Bond Ladder? Yes or No? When?

There has been a lot written about bond ladders over the recent past. Unfortunately, lots of what has been written is misinformation.

The idea of a bond ladder is to buy bonds with different maturity dates in sequence; i.e., 1-year, 2-year, 3-year, etc. so that they mature at scheduled dates at their full par value. You get all the interest and the full principal back at par value. The thought is that in this way you will never lose money in bonds if rate rise (since that is when bonds decline in value).

The problem arises when you compare a bond ladder to a traditional bond fund or ETF. The comparison usually starts with the naïve view that the bond ladder didn't lose money and outperformed the bond fund/ETF over a certain rising rate environment. However, that comparison only makes sense if the maturing pieces of the bond ladder were taken out of the ladder and spent on something like an expense. In essence, you were shortening the duration of your bond investment and of course that would outperform a bond fund with a longer duration. If the bond ladder were instead reinvested in a manner similar to an equivalent bond fund at inception maintaining its target duration, the results would be exactly the same.

The only times that a bond ladder makes sense is when the interest cash flows and maturing pieces are to be used to fund some liability or expense, immunizing the liability or expense cash flows. In that case a bond fund/ETF would be inferior since you would be taking on interest rate risk when you instead needed to shorten the duration of your assets to match the duration of your liabilities/expenses.