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?
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.
> 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.
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.
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.
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.
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).
Is there a way you think the strategy and when it's appropriate could be made more clear?
"The only real risk to principal is being locked in to a rate that's lower than inflation for an extended period."
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.
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.
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.
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.
Don't do wireheading, kids.
... how?
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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).
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
I see no tip jar OP. Let me know how I can buy you a beer.
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...
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.
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.
Glad to see this one on HN.
