When you first get serious about investing, there'll be a lot of new terms to learn. With bonds, for example, columnists and financial advisors prattle away endlessly about "coupons" and "ladders," and even more esoteric subjects. Don't worry — it'll eventually start to make sense. After all, a ladder just leads you upwards one step at a time. In its own way, that's what a bond ladder does as well.
Returns vs. Liquidity
If you're investing in bonds for long-term gains, you'll need to balance two things. One is the return your bonds will pay over time, and the other is liquidity. Bonds are sold with a maturity date, which is when you'll get back the principal from your investment. The longer you're willing to let the issuer use your money, they more they'll pay you in return. That means longer-term bonds give better rates. Unfortunately, that also means your money is tied up, or "illiquid," for the same length of time. The laddering strategy provides the benefits of long-term investing, but keeps a portion of your investment available in the short term.
Basic Laddering Strategy
Here's how it works, assuming a 10-year investment cycle. Instead of placing your entire investment into 10-year bonds, you divide it between bonds of different maturity dates. You might opt for 10 bond issues with maturity dates one year apart, or five bonds at two-year intervals. Either way, the outcome is the same. When the first bond comes to maturity, you use the cash to buy a new 10-year bond. The next year, you'll do the same with your two-year bond. Eventually all of your bonds will be at the higher-interest 10-year level, but you'll still have access every year to 10 percent of your capital.
Having access to part of your capital every year can save your bacon if you encounter unexpected expenses. You could also sell the bonds before their maturity date, but that assumes you'll find a buyer and that you won't lose money on the transaction. That, by the way, is one of the hazards of laddering. If rates are low when you renew, you might not be able to reinvest at a comparable return. Reverting to short-term bonds and waiting for rates to rise is the usual response. Laddering can also increase your expenses, since you're paying someone to buy and sell those bonds for you.
Laddering is best-suited to medium- or long-term investing, so be sure it matches your investment objectives before you plunk down your hard-earned money. If you have a modest amount of capital, a bond-based mutual fund might offer better returns and less downside than direct investing. If you opt for laddering, your choice of bonds is important. Young investors might prefer the higher rates — but higher risk — of corporate bonds. High-income investors favor municipal bonds for their tax advantages, while super-safe T-bills and other federal instruments are attractive when retirement gets closer and capital preservation is your focus.