Building a Treasury Bond Ladder

https://terenz.io/blog/20180828_building_a_treasury_bond_ladder.html

by john2373 • 8 years ago

140 99 8 years ago

If you're not a HNWI I wouldn't bother buying individual bonds (and if you are, you're probably paying someone to do it for you). You can get 99% of the benefit of this full ladder just using a few etfs. Check out $VGSH, $VGIT, $VGLT - expense ratios are only 0.07. But also if you're young you probably shouldn't worry about this. You don't hold many bonds anyway and you shouldn't be trying to time the market - just buy a total bond fund and forget it.

If however, you do want some pizzazz in your bonds, also check out barbells and bullets. The concept is the same as a ladder except you're not equal-weighted across time. And then check out Vanguard's short, intermediate and long corporate bonds and you can do similar things in the corporate space.

jterenzio17• 8 years ago

I agree for long-term investments a fund might be better (ex. in a retirement account mixed with equity funds) but if you bought those bond funds in the past few years and sold them you might not have made much of a return. For example in the past 1 year the price of VGSH went from 60.83 to 59.87 so you lost over 1% on the price change which cancels out most of the interest yield. My point is that for short-term savings in a rising rate environment this can work better.

jhfdbkofdcho• 8 years ago

Isn’t that ignoring dividend payouts? This says it’s like -0.2% over the last 12 months including payouts vs -1.6%. No idea how accurate this is but it’s an important correction to just the price returns if you’re talking about holding the shares.

https://www.etfreplay.com/chart_totalreturn.aspx

JumpCrisscross2• 8 years ago

You can get 99% of the benefit of this full ladder just using a few etfs

Bond funds churn. Not only does this create tax implications, it also means instead of earning 2% (when prevailing rates are 3%), you lose 1%.

Bond funds are better bets for foreign, high-yield and other creditors where the credit component dominates the rate component. Paying someone to buy your Treasuries, on the other hand, is wasteful.

toomuchtodo• 8 years ago

YES! This is the kind of content I love to see on HN!

I see no tip jar OP. Let me know how I can buy you a beer.

czbond• 8 years ago

Second this! I know the community is heavily "tactical tech" only (eg: react, js, go, etc) - but I love me some complex finance discussions. [Note: I agree ladders are not complex, but fun to see anyways]

ctchocula• 8 years ago

This is something I've always wondered: Are treasury bond ladders strictly better than an equivalent treasury bond fund (say VFITX), because the interest rate risk can cause the bond fund to lose value while the treasury bond ladder is guaranteed to not lose value if held to maturation?

Or is there some finance black magic that causes treasury bond ladders and treasury bond funds with the same effective maturity to have the same return (ignoring expense ratio for now) after a long period of time?

snikeris3• 8 years ago

From the article:

Bond prices fall as interest rates rise. You can avoid this by buying individual bonds and holding them until they mature (pay out their full value).

You can avoid selling the bond at a loss; however, you are still holding a bond that earns less interest than current bonds are earning. As far as I know, holding to maturity doesn't improve your returns in the face of rising interest rates despite what the author seems to be implying.

Retric• 8 years ago

Don’t forget transaction fees. If you sell bond X that pays out 100$ in 1 year for bond Y which pays out 100$ in one year you gained nothing.

jterenzio17• 8 years ago

What holding does is lock your returns and sets a floor. When you buy a bond and hold it you will be guaranteed to receive the return. Sure if rates rise afterwards you have opportunity cost because you can't invest that money at a higher rate, but that's what ladders help you do. You get the current rate when you add new bonds to the end. What alternatives exist? You can buy a bond fund which might decline in value if rates rise or just sit on cash but those don't seem optimal.

cirgue• 8 years ago

Yeah, the idea is that at any give price, holding any bond or selling it and using the proceeds to purchase bonds at the current rate are equivalent from a return perspective.

jterenzio17• 8 years ago

You are correct in rising interest rate environments where you believe the rates will continue to rise.

With bond funds you can get the same yield as the ladder (interest payments) if you hold forever and never sell, but if you sell you may take a hit because the price has gone down. That doesn't happen with ladders since you always get paid out the face value.

mywittyname• 8 years ago

When you buy the bonds directly, you're choosing an explicit exit date and you know exactly what your return will be.

When you buy a bond fund, your principal is going to be reinvested, so there's a risk of interest rates going up right before you sell.

