Have you ever wondered about the possibilities of overcoming the traditional risks involved in Bond Trading? Maybe these risks have served as a deterrent to you when involving yourself in the Bond Market? This article will attempt to explain a seemingly complex Bond investment strategy that promises just that.
This strategy is extensively used by private wealth firms such as RVW Wealth, aiming to create personalized portfolios for their customers. We are, of course, referring to Bond Ladders. Here, we will attempt to understand just how bond ladders work and extrapolate how strategies centered around bond ladders can help create ‘safe’ portfolios for investors. So without further ado, let us begin:
What are Bond Ladders?
Firstly, we must define what Bond Ladders exactly refer to. A Bond Ladder essentially conceptualizes an investment strategy whereby a portfolio includes several bonds or fixed-income securities whose maturity dates are significantly different. To be precise, a portfolio following a Bond Ladder strategy would hold securities that are evenly spaced out in terms of their maturity dates.
This allows the investor to reinvest the proceeds at regular intervals, benefitting from larger yields in the future. It also allows the investor to minimize interest rate risk, increase liquidity, and also to diversify credit risk. To establish a bond ladder with bond fund ladders as RVW Wealth does, an investor simply invests the same amount of money in different Bond ETFs, each of which has a defined maturity date that is distinct.
What exactly is the concept of “laddering”? Laddering refers to holding income-yielding assets of various types of maturities in a portfolio, with the goal of creating a reliable stream of not just cash flows but also a sustainable form of investing which allows the holder to return to their principal amount when the maturation reaches its conclusion.
How do they work?
With our laying the basic concept of bond ladder strategies, we’ll take a deeper dive underneath and look at the various mechanisms at play when we are trying to understand how such strategies work. In this section of the article, then, we will be analyzing just how a Bond Ladder strategy works.
Firstly, we must be cognizant of the fact that a bond ladder strategy can include any fixed-income instrument, ranging from bonds to Treasury notes, all the way to corporate bonds. A single ladder may even use multiple securities depending on the investor’s requirements. These requirements can range from how much money the investor wants to put in, how far into the future do they wish to invest, and how much spacing there should be between the maturity dates of their particular investments.
Such an understanding of priorities is important since it can lead to vastly differing results for the investors. For instance, the investor may prioritize the need for high liquidity in order to ensure smooth cash flows and returns.
For this reason, they may invest in bonds that are close to each other in terms of their maturity dates. However, this may also come at the cost of greater yields that could’ve been reaped had the investor chosen to space them at more distant time intervals.
Once these investments are chosen, the investor will put equal money into all the ETFs they have chosen, spacing them out against different maturity dates. This will allow them to reap regular returns and invest in larger bonds with greater time intervals.
Like a regular bond, a bond ETF has a defined maturity date whereby the principal is returned to investors plus some interest. These proceeds can be spent by the investor however s/he likes or reinvested into other assets. Most investors who have no specific need for the proceeds of a maturing bond ETF will simply re-deploy that money into another bond ETF, which will be 5 years down the line if the investor has structured a 5-year bond ladder.
Benefits of Bond Ladders
We have looked at the basic concept of Bond Ladder investment strategies and have also conceptualized an understanding of how they work within a stock portfolio. Diversified portfolios built around Bond Ladders can provide a number of benefits which we will look at in this section of the article. Let us begin:
1. Defined Stream of Cash Flows
Without a doubt, the primary purpose of structuring a bond ladder in a portfolio is to ensure return of capital when needed. The simplicity in knowing that one will receive $X per year over, say, 5 years, provides one the security knowing that money will be available when needed regardless of how stock markets do.
2. Reduction of Interest Rate Risk
Interest rate risk is something that will arise with every fixed-income security. Bond prices and interest rates move in opposite directions, exposing bond-holders to a number of risks. These risks become quite exacerbated when the bonds purchased have a long maturity date; such bonds are usually purchased in order to maintain credit quality and increase the possibility of yields.
In addition to this, as the interest rate rises, the demand for lower-interest bonds would decrease since investors can always invest in similar maturity provided by higher market interests. These two factors would normally decrease the liquidity and the prices of the bond, leading to significant risks being entailed by the investor.
These two risks can be counteracted by the use of Bond Ladder strategies, which would diversify bond-holdings along with different maturity dates. This would allow investors to roll over new bonds once interest rates rise, reinvesting in them later on at the market rate.
If an investor needs greater liquidity, the selling of short-dated bonds would also help the investor gain favorable pricing. It is safe to assume, therefore, that bond ladder strategies are especially useful against these sorts of risks.
3. Credit Quality
If an investor holds a concentrated number of bonds, spending much of their investment along with those securities, they will entail a number of risks related to credit quality. It is obvious that these investors would rely heavily upon the credit quality of the underlying bond and its implications.
If the credit quality lessens, then the investor would be at risk of losing the possible profits of their bond and will be insignificant confusion. With the use of Bond Ladders in the stock portfolio, this risk is minimized since the negative effect of credit quality would only affect part of the bond or the portfolio, making the portfolio reliable and less dependent upon concentrated numbers of bonds, securities, or ETFs.
Bond laddering investment strategies are appealing for a number of reasons. Their benefits counteract the restrictions of traditional bond investing. They are also simple to structure and provide capital to investors when needed. Such security is needed especially for those clients who have Equities in their portfolio which can be highly volatile in the short-term. In short, bond ladders provide an excellent way to create personalized fixed income portfolios as part of a diversified portfolio.
September 20, 2021