If you’re invested in bonds to generate cash flow, you should consider investing in a bond ladder.
Why? In short, because laddering helps you lock in your cash flow regardless of future changes in interest rates.
The power of laddering is so simple that you don’t need a calculator or CFA training to see it. All you need is some basic intuition.
Laddering Explained
Laddering fixed income is the strategy of owning bonds with staggered maturities, holding each bond until it matures, and collecting fixed amounts of interest and principal on fixed dates—“fixed income” in its truest form. A bond ladder can be designed to generate cash flow at different frequencies—e.g., monthly, quarterly, or annually—through the spacing between the rungs of the ladder (i.e., when each bond matures).
As an example, picture a series of bonds with maturities spaced a year apart, one in each of the next ten years. This is represented by the first column in Exhibit 1. Suppose you had $100,000 to invest, and you divided it equally, investing $10,000 into each bond. Then each year for the next decade, you’d receive $10,000 principal from the maturing bond plus interest from all remaining bonds.
The purpose of the ladder is to “lock in” your future cash flow so that it does not depend on how bond prices change in the future.
Let’s contrast that experience—truly fixed cash flow—with the investor experience in a typical bond fund in falling or rising interest rate environments.
What if Rates Fall?
Falling interest rates reveal one weakness of a typical bond fund: reinvestment risk.
Imagine yourself in mid-2006. Interest rates on two-year U.S. government bonds are a healthy 5%, and they seem safe because they’re short-maturity and low-volatility.
Two years later, in mid-2008, those bonds mature. It’s time to reinvest the principal. Where are interest rates? 2.5%.
Two years later, in mid-2010, those bonds mature. It’s time to reinvest the principal. Where are interest rates? 0.6%.
Two years later, in mid-2012, those bonds mature. It’s time to reinvest the principal. Where are interest rates? 0.3%.
A hypothetical investor who had used 2-year bonds to generate income in that 6-year period would have experienced a 94% decrease in income. Imagine if he had started with $100K of bond income and watched it dwindle to $6K. That’s reinvestment risk.
Meanwhile, if an investor had built a U.S. government bond ladder for that same time horizon, he would have experienced a 0% decrease in income. Since the U.S. government did not default, the investor would have received every penny of interest and principal from each bond on exactly the schedule he expected.
What if Rates Rise?
So what are you supposed to do—buy longer-maturity bonds instead? Rising interest rates reveal another weakness of a typical bond fund: duration risk.
Imagine yourself in January 2022. You own a bond index fund tracking the Bloomberg US Aggregate Index.ii The yield is about 1.75%, which isn’t great, but it’s better than the measly 1%at the depths of the pandemic.
Over the following 12 months, interest rates rise nearly 3%, and your investment loses 13%—a loss equivalent to 7+ years’ worth of income at a 1.75% yield.
Your choices? If you want to earn it back by collecting yield, you’ll have to wait nearly 3 years—winding up at a breakeven after a 4-year investment period. Or if you need your money sooner, you’ll have to sell your shares and take the loss. That’s duration risk.
Meanwhile, if an investor had built a bond ladder, she would have collected interest and principal on the exact timeline she expected, because the U.S. government did not default during this time.
Putting it All Together
When you invest in bonds, one of three things is going to happen:
1. Interest rates will fall at some point in the future
2. Interest rates will rise at some point in the future
3. Interest rates will stay exactly the same forever
If interest rates fall at some point in the future, reinvestment risk can hurt you.
If interest rates rise at some point in the future, duration risk can hurt you.
Perhaps interest rates will stay exactly the same forever?
Instead of betting on that, you could invest in bonds through a ladder designed for your exact investment horizon, in which case your cash flow is locked in—removing reinvestment risk and duration risk, so you’re only betting that the bond issuer won’t default. For U.S. government bonds, that still seems like a pretty good bet.
Questions? Email our team at lifex@stoneridgeam.com
i Bond investments are subject to default risk, or the risk that an issuer will fail to make some or all of their principal and/or interest payments.
ii The Bloomberg US Aggregate Index is a broad-based benchmark that measure the investment grade, US dollar-denominated, fixed-rate taxable bond market.
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