Markets have been picking up in their volatility as oil prices have plummeted and the Coronavirus has taken center stage. One of the more classic ways investors seek protection in portfolios is through the use of bonds. However, there are many ways to invest into bonds for your portfolio from ETFs, Mutual Funds, Individual Bonds, Closed Ended Funds and managed accounts just to name a few.
Maybe you’ve done some research into the topic (or maybe that’s what you are doing now!) and came across the topic of “Bond Laddering”. This term refers to investments in individual bonds with a strategic positioning of when they will come due; also know as when they will ‘mature’. The way a bond ladder works is to essentially “stack” maturities based on your goals. For the purposes of an example we will use even, round numbers:
Lets say you have $50,000 that you are looking to put into bonds with the longest maturity at any time being 5 years. The most simple way to construct the “ladder” would be to divide our total investment ($50,000) by the number of years (5) making each ‘rung’ of the ladder $10,000. In this case, we would also look at how often you would want money to be available (lets say every 12 months for this example). Therefore, we would seek to purchase bonds with 1 year, 2 year, 3 year, 4 year and 5 year maturities:
- Bond 1: (5 year maturity) $10,000
- Bond 2: (4 year maturity) $10,000
- Bond 3: (3 year maturity) $10,000
- Bond 4: (2 year maturity) $10,000
- Bond 5: (1 year maturity) $10,000
The purpose of the ladder is to hold bonds until maturity, letting interest gather in the account to either be drawn or pulled into the re-investment. However, there can be instances where opportunity presents itself to trade the bonds before maturity, and replacing them with an equivalent bond of the remainder of its time. When properly done, the ‘ladder’ will allow you to keep funds available within 12 months of any time (see below for re-investment model):
Sample Reinvestment of Ladder (after first 12 months):
- Bond 1: (5 year maturity, Purchased with bond that just matured)
- Bond 2: (Previous ‘5 year’ that has 4 years remaining until maturity)
- Bond 3: (Previous ‘4 year’ that has 3 years remaining until maturity)
- Bond 4: (Previous ‘3 year’ that has 2 years remaining until maturity)
- Bond 5: (Previous ‘2 year’ that now has 12 months left until maturity)
This approach to bond buying allows you (or your portfolio manager) to have complete control over the bond selection, quality and liquidity. This can help to avoid investor behavior such as outflows from funds or ETFs impact your value of the investment during cycles where money moves from one asset class to another.
For more information about how this can apply to you, feel free to contact us or set up a free consultation!