Happily Baffled with short term Treasuries

[ychuck46]

I'd have to go out to about five years or more. I guess if I was seriously chasing yield, I could do that. I'm just amazed at the yield I get for essentially holding cash with no market risk, and exceeding inflation for now.

The risk you run is that rates drop more and you have to renew the 3 month bills at a lower rate, while those who locked in longer terms stay with their elevated rates. On the other hand those that lock in longer terms run the risk that rates go up and they are left holding the bag with lower paying bills (yes, you can sell the originals and buy new but I'm keeping this simplistic, without going into penalties and the like). Regardless I choose the 3 month variations on all my purchases at Treasury Direct under the current rate structure. If rates drop I'll move even more into my high dividend paying stocks instead. Sure, more risk, but the higher dividends can oftentimes make up for the difference. Good luck.

 

[corn18]

That doesn't sound right. 10 year period certain vs. naked (no period certain) are usually very close in yield (only because very few people would buy a big annuity if it ended if they hit by a bus on the way out the door). But my research shows around 6-ish percent for SPIA, closer to 10% for 10 year deferred DIA.

From Immediate Annuities just now for a 10 year, period certain, $1M up front investment with immediate start date:

"Explanation: A 10 Year Period Certain annuity pays income for 10 years. It does not pay for your lifetime. If you die during the 10 year period, your beneficiaries receive this income for the remainder of the term. At the end of the 10 years, your original premium is not returned since it was paid out during the term. (10PC)
The Cashflow or Payout Rate is 12.38%. It is the percentage of premium paid out each year and includes interest plus return of principal."

That is a 2.38% return on investment. The misleading part is they say the payout rate is 12.38%. Well, 10% of that is just giving your money back.

 

[Chuckanut]

if I had a 10-year liability I would look at 10Y tips, not nominal bonds. ~ 2.3-2.4% which isn't bad -- not great but not bad.

Most of my bonds with a maturity of 5 years or more are TIPS with a fixed yield in the area of 2%.

Having lived through the high inflation of the 70’s and early 80’s when interest on 10 year treasuries hit double digits with ease, I have a hard time committing to 4.x% for 5 years or more.

 

[pb4uski]

From Immediate Annuities just now for a 10 year, period certain, $1M up front investment with immediate start date:

"Explanation: A 10 Year Period Certain annuity pays income for 10 years. It does not pay for your lifetime. If you die during the 10 year period, your beneficiaries receive this income for the remainder of the term. At the end of the 10 years, your original premium is not returned since it was paid out during the term. (10PC)
The Cashflow or Payout Rate is 12.38%. It is the percentage of premium paid out each year and includes interest plus return of principal."

That is a 2.38% return on investment. The misleading part is they say the payout rate is 12.38%. Well, 10% of that is just giving your money back.

Ah, I see what you are doing, you are subtracting 10% from the 12.38% payout rate and thing that the difference is the rate of return.

That is incorrect. You need to use the IRR formula. The rate of return would be 4.49%.

If the payout rate is 12.38% then on a $100,000 deposit you would receive $1,032 per month ($100,000 * 12.38%/12). The internal rate of return of a $100,000 cash outflow followed by 120 $1,032 monthly cash inflows would be 0.367% per month [0.367% = RATE(120,1032,-100000)]

0.367% per month would be an annualized rate of 4.49%
[4.49% = (1+0.367%)^12-1]

So the return is 4.49%, not 2.38%.

 

[pb4uski]

I'd have to go out to about five years or more. I guess if I was seriously chasing yield, I could do that. I'm just amazed at the yield I get for essentially holding cash with no market risk, and exceeding inflation for now.

The benefit of a ladder is that you lock in today's rates and immunize yourself from having to renew at lower rates if you stay short. So if you have a 3 year ladder and rates go down then you reinvest 33% of your total at those lower rates. OTOH, if you have a 7 year ladder and rates go down then you reinvest 14% of your total at those lower rates. And obviously, it can work against you as rates rise.

Let's say that you were trying to replicate VFITX, Vanguard's Intermediate term Treasury fund. The fund has a average maturity of 5.9 years. So if you instead created a 10 year Treasury ladder with equal rungs your weighted average maturity would be 5.5 years (close enough).

[1+2+3+4+5+6+7+8+9+10=55; /10=5.5 years]

 

[corn18]

Ah, I see what you are doing, you are subtracting 10% from the 12.38% payout rate and thing that the difference is the rate of return.

That is incorrect. You need to use the IRR formula. The rate of return would be 4.49%.

If the payout rate is 12.38% then on a $100,000 deposit you would receive $1,032 per month ($100,000 * 12.38%/12). The internal rate of return of a $100,000 cash outflow followed by 120 $1,032 monthly cash inflows would be 0.367% per month [0.367% = RATE(120,1032,-100000)]

0.367% per month would be an annualized rate of 4.49%
[4.49% = (1+0.367%)^12-1]

So the return is 4.49%, not 2.38%.

$1,000,000 invested
1,238,400 total paid back
238,400 more than I invested
23.8% return over 10 years

In my simple mind, that is 2.38% / year. Much lower rate at the beginning, much higher at the end. Doesn't matter, at the end of 10 years, I got an extra 23.8% total.

 

[pb4uski]

... In my simple mind...

Can't dispute that. Just pulling your leg.

Seriously though, it really doesn't work that way. Here is an IRR calculation assuming that the cash flows were annual. If it was monthly then compounding bumps it up to the 4.49% that I posted earlier. Perhaps the amortization schedule (way below) will make it clearer.

