14^th January, 2021 by elmads

Finding ways to increase our income stream is always a daunting task, despite this, people are still willing to take measure to learn and master the ways how to do it in order to achieve a secured and joyful life. One method most of us undertake to expound our income stream is through investing. Some individuals have a conservative view about investing, these people prefer wealth preservation rather than exponentially growing their accumulated wealth. It just depends on each and every persons’ risk appetite. That is why bonds are popular with the conservative investors, as they will receive a regular cash flow in a given set of time and interval.

Bond is a fixed income asset that gives its investors regular income stream through coupon payments. I have discussed bonds in detail on my blog titled “Bonds Asset Class”. Moving forward, There are two simple ways in which investors utilize this asset class, it is either by trading bonds (buy and sell) or receiving coupon payment until it matures. Knowledgeable investors who does not want to take the risk of trading bonds but still wants a good return without holding bonds for a long time found a way, and it is through bond laddering. It is a strategy that diversifies our bond holdings within our portfolio. It takes away the risk of holding a bond for longer duration namely 10 to 30 year bonds.

Why take on the bond ladder method?

For liquidity, flexibility, and predictability. Remember, that the longer maturity bond we invest in, the better the coupon rate/yield we will receive. On the flip side, If we take the longer term bond, we miss the opportunity of a higher yielding returns for newly issued bonds upon the central banks increasing the rates, and we also lock our capital for a longer time. Bond ladder takes away these downside, as it gives the flexibility to reinvest the money when rates go up while still receiving regular income from the other bonds that we hold and has not matured yet.

Steps to make a bond ladder portfolio

We’ll start a scenario to make it easier to understand. Let’s say we are a conservative investor and we have £100,000 worth of money. We decided to invest it in 5 different bonds. Each has their own maturity dates. 1^st bond matures after a year, the 2^nd bond matures after 2 years, the 3^rd after 3 years, the 4^th after 4 years and the 5^th bond will mature after 5 years. Always look for company or government bond that have a low risk of defaulting in paying their debt obligations. check my blog titled “What is a credit rating”, It is a guide for us to know the credit worthiness and safeness of a debt issued by institutions and governments.

NOTE: These are for example purposes only and are not actual company and government bonds.

Below is an illustration of how much we will receive quarterly based on the par value and coupon rate of each bond we have. We will receive the coupon payment in a quarterly basis. For example purposes, I will just show the yearly total coupon payment instead.

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Straightforward step by step process as follows:

1. Find which bonds you want to purchase
2. Every year we will have a bond that will mature. In short, we will be receiving back the Par/Face value worth £20,000 that we initially invested. It is then up to us if we will use this to purchase things in our lives, like to pay for bills or for personal expenses. Yet, as we are doing a bond ladder strategy, it is better to reinvest both the par/face value and earned interest into another bond.
3. Reinvest the received Par/Face Value to another bond that has a different maturity compared to our current bonds that we still hold.
4. Repeat steps 1-3 until we reach our financial goals.

Below is an illustration regarding bond ladder reinvesting.

Down below is a further depiction of this, which is to give you clearer explanation of what to do after the shortest bond in our ladder portfolio matures. I hope this will make the process understandable and be crystal clear.

For the bond ladder to continue we need to reinvest our Par/Face value to the next bond. By continuously doing this strategy, we remove the risk of interest rates affecting our bond’s par value because we hold the bond until its maturity and we did not trade it. Furthermore, we are able to maximize and grab the opportunity of an increasing interest rate environment as well, because we continue to reinvest into another bond when our previous bond holding matures. Also, when compared to stock investing, bond ladder strategy is somehow similar to cost averaging in which we continue to invest and reinvest our money, while not caring about the current market price levels. In this case, we will not care about the central bank interest rates and the bond market prices.

What is the disadvantage of bond laddering?

Every investment strategies have its own downside, this includes bond laddering. All of a bond’s disadvantage are included in here such as credit risk and inflation risk, except for the interest rate as we hold the bond until maturity. Second is the risk for a bond to be recalled by the issuer. This means that the institution who issued the bond will recall it and payback the par/face value to the bondholder it owes. To give us context, we are invested in a bond with a par value of 1,000 and a maturity of 10 years, then that bond has been recalled by the company during its 5^th year. That mean that we only received the 5 years worth of coupon payments plus the returned par value. This causes for the should have been interest payment in the future, not be paid to us anymore.

To sum it up

Bond ladder is indeed a wonderful strategy to undertake especially if we want a conservative steady stream of income. Plus we do not need to trade the bond and be worried about the interest rate fluctuations that greatly affects the bond’s par value price. In choosing a method, we must always remember the reason for following it and the goals that are connected to it. When the tide changes we must be ready to stay on our ground and be confident in what we do. There is no one best investing strategy for everyone. It will always depend on each and our personality, discipline, knowledge and motivation to be truly successful in our investing endeavour. Just like what Warren Buffet said;

“We don’t have to be smarter than the rest, we have to be more disciplined than the rest.”

-Warren buffett

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.