Building a portfolio of individual bonds with incrementally longer maturities is called laddering. For example, this could involve buying equal amounts of bonds with maturities of across 1 to 5 or 1 to 10 years. Since buying small quantities of individual bonds can increase costs, larger portfolios lend themselves to cost efficient laddering with more bonds.
For example, an investor with $1,000,000 in fixed income assets purchases ten individual bonds of $100,000 each with maturities from 1-10 years. The average maturity is 5.5 years. At the end of the first year, the one-year bond matures and therefore the ladder is now for only $900,000 with maturities from 1-9 years. Now the average maturity has fallen from 5.5 to 5 years. In order to maintain the desired balance between price and reinvestment risk, the ladder needs be extended by using the proceeds from the matured bond to purchase a new bond with a maturity of 10 years
The Benefits of Ladders
- They allow each investor to match maturities to expected cash flow needs.
- They allow investors to balance price and reinvestment risk.
- They allow investors to avoid the expense of a mutual fund or a separate account manager.
- There is no active trading and therefore trading expenses are kept to a minimum.
- For taxable accounts, loss harvesting can be performed at the individual bond level.
- The cash flow stays relatively constant as only a small portion of the portfolio matures each year.
A laddered maturity approach is a prudent strategy for fixed income portfolio management. The shorter maturities balance the price risk of the longer maturities, and the longer maturities balance the reinvestment risk of the shorter maturities. Over time, investors will be purchasing bonds in both high and low interest-rate environments. Laddering a bond portfolio is an effective way to diversify price risk and reinvestment risk. The laddered approach allows investors to meet current income requirements while preserving capital and keeping price and reinvestment risk at acceptable levels.
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