While bonds lost less than stocks, people seem to be more upset about the loss in their bond investments than the loss in their stock investments because they have different expectations for these investments. They know their stock investments are risky and the stock market can go down or crash at times. They expect bonds to be more stable. They also hoped that bonds would go up in value when stocks are down, in an often-cited zig-zag relationship — when stocks zig, bonds zag (“flight to quality”). Investors are disappointed to see bonds going down by almost as much as stocks.
I sympathize with this sentiment. I also wish my bond investments didn’t drop this much but I know the zig-zag relationship is a false expectation. Sometimes they zig-zag and sometimes they don’t. It’s unrealistic to expect bonds to always hold steady or move up when stocks crash.
Because many people invest in bonds through bond funds or ETFs, they wonder whether investing in bonds directly would’ve made a difference because they can avoid the loss by holding the bonds to maturity and getting paid in full when the bonds mature. Specifically, they wonder whether they should replace their bond fund or ETF with a bond ladder going forward.
What Is a Bond Ladder
A bond ladder is a collection of bonds structured to have approximately the same amount mature in approximately equal intervals. The equal amounts and the equal intervals make it look like a ladder.
For example, if you have $10,000 of bonds maturing every year in the next 10 years, that’s a 10-year bond ladder. To build this 10-year bond ladder, you buy $10,000 face value of a 1-year bond, $10,000 face value of a 2-year bond, …, and $10,000 face value of a 10-year bond.
It’s easy to build this ladder with Treasuries through a combination of new issues and secondary market purchases. See How To Buy Treasury Bills & Notes Without Fee at Online Brokers and How to Buy Treasury Bills & Notes On the Secondary Market. You can build a ladder with CDs as well.
The amount that matures each year doesn’t have to be exactly the same. You can add a small amount at each interval to account for inflation (or buy TIPS bonds that automatically adjust for inflation).
The first bond doesn’t have to mature in one year. Your first bond can be a 10-year bond followed by an 11-year bond, then a 12-year bond, and so on.
The interval doesn’t have to be one year either. You can have $20,000 maturing every two years or $5,000 maturing every six months.
As long as you have some set amount maturing at some intervals, that’s a bond ladder.
Reasons for a Bond Ladder
The primary reason for building a bond ladder is to take advantage of the fact that bonds pay back the full principal when they mature. As long as your bonds don’t default, you’re guaranteed to have your principal back on the maturity date. When each bond is guaranteed not to lose money when it matures, the bond ladder as a whole is also guaranteed not to lose money over its lifetime. It’s perceived to be safer than a bond fund or ETF.
What you do with the cash from a matured bond in a bond ladder distinguishes the type of bond ladder you have.
Collapsing Bond Ladder
If you simply spend the money from each matured bond, you have a collapsing bond ladder.
Suppose you started with a 10-year bond ladder with $10,000 maturing each year starting one year from now. After one year, your original one-year bond matures and you get $10,000 paid back as cash. Your original two-year bond has only one year left now and your original 10-year bond has nine years left.
If you spend the $10,000 cash, you’re left with a nine-year bond ladder. If you spend the $10,000 cash again next year, you’re left with an eight-year bond ladder. Your ladder becomes smaller and smaller as time goes by. That’s a collapsing bond ladder. The ladder disappears after the last bond matures.
Rolling Bond Ladder
If you reinvest the cash from the matured bond to the far end of the ladder, you have a rolling bond ladder.
Suppose you started with the same 10-year bond ladder with $10,000 maturing each year starting one year from now. After one year, your original one-year bond matures and you get $10,000 paid back as cash. Your original two-year bond has only one year left now and your original 10-year bond has nine years left. So far you have the same $10,000 cash and a nine-year bond ladder as in a collapsing bond ladder.
If you reinvest the $10,000 cash in a new 10-year bond, you will extend your nine-year bond ladder into a 10-year bond ladder. If you reinvest the $10,000 cash again next year, you’re keeping your 10-year bond ladder intact. Your ladder keeps going and going. That’s a rolling bond ladder. The ladder is maintained until you stop reinvesting and convert it into a collapsing bond ladder.
Source of Bond Loss
We need to understand the source of losses in bonds to answer the question of whether it’s better to replace a bond fund or ETF with a bond ladder.
Bond funds and ETFs hold bonds. Prices of bond funds and ETFs are determined by the prices of their underlying holdings. Investors lost money in bond funds and ETFs this year because the values of bonds held in those bond funds and ETFs dropped.
Bonds don’t know or care whether you’re holding them in a bond ladder or through a bond fund or ETF. Their values will drop by the same amount when interest rates go up. If you would hold only bonds of a certain type in a ladder (for instance, short-term Treasuries), you can invest in a bond fund or ETF that holds that type of bonds as well.
