how laddering works
the most common usage of the term laddering is found in retirement planning there it refers to buying multiple fixed income financial products of the same type such as bonds or certificates of deposit cds each with different maturity dates by spreading their investment across various maturities investors obtain ongoing cash flow as they manage their interest rate and reinvestment risks in addition to managing those two risks an investor s purpose in creating for example a bond ladder is to obtain a total return no matter the interest rate rate environment similar to the total return of a long term bond to build a bond ladder investors purchase a series of individual bonds each of which matures in a different year for example you could buy five bonds that mature in 1 2 3 4 and 5 years as the first bond matures investors reinvest the proceeds in a new five year bond this process repeats itself with each maturity thus the maturity length of the ladder is maintained the practice of laddering can help investors manage reinvestment risk because as mentioned as the shortest term bond on the ladder matures the cash is reinvested in a longer term bond on the ladder longer term bonds tend to have higher interest rates similarly the practice of bond laddering can also reduce interest rate risk if one has to sell due to the variety of maturities shorter term bond prices fluctuate less than longer term bond prices due to years to maturity and the effects of duration 1importantly the whole idea behind the ladder is to hold the bonds to maturity rather than to sell them therefore the current price of their bonds due to any change in interest rates isn t an issue investors capital is preserved reinvestment risk is the risk that investors won t be able to reinvest bond income payments and the principal they receive upon maturity at the same rate as that of the maturing bond interest rate or market price risk is the risk that the price of a bond will change as interest rates change 2laddering as a term is also used in the context of the underwriting of initial public offerings ipos here it refers to an illegal practice in which underwriters offer a below market price to investors prior to the ipo if those same investors agree to buy shares at a higher price after the ipo is completed this practice can provide unfair advantages to insiders at the expense of regular investors and is therefore prohibited under u s securities law 3example of ladderingmichaela is a diligent investor who is saving for her retirement at 55 years of age she has saved approximately 800 000 in combined retirement assets she is gradually shifting those assets toward less volatile investments michaela decides to invest 500 000 in various bonds which she has carefully combined or laddered to reduce her reinvestment and interest rate risks specifically michaela s bond portfolio consists of the following investments each year michaela takes the money from the bond that matures and reinvests it in a new bond that matures in five years by doing so she effectively ensures that she is exposed to interest rate risk only when she has to buy the new bond plus she manages a potentially lower reinvestment rate by buying the longer term higher interest rate bond by contrast if she had invested 500 000 in a single five year bond she would have risked a greater opportunity cost if interest rates had ended up rising during those five years frequently asked questions faqs 