What is laddering?
In finance, the term ladder is used in different ways depending on the industry. Its two most common uses are for retirement planning and underwriting new issues of securities.
Generally, laddering is used to describe different investment strategies that aim to produce stable cash flows by deliberately scheduling investments, creating an influx of cash at a predetermined time, and/or matching a desired risk profile. .
Although these strategies can vary widely in their execution, they have in common the practice of carefully combining a series of investments to produce the desired result.
For fixed income investors, laddering can help manage interest rate risk and reinvestment risk.
Key points to remember
- Laddering is a financial term used in various ways depending on the industry.
- It is commonly used in retirement planning where it refers to a method of reducing interest rate and reinvestment risk.
- Laddering is also used in the securities underwriting market to describe an illegal practice that benefits insiders at the expense of regular investors.
- A bond ladder is a series of bonds with particular maturities that are each held to maturity and the proceeds of which are reinvested in a new, longer-term bond to maintain the length of the ladder.
- Bond ladders are used to generate fixed income cash flow and manage certain risks.
How Laddering Works
Fixed Income Laddering
The most common use of the term laddering is in retirement planning. This involves buying several fixed income financial products of the same type, such as bonds or certificates of deposit (CDs), each with different maturity dates. By spreading their investment over various maturities, investors obtain continuous cash flows while managing their interest rate and reinvestment risks.
In addition to managing these two risks, an investor’s goal in creating, for example, a bond ladder is to achieve a total return – regardless of the interest rate environment – similar to the total return of a long-term obligation.
To construct a bond ladder, investors purchase a series of individual bonds, each maturing in a different year. For example, you can buy five bonds that mature in 1, 2, 3, 4 and 5 years. As the first bond matures, investors reinvest the proceeds in a new five-year bond. This process is repeated at each maturity. Thus, the maturity length of the scale is maintained.
The practice of laddering can help investors manage reinvestment risk because, as mentioned, as the shorter-term bond in the ladder matures, the money is reinvested in a longer-term bond. end of the scale. Longer term bonds tend to have higher interest rates.
Similarly, the practice of laddering bonds can also reduce interest rate risk (if one has to sell) due to the variety of maturities. Short-term bond prices fluctuate less than long-term bond prices due to the number of years to maturity and the effects of duration.
It is important to note that the idea behind the ladder is to hold the bonds until maturity rather than selling them. Therefore, the current price of their bonds due to any change in interest rates is not a problem. Investor capital is preserved.
Reinvestment risk is the risk that investors will not be able to reinvest bond income payments and principal they receive at maturity at the same rate as the maturing bond. Interest rate, or market price, risk is the risk that the price of a bond will change as interest rates change.
Staggering as a term is also used in the context of underwriting initial public offerings (IPOs). Here it is an illegal practice in which underwriters offer a below-market price to investors before the IPO if those same investors agree to buy shares at a higher price after the IPO. on the stock market ended. This practice may provide unfair advantages to insiders at the expense of regular investors and is therefore prohibited by US securities laws.
Example of scaling
Michaela is a diligent investor saving for her retirement. At age 55, she has saved about $800,000 in combined retirement assets. It gradually moves these assets towards less volatile investments.
Michaela decides to invest $500,000 in various bonds, which she has carefully combined — or laddered — to reduce her reinvestment and interest rate risks. Specifically, Michaela’s bond portfolio consists of the following investments:
- $100,000 in a bond maturing in 1 year
- $100,000 in a bond maturing in 2 years
- $100,000 in a bond maturing in 3 years
- $100,000 in a bond maturing in 4 years
- $100,000 in a 5-year bond
Each year, Michaela takes the money from the bond that is maturing and reinvests it in a new bond that is maturing in five years. By doing so, it effectively ensures that it is only exposed to interest rate risk when it has to buy the new bond. Additionally, it manages a potentially lower reinvestment rate by buying the longer-term, higher-interest bond.
In contrast, if she had invested $500,000 in a single five-year bond, she would have risked a higher opportunity cost if interest rates eventually rose over those five years.
What is interest rate risk?
Interest rate risk is also called market price risk. This is the risk that the price of a fixed income investment will change as interest rates change. For example, in a rising rate environment, bond prices fall. When rates go down, prices go up. So if your situation forces you to sell bonds when rates rise, you might receive less than you paid. However, if you hold bonds to maturity and are not afraid to sell them, interest rate risk will not affect those bonds.
Why do investors ladder bonds?
One of the reasons investors ladder bonds, or buy individual bonds of different maturities and reinvest in new bonds as each matures, is to take advantage of the fixed income cash flows they offer. when held to maturity. Laddering protects against market price risk (the risk that their price will fall as interest rates rise) since an investor does not expect to sell the bonds. This also helps manage reinvestment risk since the investor reinvests the proceeds from each maturity into the longer-term (higher yield) bond end of the scale.
Is a short-term bond ladder better than a longer-term ladder?
It depends on what an investor is looking for. Generally speaking, in a typical yield environment, long-term bonds offer higher yields than short-term bonds. So, a longer ladder can increase the returns an investor can get when they reinvest. However, longer-term bonds are more volatile than short-term bonds, so price movements could be an issue. So would inflation. Shorter scales tend to have lower returns and less volatile price swings. They may be less sensitive to inflation. This could mean that investors end up reinvesting a greater proportion of total capital.