If you hate seeing a lower value in your account statement, only holding bonds in a bond ladder won’t help. If you can ignore the lower market value reported in your brokerage account for your bonds in a ladder because you’re not selling them, you can ignore the lower reported market value for your bond fund or ETF as well when you’re not selling it either.
I bought some bonds two years ago. The interest rates on those bonds were good at that time, relatively speaking. After interest rates went up this year, the values of those bonds dropped. I still had a loss in those bonds even though I’m holding them to maturity.
Reinvest = Hold to Maturity
Actually it doesn’t matter whether I hold those bonds to maturity or not. If I sell them now at a loss and I reinvest the proceeds at the current rates, I’ll have exactly the same amount as holding the bonds to maturity. That’s the definition of their market value. Someone else investing a smaller amount today will grow their investment to the same amount as my bonds when they mature. It makes no difference whether I sell at a loss now and reinvest or I keep my bonds and languish while earning lower rates. I get to the same place either way.
My bonds lost value because I bought them too early. The only way to avoid the loss is not to buy those bonds two years ago. If I had kept the money in a savings account and I only buy the bonds now, I would’ve avoided the loss, but that requires knowing that interest rates would go up and bond prices would come down if I only waited. No one could’ve known that. If interest rates continue going up as much as they have this year, bond investors will lose money whether they buy bonds in a bond fund or in a bond ladder.
Bond funds and ETFs continuously reinvest. It doesn’t matter whether the bond fund managers hold their bonds to maturity or not. Growing the lower value in a bond fund or ETF at today’s higher rates will get to the same place as holding last year’s bonds to maturity in a rolling bond ladder. If you’re going to do a rolling bond ladder, in which you will continuously reinvest proceeds from matured bonds, you might as well invest in a bond fund or ETF.
Value of Holding to Maturity
Holding to maturity makes a difference when you don’t reinvest. You make up for the loss in a bad year when you reinvest at higher rates, but if you must spend the money, you lock in the loss and lose the opportunity to make up for it. Holding to maturity avoids the loss in this case.
If you’re liquidating a bond fund to cover anticipated expenses, a collapsing bond ladder helps with matching matured bonds to orderly withdrawals. This is helpful especially when the withdrawal period is short and the amount to be withdrawn is relatively predictable.
For example, if you’re paying your child’s college tuition, having a four-year collapsing bond ladder matches the cash flow from the matured bonds to the tuition bills. You pay the bill each year with a bond that matures in that year. The ladder is gone when the final tuition bill is paid.
Someone retiring at age 54 can also use a collapsing bond ladder to cover living expenses until they start withdrawing from their IRA when they’re age 59-1/2.
Someone saving money to buy a car in five years can use a reverse ladder. Instead of paying a lump sum now to have a set amount mature each year, they keep buying a bond that matures when they need the money for a car — a five-year bond now, a four-year bond next year, and so on. They’ll have a lump sum to buy the car when the bonds mature.
These are all good cases for investing in a bond ladder. The value of holding to maturity gets diluted when you have a long withdrawal period and the amount to be withdrawn each year is uncertain. If you just retired and will take withdrawals over the next 30 years, the amount to be withdrawn is small relative to the whole portfolio. Bonds don’t lose 15% every year. Not reinvesting only 3% of your bond holdings in a bad year doesn’t make that much difference.
Bond funds and ETFs can feel like a black box. You only see fluctuating prices, which stress you out when the prices keep going down.
Bonds in a ladder feel more transparent. They pay interest like clockwork and they pay back the principal as promised. This feels more orderly. It may still be worth doing when you continuously reinvest or when you withdraw only a small amount each year from your bonds even if the end results are not much different than investing in a bond fund or ETF. Feeling more comfortable psychologically helps you stay with your investments.
Just don’t pay fees to someone who sells you on managing a bond ladder for you. Some brokers sell muni bonds or corporate bonds to retirees for large hidden fees. Some financial advisors create bond ladders to justify their asset management fees by “adding value.” These are all dubious practices. If you want a bond ladder for psychological comfort, do it yourself.
The value of doing a bond ladder is in matching withdrawals with matured bonds. The shorter the time span in which you will liquidate your bond holdings, the more valuable it is to do a [collapsing] bond ladder. If you’re not withdrawing anything from your bonds and you’re only continuously reinvesting, there isn’t a financial advantage in doing a bond ladder over investing in a bond fund or ETF. When you have a long time span and you’re only withdrawing a small amount each year, a long ladder doesn’t make that much of a difference from a bond fund or ETF.
You may still choose to do a rolling bond ladder or a long ladder for psychological comfort. Just don’t think it’s worth paying someone to do it for you. If doing a rolling bond ladder or a super-long ladder becomes too much work for what it’s worth, just invest in a bond fund or ETF.
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