher rates than you’ll have access to later.
Finally, you need to factor in your risk tolerance. If you’re more risk-averse, shorter-term bonds can reduce your exposure to interest rate fluctuations. If you’re comfortable with more risk, longer-term bonds have the potential to help you capture higher yields.
Step #5: Monitor and Reinvest Your Bonds as They Mature
Once your bond ladder is set up, you can sit back, relax, and collect interest payments while waiting for them to mature. Afterward, you can roll over proceeds to new bonds, pocket the principal, or invest your funds elsewhere. The right decision will depend on your financial needs and the market conditions upon maturity.
Why Build a Bond Ladder in 2024?
When the bond curve is inverted, short-term bonds offer higher yields than long-term bonds, making it less appealing for investors to commit to longer maturities. Now that the bond curve has normalized, investors can take advantage of the improved opportunity to build a balanced bond ladder.
In the wake of the Federal Reserve’s recent rate cut predictions, bond ladders also offer a strategic way to lock in today’s elevated yields while they’re still here. Thus, if you want to optimize your fixed-income investments, now could be the perfect time to build your bond ladder.
Build Your Bond Ladder With Nicole Sennett Today
By spreading bond maturities across different time horizons, bond laddering can help you craft a resilient portfolio that can weather changing market conditions. Better yet, it can provide a consistent income and flexible liquidity. With the bond curve normalizing, now is the ideal type to explore your bond laddering options.
Want to learn if bond laddering is right for you? Nicole Sennett, an experienced financial advisor, can help you determine whether this investment strategy aligns with your financial needs, risk tolerance, and time horizon.
Nicole takes a holistic approach to investing and works closely with CPAs and attorneys. After reviewing your goals and financial situation, she can provide personalized advice on bond laddering and many other investment options.
Schedule your consultation with Nicole Sennett today.
Sources:
CNBC. Bond market ‘yield curve’ returns to normal from inverted state that had raised recession fears.
Fidelity. US Yield Curve No Longer Inverted: Why This Time The Recession Scenario Might Be Different For Investors.
Investopedia. Are CDs FDIC Insured?
