What is a Bond Ladder? & How to Use it to gain from Debt Funds?
When you invest in a bond, one of the risks you might face is interest rate risk. There is a possibility that a rise in interest rate could reduce the value of your bond. New bonds with a higher interest rate are issued when the interest rate rises. There is more demand for these new bonds with a higher interest rate and better yield. To match the market yield, the price of your old bond falls till it provides the same yield as the new bond does.
The interest rate risk is applicable only when you sell your bond in the market before maturity. Since the price of your bond falls, you will be selling it at a discount in the secondary market. When you have bonds with the same maturity period in your portfolio, you will face a higher risk from interest rates rising. That loss can be reduced if your portfolio consists of bonds that mature at different periods. This process of diversification, where your portfolio holds bonds that mature at different periods, is called laddering. The impact of interest rate fluctuations gets spread throughout your portfolio in the bond ladder strategy. It helps you avoid getting locked into a single interest rate bond and helps you to earn better yield in the long term.
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How does it work?
Bond laddering was not an easy task till the introduction of multiple target maturity debt funds. These funds come with a defined maturity period. The fund’s investments primarily consist of state development loans, PSU bonds or government bonds. These funds aim to provide steady returns despite fluctuations in interest rates. These funds typically hold the bonds until maturity so that there is no interest rate risk. Let’s understand this with an example:
Suppose you choose to invest an equal amount in 5 bonds with a different maturity period. Each of these bonds will have a different yield.
Bond A – Maturing after 2 years and yield is 4.5%
Bond B – Maturing after 5 years and yield is 5.5%
Bond C – Maturing after 7 years and yield is 5.8%
Bond D – Maturing after 9 years and yield is 6.1%
Bond E– Maturing after 10 years and yield is 6.5%
Your yield for this portfolio will be the average of the above yield, which would be 5.7%, assuming that all the bonds will be reinvested at the same rate. However, practically, this would not be the case and actual yield may vary depending on the reinvestment yield.
When a two-year maturity bond expires, the maturity amount can be reinvested at the yield of that time. If interest rates are low, your reinvestment yield will be reduced, but you will benefit by holding the higher yield from the longer maturity bonds.
On the other hand, if after 2 years, yields are higher, the bond maturity amount can be reinvested at a higher yield.
Additional Read: Why Invest in Sovereign Gold Bonds?
There are many advantages of the bond ladder. The bond ladder helps you provide better liquidity as you get the cash at frequent intervals that you can use for your liquidity needs. You can choose to create a ladder as per your liquidity needs. For example, if you don’t need money in the short term, say in the next three years, better to start a ladder with a bond maturity after three years. This would also be beneficial as mostly longer maturity bonds have a higher yield.
This strategy is helpful in both rising interest and low-interest scenarios. The maturity amount can be reinvested at a higher yield in an increasing interest scenario. In the case of a low-interest scenario, you can avoid investing all the money now in low-yield bonds.
These funds are also tax efficient as mostly maturity period of these funds is more than three years and these are eligible for long-term capital gain, which is taxed at 20% with indexation.
Additional Read: What is the Procedure to buy Government Bonds?
A bond ladder can easily be created through target maturity bond funds. These funds will help protect your debt portfolio from volatility and provide steady income. These funds are suitable for any interest rate cycle, but the key is to hold these funds till maturity.
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