When it comes to investing in bonds, we know that bond laddering is a common strategy used when building a portfolio. By buying a portfolio of bonds of different maturities, an investor can spread out interest rate risk and create a stream of cash flows for income. Today I want to talk through an example of how to construct a bond ladder and what it might look like.
To help with today’s discussion, I have invited my fictitious neighbor Bob to join us. Bob is 60 years old, retired and has some investments. He is looking to allocate a portion of his portfolio to income assets, and is evaluating how to invest it. Bob is looking for regular income, and also wants an investment that has less risk than his equity assets, a common goal among retirees at this stage in life. For an investor like Bob, building a ladder using either bonds or ETFs could be a good solution.
In a classic bond ladder, Bob would buy a range of bonds with maturity dates that are spread out evenly across different years. Each year, one of the bonds will mature and the maturity payment can be used for a large purchase (such as buying an RV) or reinvested into another rung of the ladder. Traditionally bond ladders have been built with individual bonds, but this can be challenging for a number of reasons.
- It can be difficult and time consuming to find the right bonds for your portfolio. There is no exchange that Bob can go to; instead he has to work through a broker and try to track down the bonds that will fit into his ladder.
- Transaction costs for individual bonds can be quite high. In general, when it comes to bonds, the smaller your trade, the higher the level of transaction costs you pay. This puts individuals like Bob at a big disadvantage relative to larger, institutional investors.
- Diversification can be hard to come by. Bob doesn’t want to only own a handful of bonds because it would leave him very exposed if one of the bond issuers defaulted. Ideally he would buy a lot of individual positions to spread out his risk, but this can be difficult due to the aforementioned points.
There is an alternative to using individual bonds. My team and I recently expanded a series of term maturity exchange traded funds (ETFs) called iBonds®. iBonds are ETFs that have a defined maturity date like a bond, are diversified like a mutual fund, and trade on an exchange like a stock. They are designed to be used by investors like Bob to create cost efficient laddered solutions.
A visual example of building a bond ladder
If Bob wanted to build out a 10 year ladder using iBonds, he could invest an equal amount of money into each of the funds maturing in years 2016 through 2025. Here is an illustration: