Bond ladders and rising rates

Investing in a bond ladder can be a great way to structure a bond portfolio, especially if you believe that interest rates have bottomed and the next move is up.

A bond ladder is best viewed as each rung of a ladder being a different bond with a different maturity date, so that maturing bonds are staggered over a number of years.

The advantages of laddering are the tailoring of the income stream, the continuous maturing of bonds with the face value returned, and the ability to reinvest at higher interest rates in a rising rate environment.

Risks of bond investing

Some of the risks associated with investing in bonds include interest-rate risk, reinvestment risk, credit risk, and liquidity risk. A bond portfolio that is structured as a ladder can reduce some of these risks by diversifying across different bonds.

Interest-rate risk, one of the primary risks facing bond market investors, is the risk that interest rates rise. Rising interest rates lead to falling bond prices, so if an investor sells before maturity there is a realised capital loss. Holding a diversified portfolio of bonds with different maturities will provide a buffer against adverse changes in interest rates, as maturing bonds can be replaced with higher-yielding bonds.

If interest rates are falling, laddering may also decrease reinvestment risk – in a falling risk environment, there is increased risk that an investor will receive a lower interest rate on future reinvestments. But if the ladder consists of bonds that mature in consecutive years, then the spreading out of bond maturities over time can reduce reinvestment risks. The longer-dated bonds will not require reinvestment in the near term, still reaping the benefits of the higher yields that existed prior to the fall in rates.

The predictability that a ladder provides enables investors to know, in advance, the timing of interest and principal repayments to incorporate into their investment strategy with respect to liquidity requirements. The timing of the receipts of interest is particularly beneficial to investors in retirement phase, as the ladder can be structured to enable the investor to receive a regular cash flow stream over successive years.

Diversification, the foundation of wealth management, reduces the risk of loss from a single investment by spreading the investment across different securities or assets. Laddering supports diversification as the bonds on the different rungs of the ladder will mature at different times and, depending on the interest rate cycle, reinvestment can be in either shorter- or longer-dated bonds.

In Australia there are fewer opportunities for small investors to create a bond ladder from unlisted bonds, due to the large minimum outlay required (up to $50,000 per single bond investment). In a recent Eureka Report article (see The $6,000 diversified bond portfolio) we showed that a bond ladder could be constructed for a small investment, using a mixture of listed fixed interest and hybrid securities.

Bond investment scenarios

In the example in scenario one below, an investor puts $50,000 into five bonds with varying interest rates – the first bond will mature in one year and the fifth bond will mature in five years.

In scenario two, an investor has created a bond ladder. When the first bond matures, after one year, the proceeds are reinvested at the longer end of the ladder into a higher-yielding bond.

As each subsequent bond matures, the investor can take advantage of rising rates and reinvest in higher-yielding bonds, within the context of their investment strategy. If the investor requires a regular income stream then the interest receipts may be timed to coincide with the investor’s requirements. Any major capital needs also can be met – the face value of the bonds repaid as bonds mature can be used by the investors rather than reinvested.

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Click to enlarge

Note: This is for illustrative purposes only and does not represent a recommended investment strategy or real life situation.

Summary

The benefits of a bond ladder include:

• Higher Average Yield: Investors can take advantage of higher interest rates when rates are rising by minimising exposure to fluctuating interest rates with reinvestment of the capital at current market rates. If rates are falling, then the longer-dated bonds will boost yields while the shorter-dated bonds will provide liquidity.
• Diversification: The inherent diversification benefits from laddering increase the predictability of the investor’s income stream. Some risks associated with the bond portfolio will be lower, with the structuring of the portfolio to pay a regular income stream and allow maturing bonds in consecutive years to contribute to the constant source of liquidity.
• Minimise costs: If investing in listed bonds and hybrids, the costs are similar to direct share investments. There may be an extra time commitment with respect to the maintenance of the portfolio, with the constant maturing of bonds and the reinvestment of the proceeds.
• Flexibility and control: Members of SMSFs want the flexibility and control that investors in shares enjoy and this is possible by investing in listed bonds and hybrids. A bond fund or exchange-traded fund may be considered but, as most SMSFs are set up with the purpose of giving control to the members, investing in bonds or hybrids listed on the ASX may provide a more attractive option.