Bonds are the backbone of a well-diversified portfolio. They can offer a predictable source of income, provide attractive diversification benefits and help preserve capital. But risks will always remain, no matter how diversified your fixed-income portfolio. Laddering bonds can help mitigate some of this risk.

A bond ladder comprises several fixed-income holdings, with successively longer terms to maturity. In a typical bond ladder, each holding would be the same size with maturity dates arriving at regular intervals. As bonds in a laddered portfolio mature, the cash distribution is either used to cover lifestyle needs or reinvested in new bonds at the longest maturity of the ladder at the current market interest rate.

Here’s an example:

Suppose you had $50,000 to invest in bonds. By using the bond ladder approach, you could buy five different bonds each with a face value of $10,000. Each bond would have a different term to maturity, i.e. one year, two years, three years, four years and five years.

In the example below, five bonds were bought that mature one year apart. After one year, your original one-year bond matures, and you can reinvest the money into a new five-year bond. This process ensures that your strategy doesn’t have a specified end date, allowing you to use it as long as necessary.

For illustrative purposes only

Laddered bond portfolios can help mitigate interest rate and liquidity risk. Here's how:

Interest-rate risk

What is it?

The risk that bond prices fall when interest rates rise (due to their inverse relationship), meaning that if you need to sell a bond before its maturity date, you may have to sell for less than you paid.

How can laddered bond portfolios help?

Bond ladders are a proven fixed income investment strategy that can reduce the influence of interest rate changes and minimize the impact of reinvestment risk to help maximize your bond returns.

A laddered bond strategy prevents investors from having to forecast future interest rates or make complicated reinvestment decisions. If interest rates rise, you can take advantage of the higher rate by reinvesting the money from the matured bond. On the other hand, if rates fall, a large portion of your portfolio can still benefit from the original (higher) rates that applied when you made the initial investment.

Liquidity risk

What is it?

An investor might not be able to sell a bond quickly due to a thin market (a market with few buyers and sellers). Rising rates in particular decrease the demand for lower interest-paying bonds, leaving the bond to decrease, leaving the bond less liquid since buyers are able to find bonds with similar maturity terms with higher interest payments.

How can laddered bond portfolios help?

By having a steadily maturing basket of bonds, you may be better able to meet your cash flow needs than trying to sell individual bonds in an illiquid market. If you hold a long-term bond and suddenly require funds, you may be able to break even or profit when you sell before maturity (depending on the market environment). But in the event you have to sell and rates are high, you may take a loss. By owning a portfolio with steadily maturing bonds, you have access to potentially better liquidity even when rates move higher.