Laddering is a strategy that uses "maturity weighting," which involves dividing your money among several different bonds with increasingly longer maturities, and is frequently recommended for investors interested in using bonds to generate income. Laddering is used to minimize both interest rate risk and reinvestment risk. If interest rates rise, you reinvest the bonds that are maturing at the bottom of your ladder in higher-yielding bonds. If rates fall, you are protected against reinvestment risk because you have longer-maturity bonds at the top of your ladder that aren't exposed to the drop.
For example, you might buy a two-year bond, a four-year bond and a six-year bond. If you put approximately equal amounts of money in each bond, the average maturity of the entire portfolio would be four years.
As each bond matures, you would replace it with a bond equal to the longest maturity in your portfolio. For example, when the two-year bond matures, you replace it with a six-year bond. But your older bonds are now two years closer to maturity, so the average weighted maturity of the portfolio remains the same—four years.
A laddered portfolio is not limited to the maturities described above. You can build a ladder to correspond to longer durations and include longer maturities. Your return would be higher than if you bought only short-term issues. Your risk would be less than if you bought only long-term issues. Laddering also helps you gain a greater degree of interest rate protection than if you owned bonds of a single maturity. If interest rates fall, you may have to invest your bonds with the shortest maturity date at a lower rate, but you'd be getting above-market return from the longer-maturity issues. If rates go up, your total portfolio is apt to pay a below-market return, but you could start correcting when your shorter-term bonds mature.
There is a downside to laddering: Your overall return may be lower than a non-laddered bond portfolio.
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| Benefits of Laddering
Laddering's mix of short- and medium-term bonds helps to:
- Minimize inflation risk
- Reduce holding-period risk
- Reduce the impact of interest rate fluctuations
- Generate total return on par with long-term bonds
- Encourage regular saving/investing
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