 

[mrfeh]

$1,000,000 invested
1,238,400 total paid back
238,400 more than I invested
23.8% return over 10 years

In my simple mind, that is 2.38% / year. Much lower rate at the beginning, much higher at the end. Doesn't matter, at the end of 10 years, I got an extra 23.8% total.

No, that's not how you calculate return, as pb4 points out.

 

[TickTock]

Another point is that that's the minimum return you'll get (10 year certain). If you live longer then you get more payments and the return is higher.

As pb4uski pointed out, you need to know when the annuity ends (your date of death if it's >10 years in this case) to know the actual rate of return.

 

[pb4uski]

Another point is that that's the minimum return you'll get (10 year certain). If you live longer then you get more payments and the return is higher.

As pb4uski pointed out, you need to know when the annuity ends (your date of death if it's >10 years in this case) to know the actual rate of return.

No. With a 10-year certain you get 120 months of payments and that's it.

I think you are thinking of a life annuity with 10 years of payments. For that form you get payments for as long as you live but if you die before 10 years your beneficiary receives payments.

 

[TickTock]

My understanding of "A 10 year period certain SPIA" is a life annuity with 10 years of guaranteed payments, regardless of the date of death. Are you sure you're not thinking of a 10-year MYGA?

 

[pb4uski]

^^^ You are misinformed.

A 10-year period certain annuity is a financial product that guarantees regular payments-usually monthly-for a fixed period of 10 years. If the annuitant (the person receiving payments) dies before the 10-year period ends, the remaining payments are made to a designated beneficiary until the full 10 years of payments have been completed124.


Key features:

• Payments are guaranteed for exactly 10 years, regardless of whether the annuitant is alive for the entire period1
• If the annuitant dies during the 10-year period, the beneficiary receives the remaining payments
• After 10 years, payments stop, even if the annuitant is still alive
• Period certain annuities typically pay higher monthly amounts than life annuities, since the payout period is fixed and limited.

This type of annuity is often used to provide predictable income for a set period, such as bridging the gap between retirement and the start of Social Security benefits. However, it does not protect against outliving your savings, since payments end after 10 years.

 

[TickTock]

Yes, I was thinking of a lifetime income annuity with 10-year certain rider. Thanks.

 

[pb4uski]

Yup.

 

[jim584672]

Plugged the numbers into an amortization calculator:

 

[corn18]

Thanks everyone for the detailed explanation. Now I am smarter!

 

[TickTock]

Lots of subtle distinctions between annuities. So an x-year period certain annuity is a replacement for a bond ladder of the same duration (where the ladder is depleted at the end), while a MYGA (Deferred Fixed Annuity) is a CD alternative. Annuity benefits are tax deferral, protection from interest rate risk, and higher rate; drawback is less flexibility.

 

[pb4uski]

Tax deferral is a double edged sword... the other side is that any withdrawals are interest first and principal second.

Protection from interest rate risk is somewhat illusory... its only because it isn't readily marketable so you never really see the current market value of most annuities so you never really see the interest rate risk. In a sense the interest rate risk is similar to bank CDs because both bank CDs and MYGAs usually have fixed early withdrawal or surrender charges.

So if you have a 10-year brokerage CD or Treasury ladder, rates increase 1% and you want your money back, you'll get back ~93.30. If you have a bank CD and want out early, you'll pay an early withdrawal penalty of ~18 months of interest so 7.5% assuming your ladder yields ~5%. If you have a MYGA then you'll have a sliding scale of surrender charges that typically starts at 10%, plus possibly a MVA charge.

 

[TickTock]

Tax deferral is a double edged sword... the other side is that any withdrawals are interest first and principal second.

True. Still, tax deferral benefits should outweigh tax drag on withdrawals (if any). At least for a well thought out plan.

Protection from interest rate risk is somewhat illusory... its only because it isn't readily marketable so you never really see the current market value of most annuities so you never really see the interest rate risk. In a sense the interest rate risk is similar to bank CDs because both bank CDs and MYGAs usually have fixed early withdrawal or surrender charges.

Interest rate risk is the chance that an unexpected change in interest rates will negatively affect the value of an investment (or more generally, will positively or negatively affect the value of an investment). The MYGA/period certain annuity produces the same increase in account value/cash flow regardless of interest rate changes. In that sense they are protected from interest rate risk, similarly to holding an individual bond to maturity.

So if you have a 10-year brokerage CD or Treasury ladder, rates increase 1% and you want your money back, you'll get back ~93.30. If you have a bank CD and want out early, you'll pay an early withdrawal penalty of ~18 months of interest so 7.5% assuming your ladder yields ~5%. If you have a MYGA then you'll have a sliding scale of surrender charges that typically starts at 10%, plus possibly a MVA charge.

I considered this covered under "drawback is less flexibility". I did seriously consider adding something to the effect of 'and, for MYGAs, possible penalties/charges if more withdrawals are wanted than are allowed without penalties/charges.' But at some point one has to draw the line with details and that's where I decided to draw the line at that post.

 

[pb4uski]

...The MYGA/period certain annuity produces the same increase in account value/cash flow regardless of interest rate changes. In that sense they are protected from interest rate risk, similarly to holding an individual bond to maturity.....

True, but only because MYGA/period certain annuities are not marketable so the decrease in value caused by higher interest rates isn't apparent. But nonetheless, if you tried to sell those cash flows in that higher interest rate environment that you would have to sell at a discount to account value.

If one holds bonds to maturity as I do, you can just ignore unrealized interest gains and losses...I put them out of my mind.

If I had a MYGA/period certain annuity and interest rates increased, I would know that I had an economic loss but it would be much easier to ignore since it doesn't show up on my dashboard each time I log in.