What is laddering?

Maturity period of a financial product can be defined as the date on which the principal repayment of the instrument becomes due and the interest that is generally paid on a regular basis over the instrument’s life ceases. It is always an important decision to compare the maturity periods of different financial instruments before an investment decision is made.

Laddering is an investment technique with a simple premise, this aims at investing in similar financial products such as bonds but with different maturity dates.

Explanation

The benefit of Laddering can be understood in the sense that it avoids the risk of reinvesting a large chunk of assets in an unfavorable financial environment. Each rung of the ladder can be seen as a bond with specific maturity date, on the other hand, the height of the ladder defines the difference between the longest and shortest maturity bond. The more the rungs, the more diversified is your portfolio.

An example to understand this better:

Suppose a person has both a 2021 maturing Certificate of Deposit (CD) and a 2025 maturing CD. Even if the interest rate is low in 2021 when one certificate is to be renewed, half of the income is locked in until 2025. This enables an investor to reduce his/her interest rate risk.

Therefore, if you plan on investing $60,000 in a bond with a 3 year maturity, it is advisable to rather invest $20,000 each into 3 bonds with maturity of 1, 2 and 3 years. This may not guarantee higher returns but will surely help you diversify your portfolio and reduce risk over the years.

The practice of laddering can help investors manage reinvestment risk because as one bond on the ladder matures, the cash is reinvested in the nearest bond on the ladder.

This type of investment system is often seen to be used specifically by people planning for their retirements.

Advantages of Bond Laddering

• Bond laddering strategy can offer higher average yield, because generally, the bonds with higher maturity offer higher yields. The strategy helps you invest in both long-term and short-term bonds, you benefit from higher yields of long-term bonds and liquidity of short-term bonds.
• An investor can structure a bond ladder as per their own financial situation.  
• Laddering helps you protect your investment to some extent, from changes in the interest rates and you manage to receive a more consistent yield on your investment
• As explained above Bond laddering can help reduce your reinvestment risk.
• It adds diversification to your portfolio. You invest in bonds with different maturities, different issuers, different ratings.
• It gives an investor liquidity as you have investments maturing at regular intervals.

Disadvantages of Bond Laddering

• In case of decline in the interest rates, investors may lose upon capital gain opportunities as they have to hold upon the bonds up until the maturity date.
• In a bond ladder, you may end up reinvesting your money at lower interest rates.
• Bonds are always prone to default risks, therefore it is important to choose from high quality bonds only.
• Since the strategy plans for you to hold the bond until maturity, you may be unprepared for any emergency that may strike and this may lead you to sell the bonds at a loss even if the interest rates are rising.
• If you work with a broker to set up a bond ladder, the laddering may become expensive due to commissions, i.e., the transaction cost of purchasing multiple bonds compared to one large bond.

Overall bond laddering is a good enough strategy that can help you boost your returns while reducing your level of risk.

IPO Laddering

Laddering in initial public offerings (IPOs) refers to a practice whereby the allocating underwriter requires its customers to buy additional shares of the issuer in the aftermarket as a condition for receiving shares at the offer price.

It is evident from past experiences and incidents that laddering could be more aggressive in IPOs. Secondly, profit-sharing agreements between the underwriters and their investor clients encourages laddering. It helps to increase the IPO offer price, and it contributes to long-run underperformance and negative correlation between short-run and long-run returns.

The customers who enter into a laddering agreement, also known as a tie-in agreement, are called “ladderers.” The Securities and Exchange Commission SEC) views laddering as a manipulative sales practice prohibited by Rule 101 of Regulation M under the Securities Exchange Act of 1934.

Some such examples of IPOs in which laddering occurred are given in the January 25, 2005 SEC settlement with Morgan Stanley and Goldman Sachs, in which the underwriters agreed to pay a total of $80 million to settle accusations of laddering, and the October 1, 2003 SEC settlement with J.P. Morgan Securities Inc., in which the underwriter agreed to pay a $25 million civil penalty. All such incidents forced SEC to come up with stricter rules to prohibit IPO laddering.