Explain a CD ladder please

[utrecht]

Theres something I dont understand about a CD ladder. I understand how it works. Basically if you want a 5 year ladder, you buy a 1 yr, 2 yr, 3 yr, 4 yr and 5 yr CD. When then the 1 yr CD matures, you replace it with a 5 yr CD....and so on.

Assuming each CD is for the amount of one years living expenses, you always have 5 years of living expenses in cash and dont have to sell stocks when they may be having a down year. At least thats what i understand the purpose to be....BUT..

It seems to me that that works for the 1st year, but at the end of the 1st year, you have to buy a new 5 yr CD. To do that, you have to sell stocks. Each and every year you have to sell stocks and purchase a new 5 yr CD, so arent you still always selling stocks each and every year wen they may be having a down year? In fact, it doesnt even work for the 1st year because when you set up the original ladder you have to sell stocks to do it and stocks may have just had a down year.

Im sure Im misuderstanding something, right?

 

[2B]

I think you understand it perfectly. Some people believe that you can rely on the CD ladder to avoid selling in market downturns but that also becomes a form of market timing. When the market falls, you don't know if it will go down for the next 10 years or turn around tomorrow.

I have a CD ladder but only out 2 years. Yes, I'm market timing on interest rates because I believe they will go up over the next 2 years. That also implies I believe the economy will improve significantly or the FED won't have the ability to raise interest rates.

My belief in an impoving economy and rising interest rates does not impact my asset allocation. I am 60% equities and 40% cash/fixed income. My intent is to move more money into equities if they continue to fall to maintain this balance. If they go back up, I'll sell equities to buy fixed income to achieve the same split. It's a once per year event.

 

[Mysto]

Yes, I'm market timing on interest rates because I believe they will go up over the next 2 years. That also implies I believe the economy will improve significantly or the FED won't have the ability to raise interest rates.

I guess that is market timing but I agree. At the end of the day they can't go below ZERO so I am willing to bet the next major interest rate direction is up. I can't guess rates but I feel that broad directions are pretty easy in the macro sense. Both the FED and the market usually give you pretty good hints.

I built a 10 year CD self annuity when rates were at 6+% and I will not buy again for a while. (of course in 10 years inflation may kill me but I didn't say I was good on guessing CPI )

 

[Alan]

I think CD ladders are best for maximising interest since long term interest rates are usually higher than shorter term. Then you only buy 5 year CD's and each year you will have a CD maturing so you can re-invest in another 5 year CD.

For retirement purposes I now have 5 years of expenses available in cash equivalents - I-bonds that are over 5 years old plus MM funds. Each year I plan to top up the cash bucket from my retirement portfolio and if the market is doing badly then I will put off for up to 5 years until it recovers so yes, it is a form of market timing. But hey, whenever the stock portion of my portfolio gets to 45% I sell off stocks to get back to 40% so although it is called re-balancing that is also a form of market timing

 

[hogwild]

You don't have to buy a CD every year. You have a 5 year period to weather a down market. If the market is up, buy a 1 or more years worth of CDs. If the market is down, defer selling stock until it is back up while continuing living off of the CDs.

 

[Meadbh]

At the end of the day they can't go below ZERO

Technically they can.
http://www.ledr.com/neg_rates/neg_rates_home.htm

They are currently effectively zero in Japan and have been <1% since the 1990s.
BBC NEWS | Business | Japan cuts rates to zero
Financial Markets (interest rate, yield, foreign exchange rate etc.)

 

[Nords]

I have a CD ladder but only out 2 years. Yes, I'm market timing on interest rates because I believe they will go up over the next 2 years. That also implies I believe the economy will improve significantly or the FED won't have the ability to raise interest rates.

You don't have to buy a CD every year. You have a 5 year period to weather a down market. If the market is up, buy a 1 or more years worth of CDs. If the market is down, defer selling stock until it is back up while continuing living off of the CDs.

We've managed to get our two years' living expenses into three-year CDs, which may be as far as we care to game interest rates for some time.

The idea is that you use your cash stash until your portfolio has an up year. So if you have a five-year ladder, hypothetically you can live off it for five years while letting your portfolio recover from a period like 1966-82. Then you may have to liquidate four or five years' expenses at once to replenish the stash.

We chose two years' expenses because that keeps us over 90% in equities. We're getting the yield out as long as seems reasonable in the hope that we don't have to break into a long-term CD more than once or twice a decade. And if it comes to that, there's always the options of reducing spending or of liquidating only the stocks that are big winners or those needed for portfolio rebalancing.

But it is a bummer when those 6.25% fire-sale special CDs from 2007 have to be redeemed for 4%.

 

[kcowan]

Im sure Im misuderstanding something, right?

Suppose your annual budget is $40k. Then to build a 5 year ladder, you need 7 x $40k of $280k. The first $40k you keep to spend, then buy 2 x $40k to expire in 1 year. One you keep and the other you roll over for 5 years.

