Better With Age? What Wine and Bonds Have in Common

Written by Regan Ray

Wine connoisseurs who want the perfectly aged bottle every year for a special occasion like a birthday or an anniversary might buy wines with staggered harvest dates. For example, if you believe a Malbec or Merlot benefits from 10 years in the cellar, you could buy bottles from different harvests to spread out the aged-grape perfection over the years.

By buying a bottle from each successive year it's produced, you'd be able to drink a bottle that's aged a decade every year on your milestone occasion.

What does wine have to do with bonds, you ask? Perhaps not a lot directly, but we can draw some parallels to an investing strategy known as bond laddering, which also accounts for "aging," only in the form of different bond maturing dates.

The overarching goal with bond laddering is to allow investors to benefit from potential increases in interest rates because they would be able to reinvest the maturing portion of their portfolio at new market rates.

Building a true bond ladder from scratch can be complex. However, we'll go over some of the basics to give you a bit of insight into the concept.

What is a bond ladder?

Bond laddering involves buying a portfolio of bonds that mature at different times. For example, with a three-year bond ladder, each bond on the ladder would mature in a different year, with the longest-term bond coming due in three years. When the first, shortest-term bond matures, an investor could reinvest the money in another three-year bond to keep the ladder going. If interest rates have changed, the new bond would be bought at the new interest rate. Typically, the bonds within a ladder are equally weighted and reach maturity dates at regular intervals — annually, for example.

Traditional bond laddering involves buying individual bonds. It's largely considered the most complex way to ladder, can be research-intensive and would generally require larger initial investments. A laddering strategy can also encompass managed products such as exchange-traded funds (ETFs), mutual funds and/or bundled guaranteed investment certificates (GICs). Find out more in What is an ETF? and What is a Mutual Fund?

Like all investing strategies, there can be benefits and drawbacks. Here are a few considerations:

Benefits of Laddering

• Diversification. By buying multiple bonds from different issuers with different maturity dates, a portfolio could be better diversified than one owning a larger investment in a single bond.
• Predictable income. The interest payments from multiple bonds in a ladder could provide investors with a steady source of income.
• Mitigate interest-rate risk. Accurately forecasting interest-rate trends is impossible. Owning bonds with both shorter- and longer-term maturity dates means you're spreading out the risk related to interest rates.
• Cash-Flow Management. Generally, with a custom-built bond ladder, when a bond matures you can choose to reinvest the proceeds or keep the cash. This means there's some flexibility with cash flow, if required. (Note: Managed laddering strategies such as ETFs or mutual funds would be bought and sold in shares or units of the fund itself at any time.)

Potential Drawbacks

There are a few key drawbacks to keep in mind with laddering strategies.

• Amounts needed to diversify. In order to adequately diversify within a custom-built bond ladder, an investor would need a number of separate bond investments — and many bonds have minimum investment requirements of $1,000 or more.
• Default risk. As with any bonds, there is a risk of the issuer defaulting on the interest-payment agreement. This risk is higher for any lower-grade bonds held.
• Costs. In a custom-built bond ladder, commissions for buying bonds in the retail market can add up. With a managed laddered option (ETF or mutual fund, for example), considerations include set management fees and management expense ratios, plus any trading or advisory costs.

As with tasting, buying and aging wine, fixed-income investing is an entirely personal endeavour. It's important to know your goals — a glass of 10-year aged Merlot on your 50th birthday or access to the proceeds of a $1,000 bond in two years — and work toward them with purpose.