Laddering reminds most people of a strategy often used when owning multiple CDs. Back when interest rates made them worthwhile, if you were trying to arrange cash flow, you could stagger the maturity dates of your CDs so you always had one maturing in the near term. Longer-term CDs had better rates, but they tied up your money; laddering mitigated that problem.
For example, if you had $500,000 to invest and a five-year CD was paying 6%, you could count on $30,000 in income each year. But what if you needed money before the maturity date? You could build a ladder, buying five $100,000 CDs, with one maturing each year. Sure, the CDs you initially bought in the short term would have slightly lower rates, but as each one matured, you could replace it with a five-year CD.
Once your ladder was complete, you could expect $30,000 in interest income, plus another $100,000 in liquidity each year. While constant cash flow was the main reason for doing this, laddering is a tool that has many more uses—most notably, inflation protection.
Suppose an investor bought a five-year, $100,000 CD paying 6% on January 1, 1977. The table below shows the inflation rates during the five-year period that followed.
Assuming this investor-taxpayer was in the 25% tax bracket, even if he’d reinvested his interest, he would have had a 25.9% net loss of buying power due to high inflation, as illustrated in the chart below.
By using a CD ladder, he could have mitigated some of his inflation risk. At the end of each year from 1977-1981, an investor who laddered could have rolled over a CD at the prevailing interest rate. By the end of 1981, he could have had five CDs paying rates much higher than 6%.
One note of caution: at one time, most CDs were non-callable, meaning that both the lender (us) and the bank were committed for whatever period the CD specified. Then banks started issuing callable CDs, meaning they could pay off their debt at any point during the period.
The same feature applies to bonds. If you lend money to someone and agree to callable terms, they have protection if interest rates go down. If interest rates rise, there’s a good chance you’re losing out because of inflation. Given a choice, I would take a slightly lower interest rate for a non-callable bond or CD.
The above chart tracks the interest rates for the 10-year Treasury. As you can see, overall interest rates have dropped. CDs and other fixed-income products have followed that same track. However, the trend has started to reverse, and we must protect ourselves.