What it means
Suppose you have $100,000 to invest in bonds or fixed-term deposits. You could put it all into a single five-year bond, but then you cannot touch it for five years, and you would be locked into one interest rate.
With laddering, you split the money into five equal parts maturing in one, two, three, four and five years. Each year, one rung matures and you receive cash.
If you need the money, you can spend it, and if not, you reinvest it for a new five-year term at the top of the ladder. After a few years, every rung is a five-year investment, but one of them matures every year.
The strategy helps manage interest rate risk (the risk that rates move against you). If rates rise, you can reinvest the maturing rung at the higher rate, and if rates fall, you still hold older rungs that pay the higher rate.
You never have to guess where rates are heading, because you are always buying a little at each point. Laddering also helps with liquidity (how easily you can get cash).
Companies use it for treasury cash, charities for reserve funds and retirees for income planning. The cash flows arrive on predictable dates, so they can be matched to known payments such as tax bills, loan repayments or pension drawdowns.
The strategy is not free of risk or cost. Bonds still carry credit risk (the chance an issuer cannot pay), and ladders may earn less than the best-performing single maturity.
A different meaning of the word appears in securities markets, where laddering is also the name of an illegal practice in which buyers of a new share issue are pressed to place extra orders at higher prices afterwards. A simple variation is the barbell, where money is split between very short and very long maturities with nothing in the middle.
Another is the bullet, where all the investments mature around one target date, for example when a known payment is due. Ladders are popular because they are easier to run than either, needing only a calendar and a rule for reinvesting each maturing rung.
In practice
Real-world examples.
Example
A retired couple in Spain build a ladder of five bank deposits so that one matures every year to supplement their pension. When rates rise, they reinvest the maturing deposit at the better rate. They also keep a simple spreadsheet of the maturity dates.
Example
A manufacturing company keeps $2 million of surplus cash in a ladder of government bonds maturing every quarter for a year. The treasurer lines the maturities up with quarterly tax payments. The ladder reduces the need to sell any asset at short notice.
Example
A university endowment holds a ladder of bonds to fund scholarships over the next ten years. Each year, a maturing bond pays that year's scholarship budget, and the remainder is reinvested. A rolling ladder keeps the scholarship budget steady for a decade.
Formula
Calculation
Amount per rung = total investment / number of rungs
Annual interest = sum of (rung amount x rung interest rate)
Worked example: a company invests $100,000 across five rungs of one to five years, with interest rates of 3%, 3.5%, 4%, 4.5% and 5% respectively.
Step 1: Amount per rung = 100,000 / 5 = $20,000.
Step 2: Interest on each rung = $600 (20,000 x 3%), $700 (20,000 x 3.5%), $800 (20,000 x 4%), $900 (20,000 x 4.5%) and $1,000 (20,000 x 5%).
Step 3: Total annual interest = 600 + 700 + 800 + 900 + 1,000 = $4,000.
The average yield is 4,000 / 100,000 = 4.0% a year, and $20,000 becomes available every year without selling anything early.Case study
Seen in the real world.
Greenfield Community Trust is a fictional charity with $500,000 of reserves, which it had kept in a single savings account earning a low rate. The finance officer worried about locking everything into long-term bonds, in case an emergency required cash.
She built a five-rung ladder with $100,000 maturing each year from one to five years. The shortest rung gave her a ready source of money, and the longer rungs earned higher interest.
In this illustrative story, interest rates rose in the second year, and the maturing rung was reinvested at a higher rate. Overall income rose steadily over three years, and the trustees valued the predictability. The ladder did not beat every alternative, but it removed the pressure to time the market. The trust now reviews the ladder each year at its annual meeting.
Watch out
Common mistakes.
- Building a ladder with only one issuer, which concentrates credit risk even though the maturities are spread out.
- Assuming a ladder guarantees the best return, when it is designed to balance access to cash against income.
- Forgetting to reinvest the maturing rung, which leaves the ladder shrinking each year.
Questions
People also ask.
How many rungs should a ladder have?
Most ladders have between three and ten rungs, depending on the amount invested and how often you want cash to become available.
Can I ladder things other than bonds?
Yes, fixed-term deposits, certificates of deposit and even annuities can be laddered in the same way.
Is laddering the same as diversification?
Partly, because it diversifies across maturity dates, but it does not diversify across issuers or asset types unless you also spread those.
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