
Building a Treasury Bond Ladder - jterenzio
https://terenz.io/blog/20180828_building_a_treasury_bond_ladder.html
======
valenciarose
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).

~~~
jterenzio
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?

~~~
valenciarose
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."

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rllin
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.

~~~
pjc50
>simply change your utility function

... how?

~~~
grenoire
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!

~~~
sushid
I realize your post is in jest but I can't help but wonder if the parent
comment is also a Randian parody or not

~~~
grenoire
Jesting jesters trolling trolls jesting je...

------
vinceguidry
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.

~~~
jterenzio
> 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.

------
ctlby
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...](https://www.northerntrust.com/documents/commentary/investment-
commentary/maturity-bond-funds-vs-individual-bonds.pdf)

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

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

~~~
loeg
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
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.

~~~
loeg
Yeah, I'm familiar with I bonds and EE bonds — that's why I'm familiar with
the TreasuryDirect website.

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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).

~~~
tanderson92
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](https://www.bogleheads.org/forum/viewtopic.php?f=10&t=256020)

------
ctchocula
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?

~~~
mvilim
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.

~~~
twblalock
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.

~~~
mvilim
I looked up VFITX. It looks like they pay distributions (i.e. dividends) that
are roughly proportional to the expectation of the interest rate over the
average maturity of their holdings, so you need to take this into account when
considering "what-if". They have paid approximately 1.4% in dividends during
2018. That makes their total losses around 0.6%.

This doesn't fully explain the underperformance of VFITX compared to a 3 year
bond (which should have made 8 mo/12 mo * 2% = 1.3% in interest and lost
around 0.7% on rising interest rates), a net gain of 0.6%.

So VFITX underperformed a three year bond by 1.2%. 0.13% of this is their
management fee (0.2% * 8 mo/12 mo). I'm not able to explain the last 1% of
difference.

However, in theory, a bond fund loses just as much value on an interest rate
rise as the bonds it is holding lose. In my example above, the bond is worth
~$99 after the increase to a 3% rate, just like the fund. The only difference
between the bond and the fund is the choice of when to liquidate or roll.

It's possible that VFITX got unlucky on the timing of their bond rolling (see
cousin comment).

~~~
DavidHull
According to the VFITX portfolio page ([https://investor.vanguard.com/mutual-
funds/profile/portfolio...](https://investor.vanguard.com/mutual-
funds/profile/portfolio/vfitx)), the average maturity of its holdings in 6
years, which probably explains why its performance is different than that of a
3 year treasury bond.

~~~
mvilim
Five and ten year US bonds have had lost less value than the three year bond
in the past 8 months, so that doesn't seem sufficient to explain it (i.e. it
makes the difference worse).

That said, I was very loose in my calculations. Without exact knowledge of
their holdings and careful calculations, I'm not surprised that the numbers
don't fully add up.

------
barbegal
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.

~~~
jterenzio
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.

~~~
barbegal
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.

~~~
dmoy
> past data

Can you link that data? Is it data from the past 5-10 years? Or much more
historical?

~~~
barbegal
This paper has data up to 2016
[https://www.valueeconomics.com/data/The%20Bond%20Ladder%20Fa...](https://www.valueeconomics.com/data/The%20Bond%20Ladder%20Fallacy%20-%2005-20-2016.pdf)

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DubiousPusher
> 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.

------
meritt
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.

~~~
jterenzio
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.

~~~
meritt
I think you should read
[https://personal.vanguard.com/pdf/ICRIBI.pdf](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.

~~~
jterenzio
Cool. I will read that. I'm trying to address the practical case of buying
something, earning interest, then selling it and/or having it mature, not
holding into perpetuity. Maybe I can be more clear about this in the post so
after I read this I can make an update. Thanks for linking!

I added: Some readers have pointed out that over the long term there isn't a
difference between building a ladder and using a similar bond fund. This
strategy assumes that eventually you'll want to move your principle out of
bonds and into something else like a down payment (while rates are still
rising), but you don't have a well-defined timeline. If you are planning on
keeping your principle invested in bonds into perpetuity then a bond fund
might be a more suitable investment.

Thoughts?

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tanderson92
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.

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DjMojoRisin
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.

~~~
DjMojoRisin
whoops the email is - km at shivala dot in

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microtherion
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"?

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toomuchtodo
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
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]

------
RickJWagner
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.

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

------
frgtpsswrdlame
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.

~~~
jterenzio
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
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](https://www.etfreplay.com/chart_totalreturn.aspx)

~~~
dmoy
Yes that is ignoring dividend payouts, which for a bond (edit: bond fund) is a
substantial part of the return.

