Building a Treasury Bond Ladder

This under-represents the risks of bond investment. While it&#x27;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.<p>In today&#x27;s market, it&#x27;s easy to think of holding a bond until maturity under adverse interest rate movements as &quot;not losing money&quot;. 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).<p>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.<p>While I&#x27;m currently in tech, I worked on Wall Street for years (both the trading business and IT).

Responding in general to the meme of &quot;but what is your time worth?&quot;<p>people often underestimate their ability to change their own utility functions. If you&#x27;re watching 4 hours of TV every night (or reading or w&#x2F;e other &quot;mental recharge&quot; activity) simply change your utility function to let financial planning &quot;recharge you.&quot;<p>The ultimate arb is changing your own utility function.<p>Obviously this may be harder or easier for some people, but it&#x27;s a very learnable skill.

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.<p>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.<p>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?<p>For example, I don&#x27;t see financial investment as worthwhile for the career individual except in two cases, home purchase, and retirement planning. It just doesn&#x27;t provide enough returns, and the time investment involved in trading saps quickly assumes second job status.<p>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&#x27;t need two careers, nobody needs two careers. Smart people can make forays into segments close to their careers and move up that way.<p>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&#x27;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.

This advice is dangerous and misguided. If you think rates will rise, don&#x27;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.<p>There are reasons to avoid bond funds (management fees, trading costs, tax implications), but this isn&#x27;t one of them.<p><a href="https:&#x2F;&#x2F;www.northerntrust.com&#x2F;documents&#x2F;commentary&#x2F;investment-commentary&#x2F;maturity-bond-funds-vs-individual-bonds.pdf" rel="nofollow">https:&#x2F;&#x2F;www.northerntrust.com&#x2F;documents&#x2F;commentary&#x2F;investmen...</a>

The Treasury lets you buy Treasuries directly [1]. No broker, no markup, no account fees.<p>[1] <a href="https:&#x2F;&#x2F;www.treasurydirect.gov" rel="nofollow">https:&#x2F;&#x2F;www.treasurydirect.gov</a>

If you want exposure to interest rate risk, you&#x27;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.<p>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.<p>(You also don&#x27;t have to <i>fully</i> fund the futures position, but that&#x27;s a longer and separate discussion. From a theoretical perspective, a stock&#x2F;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&#x27;re levering, so this means treasuries in general and short-term treasuries in particular. There&#x27;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).

This is something I&#x27;ve always wondered: Are treasury bond ladders <i>strictly better</i> 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?<p>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?

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.

&gt; 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).<p>Isn&#x27;t this the same fallacy as &quot;buy and hold&quot; 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.

You can also just buy a bond fund and &quot;hold to maturity&quot; 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.<p>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&#x2F;declining value due to interest rate movement and simply holds everything to maturity.

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 &quot;high rate&quot;, with no bid&#x2F;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.<p>Bid&#x2F;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&#x27;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&#x2F;maintaining a ladder.

This is a fantastic post, thanks for sharing jterenzio. I&#x27;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.

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 &quot;principle&quot; for &quot;principal&quot;?

YES! This is the kind of content I love to see on HN!<p>I see no tip jar OP. Let me know how I can buy you a beer.

Nice! Bonds seem to be a bit out of favor today, but they have the advantage of reduced volatility.<p>Glad to see this one on HN.

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

If you&#x27;re not a HNWI I wouldn&#x27;t bother buying individual bonds (and if you are, you&#x27;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&#x27;re young you probably shouldn&#x27;t worry about this. You don&#x27;t hold many bonds anyway and you shouldn&#x27;t be trying to time the market - just buy a total bond fund and forget it.<p>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&#x27;re not equal-weighted across time. And then check out Vanguard&#x27;s short, intermediate and long corporate bonds and you can do similar things in the corporate space.