What are Yield Ladders?
Yield ladders are a safe money yield enhancement technique based on the premise that yields tend to be higher as length of maturity increases. Yield ladders may be built using certificates of deposit, fixed annuities, or bonds. Laddering is designed to maximize yields without trying to guess where interest rates might go.
HOW do Yield LADDERS WORK?
Yield ladders place equal parts of the principal into the different maturities, or maturity buckets, so that you always have a part of your money available to earn new rates or meet liquidity needs.
As an example, Let’s say we have $30,000. Although a yield ladder may be for any length of time we will use a three-year period and split the money into three parts – one year, two year, three year – placing $10,000 in each segment.
We will assume the yields remain the same and are: 1 year – 2.5%, 2 year – 3.5%, 3 year – 4.5%, Now let’s see what happens over the next three years.
How to read the chart: The first column shows the years remaining until the money is liquid; the second column shows the initial maturity of the bucket, and the third shows the interest rate earned. The remaining columns multiply the money in each bucket by the interest rate earned.
We are earning 2.5% (or $250) on a maturity bucket that will be liquid in one year with an original term of one year. We are earning 3.5% (or $350) on a bucket that will be liquid in two years with an original term of two years and 4.5% (or $450) on a bucket that will be liquid in three years with an original term of three years. The total interest earned is $1,050 this is equal to 3.5% or the same rate earned on the two year maturity, and our average maturity is also two years.
At the end of the first year the 1-year ladder bucket becomes liquid. Since a year has passed the original 2-year bucket now comes due in 1 year, and the 3-year bucket comes due in 2. The fresh liquid money is placed in a new 3-year bucket, so we now have two buckets earning a 3-year rate (the original and the new one).
In the second year the yield is 4.17% ($1,250/$30,000), over half percent higher than the two year rate, but our average liquidity has stayed at two years.
At the end of the second year what originally was the 2-year rate bucket becomes liquid, all of the other buckets are one year closer to liquidity, and the fresh money is again placed in a new 3-year bucket earning the 3-year rate.
By the fifth year the average yield is 4.5%, the equivalent of the 3-year period, but the average liquidity is still two years and a third of our money is liquid in one year.
What Has HappenedBy using laddering we are earning the equivalent of 3-year rates on all of our money even though the average liquidity wait has stayed at 2 years. The power of laddering is it permits you to get the higher yields associated with longer terms, while maintaining your liquidity.
Rising Rate EnvironmentBut what happens if rates go up? There is a tendency for individuals to not use laddering because of fears they will lock in today’s rates when tomorrow’s rates may be higher. However, laddering can still provide an advantage because longer terms may offset most or all the increase.
Yield Ladders WorkYield ladders work when higher yields are paid as maturity lengthens. They work very well in stable interest rate environments and falling ones.
Yield ladders do not work as well when rates are steadily rising, but they reduce volatility of interest income. Many people sacrifice yield by keeping money in short maturity instruments because they don’t want to miss out if rates rise. A yield ladder means you always have money coming due that will earn the new rate, and you will be able to take advantage of any yield curve benefits of the longer rate term. Even though I used a three year timetable with three annual buckets a yield ladder may be any length and have any number of maturity buckets. The key to success is having the discipline to keep the ladder going.
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