Some firms offer target maturity bond funds which will is the best of both worlds.

pishpash2• 8 years ago

Liability matching is strictly more optimal. If you know when you need money you can take that portion of the risk out of the equation. On the other hand, with reinvested funds, you are paid to take the risk of interest rates going up and the lack of a fixed maturity date, by the possibility that interest rates might go down (the so-called roll-yield).

jterenzio17• 8 years ago

Some firms offer target maturity bond funds which will is the best of both worlds.

These are great for corporate bonds. Check out iShares iBonds if you want to include corporate bonds in your portfolio without building a ladder or taking on interest rate risk.

mvilim6• 8 years ago

No, bond ladders are not strictly better than a bond fund. In theory, they are equivalent. In a bond fund, you simply see your loss on rising interest rates more directly.

Scenario 1 (holding bonds to maturity, i.e. bond ladder):

Let's imagine you invest in a $100 1yr bond at a 2% rate. You will be paid $102 in a year's time. Immediately after you buy the bond, the rate goes to 3%. You are locked into the bond, so you can't switch to the higher rate (i.e. you've lost out on a potential $1).

Scenario 2 (bond funds, ignoring reinvestment):

Instead imagine that you invest $100 in a fund that currently holds 1yr bonds at a 2% rate. You expect to be able to sell this fund in a year's time for $102. Now the rate changes to 3%. You are not locked into the fund, but the fund is locked into the bonds that they bought. If you can sell your shares in the fund for $100, you could then buy the new 3% rate bonds directly (i.e. you have avoided the loss due to the interest rate change). This would be a risk-free arbitrage between the fund and the new bonds. The price of the fund needs to drop to ~$99 to be "fair" (to be precise, it's 1.02/1.03, not exactly 99). If you sell at ~$99 and buy new 3% bonds directly, you will receive $102 in a year's time, just like scenario 1.

In short, the bond fund loses value because you maintain the optionality to withdraw whenever you want (and invest at higher rates if rates go up). The expected value between bond funds and bond ladders is still the same. In essence, the difference is between holding bonds to maturity and having the possibility of selling them, which doesn't change the expected value.

jterenzio17• 8 years ago

In theory that's true if you hold the fund forever but take the example of VGSH from another comment thread. If you bought that fund exactly 1 year ago and sold today you would have realized a return of less than 2% because while the yield is currently about 2.5% the price decrease over that time was about 1.5%. Your return would have been less than buying a single treasury yielding 2% a year ago and letting it mature.

twblalock4• 8 years ago

VFITX is down ~2% since January. If I had bought shares of it in January, I would have less money than I started with. If I had bought individual treasury bonds in January, I would have more money than I started with. That seems like a significant difference between bonds and bond funds.

mvilim6• 8 years ago

Addendum: I say you're "locked into" a bond here because most people don't consider the possibility of selling bonds (i.e. they plan to hold to maturity). However, you can sell most bonds (not directly back to the issuer but to other people). This may make the similarity between funds and ladders clearer. In the scenario 1 example, if you were to sell your bond, it would also be worth ~$99 (using the same argument as in scenario 2). In other words, the fact that you don't think of this as a loss if you don't sell the bond doesn't change the fact that the bond lost value (the comment by ThrustVectoring further down this chain says this well). If you assume the market pricing of interest rates is fair and that the market is perfectly efficient (i.e. no transaction fees, management fees, etc.), then the expected value of holding, rolling, or investing in a bond holding fund is all the same.

barbegal3• 8 years ago

This seems overly complicated. The market for bonds reflects the current inflation and interest conditions so selling bonds at any moment in time should on average be as profitable as holding them to maturity (except for broker fees which are usually quite small). I would just buy bonds and sell them if and when required.

piker• 8 years ago

(except for broker fees which are usually quite small)

Not quite. Commissions are charged on equities. Markups are charged on bonds. Markups are the difference between what the broker paid and how much a retail investor has to pay the broker and are much more opaque. They can be quite hefty. One just doesn't notice.

jterenzio17• 8 years ago

It depends. In my article I pointed out that with Fidelity there are no commissions or markups on treasuries on the secondary market. If there were, it would definitely change the calculus.

jterenzio17• 8 years ago

I'm not sure that works universally. If you buy a bond with a 2% yield today that matures in 3 years and you decide to sell in 1 year instead and at that point the current rate is 3% the price you sell at will be lower than the price you paid so you won't make a 2% return in the first year...

Re: fees depends on your platform. Fidelity charges no fees or markups for treasuries but if your platform does it's something to consider in addition to bid/ask spread.

barbegal3• 8 years ago

What you're missing is that on average the market would have factored that into the price of the 1 year bond.

