Both stocks and bonds are down in 2022. As I’m writing this on November 19, 2022, the Vanguard Total Stock Market Index Fund is down 17% and the Vanguard Total Bond Market Index Fund is down 14%.
While bonds lost less than stocks, people seem to be more upset about the loss in their bond funds and ETFs 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 funds 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 mutual funds or bond ETFs, they wonder whether investing in individual bonds directly would’ve made a difference because they can avoid the loss by holding individual 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. Each bond in this portfolio of bonds forms a rung of the ladder.
It’s easy to implement this laddering strategy 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 CD ladder by buying CDs that mature in different years 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 in your bond portfolio, that’s a bond ladder.
Reasons for a Bond Ladder
The primary reason for a bond ladder strategy is to take advantage of the fact that the bond issuers guarantee to pay back the full principal when the bonds 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 laddered bond portfolio 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 laddered portfolio. 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. Bond prices fall when interest rates go up. Investors lost money in bond funds and ETFs in 2022 because the values of bonds held in those bond funds and ETFs dropped due to interest rate risk.
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 in the same interest rate environment. 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 in 2022, 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 higher yields, 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 bought the bonds after interest rates had gone up, I would’ve avoided the loss. This 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 did in 2022, 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 yields 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 yields, 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 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.
Psychological Comfort
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. The interest payments come like clockwork and the bonds pay back the principal as promised. Having a predictable income 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 municipal 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.
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The value of doing a bond ladder is in matching withdrawals with matured bonds. The shorter the time span during 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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Marc says
Thanks for the comprehensive article as always, Harry. I notice you did not delve into the pros and cons of which type of bonds to use to build the bond ladder with. Is this because you don’t believe there is much of a difference as long as you hold whatever bonds you use to build the ladder with to maturity?
You mentioned t-bills/notes and CDs as examples. I have laddered municipal bonds in the past and I am laddering I Bonds now using the spousal gifting strategy. Munis can be triple tax free but often have longer maturities making them challenging to ladder, and can sometimes be called early which would destabilize the ladder. I Bonds have the $10,000 per person per year purchasing/delivery limit, the three month interest penalty before 5 years, and are only state tax free, but provide inflarion protection.
So, to extend the ladder metaphor one more rung, does the bond material you build the ladder with matter? Thanks, as always.
Harry Sit says
The material matters but first we need to answer the questions of whether we want a ladder and why, which I’m addressing in this post. Thank you for asking this great question for a follow-up.
Kevin says
Harry, thank you so much for this article. I am currently laddering 8-week T-bills, as they seem to be the sweet spot for maximizing returns during rapidly rising interest rates. I will shift to 13-week and longer maturities when rates start to level out. I started my ladder by using your instructional article about how to buy via a brokerage at auction (https://thefinancebuff.com/treasury-bills-cd-money-market.html). Thank you so much for that article, too!
Ron Sheldon says
Harry, my thanks, also. I have used your guide for buying I Series Bonds thru Treasury Direct and your other guide to buy new and existing Treasury Bills and Notes through an account I opened with Fidelity for that purpose. I should have a T Bill and Note ladder full in place in January with a holding maturing every 13-weeks that I will roll into a 3-year Note. Eventually, that ladder with be self-perpetuating and the 3-year notes mature and automatically roll into a new issue 3-year note. And, of course, I can always interrupt the ladder if better opportunities come along for part of the fixed income portion of my overall investment portfolio.
When your follow-up guide addresses Marc’s, please consider including the various categories of Invesco and iShares Target Maturity corporate and Treasury ETFs in building a ladder versus direct purchase of Treasury and corporate bonds for that purpose.
Erik says
This is a good article- but failed to mention that many ETF bond funds trade under NAV due to liquidity concerns. So unless one is investing in liquid, on the run sovereign issues, there are concerns over that.
Harry Sit says
There are concerns during market distress but the run of the mill ETFs don’t trade much under the NAV in normal times. For example, the Vanguard bond ETF equivalent to the bond fund linked in the first paragraph closed today at $71.75, and today’s NAV was $71.71.
Scott says
This is another great article from you discussing exactly the types of things I am trying to learn. Thank you for all of your help through your blog.
SLN says
I enjoyed watching your Bogleheads presentation on buying MYGAs (Multi-Year Guaranteed Annuities – sometimes called CD Annuities or Deferred Fixed Annuities). I am using these as part of my collapsing bond ladder to bridge the seven years until I can max out Social Security. I am buying from insurance companies that allow 10% penalty free withdrawals each year. I will use them for income, if needed, and will also use this feature as an interest rate hedge and will take the money out and reinvest in bonds or CDs if rates rise.
Your MYGA talk was excellent and informative (as usual!). I would love to see you blog about this, so others can gain some of your insights into this alternative investment. Any plans?
When I describe it to friends, I tell them that it is an insurance company investing in fixed income and offering me a multi year contract that is higher than I can obtain on my own, but offers them a margin of profit.
Christopher says
It’s unclear to me how holding a bond to maturity and an ETF with the same average duration will yield the same result.
Are you saying that an increase in interest rates and thus higher monthly payouts, will compensate for the drop in the ETF’s value?
For example, 1 year bond held to maturity will be the same as holding an ETF for 1 year as long as the average duration of the ETF’s bonds are also 1 year?
Harry Sit says
It won’t yield the same result if you will sell and leave after one year, as in the case of buying a car, paying college tuition, or dumping the money into the stock market. It will yield [more or less] the same result if you continuously reinvest in new 1-year bonds.
Carol says
This is the best explanation of the difference between bond ladders and funds that I have seen! Thank you! I’ll stick with the funds for simplicity.
I also have thought that perhaps a fund makes it easier to be diversified….so one does not have to worry about defaults as much, since the number of bonds in a fund would be much greater than what a bond ladder would be.
Clark says
A really great and timely post – thanks! It took me a long time to get a feel (still learning) for market value, duration, and bond investing in general, and your discussion is a very clear and compact summary that makes a lot of sense. For our own portfolio, we use a collapsing bond ladder for RMDs in an inherited IRA, but use a longer duration bond fund for RMDs in a non-inherited IRA where RMDs are many years out, and this plan seems consistent with your discussion.
Stub says
This is the clearest explanation on this topic that I have seen. Thank you once again, Harry!
Patty Gerner says
Did you forget to mention that individual cd principal is insured by the FDIC and individual U. S. Treasury bill/bond principal is insured by the U. S. Treasury? I don’t think bond or etf bond funds have principal protection that gets passed on the the investor, do they? I thought the point of fixed income was safety…an offset to the risk of equities. Shouldn’t we get principal security in exchange for the lower returns in these instruments?
BK says
Enjoyed the article, but disagree with several assertions.
If you enjoy managing funds, and are patient, most days a CD ladder beats a treasury ladder. Each bank or CU has a different prepayment penalty, often 3 months interest if original term is 12mo or less, 6 months penalty if original term greater than 12mo. The cost benefit is easily quantified. I’ve seen 6 mo to 72 mo CDs. CD interest is by default reinvested at the CD rate, or, can be withdrawn periodically & put into another CD either at whatever yield/term is advantageous at the time; I use this for risk management.
Bond ETFs or mutual funds are generally managed to maintain a duration. iShares & Invesco have target date ETFs: treasuries, corporates, high yield, or muni, at 15 or more basis points a year. We NEED target date TIPS ETFs, which firm will initiate? Perhaps this has not been done due to TIPS volatility.
BK