Bonds can provide a safe way to invest and earn steady interest income over time. A bond index traded fund (ETF) offers exposure to multiple bonds with different maturity dates. Investing in a bond ladder ETF can help with diversification and can be easier than building a bond ladder yourself. Knowing how bond-scale ETFs work can help you decide if they’re right for you. It may also be a good idea to talk to a financial advisor if you’re considering incorporating bond ratings into your overall investment strategy. Finding a financial advisor is easy with SmartAsset’s free advisor matchmaker. Just answer a few questions and you’ll be matched with advisors serving your area.
What is a Bond Ladder Strategy?
A bond is a form of debt. When you invest in a bond, you allow the issuer of the bond to use your capital for a set period of time. Once the bond matures, the bond issuer returns your principal. During the term or maturity period, the issuer may make interest payments to you for the use of your money, usually on a semi-annual basis.
Bond laddering is an investment strategy that involves buying bonds with different maturities and interest rates. The idea is that by building a bond ladder, you can earn a steady stream of interest income over time. As each bond matures, you can decide whether to use your original principal to buy a new bond. This is similar to how CD laddering works.
Creating 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 varying risk/reward profiles. For example, you can include investment grade bonds, municipal bonds and/or 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 pools its holdings in bonds with different maturity dates. So, for example, a bond-weighted ETF might hold 15 investment-grade corporate bonds divided into five pools with maturity dates ranging from one to five years.
How a bond index ETF is structured can depend on the fund’s objective. Returning to the previous example, this type of laddered ETF has a relatively short-term focus as it only holds bonds with a maximum maturity of five years. The main objective may be to earn a high interest rate while preserving capital. The fact that the fund includes investment grade bonds means it carries less risk for investors overall.
The advantage of using a bond ETF ladder to invest in is that it can save you the time and effort of having to pick and choose individual bonds in a ladder. Instead, you can choose a fund that aligns with your goals and risk tolerance. For example, you can choose a bond ETF that increases high-yield bonds if you’re looking for higher yields.
How to build a bond ladder using ETFs
If you think the bond ladder approach could work for you, there are two ways to build one using ETFs. The first is to invest in target expiration ETFs. Target maturity ETFs hold a collection of bonds with the same maturity date. If you invest in target-date mutual funds, maturity-target bond ETFs work along the same lines. The maturity date or year of the bonds is usually in the name of the mutual fund.
You could choose to build your ladder with multiple maturity target ETFs representing different segments of the bond market, with different target years. Scaling bond ETFs this way gives you some flexibility and control, as you can decide what type of funds you want to invest in and what kind of maturity 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 Treasuries, then this may be your only exposure to bonds if you don’t have bonds elsewhere in your portfolio. However, if you’re also interested in municipal bonds or corporate bonds, you may need to branch out with additional ETFs.
ETF Ladder Topics
When comparing target-to-maturity ETFs and ladder ETFs for a bond ladder strategy, there are a few things to watch out for. First, you’ll want to look at the types of bonds the fund holds. Each type of bond carries a different level of default risk, based on the credit ratings of the bond’s issuer. This level of risk can determine how likely you are to lose money and what kind of returns you can expect.
Bonds issued by the Treasury Department are among the safest, as they are backed by the full faith and credit of the United States government. Junk bonds, on the other hand, have the lowest credit ratings and therefore the highest risk of default.
Also, consider potential returns, maturity terms, and how they align with your short- and long-term goals. If you’re planning to allocate a significant portion of your portfolio to bond ETFs, then it’s important to consider when that money will be accessible and how much you could expect to earn on your investments.
Finally, take a look at the expense ratios charged by different target-maturity ETFs and laddered ETFs. Expense reasons can vary from one ETF to another, and it’s important to understand what you’ll be paying to own each year. The higher the fee, the better the returns the fund must generate to justify the cost.
The bottom line
A bond-scale ETF strategy can help you add ongoing interest income to your portfolio while managing risk. You may prefer 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-weighted ETF, so make sure you understand your risk profile when considering different ETFs.
When comparing bond ETFs, it is also useful to consider the fund management strategy being implemented. Passively managed funds aim to respond to the market, while actively managed funds try to beat the market. Actively managed bond ETFs can yield higher returns, but they can also have higher expense ratios.
Consider talking to a financial advisor about the pros and cons of scaling 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 advisors at no cost to decide who is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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