If you look at past data there is on average no difference between buying 1 year bonds and keeping them to maturity and buying 3 year bonds and selling after 1 year.

The only case maybe for buying 1 year bonds is where you have another contract which matures in 1 year denominated in the same currency. E.g. I have a mortgage payment of $1020 that I have to make in 1 year so I should invest $1000 into a bond that pays 2% interest.

JackFr• 8 years ago

The market for bonds reflects the current inflation and interest conditions.

To say that the bond market "reflects current interest conditions" is like saying the stock market reflects current stock prices.

A dollar today is not the same as a dollar a year from now, which is also not the same as a dollar two years from now, and thus they have different prices.

I don't disagree with your conclusion. This is a technique for matching asset & liability timing (not really a market strategy), more suited to the corporate treasury than the retail investor.

vinceguidry• 8 years ago

Great explanation. One of the things I consider, as someone who will eventually find enough resources to do this, is the separation of individual economic activity into risk-reward segment tiers.

The first being direct trading of time for money, wage-salary work. Second is service, which runs the gamut from contracting to consulting. Third is deal-making, which composes together individual service providers, the value-add being management, to create business vehicles. Fourth being business, the creation of a firm that employs human resources to scale up a product or service. Fifth is finance, which treats businesses as the economic units, either through trading financial instruments or through acquisition of entire businesses.

At what point does the risk-reward profile start to favor investment into the next level of economic activity? Is it worthwhile to try to skip over a tier, how does one think clearly about the endeavor?

For example, I don't see financial investment as worthwhile for the career individual except in two cases, home purchase, and retirement planning. It just doesn't provide enough returns, and the time investment involved in trading saps quickly assumes second job status.

What amount of capital should you have liquid before you can intelligibly make a foray into a particular tier? Such that you can throw money at problems rather than invest more time into understanding the situation? I don't need two careers, nobody needs two careers. Smart people can make forays into segments close to their careers and move up that way.

The mindset for rational and sane upward mobility seems to remain stubbornly out of reach, causing many honest, decent people to save up nest eggs which are then extremely vulnerable to scammers. If we had a body of information available that's better than the current personal finance advice, which seems geared for retirement planning, then we could cut down on a lot of tragic outcomes.

jterenzio17• 8 years ago

The mindset for rational and sane upward mobility seems to remain stubbornly out of reach, causing many honest, decent people to save up nest eggs which are then extremely vulnerable to scammers. If we had a body of information available that's better than the current personal finance advice, which seems geared for retirement planning, then we could cut down on a lot of tragic outcomes.

For me, writing this post, I was hoping to make some information available to all that could promote a narrow part of investing that is safe and helps people get the most out of their shorter-term savings. But there is a much bigger picture. Personal finance basics (ex. how to save, how to spend, investing, debt, credit, buy vs. borrow, day-to-day stuff) are sorely lacking in our society and it leaves people vulnerable. It's a huge issue that is going to take a lot to address... This is just a tiny part but I hope to do more.

Please feel free to email me if you ever want to discuss more topics like this.

JumpCrisscross2• 8 years ago

The Treasury lets you buy Treasuries directly [1]. No broker, no markup, no account fees.

[1] https://www.treasurydirect.gov

jterenzio17• 8 years ago

Definitely a good alternative if your broker charges fees. As mentioned Fidelity does not but I suspect that's not the norm...

meichenf• 8 years ago

Schwab also does not charge fees for new treasury bond issues. I assume this is a loss leader for them and they make back their money in the secondary market.

loeg2• 8 years ago

Although you'll have to interact with TreasuryDirect, one of the worst, 90's era security decision websites. Their idea of secure password entry is (mandatory) clicking buttons on an on-screen keyboard.

mCOLlSVIxp6c• 8 years ago

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I agree TreasuryDirect is not the best website. No trading on the secondary market either. But it has some nice benefits. It has zero fees lower minimums than other institutions. You can also purchase savings bonds and transfer in existing paper bonds.

Savings bonds are just as secure as US treasury bonds. It's not popular to worry about inflation these days but if you are worried, take a look at Series I savings bonds.

meritt2• 8 years ago

You can also just buy a bond fund and "hold to maturity" exactly like a ladder does. That is, if you buy an intermediate bond fund, you need to hold for the 5-7 years in order to receive the stated return.

