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Financial Markets and Portfolio Management

, Volume 31, Issue 4, pp 469–489 | Cite as

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

  • Jan Henrik WosnitzaEmail author
Article
  • 611 Downloads

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.

Keywords

Bond ladder Fixed-income instrument Interest rate risk Modified duration Time deposit 

Abbreviations

BL

Bond ladder

CF

Cash flow

CR

Credit risk

CRHBL

Continuously rolling and homogenous bond ladder

DGS

Deposit guarantee scheme

DPS

Deposit protection scheme

IR

Interest rate

IRR

Interest rate risk

LtV

Loan to value

MD

Modified duration

HPB

Hypothekenpfandbrief

PV

Present value

TD

Time deposit

JEL Classification

G11 

Notes

Acknowledgements

First, I would like to thank three anonymous referees and the editor for providing very valuable comments on and suggestions for earlier versions of this paper. A very early version of the paper also benefited from discussions with participants at the World Finance Conference 2014 (Venice, Italy). Last, but not least, I thank the German Academic Exchange Service for funding my trip to this conference.

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Copyright information

© Swiss Society for Financial Market Research 2017

Authors and Affiliations

  1. 1.Deutsche BundesbankFrankfurt am MainGermany

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