Consider a scenario in which a AAA-rated bond with a 3-year tenure is offering a decent interest rate of 8% p.a. Akshay invests a lump sum amount in the bond. Akshay’s analysis shows that during these three years, market interest rates will fall, bottom out, and rise again. At the time of redeeming the bond and reinvesting the proceeds, he expects market interest rates to be either at the same level of 8% p.a. or higher.
But at the time of reinvestment, similar AAA-rated bonds were offering a substantially lower interest rate of 7% p.a. Akshay tried to time the market and got it wrong. Like Akshay, many fixed-income investors face the reinvestment risk when interest rates are lower. To overcome this situation, investors can adopt the bond laddering approach rather than trying to time market interest rates. In this article, we will understand what bond laddering is, how to build a bond ladder, its benefits, and how it can provide a regular source of income.
What is bond laddering?
Bond laddering is a process of building a bond portfolio with staggered maturity dates spaced out at fixed time intervals. The time gap between the maturity dates of 2 bonds is fixed, for example, 6 to 12 months. For example, suppose Akshay wishes to invest Rs. 10 lakhs spread across 10 years. In this case, Akshay can choose to purchase 10 bonds of Rs. 1 lakh each with maturity dates ranging from 1 to 10 years. In this case, one bond will mature every year, creating a ladder-like structure.
Building a bond ladder
Sr. No. |
Purchase year |
Bond face value |
Bond tenure |
Maturity year |
|
1 |
2026 |
Rs. 1,00,000 |
1 year |
2027 |
|
2 |
2026 |
Rs. 1,00,000 |
2 years |
2028 |
|
3 |
2026 |
Rs. 1,00,000 |
3 years |
2029 |
|
4 |
2026 |
Rs. 1,00,000 |
4 years |
2030 |
|
5 |
2026 |
Rs. 1,00,000 |
5 years |
2031 |
|
6 |
2026 |
Rs. 1,00,000 |
6 years |
2032 |
|
7 |
2026 |
Rs. 1,00,000 |
7 years |
2033 |
|
8 |
2026 |
Rs. 1,00,000 |
8 years |
2034 |
|
9 |
2026 |
Rs. 1,00,000 |
9 years |
2035 |
|
10 |
2026 |
Rs. 1,00,000 |
10 years |
2036 |
The table above shows how Akshay’s bond ladder will look. When the first bond matures in 2027, Akshay can either use the maturity proceeds for his regular expenses or reinvest. For reinvestment, he can choose a 10-year bond that will mature in 2037. The second bond will mature in 2028. Akshay can use the maturity proceeds to buy a new 10-year bond that will mature in 2038.
Every year, he can follow the same process by reinvesting the maturity proceeds into a new 10-year bond and continuing the bond laddering process.
If Akshay needs money at shorter intervals, he can choose to invest in 20 bonds of Rs. 50,000 each, with maturity dates at intervals of 6 months each. Bond laddering provides benefits such as liquidity and regular income, and avoids timing the market interest rates.
Benefits of bond laddering
Some of the benefits of bond laddering include the following.
1. Liquidity: Bond laddering provides liquidity at regular intervals. An individual can structure the bond ladder as per their liquidity requirements. In our earlier example, we saw how Akshay can design his bond ladder with one bond maturity every 6 months or 12 months.
The maturity proceeds from the bond can be used for regular expenses or to reinvest into a new bond.
2. Hedge against interest-rate changes: At maturity, a bond investor is exposed to reinvestment risk if market interest rates have fallen. However, in bond laddering, a bond matures every 6 to 12 months. In some cases, maturity proceeds will be reinvested at a lower interest rate if market interest rates have fallen. In some cases, maturity proceeds will be reinvested at a higher interest rate if market interest rates have risen. In this manner, over time, the interest rate fluctuations smoothen out as new bonds are being purchased regularly every 6 to 12 months. So, while reinvesting, the investor can ride out the interest rate cycle with every new reinvestment.
3. Risk mitigation: An investor can choose the bonds for investment based on their risk profile. For example, an investor with a conservative risk profile can choose Government bonds, PSU bonds, AAA-rated bonds, or secured bonds. Similarly, an investor with a moderate to aggressive risk profile can choose below-AA-rated corporate bonds, unsecured bonds, etc.
Ladder investment strategy with other fixed-income products
Apart from bonds, the laddering investment strategy can also be used for other fixed-income products. For example, an investor can follow the laddering investment strategy with bank fixed deposits, National Savings Certificates (NSC), etc. NSCs have a fixed tenure of 5 years. For the first 5 years, the investor will have to buy a new NSC certificate every 6 to 12 months as per required the time gap between maturity of 2 NSC certificates.
In 5 years, the NSC ladder will be in place. After that, as and when an NSC certificate matures, the investor can buy a new NSC certificate with the maturity proceeds. The Central Government declares the interest rate for NSCs every quarter. The interest rate for a calendar quarter (for example, 1st April to 30th June) is declared before the start of the quarter. The interest rate at the time of purchase of an NSC certificate remains fixed for that certificate till its maturity.
Considerations for bond laddering
An investor must consider the following factors when implementing the bond laddering strategy.
1. Rungs: Depending on the amount you want to start with, decide the break-up based on the number of bonds to be bought and their denominations. We saw earlier how Akshay can break up Rs. 10 lakhs into 10 bonds of Rs. 1 lakh each or 20 bonds of Rs. 50,000 each.
2. Fixed income instruments: The next step is to decide which fixed-income instruments you want to use for bond laddering. Some of the fixed income instruments that can be considered include Central Government securities, State Development Loans (SDLs), PSU and PSB bonds, corporate bonds, bank fixed deposits, NSCs, etc. You can even use a combination of these for your laddering investment strategy.
3. Spacing: Decide the time gap between the maturity of two fixed-income instruments. We saw earlier that Akshay can keep a spacing of 12 months between the maturity of two bonds. Based on your need, you can keep a monthly, quarterly, half-yearly, or yearly spacing.
Should you go for bond laddering?
Whether you should go for bond laddering depends on your requirement. If you are looking to invest a lump-sum amount in fixed-income instruments in a manner that can give you a fixed amount of cash flow at a fixed time frequency, you may consider bond laddering. For reinvestment, to overcome the challenge of timing market interest rates, bond laddering is a good strategy. The strategy can be considered by freelancers, self-employed individuals, business persons, and retired individuals, among others, seeking for fixed cash flows at fixed time frequency.
