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Bond investing is one reason investors seek the help of a financial professional. Learn how SmartAsset can help you find clients looking for advice.
Bonds can offer a relatively safe way to invest and earn consistent interest income over time. A bond ladder exchange-traded fund (ETF) offers exposure to multiple bonds with varying maturity dates. Investing in a bond ladder ETF can help with diversification and it 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 also may be a good idea to speak with a financial advisor if you’re thinking about incorporating bond ladders into your overall investment strategy.
How a bond ladder strategy works
A bond is a form of debt. When you invest in a bond, you’re allowing the bond issuer the user of your capital for a set time period. Once 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 the use of your money, typically on a semiannual basis.
Bond laddering is an investment strategy that involves purchasing bonds with different maturity terms and interest rates. The idea is that by creating a ladder of bonds, you can earn a continuous 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 CD laddering works.
Building a bond ladder can help with managing 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 varying risk/reward profiles. For example, you might include investment-grade bonds, municipal bonds and junk or high-yield bonds in a bond ladder strategy.
What Is a laddered 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 a single basket. A laddered ETF concentrates its holdings on bonds with varying maturity dates. So, for example, a bond-laddered ETF might hold 15 investment-grade corporate bonds divided into five groups with maturity dates ranging from one to five years.
The way a bond ladder ETF is structured can depend on the fund’s objective. Going back to the previous example, this type of laddered ETF has a relatively short-term focus, since it only holds bonds with a maximum maturity term of five years. The main objective may be earning a high rate of interest while preserving capital. The fact that the fund includes investment-grade bonds means it carries less risk to investors overall.
The advantage of using a bond ladder ETF to invest is that it can save you the time and effort of having to pick and choose individual bonds to ladder. Instead, you can select a fund that aligns with your goals and risk tolerance. For example, you might choose a bond ETF that ladders high-yield bonds if you’re looking for higher returns.
How to build a bond ladder using ETFs
If you think the bond laddering approach could 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, target-maturity bond ETFs work along the same lines. The date or year that the bonds will maturity is typically in the name of the fund.
You could choose to build your ladder with multiple target-maturity ETFs representing different segments of the bond market, with different target years. Laddering bond ETFs this way gives you some flexibility and control since you can decide which type of funds you want to invest in and what kind of maturity term you’re looking for.
If you’re interested in laddering bonds but don’t want to choose individual ETFs, you can invest in a single bond ladder ETF. If you invest in a laddered ETF that holds Treasury securities, then that might be your only bond exposure if you don’t own bonds elsewhere in your portfolio. However, if you’re also interested in municipal bonds or corporate bonds then you might need to branch out with additional ETFs.
What to consider when building a bond ladder ETF
When comparing target-maturity ETFs and laddered ETFs for a bond laddering strategy, there are a few things to pay attention to. First, you’ll want to look at what types of bonds the fund holds. Each type of bond carries a different default risk level, based on the credit ratings of the bond issuer. This risk level can determine how likely you are to lose money and what type of returns you can expect to see.
Bonds issued by the Treasury are among the safest since they’re backed by the full faith and credit of the U.S. government. Junk bonds, on the other hand, have the lowest credit ratings and therefore, the highest risk of default.
Also, consider the potential returns, maturity terms and how they align with your short and long-term goals. If you’re planning to allocate a sizable portion of your portfolio to bond ETFs, then it’s important to consider when that money will be accessible to you and how much you could expect to earn from your investments.
Finally, take a look at the expense ratios that different target-maturity ETFs and laddered ETFs charge. Expense ratios can vary from one ETF to another and it’s important to understand what you’ll pay to own each one year to year. The higher the fee, the better the returns the fund needs to produce to justify the cost.
A bond ladder ETF strategy can help you add continuous 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 choosing 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.
Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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