Lets start with the basics. Ladders have traditionally been used by investors to increase their returns while still enabling them to maintain the flexibility to reinvest their funds at higher rates as interest rates rise.
The current investment environment presents an excellent opportunity for using a bond ladder: interest rates are at all time lows and expected to rise in the years ahead.
A ladder is a strategy that divides your initial capital into a set of investments, which are made separately over a consecutive series of years or time periods. Let’s look at an example: With a Certificate of Deposit (CD) you could earn up to perhaps 1.70% or 1.75% interest. The downside of this higher rate of return is that your money will be locked up for the entire period of the certificate and you will be unable to take advantage of any future improvements in interest rates.
By using a ladder, however, and dividing your assets as follows, you are able not only to realize an average weighted yield of 1.41% but also to remain relatively liquid throughout the entire period of investment:
$25,000 in a 1 year CD @ 1.10%
$25,000 in a 2 year CD @ 1.25%
$25,000 in a 3 year CD @ 1.42%
$25,000 in a 4 year CD @ 1.55% and
$25,000 in a 5 year CD @ 1.75%
Since your funds will come down every year you will have the opportunity to reinvest your money at a higher rate of interest. This ladder strategy can be used with bonds, CDs, mutual funds, and ETFs. You do want to be careful not to put too much money in any single bond or CD.
It’s better to diversify the credit risk of the CD/bond issuer.
Ladders don’t stop there. They can be used as a retirement strategy, with fixed annuities and with term life insurance policies. For example, a couple may feel they need $500,000 in life insurance for the first 10 years, $300,000 for the next 15 years, $200,000 for the next 20 years, and finally $100,000 for the last 10 years. Is a ladder important for you? It very well could be!