Interest rates are notoriously difficult to predict. When an investor allocates a portion of his portfolio to fixed income, the question arises as to what maturity or maturities he should choose. To take the guesswork out of it, he can buy bonds or CDs scheduled to mature at regular intervals and then, upon maturity, make new investment decisions based on prevailing market conditions.
When interest rates are low, it pays to keep maturities short in order to take advantage of future rate increases. When interest rates are high, it pays to go with the longest maturities to lock in the high rates before they drop. An investor with a ladder can apply this strategy as his bonds mature one by one. If no changes in interest rates have occurred, he can reinvest the maturing bond into a new one that matures after the last bond in the ladder.
An investor builds a ladder of five bonds maturing once a year for the next five years. At the end of year one, the first bond matures and the five-year bond has four years left to maturity. If interest rates have not changed, the investor buys another five-year bond with the proceeds. If, instead, interest rates have risen, he can purchase a 10-year bond to lock in higher interest.