The only difference is a bond fund allows you see the true value of your holdings at any given time, where the ladder approach blissfully ignores the increasing/declining value due to interest rate movement and simply holds everything to maturity.

jterenzio17• 8 years ago

I am not sure if that's true for non-fixed-maturity funds because the fund manager will keep the ladder rolling after 5-7 years, ie. the fund won't just pay out at maturity - they will keep reinvesting further and further into the future.

There are some bond funds called fixed-maturity funds that actually mature on a date and pay back the principal. Ie. they let all the bonds inside mature without reinvesting them. iShares iBonds are an example. But this is not the norm for bond funds.

meritt2• 8 years ago

I think you should read https://personal.vanguard.com/pdf/ICRIBI.pdf

You generally seem to be conflating face (static) value with market (dynamic) value. You're not wrong but your article makes a number of statements implying a ladder is better/safer simply because you refuse to recognize that the current value will deviate from par.

rllin• 8 years ago

Responding in general to the meme of "but what is your time worth?"

people often underestimate their ability to change their own utility functions. If you're watching 4 hours of TV every night (or reading or w/e other "mental recharge" activity) simply change your utility function to let financial planning "recharge you."

The ultimate arb is changing your own utility function.

Obviously this may be harder or easier for some people, but it's a very learnable skill.

briffle• 8 years ago

Not sure for treasury bonds, but many banks/credit unions will ladder your CD's for you, and continue to do it unless you say stop.

jterenzio17• 8 years ago

Automated CD ladders are great too. The only issues are if you need to liquidate in an emergency you take a bigger hit, and you owe state tax but in general they can be good enough for many people.

ThrustVectoring11• 8 years ago

At that point, why not change your utility function to enjoy simply sitting there thinking about how happy you are?

Don't do wireheading, kids.

pjc50• 8 years ago

simply change your utility function

... how?

grenoire2• 8 years ago

First you have to take an introduction to neo-classical microecomics class... and then not delve any deeper into economics whatsoever. This will lead you to believe, as OP does, and as such give you the ability to change by the means of your belief!

DjMojoRisin2• 8 years ago

This is a fantastic post, thanks for sharing jterenzio. I'm working on building something that does something similar, and would love feedback from folks. If you are interested in chatting, please drop me a note at km at shivala dot com.

DjMojoRisin2• 8 years ago

whoops the email is - km at shivala dot in

paulpauper• 8 years ago

My favorite bond fund is the LQD etf. Good returns, stability, medium duration, low fees

valenciarose2• 8 years ago

This under-represents the risks of bond investment. While it's true that the credit risk of treasuries is incredibly low, interest rate and inflation risk needs to be addressed more seriously than it is in this post.

In today's market, it's easy to think of holding a bond until maturity under adverse interest rate movements as "not losing money". This is a false model. For example, a ten year treasury purchased at issue in mid-2016 is paying less than the current rate of inflation. When interest rates increase, bond holders lose money. Holding the bond just changes the accounting (and exposure to future swings).

Diversification of bond duration is important in terms of risk management and not just cash flow concerns. Prudent portfolios include equities as well as debt.

While I'm currently in tech, I worked on Wall Street for years (both the trading business and IT).

jterenzio17• 8 years ago

Thanks for the comment. I was trying to make clear this is a short-term strategy in a rising rate environment where you eventually want the principal back and don't want to take much risk. In accounts with longer term goals like retirement accounts you'd probably mix equities and more diversified bond funds.

Is there a way you think the strategy and when it's appropriate could be made more clear?

snikeris3• 8 years ago

Is there a way you think the strategy and when it's appropriate could be made more clear?

I think it's a useful strategy as part of a diversivied portfolio. As the GP mentioned:

Prudent portfolios include equities as well as debt.

Your guide to building a treasury ladder would be useful to someone implementing Harry Browne's Permanent Portfolio concept, which holds 50% of its assets in US Treasuries. However, building a diversified portfolio is likely outside the scope of your guide.

valenciarose2• 8 years ago

It's a good article and the strategy is appropriate as part of a more diverse portfolio. My point wasn't that the article was bad, but that holding till maturity only gives the illusion of bypassing interest rate risk.

"The only real risk to principal is being locked in to a rate that's lower than inflation for an extended period."

whitepoplar2• 8 years ago

So buy TIPS? But the elephant in the room is that inflation isn't the same for everyone. It's calculated based on a basic basket of goods, but if you're high income, it may not replicate your spending habits. Private school isn't factored into the CPI.

