EXECUTIVE SUMMARY
- A bond ladder theoretically offers a means to manage cash flows and provide investors with a stream of income.
- Bond laddering with indices can capture the benefits of a traditional bond ladder strategy with additional advantages of diversification and transparency.
Bond laddering is a mechanism widely used by the investment community to mitigate the potential risks related to buying individual bonds. In this paper, we explain the potential risks, return, and diversification of using a ladder strategy in the municipal bond market.
Bond laddering is a strategy that calls for maturity weighting, which involves dividing bond investments among several different bonds with increasingly longer maturities. For example, instead of buying one bond with a six-year maturity, market participants can allocate to six different bonds, where each bond matures at a different year throughout the six-year horizon.
Bond ladders may be constructed to address both interest rate and reinvestment risk. If interest rates rise, the strategy calls for reinvestment of the funds from bonds that are maturing at the bottom of the ladder into bonds earning higher yields, and these are in turn added to the top of the ladder. If rates fall, this strategy seeks to mitigate reinvestment risk, because longer-dated bonds at the top of the ladder, which presumably were purchased when interest rates were higher, should be yielding higher returns.
