Managing money to cover short term needs can be challenging. Money needs to be available at the right time while still earning a reasonable rate of interest and without taking too much risk. Added to these issues is the uncertainty of which way interest rates will go in future. A strategy called ‘laddering’ can be used to minimise the effect of interest rate uncertainty and enable an investor to take advantage of opportunities when interest rates go up while also reducing the impact of falling interest rates.
Many investors make the mistake of investing most of their short term funds in one or two large amounts, with the income from the investments providing a top-up for income from other sources. This can present problems. Firstly, the income from the investments may not be enough to top-up other income, especially when interest rates are low. Tapping into the capital may involve costs, loss of capital or loss or income. Once the investment matures, it will need to be reinvested at whatever the going market rate is, which may be unfavourable at that time.
A fixed interest ladder is a portfolio of fixed income investments (term deposits or bonds) which have staggered maturities. The total amount to be invested is divided into smaller amounts with each amount initially invested for maturities six to twelve months apart. As each amount matures, it can be reinvested for a period six to twelve months after the longest maturity. Once set up, this means that funds maturing can be invested for the medium term in the knowledge that the next maturing amount will be available in the short term if required. Reinvesting in smaller amounts reduces the uncertainty of reinvestment interest rates. Overall, the regular maturities and interest rate payments provide more certainty of cash flow.