4.5.4. Laddering
Laddering is a strategy whereby a fixed-income investor buys multiple bonds or CDs at different maturities in order to avoid being locked into a single interest rate and a single maturity. Laddering is a way to reduce interest rate risk and spread out reinvestment risk. If the exam asks how a fixed-income investor can save for a target date and reduce interest rate risk, laddering may be the answer. Through laddering, bonds or CDs can be purchased to mature when cash is needed by the investor. See the figure that follows. When this is done, the short-term bonds offer liquidity, while the longer-term bonds offer higher coupon rates. This is an especially effective strategy for retirees who need continuous cash flow or clients who need money in the future to pay for college tuition. Laddering reduces both interest rate risk and reinvestment risk, because an investor is not stuck at one interest rate for long. Because he has bonds maturing at different times, he will have cash flow to get back into higher paying securities if he desires and if interest rates rise.
Ladders can be filled with a variety of different kinds of bonds to diversify default risk. Corporate bonds, municipals, government bonds, Treasuries, and CDs are all possibilities. The number of rungs and distance between the rungs can also vary. The more rungs, the more diversified an investor’s portfolio will be. The distance between rungs is equal to the difference between the maturities in the bonds. The greater the distance between the rungs, the greater the average return in the portfolio, because more money will be distributed to the later rungs, which have higher returns. But the greater average return will be offset by greater reinvestment risk and decreased liquidity. It is also important to note that callable bonds should not be included in a ladder, or the intended goals may not be reached.
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