How to build a bond ladder

Rock-bottom interest rates make it hard to get decent levels of income from your investments without taking lots of risk. While some stocks offer an attractive income, the ups and downs of the stock market are just too uncomfortable for some people.

So, investing in bonds has always been seen as a good alternative for those who want a regular income, with less volatility (fewer ups and downs).

Of course, bonds are not the same as cash in the bank. They are by no means risk-free. There’s always the possibility that the issuer of the bond won’t be able to pay you the interest due, or to give you your money back.

The price of bonds also changes when interest rates change (bond prices and interest rates are like a seesaw – prices go up when rates fall and go down when rates rise). The distinct possibility of rising interest rates in the future has put many investors off bonds in recent times.

However, there is a way that you can reduce the ‘interest-rate risk’ associated with bonds, while securing a regular and predictable source of income. You just have to build yourself a ‘bond ladder’.

What is a bond ladder?

A bond ladder is a portfolio of bonds with different maturity dates (this is the date on which the bond repays its face value). So, for example, someone with £100,000 might split their bond portfolio evenly into five different parts (these are the rungs of the ladder), with maturities of two, four, six, eight and ten years (see the example in the table below).

Why do it like this? Well, say you buy a single ten-year bond with an interest rate of 3%. If interest rates then rise to 5%, you can’t take advantage of these higher rates – apart from by reinvesting the 3% interest – until the bond matures.

(You could sell the 3% bond, but you would be likely to end up losing a lot of money, as the bond would have fallen in price as rates rise.)

By building a bond ladder instead, you can take advantage of rising interest rates by having bonds mature at regular intervals – in this case two years. So when the two-year bond matures, your longest maturity bond is now eight years. To maintain the ladder you would invest in another bond with a ten-year maturity.

If interest rates have gone up between times, this will boost the income of your bond portfolio. If they have fallen, you won’t be reinvesting all of your portfolio at once and so will be able to hang on for a while at existing higher interest rates.

As well as reducing interest-rate risk, bond laddering gives you a portfolio with predictable cash flows (providing the issuer doesn’t go bust). You hold the bonds until they mature, so you know how much interest and bond repayment (£100 per bond, say) you will receive each year, which is useful for planning.

How to build one

1. Decide how many years you want your ladder to last. Generally speaking, the longer you invest for, the more income you should receive as interest rates usually – but not always – increase over time.

2. How many rungs are on your ladder? In other words, how often do you want your bonds to mature? This will give you the number of bonds in your portfolio. The more you have, the more diversified your portfolio will be.

3. What will your ladder be made of? You could stick to government bonds, or you could add corporate bonds or even fixed-term savings accounts.

Putting a bond ladder together in practice is not as easy as it is in theory. It can be tricky to buy bonds with the exact maturities you need.

Using the example of a ten-year ladder, with rungs at approximately every two years, I’ve put together a model portfolio below with current UK government bonds. To keep things simple, I’ve ignored trading costs, taxes and accrued interest.

Someone buying these five bonds could lock in an income stream of 3.23% until December 2015, when the first bond matures. To maintain the ladder, the proceeds would be re-invested into a bond maturing in 2025 or 2026, such as Treasury 5% March 2025.

If rates remain unchanged, buying this bond would boost the income to £3,624 and the yield of the portfolio to 3.7% until March 2018.

What to look out for

Unless you are buying bonds when they are first issued at their ‘par’ value (£100 in the case of gilts), there can be losses or gains of capital when bonds mature.

Four of the bonds below will repay less than you paid for them because they were bought above their par values. If you need your cash early, selling bonds before maturity could see further losses if rates rise.

You also need a relatively large portfolio to own a lot of individual bonds so that you spread your risks. This can be very expensive when commissions and spreads (the difference between the buying and selling prices of the bonds) are taken into account.

One alternative is to make a bond ladder using funds or exchange-traded funds (ETFs), although these will also come with costs.

Bond Coupon Price Yield Investment Income
Treasury December 2015 2% 113p 1.77% £20,000 £354
Treasury March 2018 5% 114p 4.39% £20,000 £877
Treasury March 2020 4.75% 115.6p 4.11% £20,000 £822
Treasury March 2022 4% 111.78p 3.58% £20,000 £716
Treasury September 2023 2.25% 96.58 2.33% £20,000 £466
Total income £3,235
Portfolio yield 3.23%

 

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