Money Prof:
Had a member ask me to explain "laddering CDs".
Laddering CDs and BondsBy Henry K. Hebeler
It’s often hard for people to grasp the advantage of laddering certificates of deposits (CDs) or bonds. Laddering increases the returns in most cases, so it’s worthwhile to take the time to understand the principals behind laddering.
Of course, the most fundamental point is that longer maturity times of CDs or bonds have higher interest rates for the same risk. You will get much higher interest from a five-year CD than a one year CD. For example, a one-year CD might have a return of 2.5% while a five-year CD might have a return of 4.5%.
The next fundamental point is that interest rates change all of the time.
This means that if you do not wait until a CD or bond matures, you will not get the face value of the security when you sell it. If interest rates have gone up, you will get less because the current value of a fixed income security goes down when interest rates go up and vice versa. Further, if you don’t wait until the CD or bond matures, you will have a broker’s selling costs or bank penalties.
If you buy a bond mutual fund, you almost maximize your vulnerability to interest rate changes and investment costs. The principal in your account varies every day. In recent years, principal values have increased because interest rates dropped to such low values. In fact, the returns from bond funds have been greater than most stock funds, but people are now worried that interest rates will go up. This means that the value of their current and new investments in bond funds will go down.
You never lose money from interest rate changes if you buy CDs or bonds yourself instead of through a mutual fund
and if you always wait until a CD or bond matures instead of trying to sell if before its maturity date. If you knew exactly that you needed a certain sum in a particular future year, you could buy a CD or bond of just the right amount that would mature in that future year. More often, you just want part of your total investments to be in CDs or bonds to meet some allocation goal.
The best approach is to "ladder" your CDs or bonds. This means that when you first establish your portfolio, you would invest equal amounts that will mature in successive years. We’ll use an example using CDs where you would initially buy equal amounts of a one-year CD with 2.5% interest, a two-year CD with 3.0% interest, a three-year CD with 3.5% interest, and a four-year CD with 4.0% interest. The average interest rate for this case would be (2.5% + 3.0% + 3.5% + 4.0%) / 4 = 3.25%.
After one year has passed, the 2.5% CD matured, so the cash from that would go into a new CD that would mature in four years in order that one CD would still mature in each future year. If four-year CDs would still have 4.0% interest, the new average interest rate in this second year would be (3.0% + 3.5% + 4.0% + 4.0%) / 4 = 3.625%. After another year has passed, and the 3.0% CD matured, the money from that would also go into a four-year CD. So in the third year, the average interest rate would be (3.5% + 4.0% + 4.0% + 4.0%) / 4 = 3.875% if the new four-year CD rate was still 4%.
Finally, in the fourth year, the 3.5% CD would have matured and been replaced by a four-year CD so that all four CDs would now have an interest rate of 4.0%. Now, this has morphed into a great CD portfolio because one of the older four-year CDs would mature each year. It even gets better if, say, the portfolio started with bonds that varied from one-year to twenty-year maturities even though it would take twenty years to have all twenty-year bonds, each one of which would mature in successive years.
The reason that we started laddering in the first place was because we didn’t know what would happen to future interest rates. It’s tempting to keep money in very liquid money markets until interest rates go up before buying CDs or bonds. The problem is that interest rates might go either up or down. We don’t know. Using the same example, let’s see what happens if interest rates do go up so that in all subsequent years the replacement CDs have 5.0% interest instead of 4.0%.
The interest rates in the first year would still be 2.5%, 3.0%, 3.5% and 4.0%. However, in the second year, they would be 3.0%, 3.5%, 4.0% and 5.0% for an average of 3.875%. At the end of four years, the interest rates would be 5.0%, 5.0%, 5.0% and 5.0% because all of the CDs would be replaced with the new higher interest rate CDs.
Conversely, if interest rates fell to 3% in all subsequent years, the second year rates would be 3.0%, 3.5%, 4.0% and 3.0% for an average of 3.375%. At the end of four years, the interest rates would then be all 3.0% if the interest rates held at the new values.
So, by laddering, we had a portfolio rate of 3.25% in the first year and 3.625% in the second year if interest rates stayed the same. If interest rates went up 1%, the portfolio would have a rate of 3.875% in the second year. On the other hand, if interest rates dropped 1%, the portfolio rate would only drop to 3.375% in the second year.
In the short term, getting 3.25% from a ladder would be a lot better than holding money at 2.5% (or less from a money market) trying to decide what will happen to interest rates before buying the CDs. After several years have passed, the continual process of replacing the maturing CDs with long-term CDs really improves the returns and your principal is virtually guaranteed. Conversely, if you had your money in a bond mutual fund, a 1% rise in the interest rate could reduce your principal value by as much as 20%, and each year you would pay investment costs.
