Laddering

What is Laddering?

In the finance world, laddering is used in several ways, based on the Industry. The most common uses of laddering are associated with the underwriting of newer security issues and Retirement planning.

As mentioned above, the most common uses of laddering can be found in retirement planning where it is referred to purchasing several financial products of the similar type, such as Certificates of Deposit (CDs) or Bonds, each of them with varying maturity periods.

By spreading the investors around multiple maturities, investors get to decrease their reinvestment risks and interest rates. The laddering practice helps investors Handle reinvestment risk as one bond present on the ladder matures, the cash gets reinvested in the nearest bond available on the ladder.

Likewise, this practice can also decrease interest rate risk, considering that in case rates decrease during the period of holding of one of the bonds, the small reinvestment amount alleviates the risk of Investing a lot of amount at a lower return.

The term “laddering” can also be used in association with Initial Public Offerings (IPOs) underwriting. Here, it is referred to an illegal practice wherein the underwriter provide a below-Market price to investors before the IPO is executed if the same investors affirm to buying shares at a high price after the IPO gets completed.

Example of Laddering

Let’s understand more with laddering example here. Suppose there is a diligent investor, named ABC, who is saving for his retirement. At the age of 55 years, he managed to save around Rs. 800,000 in his combined retirement assets, slowly shifting them toward a lesser volatile investment.

Currently, ABC has invested Rs. 500,000 of assets in different bonds, which he has combined carefully, or laddered, to decrease his interest rate and reinvestment risks. Primarily, ABC’s bond Portfolio comprises the following investments:

• Rs. 100,000 in a bond with a mature period of 1 year
• Rs. 100,000 in a bond with a mature period of 2 years
• Rs. 100,000 in a bond with a mature period of 3 years
• Rs. 100,000 in a bond with a mature period of 4 years
• Rs. 100,000 in a bond with a mature period of 5 years

Every year, the investor takes money from a bond that matures and reinvests the same in a bond that will mature in five years. With this, he makes sure that he is exposed to interest risk of one year at a given time.