The Mentor Journal
Portfolio Management
How to Build and Manage a Bond Ladder
Businessmen building a ladder, concept of building a bond ladder
By Chris Nelson
June 26, 2023
Reading Time: 6 minutes

Table of Contents

Over the past couple of months, I’ve been having more conversations with community bankers about liquidity and how to manage it.  An essential part of any solid liquidity management plan is having an investment portfolio that plays its role in the process.  This is especially crucial when unforeseen challenges arise, or market conditions become more volatile.

Two Ways to Generate Investment Liquidity

There are two primary ways that the investment portfolio can be a source of liquidity for financial institutions:

Option #1: Sell Them – Selling securities to generate cash is the way that is typically most thought of when planning how to manage a bank’s or credit union’s liquidity position.  Unfortunately, that’s easier said than done these days because of the unrealized losses hanging over community bankers’ heads.  Let’s face it – nobody is thrilled about possibly realizing potentially sizable losses when trying to raise liquidity.

Option #2: The Investment Liquidity “Secret Weapon” – Fortunately, there is a way to create a source of liquidity that doesn’t involve having to sell anything.  That’s through managing the investment portfolio’s cash flow.  I consider investment cash flow the secret weapon for effective liquidity management when it comes to an institution’s investment portfolio, and it’s one of the things I focus on when I’m working with my clients.

Managing Investment Cash Flow with Bond Ladders

There are several ways to manage cash flow in the investment portfolio.  One that I’ve been getting more questions about recently is using a bond ladder.  Bond ladders are a great strategy and can be an important part of your investment liquidity management efforts.

A bond ladder is a way of structuring the bond portion of the investment portfolio so that the holdings have staggered maturities.  Basically, you stretch your investment dollars out over several years, evenly spaced like the rungs on a ladder (which is where its name comes from).

Here is a simple example of what a bond ladder might look like:

Chart showing an example of a bond ladder

Because the maturities are spaced this way, the portfolio’s principal cash flows occur at more regular and periodic intervals as bonds mature.  The benefit is that you have access to a source of liquidity without having to sell securities!

If you need the cash to fund loan growth or offset deposit runoff, it’s ready for you.  If not, you can reinvest the runoff into new bond investments in the ladder.

How to Establish a Bond Ladder Strategy

So how do you go about building a bond ladder?  Let me share with you six steps to creating one in the portfolio.

Step #1: Determine Bond Allocation

The first step is to decide what portion of the portfolio will be allocated to bonds.  For some investors, it may represent the whole portfolio.  Others may blend in additional investments like mortgage-backed securities, which are also great for cash flow given their monthly principal payments.

Step #2: Design the Ladder Structure

Once you know the total dollar amount for the bond ladder allocation, it’s time to establish the various maturity buckets representing the “rungs” on the ladder.  For example, you’d have a one-year bucket, a two-year bucket, and so on.

One question I am asked frequently is, “What is the maximum maturity I should use when setting up a bond ladder?”  In other words, how many maturity buckets should you have? 

The short answer is, “It depends.”  It depends on several factors driven by your balance sheet, its risks, your policies, and even the market you’re in.

  • For example, your ALM model and related interest rate risk exposure can provide clues.  If your institution is asset-sensitive (meaning assets reprice faster when interest rates change), you could consider building a longer bond ladder than an institution with liability sensitivity (meaning liabilities reprice faster when interest rates change).
  • The existing liquidity position is also a factor.  A bank with a lower loan-to-deposit ratio could consider building a longer bond ladder.  Other liquidity factors include your net cash or borrowing position (net borrowers are more likely to need a shorter ladder) or the degree to which you have potentially higher loan demand or large deposit withdrawals (also considerations for a shorter bond ladder).
  • You’d also want to consider credit and capital risk exposures.  If your bank or credit union has a lower level of loan charge-offs and healthier capital buffers, you could consider creating a longer bond ladder.
  • Market factors should also be considered, including competition from other institutions and customer deposit rate sensitivity.  More competition and higher customer sensitivity generally mean building a shorter bond ladder. (Side note:  You may already know this, but revisiting any assumptions regarding depositor rate sensitivity is critical.  That sensitivity is potentially higher in this environment than we’ve seen in quite some time.)
  • The last factor is one that sits above the rest – your institution’s risk appetite, or what I call its “comfort zone.”  It doesn’t matter what the numbers say – if your institution isn’t ever going to be comfortable investing in longer maturities (even if you have room to do so), then don’t do it.  It might mean you earn a slightly lower yield, but that’s the trade-off for peace of mind. 

As you review these different factors, they’ll help shape how long your bond ladder could be.  It might turn out that your ladder will only extend out a few years, such as 3-5 years, or perhaps you have the room to consider a longer ladder structure with maturities in 7-10 years.  The final decision will depend on the situation at your institution.

Step #3: Divide the Funds Evenly in the Ladder

Once you know how many maturity buckets or “ladder rungs” you have to work with, it’s time to divide the dollars evenly into each bucket.  Generally, you would allocate the same dollar amount for each maturity term that makes up the bond ladder structure.

For instance, let’s assume a community financial institution is building a $90 million bond ladder with a maximum maturity of six years.  Dividing the cash equally results in $15 million allocated each year in the ladder.

Is it okay to have more cash in a given year than the target level?  Sure, but you want to be careful not to load up or overfill a bucket with substantially more dollars than is needed.  While adding a little extra to a given year in the bond ladder may be alright, you want to avoid creating a wall of cash flow in one or two years that undoes the ladder’s purpose.

Step #4: Select Suitable Securities

Once you know how much will be allocated per year in the bond ladder, you’ll want to decide on the types of fixed-income securities to use.  There are several investment types to consider, including Treasuries, agency bonds, municipal bonds, or commercial mortgage-backed securities.  At this point, you’ll also want to consider market conditions to determine where the best yield and spread opportunities exist. 

Important! – You’ll want to be careful of using highly callable securities or bonds callable at a time that is materially different from the final maturity.  Bonds with call options can upset the cash flow you’re trying to build in a bond ladder, with bonds maturing sooner or later than you’d planned. 

Step #5: Monitor and Adjust

The last step is monitoring the bond ladder, adjusting for changes within the portfolio and your institution’s balance sheet.  As we’ve all seen in the past few years, nothing stays the same, and changing conditions may warrant you revisiting the assumptions you initially used to build the ladder. 

A Valuable Tool in the Portfolio Management Toolbox

A well-structured bond ladder can serve as a valuable tool for managing liquidity within an investment portfolio.  By diversifying maturities and strategically spacing cash flows, community financial institutions can access steady cash flow and liquidity without having to sell securities, providing a source of support for loan growth or deposit runoff.

By tailoring the bond ladder to align with the institution’s balance sheet, risk exposures, and market factors, a community banker can create an effective risk management tool and help the institution navigate challenging conditions when they arise.

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