Interest rates may be going up in 2022 — and a bond ladder is one way for investors to manage the risk.
Prices for existing bonds generally fall as interest rates (or yields) rise, since the yields on new bonds look more attractive by comparison.
That dynamic played out in 2021: U.S. bonds posted their first negative return in years, fueled by a pop in interest rates. Returns may come under additional pressure if the Federal Reserve hikes its benchmark interest rate this year, as expected, to combat high inflation.
“We are in a very precarious position with bonds right now,” said Michael McClary, chief investment officer at Valmark Financial Group in Akron, Ohio.
How bond ladders work
Here’s how a bond ladder can prevent losses if rates rise.
The basic strategy entails holding individual bonds like U.S. Treasurys to the end of their term.
Holding an individual bond to maturity guarantees the investor will get back their principal plus the stated interest rate. It locks in their price.
For example, an investor who puts $100,000 in a 10-year U.S. Treasury paying a 2% rate would get back $102,000 after the 10-year period.
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“What you see is what you get,” Christine Benz, director of personal finance at Morningstar, said of returns on individual bonds.
(This assumes the bond issuer is creditworthy and has an extremely high likelihood of paying back its debts, as is the case with U.S. government bonds.)
The typical bond fund doesn’t work this way. Fund managers, who try to beat benchmarks, don’t hold all bonds to maturity and therefore don’t guarantee returns.
But someone who locks their money away in one 10-year bond may miss out on higher-yielding ones issued during that decade.
A bond ladder alleviates that risk.
An investor holds many individual bonds, with different maturity dates, to the end of their term. When a bond expires, the investor re-invests the principal in a new bond at the end of the ladder, capturing a higher rate that may be paid at the time.
Here’s a basic example: An investor has $1 million. They put $100,000 into each of 10 different U.S. Treasury bonds starting in January 2022: a one-year bond with a maturity of January 2023; a two-year bond with a January 2024 maturity, and so on until a 10-year bond maturing in January 2032.
When the first bond expires in January 2023, the investor uses the $100,000 principal to buy a new, 10-year bond expiring in January 2033 — thereby adding an additional year to the end of the ladder.
The process would repeat each year for as long as the investor likes.
“The ladder would enable you to make multiple purchases over time and take advantage of higher yields as they come online, while simultaneously not putting your principal at risk,” Benz said.
The approach is somewhat like dollar-cost averaging in a 401(k) plan, whereby a retirement saver invests in small increments per paycheck and buys into the market at various price points over time.
Investors don’t have to limit laddering to bonds — the concept also works with certificates of deposit, for example.
And there are alternative ways to execute the strategy; for example, an investor could start their ladder with a five-year bond, meaning they wouldn’t have to make a new bond purchase during that initial five-year maturity period.
Downsides
Of course, there are drawbacks for investors.
Among the biggest downsides is having too many moving pieces that are hard for the average person to track and maintain. That will especially be the case if investors choose to diversify the types of bonds they ladder, like investment-grade corporate and U.S. Treasury bonds, for example.
“That starts to make bond funds look like awfully good value,” even despite the risk of loss over certain time periods, Benz said of the potential legwork involved.
Certain bonds may come with a cost markup for retail investors, which could erode some of the financial benefits of the laddering strategy, McClary said.
Some asset managers offer “target maturity” exchange-traded funds that may help investors ladder while also diversifying their bond holdings and helping to keep costs down, McClary said. (He uses such ETFs in laddering strategies for client portfolios.)
These ETFs buy bonds with similar maturity dates; at the end of the term, the fund closes and bond managers issue proceeds to investors. However, the funds don’t lock in a return as with individual bonds.