If you have spent much time studying the bond market you have likely heard of bond ladders. If not the concept is pretty simple. You buy individual bonds with maturity dates that are spaced out over a number of years. When the bonds with the shortest maturities mature, you roll them over into the longest maturity you have chosen for your ladder.
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One of the purposes of a bond ladder is to protect you from rising interest rates. When interest rates go up you are able to invest money at at the higher rates as your short term bonds mature, helping to offset the losses on your longer term bonds. You can read more about bond ladders here.
A primary issue with bond ladders however, is that unless you are using treasuries for your bond ladder, you need to spread your purchases out over a large number of bonds in order to minimize credit risk. For many people with smaller investment sizes, creating a well diversified bond ladder using individual bonds is not possible.
To help with this issue, BMO Financial Group recently came out with an an article outlining how you can create a ladder using bond funds instead of individual bonds. As most bond funds are invested in hundreds if not thousands of individual bonds, you can get similar protection to rising rates with smaller investment sizes.
As BMO points also points out, that is not the only benefit of using bond fund ladders instead of individual bond ladders. Other benefits are:
- Liquidity: If you are using an individual bond ladder and need to exit some of your bonds before maturity, then you are likely to incur large transaction costs in order to do so. Most bond funds on the other hand have daily liquidity, meaning that you can exit your bond fund at anytime for minimal transaction costs. You can read more about bonds vs. bond funds here.
- Floating Rate Exposure: The BMO funds used in the article include around 20% exposure to floating rate bonds. The interest paid on floating rate bonds adjusts up and down along with market interest rates on a daily basis. This means that a portion of your portfolio will be investing at the higher rates much faster in your bond fund ladder than when individual bonds are used. You can read more about floating rate bonds here.
- Potentially Higher Income: In this example a significantly higher yield was obtained by using the bond fund ladder vs. individual bonds.
Keep in mind that the floating rate exposure component is key to the bond fund ladder. If the funds that you use for the ladder do not contain this floating rate exposure, then you will be subjecting yourself to greater interest rate risk than you would be with the individual bond ladder.
You can read the full article from BMO here.
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