In this article you will find out more about:
Meaning of Income Ladder
An income ladder, also often referred to as fixed income ladder, is a financial strategy used by investors to manage interest rate risk and potentially generate a predictable stream of income. It involves diversifying investments in fixed-income securities, such as bonds or certificates of deposit (CDs), with varying maturities. These investments are structured in such a way that they mature at different intervals, creating a "ladder" of maturities.
In order to build an income ladder, also called laddering, the investments must have a set maturity date. Bond etfs holding fixed income securities with a maturity band (e.g., 0-1, 1-3 years, 3-7 years) are not suitable, because those bond etfs are selling the bonds as soon as they are no longer within the maturity band of the etf. Accordingly, such bond etfs without set maturity date are also exposed to losses due to rising interest rates (long-term bonds more than short-term fixed income securities).
What are Benefits of an Income Ladder
An income ladder provides several advantages over the investment into one single bond, a bond etf with a band of maturities or time deposit. The primary goals of a fixed income ladder are to:
Manage Interest Rate Risk: Interest rates can have a significant impact on the value of fixed-income securities. When interest rates rise, the prices of existing bonds tend to fall. Conversely, when interest rates fall, the prices of existing bonds tend to rise. By creating a ladder of bonds with different maturities, investors can reduce their exposure to interest rate risk. If rates rise, only a portion of the portfolio will be affected at any given time, while the rest will continue to earn interest at the original, higher rates.
Generate Income: A fixed income ladder can be designed to provide a regular and predictable stream of income. As each bond or CD in the ladder matures, the proceeds can be reinvested or used for income needs. This structure allows investors to have a portion of their portfolio maturing regularly, providing liquidity and cash flow.
Preserve Principal: Fixed income ladders often include bonds or CDs with different credit qualities, helping to spread credit risk. High-quality bonds, such as U.S. Treasuries or corporate bonds with investment grade, are typically used in this strategy to help preserve principal.
Catch Higher Yields: In times of rising interests, investors can benefit from higher interest rates by dividing their investment into portions and investing them in time deposits, fixed income instruments or bond etfs (with set maturity date, such as iShares iBonds) with varying maturities. Investors might achieve a higher blended yield over time by rolling maturing investments into new time deposits or fixed income instruments.
How to Build an Income Ladder
Creating an income ladder with bonds, bond etfs with set maturity date as iBonds or time deposits is easy.
Income Ladder with Bonds
Here's an example of how a fixed income ladder using a bond might be structured:
- Year 1: Purchase a bond with a 1-year maturity, 2-year maturity, 3-year maturity, 4-year maturity
- Year 2: reinvest the bond with 1-year maturity into a new bond with 4-year maturity
- Year 3: reinvest the bond with 2-year maturity into a new bond with 4-year maturity
- Year 4: reinvest the bond with 3-year maturity into a new bond with 4-year maturity
- Year 5: reinvest the bond with 4-year maturity into a new bond with 4-year maturity
- Year 6: reinvest the bond with 4-year maturity from year 2 into a new bond with 4-year maturity
After the first year, the 1-year bond matures, and the proceeds can be reinvested in a new 4-year bond, effectively extending the ladder. This process continues each year, providing a balance between current income, interest rate flexibility, and the potential for capital appreciation.
A fixed income ladder can be tailored to your specific needs and risk tolerance, with the choice of bonds and their maturities carefully selected to align with those objectives. It is a strategy that provides a degree of stability and predictability in an investor's fixed income portfolio.
Income Ladder with Time Deposits
An income ladder with time deposits works the same way: matured assets are reinvested into new ones with longer maturity. Usually, an investor will choose the maturity of time deposits depending on the interests offered by financial institutes and might want to create a faster rolling income ladder. This can be achieved by investing, for example, into overnight money and time deposits with 1, 3, 6, 9 or more months maturity.
Fixed income securities and time deposits can also be combined by investors to diversify not only in maturity dates but also in asset kinds. Find out more about benefits of portfolio diversification here.
Downside of Income Laddering
Although an income ladder with time deposits, single bonds or bond etfs with set maturity comes along with many advantages, there are some aspects to be considered:
Income ladder creates additional work: Instead of buy-and-hold or reinvesting only from time to time, an income ladder has to be maintained. Incoming cashflow from repayment of principal or matured time deposits must be reinvested regularly.
Income ladder causes transaction costs: In case, your income ladder is consisting of single bonds with different maturity dates, then you need to buy new bonds every time you received the principle of a matured bond. Every buy order causes direct (order fee) and indirect costs (spread).
Income ladder lowers return: In high interest environments you might want to lock in the high interest rate for longer, as chances for falling rates are higher. Income laddering is best suited in environments with rising interests.
Income Ladder Calculator
When holding only one time deposit or a single bond it is pretty simple to determine the yield you earn. But when creating an income ladder consisting out of several time deposits with different interest rate and maturity date it becomes more of a challenge.
The German website www.zinsen-berechnen.de offers a yield calculator for such cases here. What you need to enter is investment amount, start date, end date and amount including interests received at the end.
For bond etfs with predefined maturity date such as the iBonds from iShares, the asset management company offers a calculator of the estimated yield you can expect when you hold until maturity date. Simply choose one etf you want to invest in from the list of all iShares iBonds here, enter the purchase price per unit into the calculator and you receive a term sheet even considering the total expense ratio.
On the US website of iShares US investor can simulate with the iBond ladder tool how composition of iBonds with different maturity dates impacts the net acquisition yield and other key metrics of a bond portfolio.
Investors holding a free brokerage account with InteractiveBrokers will see from their PortfolioAnalyst report a specific section dedicated to their fixed income part of their portfolio, showing the total market and face value, average yield to maturity, duration, credit quality summary, cashflow overview by month and many other key metrics.
Further Readings
Should you consider using single bonds for creating a fixed income ladder, you might want to know which type of bonds to own. If you decide for corporate or government bonds, there are a few things to know about single bonds and bond etfs.
Disclaimer: The scenarios or investment products presented above should not be construed as investment advice. All investments involve some level of risk, and past performance is never a guarantee of future returns. As always, do your own research in order to validate and better understand the underlying risks.
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