How to Build a Bond Ladder

A bond ladder can be a balanced strategy for investors seeking investment returns and manageable risk. It can also be an effective tool for those looking to build diversified portfolios that pursue reliable income streams.

Here, we'll explore a bond ladder, its benefits and risks, and step-by-step instructions for building one.

What is a Bond Ladder?

A bond ladder is a portfolio of fixed-income securities in which each security has a significantly different maturity date.¹ This strategy means that rather than having one large bond with a single maturity date, you have several smaller bonds with varying maturity dates to increase liquidity and diversify risk. A bond ladder is a portfolio strategy that aims to manage interest rate risk and provide a predictable income stream.

Benefits of a Bond Ladder

There are quite a few benefits of a bond ladder. Here are a few to consider:

Diversification
By spreading investments across bonds with different maturities, you spread risk. Short-term bonds are less affected by interest rate changes, while long-term bonds offer higher yields.² A ladder combines these advantages. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. 

Income Stream
The staggered maturities mean you receive regular interest and principal payments as each bond matures. This can potentially provide a steady cash flow, which is useful for retirement planning or funding specific goals.

Flexibility
As each bond matures, you can reinvest or use the funds. This flexibility can be crucial for adapting to changing financial needs or market conditions.

Risk Management
While all investments carry risk, a bond ladder can help mitigate interest rate risk. If rates rise, only a portion of your portfolio is affected, and you can reinvest at the new, higher rates as bonds mature.

How to Build a Bond Ladder

Now that you understand more about a bond ladder and its benefits let’s examine how to build one.

Step 1: Determine Your Goals and Timeline
Before building your ladder, consider your financial goals and timeline. Are you saving for retirement, a child's education, or another milestone? Knowing your objectives helps you determine the bond maturities that align with your needs.

Step 2: Assess Your Risk Tolerance
Bonds come with varying levels of risk. Government bonds are generally considered safer but offer lower yields. Corporate bonds can provide higher yields but carry more risk. Understand your risk tolerance before selecting bonds for your ladder. Please note that investors looking for a higher yield by purchasing a bond with a longer maturity are exposed to three types of risk: interest rate risk, credit risk, and liquidity risk. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. 

Step 3: Choose Bond Types and Maturities
Decide on the types of bonds you want in your ladder. This could include Treasury bonds, municipal bonds, corporate bonds, or a mix. Next, select maturities. A typical ladder might consist of bonds maturing in one, two, three, four, and five years for a five-year ladder.

Step 4: Research and Purchase Bonds
Research individual bonds or bond funds that fit your criteria. Look at credit ratings, yields, and fees. You can buy bonds directly from the issuer or through a brokerage. Ensure you understand the terms and conditions before purchasing. Bond yields are subject to change. Certain call or special redemption features may exist which could impact yield. 

Step 5: Build Your Ladder
With your chosen bonds, assemble your ladder. For example, if you have $50,000 to invest:

• Buy $10,000 worth of one-year bonds
• Buy $10,000 worth of two-year bonds
• Repeat for three, four, and five-year bonds

As each bond matures, reinvest the proceeds in a new bond at the most extended maturity in your ladder. This aims to maintain the ladder's structure and a steady income stream. This is a hypothetical example and is not representative of any specific investment. Your results may vary.

Step 6: Monitor and Rebalance
Regularly review your ladder to ensure it aligns with your goals and risk tolerance. As bonds mature, you'll need to reinvest. Consider adjusting your ladder if market conditions change or your goals shift.

Building a bond ladder is a strategic approach to investing that offers stability, regular income, and flexibility. Whether you're planning for retirement, saving for a major purchase, or simply diversifying your portfolio, a bond ladder can be a valuable addition. Please call Gallagher Wealth Management to decide if a bond ladder suits your unique needs.