What is a ‘Bond Ladder’?
A Bond ladder is a concept in finance that refers to the portfolio in which every security is attributed a different date of maturity.
The Portfolio is mainly of fixed income securities and hence takes into account only that type of securities.
The main purpose behind this is that investors tend to increase their liquidity hence instead of investing in only one security with just a single maturity date they tend to invest in different types of securities that have different maturity dates.
This allows them to ensure that the interest rate risk factor is minimized but at the same time, the chances of an increased liquidity with a diversified credit risk are increased.
Moreover, under the bond ladder principle, the maturity dates are spread out at a distance evenly, which ensures that the proceeds that are linked to different types of bonds are invested at different intervals while bond matures.
The closeness of the maturity of the bond is dependent mainly on the liquidity the investor needs.
Why Companies and Investors make use of Bond Ladder?
Many people often wonder that why companies and investors make use of the bond ladder principle.
The investors who deal in purchasing bonds usually buy them to make an income out of it but in a more conservative manner.
The time of maturity that is linked to a bond determines the yield that an investor can get out of it.
The bond that has a longer time period of maturity tend to give investors a high-quality yield and with less reduction in the quality of the credit.
However, even such step can expose the investor to three major types of risks that include the following:
Interest Risk –
Interest risk is the risk that is involved in an investment that if the value of an investment will change because of a change that occurs in the absolute levels of the interest rates.
Credit Risk –
Credit risk is the risk that is involved in the process of borrowing. It occurs when the borrower is unable to make the required payments on time.
Liquidity Risk –
Liquidity risk is the risk that is linked mainly to a particular company or a bank. It is involved when any company or any bank is unable to achieve or complete its financial demands.
How does the Bond Ladder Operate?
A bond tends to react in an inverse manner if the interest rate increases with time. It means that the bond that is likely to mature within a period of 10 years will experience less fluctuation in terms of price as compared to a bond that is more likely to mature in a period of 30 – 40 years.
Similarly, if there is an increase in the interest rates it will have an impact on the demand for the lower interest paying bonds.
The demand for them will decrease thus it reduces the liquidity of the bond and the investor has other matured bonds available that have high-interest rate payments.
Apart from this, if an investor buys a large position in any of the bonds then he is at a huge credit risk as compared to other investors involved.
The overall price of the bond is dependent mainly on the credit of the institution or the company to which it is linked.
If the investor is mainly looking for higher liquidity then he should focus on selling the bonds with a very short maturity levels as it will help them get the most favorable price out of them.
A downgrade or decrease in the credit quality does not affect the entire bond ladder but it just impacts a portion of it.