ThrustVectoring11• 8 years ago

Over a long timeframe, the investment with the lowest risk of underperforming against inflation is broad-market equity index funds. Bear markets and corrections happen, sure, but the nigh-inevitable performance during bull markets more than covers for that. Over something like 30 years, the only question is whether your investment will outperform inflation or massively outperform it.

Like, the 5th percentile worst result is definitely worse for stocks compared to bonds over a one-year timeframe. But, the advantage of a better compound annual growth rate means that as you add more and more time to your investment timeframe, worst-case results for stocks get better compared to bonds. IIRC, the crossover point is very roughly 20 years out - at this point, the risk of stock corrections has been completely absorbed by having superior expected returns.

snikeris3• 8 years ago

TIPS is like buying fire insurance from an arsonist.

jldugger• 8 years ago

inflation risk

This is somewhat mitigated by TIPS.

interest rate risk

At least personally, I'm reading article as an alternative for a subportion of my portfolio, where the options are basically CD ladders and savings accounts. Which have roughly the same interest rate risk as bonds of equal duration. The more interesting question from this perspective is comparing interest rate risk versus the premium you're earning. Ally savings' APR is at like 1.8, their 'no penalty' CDs are at 1.9, and 1 year treasuries are at 2.5. How far would rates have to go up before the risk outweighs reward, etc.

ThrustVectoring11• 8 years ago

If you want exposure to interest rate risk, you're generally better off getting it in the futures market than the physical one. Roughly speaking, instead of buying $200k of 2-year treasuries, you can open a single 2-year treasury futures contract, fully fund it with a 3-month treasury bill purchase, and get the same return.

Why do this? Treasury bond income gets taxed as ordinary income, while treasury futures get treated as 60% long-term and 40% short-term capital gains. The extra compensation you receive for taking on this risk is more favorably taxed if you do so through futures.

(You also don't have to fully fund the futures position, but that's a longer and separate discussion. From a theoretical perspective, a stock/bond portfolio should take the best risk-adjusted return mix and then lever it up or down somewhere short of the Kelley Criterion maximum, depending on personal timeline. The best place to take on leverage is where you have the most information about what you're levering, so this means treasuries in general and short-term treasuries in particular. There's also bet-against-beta as an investing factor - rational market participants can have leverage restrictions, so they rationally overbid on investments that need less leverage to get the desired return. This holds generally across markets, and in treasuries it means that getting duration through 2-year treasury futures is cheaper than through 30-year treasuries).

tanderson922• 8 years ago

Hello from the Bogleheads 90/60 thread ;-)

For others, you can extend this to building a 60/40 balanced equity portfolio. See: https://www.bogleheads.org/forum/viewtopic.php?f=10&t=256020

ctlby• 8 years ago

This advice is dangerous and misguided. If you think rates will rise, don't be long duration. Holding to maturity does not insulate you from interest rate risk--you will certainly make nominal dollars, but in real terms, you will under-perform or even lose.

There are reasons to avoid bond funds (management fees, trading costs, tax implications), but this isn't one of them.

https://www.northerntrust.com/documents/commentary/investmen...

tanderson922• 8 years ago

One thing that is not discussed is that one can participate in U.S. Treasury auctions at brokerages (as well as TreasuryDirect but I sympathize with those who would want to avoid that site). Fidelity and Schwab both promise retail investors the so-called "high rate", with no bid/ask spread on new treasury auctions. There are no markups or fees. Furthermore, at Fidelity one can manually roll over treasuries into new auctions and at Schwab it is not much harder but is done manually a day or two before the auction.

Bid/ask spreads are an annoying feature of OTC bond markets since bonds are not currently traded on exchanges (hello SEC! Please fix this) for retail customers since they don't have the volume to obtain the tightest spreads. So, one can just avoid spreads entirely by only participating in auctions, at least while building/maintaining a ladder.

microtherion• 8 years ago

Thanks for an instructive article! But may I offer the somewhat petty advice that your writing in this field would be greatly enhanced if you did not write "principle" for "principal"?

RickJWagner• 8 years ago

Nice! Bonds seem to be a bit out of favor today, but they have the advantage of reduced volatility.

Glad to see this one on HN.

DubiousPusher• 8 years ago

bond prices fall as interest rates rise. You can avoid this by buying individual bonds and holding them until they mature (pay out their full value).

Isn't this the same fallacy as "buy and hold" stock strategies? Basically, it ignores opportunity cost? If the cost to sell the discounted bond is less than the upside of the better payout of a new bond, you should sell.

Building a Treasury Bond Ladder

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