Now you spend down the ladder starting in year 2 unless you replenish it from your equity side. This gives you 3 years in which to decide when to replenish the ladder. You can refill it for any period you want depending on your confidence in the market futures.

 

[utrecht]

OK, now I get it. You dont just keep buying a new CD every year and selling stock to do it. You wait for an upswing in the market to rebuild the ladder. If the market has a down year you dont replenish. If the market snaps back the following year, you buy 2 rungs of the ladder back with your now higher priced stock.

Thanks!

 

[jIMOh]

I have a CD ladder for my emergency funds- 3 months expenses, 1 months expenses in a 90 day ladder, with one CD maturing every 30 days.

I could see a CD ladder helping in a down market by doing the following:

1) 5 year ladder as you suggest
2) try to have dividends and capital gains from portfolio be the equalivalent of one rung from the ladder (so the dividends can be lived on and the ladder is never truly touched unless dividends do not cover expenses).

More of the bucket approach.

 

[NudistsInParadise]

We are retiring this month at 51 and we have a five-year, $60k ladder in place, and from what we see from our budget estimates, we won't spend all $60k/year. That means the $300k in bond ladder money we have socked away may last us six or more years, or at least more than five years.

So, going by the advice above, we should watch the expenditures and only refill the bond ladder from sales of long-term cap gains equities during the market upswings, and stay on the sidelines and live off the ladder funds during flat or down years?

Later,

Mike

 

[free4now]

Ladders seem to be one place where even people who don't consider themselves market timers like to time the market. To me, that is a form of "if I don't recognize the loss it doesn't exist" thinking, so my plan is to replenish my ladder right away even in down markets.

The problem with not replenishing the ladder in down markets is that you set yourself up for worse failure in a long term down market, one which lasts longer than your ladder.

Me, I'm willing to absorb the small losses (replenishing the ladder) to avoid the big losses (not having a ladder at all because it was spent away).

 

[kaneohe]

Ladders seem to be one place where even people who don't consider themselves market timers like to time the market. To me, that is a form of "if I don't recognize the loss it doesn't exist" thinking, so my plan is to replenish my ladder right away even in down markets.

The problem with not replenishing the ladder in down markets is that you set yourself up for worse failure in a long term down market, one which lasts longer than your ladder.

Me, I'm willing to absorb the small losses (replenishing the ladder) to avoid the big losses (not having a ladder at all because it was spent away).

I generally agree w/ you. Maybe this means that you have another rung or two on the ladder which is liquid cash so that you can still do the CD reinvestment as well as have spending money for that yr even when equities are doing badly. Also so you can be opportunistic when the 6.25% PenFed CDs come around.

 

[utrecht]

Ok, this brings me back to my original point (which I never made). If you are going to replenish the ladder at the end of each period even in down markets, then whats the point of having a ladder at all?

Lets assume that the long term returns of the rest of your portifolio (65/35 or whatever) are about 6-7% or so.

Your probably only going to be getting 4% or so on avg from your CD ladder. (rough estimate). In any case, returns from your portfolio should be higher than the CD ladder portion.

If you are going to sell securites to replenish the CD ladder in any market, why have the ladder at all?

 

[jIMOh]

One other point about ladders is the ladder reduces interest rate risk. You should have a security maturing at regular intervals with an interest rate fixed for an extended period. If rates change, you have your rates locked in, except for the rung currently maturing.

 

[Kronk]

One other point about ladders is the ladder reduces interest rate risk. You should have a security maturing at regular intervals with an interest rate fixed for an extended period. If rates change, you have your rates locked in, except for the rung currently maturing.

But doesn't it increase the risk that you'd be locked into a lower rate than what you could currently find? So it eliminates downside risk, but you are more at risk if inflation and interest rates go up, right? I guess some lenders allow you to roll to a higher interest rate, though.

I've never owned a CD, and they just don't seem that appealing to me. Does anyone have data on what the historic returns for a CD ladder really were compared to something like a Vanguard Money Market fund? If the CD premium is small, I'd rather just leave it in one account, have access to it at any time, and be able to forget about it.

 

[StJohnsWood]

I keep 6 months of living expenses in a 6 month CD later. One 6 month CD comes due each month. If I do not need the money, I let it rollover. Plus I keep 1 month of living expenses in my money market so I can keep 7 months of living expenses.

 

[free4now]

The point of having the replenished ladder is to serve as an uncorrelated and lower volatility asset class which balances out equity market swings. Modern portfolio theory has shown that it makes the worst case scenario better, allowing you to take slightly larger withdrawals with less risk.

 

[free4now]

BTW, replenishing doesn't have to be a chore... I have my ladder in the form of a bond fund, which is effectively a ladder that automatically replenishes... I don't have to lift a finger.

 

[CitricAcid]

I think the big point for the ladders, as mentioned previously, is that, once established, it eliminates the tradeoff between different maturity rates on the ladder between liquidity and interest rates. If you have a ladder expiring every year for five straight years at five year rates, you will get much more attractive returns than putting in five separate one year CDs.

