Quick Answer
A longer-maturity debt holding carries more price risk if sold before maturity, while a shorter-maturity holding returns principal sooner but raises reinvestment risk. A laddered portfolio spreads maturities across a range of dates so only part of the principal comes due at once. A bullet portfolio concentrates both risks at a single date.
Maturity length is a trade-off, not a free choice. Laddering is the standard technique for managing that trade-off across a portfolio instead of at one point in time.
How Does Maturity Length Trade Price Risk for Reinvestment Risk?
- A longer-maturity debt obligation carries greater price risk (interest-rate-driven price movement) if sold before maturity, because more of its cash flows sit further in the future.
- A shorter-maturity debt obligation returns principal sooner, lowering price risk but raising reinvestment risk: how often that principal must be redeployed at whatever rate then prevails.
What Does Laddering Do That a Single Maturity Cannot?
- A laddered portfolio spreads debt holdings across a range of maturities, so that only a portion of the portfolio's principal comes due and must be reinvested at any one time.
- The opposite structure, a bullet portfolio, concentrates maturities around a single date, concentrating both price risk and reinvestment risk at that date.
- Laddering is the standard technique for building an appropriate mix of maturity schedules. It limits how much principal and income is exposed to a rate move or a reinvestment event at any single point in time.
- What counts as appropriate comes from the customer, not from the ladder. A customer who cannot afford to lose principal or income needs shorter maturities, even at the cost of more reinvestment risk. One who can absorb that loss can stretch the ladder out to longer maturities, taking on more price risk in exchange for less reinvestment risk.
Exam Tip: Gotchas
- Laddering does not eliminate price risk or reinvestment risk. It spreads each risk's impact across time instead of concentrating it at one maturity date.
What Should You Check on Exam Day?
- Pair maturity length with the right risk: longer maturity means more price risk, shorter maturity means more reinvestment risk.
- Contrast laddering with a bullet structure: laddering spreads both risks across time, a bullet portfolio concentrates them at one date.
- Do not credit laddering with eliminating either risk; it only spreads the impact across time.