Bond laddering might seem to be one of the techniques that only advanced investors do, but it’s actually a little simpler than that.
At its most basic, it involves putting money in bonds that have different maturity dates, then reinvesting each time you get your investment back. However, there are a few details you should consider before getting started.
Choose your bonds carefully
The reason that this technique is called laddering is because you’ll be creating “rungs” by putting your money in bonds that have staggered maturity. Doing this means choosing a combination of short- and long-term bonds.
For example, you could have a combination of 5-year and 3-year bonds, and make sure that they’re spaced out enough for one to mature every year. Remember though that these bonds shouldn’t all be from the same issuer, for proper diversification.
Also, as much as possible try not to pick callable bonds. These can be “called,” meaning that the company can decide to give your money back and stop paying you interest even before the set maturity, so they could disrupt your strategy.
Bond laddering offer 3 main advantages. First, it helps you deal with reinvestment risk, which is what happens if your bonds mature at a time when low interest rates cause bond offerings to have low coupon rates. If you reinvested at that time, you would earn less than if the coupon rates were higher.
Laddering can also be useful in managing your investment’s liquidity in case you choose to sell it on the second-hand market. If bond prices were low, you might have to sell them for lower than you’d like.
The last advantage of laddering is that it can help you manage credit risk. This is what your money would face if you chose to invest a lot in one bond, and the creditworthiness of the issuer fell for some reason (which would also make the bond prices drop).
Reinvesting is key
When doing laddering, don’t forget that as each bond matures, you should be reinvesting the principal and the profit you earned from the coupons. That way, you’ll continue to reap the benefits of putting money in a fixed-income instrument.
You’ll eventually have to use the money that the coupons earn. By this time, you may have invested enough to not need the principal for your expenses or other purposes. If that happens, you can continue the bond laddering, but without the compounding.
Don’t forget that you won’t be experiencing the same level of growth as before if you do this. Still, if it’s all part of your plan, there’ll be nothing to worry about.
Consider a bond fund
If you think that bond laddering might be a little too difficult or stressful for you to plan out and actually do, you can consider investing in a pooled fund that specializes in bonds (like a bond Unit Investment Trust Fund or UITF) instead.
That way, the fund’s manager will be the one figuring out which bonds are the right ones to put money in.
If you do this, note that such funds aim to achieve growth and so the coupons may be reinvested to help the funds grow as part of the strategy. If this happens, they won’t be passed on to you in your settlement account.
