How Long is Your Ladder?

[wabmester]

I arbitrarily chose 7 years for the length of my CD ladder.  I'm still trying to figure out the downside of ladders and the optimal length.  With a 7-year ladder, I consistently get a high yield, my average maturity is 4 years, and the thing is 1/7 liquid each year.

Has anybody done any analysis on ladder construction?  Do you typically include all of your fixed income investments in one big ladder, or do you construct separate ladders for each security type?

Are there any bond funds available that behave something like a ladder, ie principal guaranteed, short-term liquidity, long-term yield?

 

[wzd]

Are there any bond funds available that behave something like a ladder, ie principal guaranteed, short-term liquidity, long-term yield?

These used to be available, but I haven't seen them in years. I think the costs were too high.

Wayne

 

[sgeeeee]

Has anybody done any analysis on ladder construction?  Do you typically include all of your fixed income investments in one big ladder, or do you construct separate ladders for each security type?

I use a 5 year bond ladder and have 1 year in mm/cash. The bond ladder makes up about 60% of my total bond allocation. The rest is in indexed bond funds.

I don't really feel comfortable holding bond funds as opposed to individual bonds, but it takes time to shop bonds and I haven't spent the time required to reduce my bond fund exposure yet.

It hasn't occured to me to build ladders for each security type. I can see some advantages to doing that, but it would be nice to see some analysis before I go to that much trouble.

 

[eytonxav]

I am looking into establishing some sort of CD/Bond ladder and it appears that ladder's typically are built for 5-7 year periods. But with interest rates at all time lows, I am considering even a 3-4 year ladder, as I don't want to have too much $ long at relatively low rates. There is also something called a barbell where you put $ both short and long with nothing in the middle.

One other thought if you use bonds is to use lower grade for perhaps years 1-2 (BBB), and as you move out in time go to high grade securities (A-AAA). Generally the risk is small on a short term BBB, and you can get your yield up that way. I may also do a mix of individual bonds and CDs.

Doug

 

[Ted]

I  With a 7-year ladder, I consistently get a high yield, my average maturity is 4 years, and the thing is 1/7 liquid each year.

Are there any bond funds available that behave something like a ladder, ie principal guaranteed, short-term liquidity, long-term yield?

With this and most other ladders, the yield will be pretty close to the yield on the securities having a maturity about equal to the average maturity of all of the bonds in the "ladder." In this case, that is 4 years. There is nothing especially "magical" about a 4 year maturity, in terms of return vs. risk, and it certainly is not "long term." You could get essentially the same yield and liquidity by owning a short term or intermediate term bond fund (or combination of the two) having a similar average maturity.

Right now, I'm personally avoiding long-term bonds, but if a person were interested in weighting their portfolio towards long-term bonds, a "ladder" would not be the way to do it.

 

[John Galt]

Hello GDER. I was loaded with CDs until rates
sank. Presently like you, I hold none. My bonds
(a little junk included) go out as far as 26 years, paying
from 5% to 7.375% for the most part.
Here is the deal. I am sure I can make it on what
these bonds pay, plus SS which kicks in soon. Also,
I have enough held out (currently bank MMs) for a
"cushion". Inflation is a worry, but I still have my real estate and SS will provide a little protection. I looked at
TIPS, mostly because Ted was promoting them. I get it,
but couldn't work up the required level of enthusiasm.

John Galt

 

[wabmester]

With this and most other ladders, the yield will be pretty close to the yield on the securities having a maturity about equal to the average maturity of all of the bonds in the "ladder." In this case, that is 4 years.

I'm not sure I follow you. Since I'm always adding to the long end of the ladder, my yield is an average of the 7-year yield over the last 7 years, which is currently slightly higher than the current 7-year CD yield. Why do you feel the yield should match the average maturity?

You could get essentially the same yield and liquidity by owning a short term or intermediate term bond fund (or combination of the two) having a similar average maturity.

Again, that doesn't seem to be the case in practice. The yield for a bond fund with similar average maturity is lower, and the NAV is much less predictible. Maybe the former is just an artifact of the recent interest rate trends, but I suspect it's also a side-effect of the way bond funds are managed. Don't they tend to sell off some of their higher yielding bonds to realize cap gains that smooth out their NAV y-o-y?

Right now, I'm personally avoiding long-term bonds, but if a person were interested in weighting their portfolio towards long-term bonds, a "ladder" would not be the way to do it.

I don't like long-term right now either, but I'm not sure I'd rather be in a LT bond fund than a LT ladder. Why do you think so?

