Reader Question
Your blog is outstanding! I had a question about bond ladders; some people like Larry Swedroe feel that constructing a ladder of individual bonds may be more advantageous than holding a bond fund. What are your thoughts? Thank you! http://www.cbsnews.com/8301-505123_162-37841787/how-to-build-a-bond-portfolio/?tag=mwuser (Is there any way you can add a search engine for your blog; I couldn't find one to search for "bond ladders")
My Reply
Glad you are liking my blog! I moved up the "Search" feature on the right-hand side -- it was buried all the way at the bottom before. Thank you for that suggestion.
As far as bond ladders go, I agree with most of what Larry Swedroe says in that article and I agree that a bond ladder can absolutely replace a bond fund but with a condition that, unfortunately, makes bond ladders impractical today.
That condition is that nobody should sacrifice diversification of a bond fund for the few nice, but ultimately minor advantages of a bond ladder. You should not attempt to build a ladder using individual corporate or municipal bonds because you would immediately be exposing yourself to a lot of undiversified risk. I would not do this even with AAA-rated securities. The only kinds of bonds I would feel comfortable laddering are US treasuries and TIPS. Not that US could never possibly default, but if/when it does the whole financial world will more or less go to heck in a handbasket anyway. There will be no fixed income securities that would not tumble along with the US treasuries. It's just not the type of risk that can be diversified away, so you would not be sacrificing any diversification by laddering treasuries or TIPS. There is also a more practical reason to limit bond ladders to treasuries and TIPS -- they are the most liquid of bonds in case you need to liquidate your holdings for whatever reason. But it is the lack of diversification, not lack of liquidity, that is the major reason to not ladder corporates or municipals.
Having established that only treasuries and TIPS are suitable for laddering, we have to ask ourselves whether they are worth holding at all -- in a ladder or otherwise -- at today's valuations. The answer there is a pretty clear no. Their yield is 0.5-1.0% less than what it should be. You can trivially obtain equivalent safety from default, better safety from rising interest rates, and higher yield from FDIC-insured CDs with an option to break early, such as available from PenFed. EE-Bonds are similarly attractive relative to longer treasuries. TIPS are likewise easily trumped by I-Bonds.
So the kinds of ladders I would be looking to build today are using those three types: CDs, I-Bonds, EE-Bonds. In fact, I-Bonds and EE-Bonds naturally become ladders of sort since you can only buy $10,000 of each per year per Social Security number. So you'll have $10,000 in 2012, another $10,000 in 2013, and so on. I-Bonds, of course, can be redeemed at any time with little or no penalty so you can think of them outside of ladder terms. EE-Bonds do have 20-year maturities to capture meaningful return, so they more naturally fit the ladder metaphor.
About the only non-CD/I/EE security I would consider laddering today are 30-year TIPS in a tax-advantaged account (not in taxable). It doesn't feel great to lock into today's 0.4-0.5% real return for 30 years, but that's still better than be guaranteed by alternatives. Not that those alternatives are unlikely to match or exceed it -- just that they can't guarantee it and, historically, there have been times when even such low real returns would have been desirable. So I don't think it's crazy to start or continue building a 30-year TIPS ladder even at today's rates. For just about every other nominal treasury bond or TIPS you can do better by building ladders using CDs, I-Bonds, and EE-Bonds -- not to mention by simply holding diversified corporate and/or muni bond funds.
Very good article on bond ladder. I like reading your blog.
ReplyDeleteWe are building monthly ladder with I-series bonds. I call it protection against extended periods of no income. The withdrawal options with 3 months interest penalty makes them attractive for such emergencies with little risk. Also, automated monthly withdrawal by treasury direct makes the contribution invisible, similar to 401k contribution.
Our goal is to have enough in I-series bonds so that we can withdraw every month to cover monthly expenses and preferably monthly income for years if needed.
Sounds like a great plan. Even back in the "normal" days I-Bonds made for a great emergency fund. Now that interest rates are depressed across the board, I-Bonds are at or near the top of the list for long-term fixed-income investments too. Until and unless interest rates go back up, and by a lot, almost every investor should aim to max out annual I-Bond purchases.
DeleteI really appreciate your blog. I don't know how you find the time to make so many entries with so much detailed analysis, but it's really, really helpful. Thanks so much for sharing your wisdom.
ReplyDeleteI have been following your posts on TIPS and what to do for higher yields in the current environment, but I am still confused about the difference in strategy, if any, when one is invested in individual TIPS and when one is invested in a TIPS fund. Specifically, I have about $60,000 in my IRA account invested between a TIPS ETF (SCHP) and a TIPS mutual fund (SWRSX). Both funds have performed relatively well during the past two years and have accumulated a couple of thousand dollars in "unrealized gains" owing to an increase in share price. Would you suggest that I take those gains (understanding that they won't be taxed at this point) and sell my investment in the TIPS funds at this time? If so, given the low yield on alternative investments, what would you suggest this money be reinvested in? (I can't do a "swap" to purchase a municipal bond fund with money in my taxable account because I would have to sell equity investments that would generate capital gains in order to do so.) Thanks again for all your advice.
Thank you -- unfortunately, finding the time to answer all the questions and requests is becoming a real problem. I am doing best I can.
