Learn what are bond ladders. Learn two very cool things about investing in bonds using individual bonds and bond ladders in this episode.
Video transcript: What Are Bond Ladders?
At least two things are cool about individual bonds and bond ladders! That’s next.
If new bonds are purchased as older bonds mature, then you get a recurring, or rolling, ladder. A ladder may be comprised of any sort of bonds to effectively achieve a self-managed fund. In practice, it’s only practical for CDs and U.S. Treasuries—because you can purchase these without a transaction cost or commission.
So if you have the time and discipline, you can build your own fund—thereby avoiding the expenses of a managed fund. That would be one of two good reasons to use individual bonds rather than a bond fund. But it’s hard to beat the expense ratio of a good bond fund and we’ll talk about these in the next video.
The second good reason to own individual bonds is a little less common, but it’s worth mentioning.
Last video we introduced the concept of “duration” as a measure of a bond’s price sensitivity to a change in the interest rates. A bond fund usually maintains a relatively constant duration. But both an individual bond or CD, and a non-rolling bond ladder, has a duration that decreases over time to zero. This means they become less sensitive to interest-rate changes as they approach maturity. That makes them perfect to fund a date-certain future liability. In fact, you could continue to buy them for that target date as I’m showing here. This collection of CDs or bonds is called a non-rolling ladder.
Now it’s time for some fun. I’ll give you two facts. You choose the fact that is true.
Here’s one: Bond ladders can have lower annual expenses. (T)
The other: A bond fund is riskier than a bond ladder. (F)
A bond fund is no riskier than a bond ladder with the same duration. All bonds have interest rate risk, and a fund is just a portfolio of individual bonds. If interest rates rise, whatever kind of bond you own is instantly worth less. It doesn’t matter if you stay invested and don’t realize the loss, it is worth less from the amount of the opportunity you are losing out on if you could invest at the new higher rate—or if you’re using CDs, limited by the amount of the early withdrawal fees.
But suppose you answered the question thinking of a long-term bond fund and a short-term bond ladder? Well, then it would be riskier, and kudos to you if you recognized that. The importance of duration is one of the most important things to understand about bonds.
This is True… It is usually possible to buy CDs, or Treasury Bonds when issued, without a fee. So a rolling ladder comprised of these would be a way to create a bond fund with the lowest possible annual expense.
However, stay away from other types of individual bonds. They often come with hefty fees of a few percent that are, unfortunately, not visible to ordinary investors.(1) You’re usually better off buying a low-cost bond fund, and that’s what we will talk about next.
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Footnotes and Video Production Credits for Bond Basics 4: What is a bond ladder?
“Bonds vs. Bond Funds? An Easy Choice!” by Allan Roth, www.cbsnews.com , December 14, 2009.
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Video copyright 2009-2014 Rick Van Ness.