The optimal trade-off between interest rate risk and annual return of bond ladders

Abstract

"Bond laddering is a popular fixed-income investment strategy. The main purpose of this paper is to develop a methodology for determining private investors’ most interest rate risk (IRR)-return-efficient investment horizon for bond ladders (BLs), which are virtually free of credit risk. Two IRR measures of a continuously rolling and homogenous BL (CRHBL) are analytically derived under the assumption that interest rates are martingales. The first measure is the modified duration, which assumes a flat term structure of interest rates. However, this assumption is not fully supported by the empirical data and, thus, an additional IRR measure is proposed. Under each of these two measures, the ratios between the annual return in excess of the demand deposit rate and IRR of CRHBLs with different investment horizons are calculated. As expected, CRHBLs with rather low IRR are most risk-return-efficient. The results for the theoretical CRHBLs also apply to “real-world” discrete BLs. Thus, the proposed methodology can help private investors construct IRR-return-efficient discrete BLs."