Bond Laddering

Bond laddering helps to minimize reinvestment risks

26/10/2009 Mint

A bond ladder tries to minimize the risk associated with the future movements in interest rates while creating a regular flow of money for the bond holder

Bond investing is much like a game of musical chairs in which bond prices move to the tune of interest rates. Sometimes you might feel that you have no control over what happens to your bond portfolio with the future movements in interest rates. But by slightly tweaking your bond portfolio you can effectively deal with what is called reinvestment risk. No rocket science is involved here. You just need to be familiar with bond laddering, an investment strategy, that can take your bond portfolio to new heights.

Johnny: Bond laddering? What does that mean?

Jinny: A bond ladder or bond laddering is an investment strategy based on a very simple concept. A bond ladder tries to minimize the risk associated with the future movements in interest rates while creating a regular flow of money for the bond holder. A bond portfolio using laddering would consist of bonds having different maturity dates at a regular interval. However, the face value of each bond might be same. For example, a bond portfolio of Rs10 lakh may have 10 different bonds of Rs1 lakh each maturing after one year, two years, three years and so on.

In such a situation, your bond portfolio would actually look like a ladder in which every year some of your bonds would be maturing, generating a steady cash flow which, if you so like, you can reinvest again to create another rung of a bond ladder.

This kind of strategy ensures that your entire bond portfolio does not mature on the same date.

Johnny: Looks sensible. But I still don’t understand the arithmetic behind a bond ladder strategy.

Jinny: A bond ladder strategy is very useful in dealing with one of the most common risks facing your bond portfolio: reinvestment risk. How? Well, reinvestment risk of a bond is something that arises due to future movements in interest rates. Suppose you hold a bond portfolio which is currently earning you an interest of 8%. Your bonds would continue to earn an interest of 8% till the date of maturity. In the meantime, interest rates might not remain static. They can very well go up or down. In case you choose to hold your bonds till maturity, your entire portfolio would be maturing on the same day, which means that you can reinvest your money only at the interest rates prevailing in the future. In case the rates are higher, you are lucky. But in case the rates are lower, your entire portfolio gets invested at a lower interest rate. This is what we call reinvestment risk. The arithmetic behind a bond ladder strategy is simple. Spreading out bond maturity dates in fact spreads out reinvestment risk.

Johnny: It seems like not putting all your eggs in the same basket. Likewise, your entire bond portfolio should not mature on the same date. Right?

Jinny: That’s right. But it’s not just about bonds. The same logic would also apply to any other fixed income security, say, for instance, a certificate of deposit or even a bank’s fixed deposit, all of which are subject to reinvestment risk. But you should also keep in mind that spreading out your risk might also lower your overall return. The simple truth is that when you gain something then you might also lose something. The whole mechanism of bond laddering may require you to bear some kind of cost. For instance, bonds of different maturity in a bond ladder would be earning different interest rates. In a normal situation, bonds maturing early pay lower interest than bonds maturing at a later date. So by investing your entire money into bonds of longer maturity you could get a higher rate of return, whereas a portfolio consisting of bonds of different maturity would give you lower overall return.

Johnny: Lower overall return—that’s something we should keep in mind while using bond ladder strategy.

Jinny: But despite lower overall rate of return, the prospects of a bond ladder look bright. As said, every year a part of your portfolio would be maturing, which means that every year you have an opportunity of making a new investment. In case the interest rates have come down, you can reinvest your money only at a lower interest rate. But look at the other side, the majority of your investment is still fetching higher interest rate. In case the rates have moved up, you have a chance to invest a part of your portfolio at a higher rate. With rates continuously moving upwards, your portfolio might actually end up earning higher overall rate of return than what you might have earned by locking your entire money for the long term at once. You should always keep in mind that interest rates move in cycles and it is always very tough to predict the exact timing of a cycle. The best way of dealing with the interest rate cycle is to create your own investment cycle.

Johnny: It is always better to keep your options open. You never know when you might get caught on the wrong side of the interest rate cycle.

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What: Bond laddering is an investment strategy that tries to minimize the risk associated with the future movement in interest rates.

How: A bond portfolio using laddering would consist of bonds having same face value maturing on different dates at a regular interval.

Why: Bond laddering strategy is useful because it helps us in minimizing the reinvestment risk.

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