What Is Laddering?

What Is Laddering?

In finance, the term laddering is used in a variety of ways depending on the industry. Its two most common usages relate to retirement planning and the underwriting of new securities issues.

Generally, laddering is used to describe different investing strategies that aim to produce steady cash flow by deliberately planning investments, creating an influx of liquidity at a predetermined time, and/or matching a desired risk profile. For fixed-income investors, laddering can help manage interest rate risk and reinvestment risk.

Understanding Laddering

In finance, laddering can mean a few things. Most commonly, it is an investment strategy that involves purchasing multiple financial instruments with different maturity dates to manage risk and create a steady stream of income. This technique is commonly used in retirement planning and can be applied to various types of investments, such as bonds, certificates of deposit, and annuities.

In securities underwriting, especially for IPOs, "laddering" has a controversial meaning. It's an illegal practice where underwriters offer discounted shares to certain investors before the IPO. It require these investors to buy more shares at higher prices after the IPO. This tactic artificially inflates the stock price and creates false demand, misleading other investors.

We'll discuss more in-depth in the following sections.

How Fixed-Income 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.

Importantly, 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.

Advantages of Fixed-Income Laddering

One of the primary benefits of laddering is the ability to manage interest rate risk. By staggering maturities across different time periods, investors can mitigate the impact of interest rate fluctuations. As bonds in the ladder mature, investors can reinvest at prevailing market rates, potentially taking advantage of higher yields if rates have risen while continuing the ladder cycle.

Another advantage of bond laddering is the creation of a predictable and steady income stream. As each bond in the ladder reaches maturity, it provides a known amount of income. This can be great for retirees or investors who rely on their investments for regular cash flow.

Laddering also offers flexibility and liquidity compared to investing in a single long-term bond. While longer-term bonds typically offer higher yields, they also have increased interest rate risk and reduced liquidity. A bond ladder allows investors to benefit from the higher yields of longer-term bonds while maintaining access to a portion of their investment as shorter-term bonds mature.

Fixed-Income Laddering Strategies

When laddering fixed-income securities, there are a couple of strategies to keep in mind. First, it's important to determine the appropriate time horizon and maturity range for your ladder. A typical ladder might span 5-10 years with bonds maturing at regular intervals (for example, annually). Shorter ladders provide more liquidity but potentially lower yields, while longer ladders can offer higher yields but less flexibility.

The selection of bond types is another consideration. Investors can create ladders using various fixed-income securities like corporate bonds, municipal bonds, Treasury securities, or certificates of deposit. Diversifying across different bond types can help manage credit risk, though you may want to simply keep the same security across all durations for consistency.

Proper sizing of each "rung" in the ladder is also important. Typically, investors divide their total investment amount equally across the chosen maturities. This ensures a consistent amount of principal becomes available for reinvestment as bonds mature. For example, if you have $100,000 to invest in a 5-year ladder, you might allocate $20,000 to bonds maturing in each of the next five years. Keep in mind that as you roll each bond as it matures, you may choose to reinvest the original amount ($20,000 above) or the original amount plus the earnings it has accumulated.

Last, even though it is a passive investment strategy, you should still plan to manage and monitor your ladder. Regularly review the credit quality of your holdings, especially for corporate or municipal bonds. Be prepared to make adjustments if you don't feel like your risk-to-reward profile is fair. Additionally, consider using tools or working with a financial advisor to help track your ladder's performance so you can better understand how much liquidity you will have at certain times.

Risks to Fixed-Income Laddering

Interest rate risk remains a concern for laddered portfolios, though it tends to be a lesser degree than with a single long-term bond. If interest rates rise significantly, the longer-term bonds in the ladder may lose value. Although the strategy allows for reinvestment at higher rates as shorter-term bonds mature, the overall portfolio may still underperform in a rapidly rising rate environment. Conversely, in a falling rate environment, reinvestment risk becomes more pronounced as maturing bonds are reinvested at lower yields.

Credit risk is another important factor to consider, especially for ladders constructed with corporate or municipal bonds. There's always the possibility that an issuer may default on their obligations, potentially leading to a loss of principal.

Inflation risk is a concern for all fixed-income investments, including laddered portfolios. If inflation rates exceed the yield of the bonds on the ladder, the real return may be negative. This risk is particularly relevant in the current low-yield environment, where even longer-term bonds may not offer yields that keep pace with inflation.

Finally, there's the opportunity cost to consider. While laddering can provide a balanced approach to fixed-income investing, it may underperform other investment strategies in certain market conditions. Very generally speaking, fixed-income securities tend to underperform compared to equity investments. In exchange for greater security and lower risk with ladders, you may not earn as much.

How Laddering IPOs Work

Laddering as a term is also used in the context of the underwriting of initial public offerings (IPOs). The mechanics of IPO laddering typically unfold in three distinct stages. In the initial phase, the underwriter strategically identifies and approaches key investors, often institutional clients or high-net-worth individuals. These select investors are offered a portion of the IPO allocation at a discounted price, below what will be offered to the general public. This preferential treatment serves as an incentive for these investors to participate in the scheme.

The second stage involves a quid pro quo arrangement between the underwriter and the selected investors. In exchange for the discounted IPO shares, these investors agree to purchase additional shares once the stock begins trading publicly. These subsequent purchases are often required to be made at specified price points above the IPO price. This agreement is typically implicit and not formally documented to avoid regulatory scrutiny.

The final stage unfolds in the immediate aftermath of the IPO. As trading begins, the pre-selected investors fulfill their commitments by purchasing additional shares at the agreed-upon prices above the IPO price. These coordinated purchases create an illusion of strong demand for the stock, driving up its price. The rising price and apparent demand can trigger a cascade effect, attracting other market participants who fear missing out on a rapidly appreciating stock.

Example of Laddering

Michaela 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:

• $100,000 in a bond maturing in 1 year
• $100,000 in a bond maturing in 2 years
• $100,000 in a bond maturing in 3 years
• $100,000 in a bond maturing in 4 years
• $100,000 in a bond maturing in 5 years

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.

The Bottom Line

In retirement planning, laddering describes when an investor buys bonds with various ascending maturity years. As the bonds reach maturity one-by-one, the investor reinvests them into bonds of equal maturity length. When these bonds mature, they are reinvested, and the cycle continues. Using this strategy, investors can maintain a steady cash-flow and reduce interest rate and reinvestment risk.

Investors can create short- or long-term ladders, depending on the bond maturity length they select. While long-term bonds tend to have higher yields than short-term ones, they are also subject to more unpredictable price changes.