 

[Ted]

Wabmester,

The thing that determines the yield to maturity of a bond (given a particular credit rating) is the length of time remaining until it matures.  When it was issued, or when you bought it, is irrelevant.  So if one of your bonds has, say, one year to mature, it's total return over the next year (i.e., its yield to maturity)will be about equal to that of a one year Treasury Bill.  That is why the total return on a portfolio of bonds will be about the same as the total return on a bond having the average maturity (or, more accurately, average duration) of the total portfolio.

And here's an example problem that most financial experts probably would not get right.  Say that you buy a recently-issued 10 year Treasury Note at par with a 5% coupon.  Its yield to maturity will therefore be 5%.  But assume that the yield curve on Treasury securities is positive and stays the same as the note matures.  (In other words, short term yields are lower than long term yields and stay that way.)  During the first year that you hold the 10 year Note, the total return will be:

a. 5%
b. Greater than 5%
c. Less than 5%

Let's see how many responses we get before I explain the answer. (This is not a trick question that involves taxes or other expenses, the effect of leap years, or anything like that which is not stated.)

 

[wabmester]

Ted, you'll note that my example was for a CD ladder rather than a bond ladder. I'm not aware of CD's being available on the secondary market, so the yield stays constant, doesn't it?

I think I understand the point you're making: on the secondary market, the value of a bond of a given coupon goes up the closer you get to maturity, so the yield to maturity goes down relative to the new higher value of the bond. I'm not sure how this is relevant to ladder building since the idea is to hold to maturity, and then reinvest the principal at the long end once a given rung matures.

Regarding your puzzle, I'll give you three different answers:

Your return on your initial investment was 5%.

The yield on the new value of your bond will be less than 5%, but the value will have risen.

The return you got in the first year is greater than the resulting yield at the end of the year, so the return relative to, say, $1000 worth of the bond is greater than 5%.

 

[wzd]

The total return for the first year will depend on the change in interest rates. If interest rates rise, such that the 9 year rate is 5%, then the return the first year will be 5%. If interest rates rise less than that, the return will be >5%. If more, <5%. The total return for the first year is not known until the end of the first year.

You state that we should assume the yield curve stays the same. If by that you mean the curve, AND the values on the curve stay the same, then the yield on a 9 year bond will be <5%, and therefore the total return the first year will be >5%.

Wayne

 

[Ted]

I'm sorry. I was fixated on the more usual arrangement of having a bond ladder. With a CD ladder you do "lock in" the yield of the longest term CD. But that will typically be less than the yield on a bond of equivalent maturity.

WZD is right about the total return on a bond initially being greater than its interest yield, when the yield curve is positive, because the bond will initially gain market value. When the bond is about half way to maturity, the premium on its market value begins to shrink, causing the total return to be less than the interest yield. Thus, over the life of the bond its yield to maturity is its interest yield, but the annual total return first rises and then falls (when the yield curve is positive, as it usually is).

 

[wabmester]

Thanks, professor I've learned that I should sell my bonds before they get half way to maturity, and I should buy bonds closer to maturity to pick up the premium the market is throwing away.

As far as ladders goes, I'll probably stick pretty close to the knee of the yield curve. I don't see a big advantage to going very long-term.

And wrt your comment about bond yields typically being higher than CD yields, I can't explain it, but today I can get a 3-yr CD that yields more than a 10-yr treasury, so I'm buying CDs for now.

 

[wabmester]

I just read this article on fixed income strategy by DFA:

http://www.dfaus.com/strategies/fixed/

One of the strategies they employ is to take advantage of the yield curve (a la Ted), which generally means they don't hold bonds to maturity.

This seems to be a pretty good argument against both bond ladders and passive bond funds.

Can anybody recommend an actively managed bond fund in the style of DFA from, say, Vanguard? Or is it safe to assume that all bond fund managers have a standard bag of tricks like this?

 

[Brat]

You might like to review the answers I got on Fund Alarm's discussion board about FSICX (Fidelity Strategic Income) and FFRHX (Fidelity Floating Rate).

 

[John Galt]

I have some of the American High Yield Bonds Fund.
Bought it mostly on my broker's rec. (obviously it carries a front end load) and didn't really do
my homework (lazy). Anyway, the February issue of MONEY ranks thousands of stock and bond funds.
I even bought the mag., which I hardly ever do
(read it at the library). The point is that even though I
did my research "after the fact", I probably would have bought it anyway. You can drive yourself crazy trying
to compare all the choices out there. That includes me
even after I eliminate a huge universe of "possibles".

I have a bunch of stuff at pretty high rates which is callable over the next year or so. If rates stay where
they are, I expect these bonds to be called. Then,
more decisions on where to put the money. I gotta
tell you though; it's better than not having any money to
worry about .

John Galt

 

[wabmester]

I wouldn't go into junk bonds right now. The spread has narrowed for junk, so it looks like it's all downhill from here.

The floating rate fund looks interesting, though.