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Building a Treasury Bond Ladder

terenz.io

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Re: Building a Treasury Bond Ladder

#61

Post by mvilim »

jterenzio wrote: post #54
mvilim wrote: post #46

Earlier quoted context omitted.

I don't think this has anything to do with how long you hold the fund. In essence, the original comment was using bond ladders as a proxy for holding bonds till expiration and using bond funds as a proxy for always liquidating your bonds and reinvesting at the new rate on any rate change. The question is really about holding vs liquidating bonds, not funds vs ladders (which theoretically could hold or liquidate, depe…

I added a note in my article to clarify this. My strategy here is short-term. You want to withdraw your capital eventually, not hold forever. Maybe you are saving for a house in a few years. If you suspect that rates are still rising when you let your ladder burn down then this can be a good approach. I agree that for long term investments (ex. a retirement account) this is probably not the right approach. Thoughts o…

I think your key point is this: "If you suspect that rates are still rising when you let your ladder burn down then this can be a good approach." I agree with this statement.

If you disagree with the market pricing of interest rates, then yes, you should do something other than the market (i.e. what the bond fund would do). Letting the ladder burn down (as opposed to continuing to roll, as the fund would) is claiming that the rates will be higher than the market is currently pricing them.

If you agree with the market pricing of bonds, then the ladder is equivalent to the bond fund (because the bond fund is simply managing the ladder for you by proxy).

Re: Building a Treasury Bond Ladder

#62

Post by jstrom »

twblalock wrote: post #44
mvilim wrote: post #34

Earlier quoted context omitted.

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 yo…

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.

If you attempted to sell those treasury bonds now on the secondary, you would have to accept the same $99 the shares of VFITX are worth. The immediate, liquid value is the same either way. (You need a common unit to comapre in instead of VFITX in now-$ to bonds in principle-$.)

If you hold the bonds and/or VFITX instead, the interest pay out of the bonds and the distributions of VFITX should also come out equal (except not, the fund has the advantage that it can change its composition from buying/selling bonds, but also has the overhead of selecting and performing those transactions).

(In reference to your below comment, yes, fund != holding bonds. The fund is closer to you buying the bonds, but also buying/selling as bonds mature or you anticipate changes in rates)

Re: Building a Treasury Bond Ladder

#63

Post by jterenzio »

valenciarose wrote: post #59

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 is…

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?

Re: Building a Treasury Bond Ladder

#64

Post by meichenf »

jterenzio wrote: post #30
JumpCrisscross wrote: post #26

The Treasury lets you buy Treasuries directly [1]. No broker, no markup, no account fees. [1] https://www.treasurydirect.gov

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

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.

Re: Building a Treasury Bond Ladder

#65

Post by mCOLlSVIxp6c »

loeg wrote: post #38
JumpCrisscross wrote: post #26

The Treasury lets you buy Treasuries directly [1]. No broker, no markup, no account fees. [1] https://www.treasurydirect.gov

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.

This Bookmarklet makes the field editable: javascript:$(":password").removeAttr("readonly")

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.

Re: Building a Treasury Bond Ladder

#66

Post by twblalock »

jstrom wrote: post #62
twblalock wrote: post #44

Earlier quoted context omitted.

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.

If you attempted to sell those treasury bonds now on the secondary, you would have to accept the same $99 the shares of VFITX are worth. The immediate, liquid value is the same either way. (You need a common unit to comapre in instead of VFITX in now-$ to bonds in principle-$.) If you hold the bonds and/or VFITX instead, the interest pay out of the bonds and the distributions of VFITX should also come out equal (exce…

As mvilim noted in his response to my comment, the outcome is actually not equal, and VFITX underperformed bonds over the same period, by a larger amount than can be explained by its expense ratio.

Re: Building a Treasury Bond Ladder

#67

Post by ThrustVectoring »

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).

Re: Building a Treasury Bond Ladder

#68

Post by ThrustVectoring »

jterenzio wrote: post #40
mywittyname wrote: post #20

Earlier quoted context omitted.

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.

> 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.

You don't want to include corporate bonds in your portfolio. Generally speaking, buying equities gets you a better price for the risk you take; a slightly higher equity percentage with government-backed bonds will generally outperform at the same level of risk.

Re: Building a Treasury Bond Ladder

#69

Post by whitepoplar »

valenciarose wrote: post #59

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 is…

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.

Re: Building a Treasury Bond Ladder

#70

Post by mvilim »

mvilim wrote: post #34
ctchocula wrote: post #5

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 h…

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 yo…

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.
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