What is a bond ladder? Bond laddering explained
Laddering fixed income is the strategy of owning bonds with staggered maturities, holding each bond until it matures, and collecting fixed amounts of interest and principal on fixed dates—“fixed income” in its truest form. A bond ladder can be designed to generate cash flow at different frequencies—e.g., monthly, quarterly, or annually—through the spacing between the rungs of the ladder (i.e., when each bond matures).
As an example, picture a series of bonds with maturities spaced a year apart, one in each of the next ten years. This is represented by the first column in Exhibit 1. Suppose you had $100,000 to invest, and you divided it equally, investing $10,000 into each bond. Then each year for the next decade, you’d receive $10,000 principal from the maturing bond plus interest (i.e., a “bond coupon”) from all remaining bonds.
The purpose of the ladder is to “lock in” your future cash flow so that it does not depend on how bond prices change in the future.1 In other words, bond laddering is a bet on bond coupons, not bond prices.
What are the key design choices in a bond ladder?
To know how to build a bond ladder that’s right for you, you’ll want to start with a clear goal. Do you want to create a reliable income stream for your retirement plan? Or are you simply trying to lock in the current interest rates in the market?
Here are a few questions to ask yourself:
- How frequently do you want to receive cash flow? While individual bonds typically pay interest semi-annually, it’s possible to build a bond ladder that generates monthly cash flow. Monthly cash flow may be ideal for you if the purpose of the bond ladder is to help you cover your spending needs.
- How long do you want your bond ladder to last? If you’re planning for retirement, you may want to build a bond ladder that lasts 10 years or more.
- How much risk do you want to take? If your goal is to create reliable income, you will likely prefer to build a bond ladder using U.S. government bonds rather than corporate or junk bonds.
Let’s look at an example: Cindy is 65 years old and wants to plan on spending $100,000 per year in retirement. She receives $40,000 per year from Social Security, so she needs to design a cash flow plan to cover the remaining $60,000, or $5,000 per month.
Cindy is financially risk-averse, and while she’s heard about monthly dividend ETFs, she doesn't want to generate income that depends on stocks. She’s also worried about inflation. Cindy likes that a bond ladder is a simple solution for spending money in retirement.
As a result, Cindy might consider building a bond ladder designed to generate $5,000 of monthly cash flow for the next 30 years. To protect against inflation, she could build that bond ladder using Treasury Inflation-Protected Securities (“TIPS”). With a TIPS bond ladder, she’d be relying on the U.S. government’s full faith and credit to generate her monthly cash flow with inflation protection.
How to build a bond ladder
Historically, to build a bond ladder, you needed to build a (long) list of the bonds to purchase and then go purchase them one by one.
In addition to being time-consuming and tedious, that process also left you exposed to trading costs on each individual bond. For example, if you wanted to build a bond ladder to create monthly income for the next decade, you’d have needed to buy 120 individual bonds!
In Cindy’s case, it wouldn’t be easy to figure out which TIPS to buy and how much to invest in each to produce $5,000 a month of cash flow.
Now there’s a better way. Instead of building a ladder on your own, you can buy an institutionally managed bond ladder with the ease and convenience of an ETF.
With LifeX, you no longer have to worry about how to build a bond ladder. We’ve done it for you.
That 10-year bond ladder that would have required you to buy 120 individual bonds? Instead, there’s LDDR.
Prefer a 30-year TIPS ladder like Cindy? Take a look at LIAM.
To learn more about buying vs. building a bond ladder, you can read this article that discusses the differences. To find the right bond ladder ETF for you, see the tool below.
- Bond investments are subject to default risk, or the risk that an issuer will fail to make some or all of their principal and/or interest payments.