DeleteFor your question the key to understand is that both SCHP and SWRSX will likely not even keep up with inflation (the Bureau of Labor Statistics' CPI-U) for the next 10 years or so. This is just the consequence of how expensive TIPS are today. If real interest rates spike for whatever reason they could also be subject to significant, if temporary losses, that may take a year or three or even longer to recover from. By contrast, you can buy US I Savings Bonds today which will exactly keep up with inflation, will never have any losses, regardless of interest rates, are not subject to taxes till redemption -- which can be 30 years away (thus acting much like an IRA), and that can be redeemed after a year for a small penalty (and penalty-free after 5 years) any time either for emergency reasons or to re-invest the capital into higher yielding instruments.
My advice would be to buy $10,000 of I-Bonds in taxable via TreasuryDirect.gov, sell $10,000 of SWRSX in IRA and use that space by selling equities in taxable accounts and buying them in the IRA (assuming you have some taxable equities that carry no capital gains such as might be the case with foreign equities today that you bought 5 years ago). If you don't have such equities in taxable you can use the newly open IRA space for new equities purchases or to transfer it to a place like PenFed and their CDs (though that might be too much hassle for a $10,000 move) or even to hold other bond funds. The main point is that I-Bonds are easily better than SCHP or SWRSX or pretty much any other TIPS investment today, so you should exchange your TIPS for I-Bonds as much as possible, assuming there are no tax consequences. If you are married, then your wife is also eligible to buy up to $10,000 in I-Bonds every year, so that lets you exchange $20,000 of TIPS investments into I-Bonds. Then you can do any number of things with newly opened IRA space. The main point is that I-Bonds are simply better than TIPS (with possible exclusion of very long 30-year TIPS) on every count, so it's a "free lunch" of sorts.
Thanks for replying so quickly. I had already taken your advice and purchased my wife's and my allotment of I-bonds for the year with our taxable funds, and unfortunately (or not, in the bigger picture), selling any of our remaining taxable investments would generate capital gains (we had already tax-harvested the losses from the unsuccessful investments), so it looks like we should just sell the TIPS funds and use those funds in our IRA to purchase low-risk equities or, if possible, a couple of Pen-Fed CDs. Do you happen to know whether the CDs can be purchased as an investment within an existing IRA, or whether we'd have to open a new IRA with PenFed and rollover the funds necessary to purchase the CDs to that IRA?
DeleteIt's ironic that we bought the TIPS funds a few years ago based upon advice at the time that they would be a valuable inflation-hedging mechanism for the long run, even if their yields at the time were not so great. Now, it seems that they have little long-term value as an inflation hedge, but they turned out to provide a pretty nice return in the short term. Do you think that we still need to have some sort of inflation hedge in our portfolio (beyond the equity funds that are likely to rise with inflation anyway)? I suppose we can always keep an eye on the inflation trend, and if it starts to show movement upwards, we can jump back into a TIPS fund at that time, no?
Depending on which brokerage your IRA is at there may be brokered CDs available to you inside the IRA but they are unlikely to be as good a deal as what PenFed provides (both in terms of yield and in terms of having the option to break the CD early with minimal penalty). So you'd probably want to fund the PenFed IRA with the $20,000 or whatever amount you wish to use. I haven't actually done this myself, so unfortunately I couldn't tell you the detailed steps, but I'm pretty sure it should be possible to transfer part of your existing IRA to PenFed and fund the CD with it. You might need to call PenFed to get the detailed instructions.
DeleteAs far as "inflation hedge" in a portfolio, I wouldn't stress over it too much. No investment will save any of us in a catastrophic hyperinflation scenario -- maybe not even gold. And for a ho-hum 1970s-style inflation, it won't be anything great but your stocks will keep up with it over time, your wages will keep up with it, your Social Security will keep up with it, your fixed-rate mortgage (if any) will hugely benefit from it, your cash and short-term bonds will keep up with it reasonably well. Only long-term nominal bonds will suffer a lot.
So if inflation really scares you, keep your bonds to under 5-10 year average maturity and look for cheap options to break in CDs (and use I-Bonds as you already do, of course).
Finally, remember that once the back of inflation is broken -- and it will be, sooner or later -- whatever bonds you hold at that time are likely to generate great returns to their maturity. This is exactly what happened after inflation was brought under control in the early 1980s. Not that inflation is a walk in the park but I think the talk of it and the fear of it are overblown compared to all the other things that can go wrong with the world. I'd be more scared of deflation than inflation.
I agree that it doesn't make sense to be overly concerned about inflation, especially in the current environment. I'm willing to put my faith in Krugman, who has been pretty accurate to date in saying that the fears of bond vigilantes and skyrocketing interest rates are overblown. My only concern is that I'm probably only a year or two away from retirement and, aside from social security and a minimal amount invested in I-Bonds, we don't have anything else that is directly protected against the eroding influence of inflation.
DeleteFinal question: I was curious about your statement that "cash" will keep up with inflation reasonably well. I thought cash was the classic example of an "investment" that will be certain to decrease in value due to inflation. Are you assuming that the cash is being invested in an interest-bearing savings account or something? Even then, the available interest rates seem far below the rates of inflation.
Historically cash has kept up with inflation reasonably well. Here's a chart of the two: http://www.longtermreturns.com/p/historical-investment-returns.html?fromyear=1928&toyear=2011&real=0&log=0&plots=Bills_Inflation&customplots1=none . The last few years have been an aberration due to the zero-interest rate policy of the Fed.
DeleteAnd remember that your stocks will keep up with inflation too, though it might happen in fits and starts.