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Bond Laddering
The Laddering Strategy is designed to help investors maintain a reasonable level of liquidity using a variety of bond maturities while attempting to attain a higher overall yield using higher yield, longer term, Church Bonds. This strategy is no guarantee an investor will always obtain higher yields or achieve certain levels of liquidity or a perfect combination of the two, but it is a very useful tool for developing a Church Bond portfolio and should be seriously considered.
The parameters in the examples primarily focus on portfolio liquidity versus the average yearly interest rate of a Laddered portfolio. The term "liquidity" used in Bond Laddering does not refer to selling Church Bonds for cash prior to their stated maturity. Instead, "liquidity" means that a one-year bond is viewed as more liquid than a five-year bond; a five-year bond is viewed as more liquid than a ten-year bond and so on. As in any strategy or investment, there are numerous other factors investors should consider. The examples below illustrate the Bond Ladder Strategy.
Let's assume John Doe wants to create a $30,000 Church Bond portfolio using Laddering.
The strategy stipulates John should evenly apportion his $30,000 into equal segments. In this example, the $30,000 will be apportioned in 6 segments totaling $5,000 each. The first $5,000 segment will be invested in bonds having a maturity of 4 years. The second $5,000 will be invested in bonds having a maturity of 8 years. The third $5,000 will be invested in 12-year maturities and so on until the entire $30,000 is evenly invested at four year intervals over a 24-year period. Prior to beginning this strategy, investors should define their own parameters that are consistent with their investment goals and liquidity needs.
The interest rates for each of the maturities below are actual as of September 17, 2009. We will endeavor to keep these updated as market conditions dictate. Applying the parameters previously described above to construct John's Laddered portfolio, it would look like this:
$5,000 @ 4 years: 6.25%
$5,000 @ 8 years: 7.00%
$5,000 @ 12 years: 7.75%
$5,000 @ 16 years: 7.75%
$5,000 @ 20 years: 7.75%
$5,000 @ 24 years: 8.00%
The sum by adding each of the interest rates above totals 44.5% then, dividing by 6 (since the portfolio was evenly distributed into six $5,000 increments) would provide an average interest rate of 7.42% for the portfolio.
Compared to investing the entire $30,000 in 4-year, 6.25% bonds, John is able to increase the interest rate of his Laddered portfolio by 18.72% to 7.42%. (1.17% ÷ 6.25% = 18.72%) Although John has reduced the liquidity of his $30,000 investment, one-sixth or $5,000 of his portfolio is still never more than 4 years away from maturing. However, had John invested the entire amount strictly in 4-year maturities in order to maintain a higher level of liquidity, the "cost of liquidity" would be $30,000 x 1.17% or $351 per year. (The average Laddered interest rate of 7.42% minus the interest rate of 6.25% paid by the more liquid 4-year bonds equals 1.17%.)
Four years later, John receives $5,000 as a result of his 4-year bonds maturing. What if John wants to reinvest this $5,000 to maintain his Laddered portfolio? The strategy dictates the $5,000 be reinvested in bonds maturing in 24 years, due to the simple fact the bonds remaining in his portfolio have four years less time remaining until maturity.
Prior to reinvesting his $5,000 cash, his Laddered portfolio looks like this:
$5,000 @ 4 years 7.00%
$5,000 @ 8 years 7.75%
$5,000 @ 12 years 7.75%
$5,000 @ 16 years 7.75%
$5,000 @ 20 years 8.00%
Due to Laddering, the average annual interest rate of the remaining $25,000 portfolio increases from the original 7.5% to 7.65%! (38.25% ÷ 5 = 7.65%)
What if interest rates have increased when John reinvests?
Assuming Church Bond interest rates covering all maturities increased a full 1% during the last four years. A 24-year maturity Church Bond pays an interest rate of 9%. Consistently appling the Laddering Strategy, John reinvests the $5,000 received from his matured 4-year bond into a 24-year, 9% bond. His portfolio now looks like this:
$5,000 @ 4 years 7.00%
$5,000 @ 8 years 7.75%
$5,000 @ 12 years 7.75%
$5,000 @ 16 years 7.75%
$5,000 @ 20 years 8.00%
$5,000 @ 24 years 9.00%
After the reinvestment, John's Laddered portfolio average interest rate increases to 8% (47.25% ÷ 6 = 7.875%), but continues to maintain the same liquidity level as before with one-sixth of his portfolio never being more than 4 years away from maturing.
In comparison, if John insists on maintaining a higher level of liquidity on the entire $30,000 as he had done before, he would reinvest the entire amount in 4-year bonds currently paying 7.25%. By maintaining this higher level of liquidity, John sacrifices the difference of the higher average "Laddered" interest rate of 7.875% versus the more liquid interest rate of 7.25%. The "cost of liquidity" for John to maintain this higher level of liquidity is .625% x $30,000 or $187.50 per year. (The average Laddered interest rate of 7.875% minus the interest rate of 7.25% paid by the more liquid 4-year bonds equals .625%.)
What if interest rates are lower when John reinvests?
In comparison to higher rates, assume Church Bond interest rates covering all maturities have dropped a full 1% during the last four years. A 24-year maturity bond now pays an interest rate of 7% instead of 8%. Again, consistently applying Laddering, John reinvests his $5,000 received from his matured 4-year, 6.25% bond into the 7% bond maturing in 24 years. His portfolio now looks like this:
4 years 7.00%
8 years 7.75%
12 years 7.75%
16 years 7.75%
20 years 8.00%
24 years 7.00%
After the reinvestment, John's Laddered portfolio average interest rate decreases to 7.66% (45.25% ÷ 6 = 7.54%), but continues to maintain the same liquidity level with one-sixth of his portfolio never being more than four years away from maturing. (Please note the current, Laddered portfolio average interest rate of 7.54% is still higher than the initial Laddered average rate of 7.42% four years earlier even though rates have fallen!)
In comparison, if John insists in maintaining the higher level of liquidity on the entire $30,000 as before, he would reinvest the entire amount in 4-year bonds currently paying 5.25%. By maintaining this higher level of liquidity, John sacrifices the difference of the higher average "Laddered" interest rate of 7.54% versus the more liquid interest rate of 5.25%. The "cost of liquidity" for John to maintain the higher level of liquidity is 2.29% or $687 per year! (The average Laddered interest rate of 7.54% minus the interest rate of 5.25% paid by the more liquid 4-year bonds equals 2.29%.)
What if there are no bonds available at the maturity date John needs for reinvestment?
There is always a risk that bonds may not be available at the desired maturity. The remarkable thing about the Laddering Strategy is that it is flexible and can usually accomodate the curves the market often throws. Since Church Bond offerings are continuously being underwritten and offered, John could place his $5,000 in a money market account until the next bond offering becomes available or some other suitable Church Bond offering.
There are other considerations investors should take into account. Churches may pre-pay part or all of their bonds PRIOR to maturity which is termed a "bond call". Although partial or full bond calls can occur at any time, they are most prevalent during times where interest rates have fallen significantly. There is no guarantee the Laddering Strategy will perform as expected or insure against loss. Our licensed agents are available to discuss and explain risks and other considerations.
Church bonds contain risks. Church revenues come primarily from member charitable contributions. In the event of a loss of membership or other factors, there is no assurance sufficient funds will be available to pay investors. The real estate collateral may not be sold in an amount sufficient to fully repay investors in the event of a church's financial failure. For other risks to consider, please see "Risks" under "Church Bonds" on this website.
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