Bonds can offer a safe way to invest and earn consistent interest income over time. A bond ladder exchange traded fund (ETF) gives exposure to multiple bonds with different maturity dates. Investing in a bond ladder ETF can help diversify and can be easier than building a bond ladder yourself. Knowing how bond ladder ETFs work can help you decide if they’re right for you. It may be a good idea to speak to a financial advisor if you are considering incorporating bond ladders into your overall investment strategy. Finding a financial advisor is easy with SmartAsset’s free advisor matching tool. Answer a few questions and you’ll be matched with counselors who serve your area.
What is a Bond Ladder Strategy?
A bond is a form of debt. When you invest in a bond, you are letting the bond issuer use your capital for a set period of time. When the bond matures, the bond issuer returns your capital to you. During the maturity period or term, the issuer can make interest payments to you for using your money, usually on a semi-annual basis.
A bond ladder is an investment strategy that involves buying bonds with different maturity terms and interest rates. The idea is that by creating a bond ladder, you can earn a constant stream of interest income over time. As each bond matures, you can decide whether to use your original capital to buy a new bond. This is similar to the way a CD ladder works.
Building a bond ladder can help manage interest rate risk. As interest rates rise, bond prices fall and vice versa. You can use a bond ladder to invest in different types of bonds with different risk/reward profiles. For example, you could include investment grade bonds, municipal bonds and/or junk bonds or high yield bonds in a bond ladder strategy.
What is a Ladder ETF?
Exchange-traded funds or ETFs are mutual funds that trade on an exchange like a stock. When you own an ETF, you own a collection of securities in one basket. A ladder ETF focuses its holdings on bonds with different maturity dates. So, for example, a bond ladder ETF might hold 15 investment-grade corporate bonds divided into five groups with maturity dates between one and five years.
The way an ETF is structured can ladder bonds depending on the fund’s objective. Going back to the previous example, this type of ladder ETF has a relatively short-term focus, since it only holds bonds with a maximum maturity of five years. Perhaps the main objective is to earn a high rate of interest and preserve capital. As the fund includes investment grade bonds, it is less risky for investors overall.
The advantage of using a bond ladder ETF to invest in is that it can save you the time and effort of picking and choosing individual bonds on the ladder. Instead, you can choose a fund that aligns with your goals and risk tolerance. For example, you might choose a bond ETF that ranks high-yield bonds if you’re looking for higher returns.
How to Build a Bond Ladder Using ETFs
If you think the bond ladder approach would work for you, there are two ways to build one using ETFs. The first is to invest in target-maturity ETFs. Target maturity ETFs hold a collection of bonds with the same maturity date. If you invest in target-date funds, a target-maturity bond ETF works similarly. The date or year the bonds will mature is usually in the name of the fund.
You could choose to build your ladder with multi-target ETFs that represent different segments of the bond market, with different target years. A laddered bond ETF in this way gives you some flexibility and control because you can decide what kind of funds you want to invest in and what kind of maturity term you’re looking for.
If you’re interested in laddered bonds but don’t want to choose individual ETFs, you can invest in an individual bond ladder ETF. If you invest in a ladder ETF that holds Treasury securities, that may be your only bond exposure if you don’t have bonds elsewhere in your portfolio. However, if you are also interested in municipal bonds or corporate bonds you may need to branch out with additional ETFs.
Bond Ladder ETF Considerations
When comparing target maturity ETFs and ladder ETFs for a bond ladder strategy, there are a few things to keep in mind. First, you’ll want to look at the types of bonds the fund holds. Each type of bond has a different default risk level, based on the credit ratings of the bond issuer. This level of risk can determine how likely you are to lose money and what kind of returns you can expect to see.
Bonds issued by the Treasury are among the safest since they are backed by the full faith and credit of the United States government. On the other hand, junk bonds have the lowest credit ratings and, therefore, the highest risk of default.
Also, consider the potential returns, maturity terms and how they fit into your short- and long-term goals. If you plan to allocate a large portion of your portfolio to bond ETFs, it’s important to consider when that money will be accessible to you and how much you can expect to earn from your investments.
Finally, look at the expense ratios charged by different target maturity ETFs and ladder ETFs. Expense ratios can vary from one ETF to another and it is important to understand what you will pay to own each year. The higher the fee, the better the repayments the fund needs to cover the cost.
The Bottom Line
A bond ladder ETF strategy can help you add ongoing interest income to your portfolio while managing risk. You may favor this approach if you want to invest in bonds without having to do the heavy lifting of selecting individual bond options. Remember, it’s important to do your research before investing in a bond ladder ETF, so make sure you understand your risk profile when considering different ETFs.
Tips for Investing
When comparing bond ETFs, it is also helpful to consider the fund management strategy being used. Passively managed funds aim to meet the market while actively managed funds try to beat the market. Actively managed bond ETFs may deliver higher returns but can also carry higher expense ratios.
Consider talking to a financial advisor about the pros and cons of ladder bonds in your portfolio. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors serving your area, and you can interview your advisor at no cost to decide which one is right for you. If you’re ready to find an advisor to help you achieve your financial goals, get started now.
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