Investors who are seeking regular returns and a promise of the return of principal often choose to include fixed-income investments, such as bonds and certificates of deposit (CDs), in their portfolio. Conservative fixed-income investments, particularly government securities and federally insured CDs, are generally considered less volatile than other investment vehicles, such as common stock and, as a result, they tend to provide lower rates of return.
A portfolio that relies too heavily on fixed-income investments may be vulnerable to inflation or fluctuating interest rates. One technique commonly used to balance the return and risk of this particular asset class with an investor's time horizon is laddering—a method of maintaining a series of fixed-interest investments with different maturities.
How It Works
With a "laddered" portfolio, fixed-interest investments come due in staggered intervals at which time they may be cashed or reinvested. Because investments with shorter maturities generally have lower interest rates, laddering looks to provide an investor with the financial benefits of long-term interest rates, but the flexibility of shorter-term maturities.
Each investment acts like a rung on a ladder, so that rather than an investor taking one big step—such as investing in a single, long-term savings vehicle—he or she can take smaller steps toward long-term savings goals. Furthermore, stepped maturity dates may provide liquidity options that enable an investor to hold a security until its date of maturity, which may protect against early withdrawal penalties or a downturn in market value. For illustrative purposes, consider the following hypothetical example, which assumes no federal taxes or fluctuation in interest rates and does not represent the performance of any particular investment.
Alice Blackwell wants to invest part of her savings in a portfolio that will provide her access to her funds in the event she goes to graduate school. She chooses to deposit $10,000 into a laddered bond portfolio, and reinvest the principal until she needs the funds. To start, Alice splits her principal between five bonds, each with different maturities and interest rates. Every year during the next five years, one of her bonds will mature.
Upon maturity of the one-year bond, Alice pockets the interest earned and purchases a five-year bond with a higher interest rate that will mature in 2009. When her two-year bond matures, she takes the earnings as income and, with the original principal, purchases another higher yielding five-year bond, which will mature in 2010. While Alice is buying bonds with longer maturities and larger returns, one of her bonds will still reach maturity every year, providing her either access to her money, or the opportunity to reinvest.
Laddering offers fixed-income investors a way to manage certain risks and add liquidity to their portfolios. When implementing any investment strategy, be aware that different securities have varying levels of risk. The principal value of bonds may fluctuate due to market conditions. If redeemed prior to maturity, bonds may be worth more or less than their original cost.