If the future federal funds rate always matches market expectations, laddered bonds that include many durations should have roughly the same return as a single bond, with a single duration (there is a small premium for increased duration). In the more likely scenario that the future fed rate over next x years does not exactly match current market expectations, then laddering reduces the risk of getting stuck with a subpar rate.
As an example, following the COVID stock market crash in March 2020, many investors were scared of the stock market and wanted to switch from equity to fixed income. At the time, the fed rate was 0%, as it had been for better part of 11 years since the Global Financial Crisis and market expected low fed rate to persist, so 10-year treasury bonds only yielded ~0.7%. If an investor bought a 10-year treasury bond and held to maturity, they’d lock in this ~0.7%/year, and many investors were okay with doing so at the time. CDs, banks, and other fixed income products also payed <1%, and at least the treasury product was more tax favorable. 0.7% was also higher than the ~0.0% for short duration. However, if the investor instead had a treasury ladder that included some shorter durations, then the shorter duration portions could be updated to lock in the far higher than expected bond rates that occurred throughout 2022, with increasing inflation and corresponding fed rate increases.
Shorter duration fixed income performs better if future fed rate increases higher than current market expectations, like 2022. Longer duration performs better if fed rate decreases beyond below market expectations which has been common during 1980s/1990s/2000s A ladder or bond fund often includes a variety of durations, hedges against either scenario, rather than putting all eggs in a single duration basket.
The graph below shows current market expectations of future fed rate, and how that expectation has changed from start of year. If you know whether the future fed rate is going to be lower/higher than the graphed blue curve, then choose the corresponding duration that maximizes return during those years. If you don’t know the future better than the market, then mixed duration can mitigate this risk. Laddering can also reduce risk of the investor’s duration prior to selling differing from expectations. The investor may initially plan to hold the bond to the x year maturity, then something comes up and they need to withdraw early by selling on secondary market when bond price may have loss (2022).
