Wealthfront’s Automated Bond Ladder: Taking the hard work out of buying Treasurys

A bond ladder is one way that investors can generate stable income over time and reduce risk, but it’s been cumbersome to research bonds and actually build the ladder. Now robo-advisor Wealthfront has created what it calls an Automated Bond Ladder, which eliminates the hard parts of this strategy, letting investors simply deposit money while Wealthfront does the rest.

Wealthfront’s new product has the potential to greatly simplify the process of building a bond ladder, and it has the added benefit of providing some extra tax-advantaged income, too.

What is a bond ladder and what are its benefits?

A bond ladder is a way to structure your investment in bonds, with bonds maturing at regular intervals. For example, an investor might have bonds with maturities every year for the next five years. As each bond matures, the principal is rolled over into a bond at the top of the ladder. When the one-year bond matures in a year, the investor would then purchase a new five-year bond, maintaining a ladder of bonds with maturities ranging from one to five years.

A ladder is one investment strategy for bonds that allows you to reduce your reinvestment risk, the risk that new bonds won’t pay as much as your older bonds. The strategy is a kind of diversification that reduces the risk of putting all your money into one bond at one time.

Like a CD ladder, a bond ladder offers several advantages for investors:

• Offers predictable income: If you set up a bond ladder, you’ll know the income you’ll receive over the life of the ladder. That can offer particular benefits for retirees who need to pay careful attention to their budgets.
• Reduces reinvestment risk: By spreading out the maturities, the ladder minimizes short-term impacts of fluctuating interest rates. If rates fall when it’s time to invest, you’re reinvesting only a portion of your money at the top end of the ladder, limiting the impact. If rates move higher, then you can reinvest and earn more.
• Provides flexibility: The ladder has bonds that are maturing on a relatively short time frame, giving you regular access to ready cash. If you need it for another purpose – living expenses, emergency expenses or even another investment – you can access it.

So a bond ladder can be a useful investment strategy to generate income and reduce risk.

How can Wealthfront’s bond ladder work?

The appeal of Wealthfront’s Automated Bond Ladder is obvious – it takes all the heavy lifting of the laddering strategy and reduces it to the investor just depositing cash into an account. Then Wealthfront does all the work on the back end. Here’s how it works and the key benefits.

Wealthfront’s strategy ladders U.S. Treasurys, debt securities backed by the U.S. government, to form its backbone. They’re considered the safest debt in the world, and they offer plenty of liquidity for investors, meaning they can get in and out quickly, if needed. Plus, investors can avoid state and local taxes on the bonds’ interest payments, raising their tax-equivalent yield.

That tax-efficiency offers Treasurys a better after-tax yield than high-yield savings accounts or  CDs, but is especially beneficial for those in high tax brackets or living in high-tax states.

The Automated Bond Ladder looks at hundreds of Treasury securities when building a ladder, and then selects maturities from six months to six years. This approach preserves principal, since it focuses on the shorter end of the yield curve, where changes in prevailing interest rates impact bonds less. It reduces volatility, making the ride a lot less bumpy for clients. Of course, now is a particularly good time for shorter-term interest rates, with the Fed holding rates high.

Another appeal for investors is that it takes little money to get started here, compared to setting up a bond ladder on your own. In the old manual way, you’d need several thousand to even begin. Instead, clients can get started with $500 and may add as little as $100 each time they want to increase their allocation there. So it’s simple to add money as you go.

Finally, in the old way of setting up a bond ladder, you’d have to do plenty of legwork to get started and then roll over the bonds yourself when they matured. Here Wealthfront’s strategy automatically reinvests your interest earnings and any cash from maturing bonds.

The simplicity of this approach can make it easy for investors to take advantage of a bond ladder without all the previous hassles, and makes Wealthfront one of the best robo-advisors.

What are the risks of investing in bonds?

Of course any investment entails some risk, and it’s no different with bonds:

• Settles for average returns: By diversifying your exposure, a bond ladder reduces risks and gets you average returns rather than the potential to get the best returns – which would happen only if you guess right about interest rates.
• May not outpace inflation: One issue with bonds generally is that their relatively lower returns, compared to stocks, may not outpace inflation over time. And the fixed nature of the payout means that as prevailing interest rates rise, bond prices fall.
• Can be hard to research and understand: Bonds are a complex area of the market, and many investors simply leave the area to the experts. It can be harder to find an “edge” in the bond market because many pro investors know the market so well.
• Not as diverse as a bond fund: A bond ladder won’t likely have as much diversification as a bond fund, which may own hundreds of positions across issuers, time frames (short-, medium- and long-term) and credit quality, among other factors.
• Offers low overall return potential: Bonds are a relatively low-return investment, compared to stocks. Over time the key source of return on the bond is its interest payment, not its potential for capital gain, as it is with stocks.

Wealthfront’s Automated Bond Ladder helps solve for some of these issues – the research issue, for example – but can’t affect others that are inherent to bonds – lower total return potential and the potential inability to outpace inflation. Given some limitations of a bond ladder strategy, investors will want to consider whether the best bond ETFs may fit their needs better.