I, myself, would much prefer fixed income for living expenses coming from bonds or even a MM, but to each his own, FDIC is sometimes fun.

 

[jIMOh]

But doesn't it increase the risk that you'd be locked into a lower rate than what you could currently find? So it eliminates downside risk, but you are more at risk if inflation and interest rates go up, right? I guess some lenders allow you to roll to a higher interest rate, though.

I've never owned a CD, and they just don't seem that appealing to me. Does anyone have data on what the historic returns for a CD ladder really were compared to something like a Vanguard Money Market fund? If the CD premium is small, I'd rather just leave it in one account, have access to it at any time, and be able to forget about it.

If you can get the interest from the ladder to generate the income needed, the ladder would be more effective than if you spent the principal. Consider a 10 year bond or CD ladder, for example, with the interest from the ladder being spent each year (supplemented by other sources as needed). The ladder reduces the interest rate risk of a bond fund, money market or similar having the yield change each day/week/month/year. A bond or CD ladder locks in current rates for a short amount of time- so even if rates fall and the maturing bond/CD has a low yield, you have 9 other rungs in the ladder locked in at a much higher yield carrying their weight for income generation.

Consider a 5 year CD ladder, for example. Each CD has 50k in it.

Year 1, CD A for 5 years with a 4% yield. Creates 2k of income annually.
year 2, CD B for 5 years with a 5% yield. Creates 2.5k of income annually
Year 3, CD C for 5 years with a 4.5% yield. Creates 2.25k of income annually.
Year 4 CD D for 5 years with a 7% yield. Creates 3.5k of income annually.
Year 5 CD E for 5 years with an 8% yield. Creates 4k of income annually.

18.25k of income annually from the ladder.

In year 6, when CD A matures, it locks in prevailing rates. The other 4 CDs do not.

If you are spending the principal, I do agree there are probably better ways to do this (dividends, capital gains, hold more cash or something).

If you are using interest as income and not spending principal, the purpose of the ladder is to spread the interest rate risk out. If all CDs were to mature in same year, you only can get the yield the market provides that one year... so if the 8% 5 year CDs from 2003 are maturing now, you are locked into a low rate for next 5 years. The ladder reduces the risk by applying that rate to only 1/5 of the total portfolio value.

 

[OAG]

I have had a CD ladder for the past about 30 years. I have built them out as long as 10 years using 2 Credit Unions and, from time to time a Bank. Current ladder goes out 8 years and current ROR is 5.7% and consists of 55 CD's. My AVERAGE rate of return has ever since 1/1/78 has coincidentally been 5.7%. They are and have always been either CU or Bank Insured CD's (nothing exotic). Currently waiting to finish the 2015 rung which was the latest 6.00% PENFED offering back in late 2007. Usually I just let the interest accrue to the respective CD unless I have a need for additional funds in which case I "pull" the interest monthly. Never had to redeem early. Currently holding funds in MMA until something safe comes along that is equal to 5.7% or greater return (may be a while).

BTW I have found it next to impossible to find a true "CD rate over time" (other than my own) and find Bank Rate numbers very low.

 

[ChrisC]

I'm glad people have explained how they rung ladders with CDs. It would have never occurred to me that people were invading principal to meet expense needs -- I just assumed that people were creating CD ladders so that interest income would pay for some dedicated expenses and spread out interest rate risk; I had intended to use a CD ladder in my case to supplement streams of pension and retirement account income and that's all.

 

[jIMOh]

I have had a CD ladder for the past about 30 years. I have built them out as long as 10 years using 2 Credit Unions and, from time to time a Bank. Current ladder goes out 8 years and current ROR is 5.7% and consists of 55 CD's. My AVERAGE rate of return has ever since 1/1/78 has coincidentally been 5.7%. They are and have always been either CU or Bank Insured CD's (nothing exotic). Currently waiting to finish the 2015 rung which was the latest 6.00% PENFED offering back in late 2007. Usually I just let the interest accrue to the respective CD unless I have a need for additional funds in which case I "pull" the interest monthly. Never had to redeem early. Currently holding funds in MMA until something safe comes along that is equal to 5.7% or greater return (may be a while).

BTW I have found it next to impossible to find a true "CD rate over time" (other than my own) and find Bank Rate numbers very low.

what is the duration of the ladder (all 10 year CDs?, all 8 year CDs, varying maturities?)? Do you keep the rungs in equal increments? when a CD matures do you stay at same bank or shop around?

Do you feel your return has beaten money markets over same time period?

 

[Kronk]

Thanks, OAG.

5.7% is what Vanguard gives as its "Average Annual Total Return" since inception (1981) of its Federal Money Market Fund. Prime Money Market Fund inception was 1975, and has a 6.42%, but obviously interest rates where really high between 75 and 78.

But it does seem like Money Market Funds and CDs are pretty much in the same ballpark. Makes me think I probably will take the easy road when I get around to having some cash in my portfolio.