Bond ladders and holding to maturity

What you will learn

• What holding a bond to maturity really protects you from, and what risks remain
• How a bond ladder is built: rungs, spacing and reinvestment
• How to calculate the income, average yield and average maturity of a ladder
• How to match a ladder to known future spending

Explanation

Duration and price risk were covered earlier in this course. This lesson shows a practical way to live with that risk.

Holding to maturity

If the issuer does not default, a bond pays its coupons and returns its nominal value on the maturity date. Price changes along the way therefore do not matter for the final result if you really hold until maturity. Your return is close to the yield to maturity you locked in when buying, apart from the effect of reinvesting coupons.

Holding to maturity does not remove these risks:

• Default risk: the issuer may not pay. This is why ladders for safety usually use high-quality government or top-rated bonds.
• Inflation risk: a fixed nominal payment can buy less in the future.
• Opportunity cost: if yields rise, your money stays locked at the old, lower yield.
• Liquidity risk: if you must sell early, you get the market price, which may be lower than what you paid.
• Call risk: some bonds can be repaid early by the issuer (callable bonds), usually when that is bad for you.

What a bond ladder is

A bond ladder splits money into bonds that mature at regular intervals, for example yearly for five years. Each bond is a rung. When the shortest rung matures, you either spend the money or buy a new bond at the long end of the ladder. This is called rolling the ladder.

A ladder offers a middle path between two extremes:

• Putting everything in one short bond gives low rate risk but high reinvestment risk: if yields fall, all your money must be reinvested at lower yields at once.
• Putting everything in one long bond locks in a yield but creates large price risk and no cash before maturity.

With a ladder, only one part of the money is reinvested each year, so you reinvest at a mix of rates over time. The ladder's interest-rate sensitivity stays roughly constant as you keep rolling.

Design choices

• Length: the longest maturity. Longer ladders usually earn more when the yield curve slopes upward, but carry more price risk.
• Spacing: yearly rungs are common; half-yearly rungs need more money and more trades.
• Rung size: equal amounts give even cash flows; unequal amounts can match known expenses.
• Quality: for a safety ladder, choose issuers whose default you would consider very unlikely, and avoid callable bonds.

Average maturity of an equal-weight ladder is roughly the mid-point of its rungs. A 1-to-5-year ladder has an average maturity of 3 years.

In Germany, a ladder can also be built from fixed-term deposits (Festgeld) within deposit protection limits, which are covered in the personal finance course. Bonds add the option to sell before maturity, at the market price.

Worked example

Hypothetical example: You invest €20,000 in five government bonds of €4,000 each, maturing in 1, 2, 3, 4 and 5 years. To keep the maths simple, assume each bond is bought at par (100), so its yield equals its coupon. Fees and taxes are excluded.

1. Annual income: €80 + €88 + €96 + €104 + €112 = €480.
2. Average yield: €480 ÷ €20,000 = 2.4%.
3. Average maturity: (1 + 2 + 3 + 4 + 5) ÷ 5 = 3 years.
4. After one year, rung 1 repays €4,000. You buy a new 5-year bond. If the curve is unchanged, it yields 2.8%.
5. The ladder now holds coupons of 2.2%, 2.4%, 2.6%, 2.8% and 2.8%. New income: €88 + €96 + €104 + €112 + €112 = €512, an average yield of 2.56%.

If yields had fallen instead, only the €4,000 rung would be reinvested at the lower yield, not the whole €20,000.

Common mistake

Practice activity

You put €15,000 into a 3-rung ladder: €5,000 each in bonds maturing in 1, 2 and 3 years, bought at par with coupons of 2.1%, 2.4% and 2.7%. (a) What is the annual income and average yield? (b) After one year, you reinvest the matured €5,000 in a new 3-year bond at 2.7%. What is the new annual income?

Key takeaways

• Holding a bond to maturity removes price risk only if the issuer pays; inflation, opportunity cost and liquidity risk remain.
• A ladder spreads maturities so only one part of the money is reinvested at a time.
• Rolling the shortest rung into a new long rung keeps the ladder's length and rate sensitivity stable.
• Use high-quality, non-callable bonds for a safety ladder, and size rungs to match known expenses.

Next step

Next, you will compare single bonds and ladders with bond funds and ETFs, which never mature.