Many investors prefer to have a fixed income but often have to deal with fluctuating interest rates. In India, we are now seeing a slow rise in interest rates. However, in the last few years, the interest rates had been low. Such movements can prove challenging for investors who are dependent on a fixed income from their investments. To deal with this, an easy and effective approach is to opt for laddering of investment. This technique helps in enhancing investment returns and avoiding significant losses due to interest rate fluctuations.
Here, we will talk about the laddering strategy in detail and explain how it is done.
What is laddering of investments?
A laddered investment involves dividing total investment into portions such that the maturity dates of all portions are staggered. This way, each portion of the portfolio will mature at regular intervals and investors can generate a regular income flow.
Every step of the ladder represents a different maturity date. The more steps in the ladder, the lower will be the overall risk of interest rate fluctuations. This strategy, therefore, aims at enhancing a portfolio’s average yields. Laddering helps investors earn higher interest rates through long-term investments while still enjoying some liquidity.
Laddering is primarily used in bond investments since investors can look for varying bond maturities. An investor can invest in bonds that may mature in one year and also in those that have maturity after ten years or more.
How does laddering work
Suppose you want to invest Rs. 5 lakhs in fixed income instruments for overall portfolio diversification. Instead of allocating the entire amount in a single bond category, you can invest Rs. 1 lakh in bonds with a maturity of one year. Another Rs. 2 lakhs can be invested in bonds with a maturity of 3 years and the remaining can go in bonds that are maturing in 5-10 years. Since each will offer a different yield and varying maturities, you can get a better average yield on the portfolio across different timelines.
Also, as soon as the 1-year bond reaches maturity, you use the amount to invest in a new bond. Similarly, after the 3rd year, as the investment matures, you can purchase a new 3-year bond. This way, most of all the bonds you invest in will be earning higher rates as you churn the capital. As an added benefit, you also get easier access to some of your principal investment as the bonds mature in the process.
Did you know
You can also use the laddering strategy for FD investments. Divide the investment amount into smaller FDs and book them in intervals of 3-5 years. With a longer gap between the first and last FD, you can enhance your income from FDs and minimise the impact of RBI’s rate cuts.
Benefits of laddering investments
The table below talks about the benefits of this strategy:
| Avoid timing rate movements | With a laddered investment, in FDs or bonds, you need not speculate on interest rate movements to book your investment. While you may not book FDs or bonds at the highest rate, you can still be secured against lower rates for your entire portfolio. |
| Avail best interest rates | Since interest rates keep changing across tenures, it is difficult to say whether short-term or long-term investments will fetch the best returns. With a laddering technique, you can divide a big investment into several small bonds or FDs to benefit from different interest rates. |
| Enhanced liquidity | A ladder strategy improves portfolio liquidity. For instance, an FD booked for a longer tenure may not allow you to easily access the funds in an emergency. With a ladder approach, the amount gets divided across maturities and allows redemption at different points. |
Conclusion
An investor can use the laddering approach by spreading the investment across different FDs or bonds. For it to work appropriately, this strategy has to be aligned with individual financial goals, personal risk appetite, income levels and liquidity needs. This way, one can lower the overall risk factor related to interest rate movements while still achieving expected returns.
FAQs
Laddering strategy mostly works in fixed income investment avenues such as fixed deposits or bonds since these involve interest rates that may fluctuate over time.
Yes, laddering strategy essentially protects investments against falling interest rates while maximising the benefits of rising interest rates in the long run.
Laddering strategy mostly works in the long run by taming the ever-changing interest rates. If interest rates rise in the long run, one can maximise profits and if they fall, an investor can minimise losses.
If interest rates go down, there are chances of generating lower profits from fixed deposit investments. In such cases, a laddering strategy can help protect against falling profits or losses by constantly churning the investment using different maturities.
