Summary of this article
Institutional investors have used bond laddering to manage interest rate risks
Here's how bond laddering works and who can use the strategy
At a time when interest rates look uncertain, and volatility in equity markets drives investments into debt markets, institutional investors often use bond laddering strategy for providing predictable and clear returns on investments. The strategy also offers investors the necessary diversification in the portfolio required with limited risks to volatility in interest rates.
What is Bond Laddering?
In simple terms, bond laddering is an investment strategy which works by investing in multiple debt instruments with different maturities. In this strategy, instead of locking the lump sum investment into a single bond, investors spread the investment across different bonds with different maturities, thus ensuring that a part of the portfolio matures each year, say with investments of bonds maturing in one year, two, three, or four years.
The amount matured from investing in a bond is then used to reinvest in other bonds maturing over the years. This cycle of maturity and reinvesting generates both liquidity to the investor’s portfolio and creates a long-term consistency. This helps investors create a bond portfolio which is laddered and can provide stability to investors.
How it Works
Let’s say you are investing in bonds today when the key policy repo rate of the Reserve Bank of India (RBI) is at 5.25 per cent, and wish to stay put in your investments for the next 10 years.
You are also investing in a single 10-year benchmark bond with a coupon rate of around 6.48 per cent annually. But now, if there is an interest rate hike, the 10-year bond will still give you a coupon of 6.48 per cent. But, if there is a new bond issued after the rate hike, the coupon payment of the new bond will also reflect the hike.
In a bond laddering strategy, the reinvestment opportunity uses the interest rate changes and averages out your returns over a period of time. When interest rates rise, shorter tenure bonds can be reinvested at higher yields upon maturity. Similarly, when interest rates fall, the longer term bond invested will keep earning higher rates locked in earlier. The bond laddering strategy balances automatically, providing smooth returns without the risk of properly timing the market.
To build a bond ladder, the first step is to decide your cash flow requirements. Defining how much liquidity you want every year will help decide how to build a ladder that is aligned to your personal preference. An ideal bond ladder also includes different qualities of bonds across tenures. One can consider a mix of government bonds, AAA rated corporate and PSU of different maturities. Ideally, verify the credentials, yields, and ratings, and make a careful decision to invest through regulated bond investment platforms.
Another aspect of a bond ladder is, when one bond matures, you can reinvest that amount in a new long-term bond, thus having the choice to extend your investments. This will ensure continuous income, along with capturing any future interest rate movements, while managing interest rate risk.
Who Can Use Bond Laddering?
The answer is anyone can. Institutional investors have been using the strategy to hedge their interest rate risks at times when markets and rates have been volatile. For any long-term investor, this strategy can provide predictable income patterns without depleting the initial investment.
This can also be used by retail investors who wish to access an annual fund for planned expenses, while also wanting to earn through a fixed income investment option. This can also serve as a secondary investment option for individuals with irregular investment patterns.
However, the decision to invest must be calibrated and carefully thought through. For investors who prefer a more hands-off approach, debt funds can also offer similar payout strategies.
