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This is something I've always wondered: Are treasury bond ladders strictly better than an equivalent treasury bond fund (say VFITX), because the interest rate r

This is something I've always wondered: Are treasury bond ladders strictly better 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? 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?

snikeris 8y ago
From the article: > 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). You can avoid selling the bond at a loss; however, you are still holding a bond that earns less interest than current bonds are earning. As far as I know, holding to maturity doesn't improve your returns in the face of rising interest rates despite what the author seems to be implying.
- Retric 8y ago
  Don’t forget transaction fees. If you sell bond X that pays out 100$ in 1 year for bond Y which pays out 100$ in one year you gained nothing.
- jterenzio 8y ago
  What holding does is lock your returns and sets a floor. When you buy a bond and hold it you will be guaranteed to receive the return. Sure if rates rise afterwards you have opportunity cost because you can't invest that money at a higher rate, but that's what ladders help you do. You get the current rate when you add new bonds to the end. What alternatives exist? You can buy a bond fund which might decline in value if rates rise or just sit on cash but those don't seem optimal.
- cirgue 8y ago
  Yeah, the idea is that at any give price, holding any bond or selling it and using the proceeds to purchase bonds at the current rate are equivalent from a return perspective.
frgtpsswrdlame 8y ago
>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? Yes they converge in the long-term. A treasury bond fund is just a ladder (albeit maybe weighted a little differently) that reinvests in a convenient wrapper. The case being made here is that if you may need to pull money from the bond strategy then the ladder is good because there is always a bond that is very close to maturity.
jterenzio 8y ago
You are correct in rising interest rate environments where you believe the rates will continue to rise. With bond funds you can get the same yield as the ladder (interest payments) if you hold forever and never sell, but if you sell you may take a hit because the price has gone down. That doesn't happen with ladders since you always get paid out the face value.
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mywittyname 8y ago
When you buy the bonds directly, you're choosing an explicit exit date and you know exactly what your return will be. When you buy a bond fund, your principal is going to be reinvested, so there's a risk of interest rates going up right before you sell. Some firms offer target maturity bond funds which will is the best of both worlds.
- pishpash 8y ago
  Liability matching is strictly more optimal. If you know when you need money you can take that portion of the risk out of the equation. On the other hand, with reinvested funds, you are paid to take the risk of interest rates going up and the lack of a fixed maturity date, by the possibility that interest rates might go down (the so-called roll-yield).
- jterenzio 8y ago
  > Some firms offer target maturity bond funds which will is the best of both worlds. These are great for corporate bonds. Check out iShares iBonds if you want to include corporate bonds in your portfolio without building a ladder or taking on interest rate risk.
  - ThrustVectoring 8y ago
    You don't want to include corporate bonds in your portfolio. Generally speaking, buying equities gets you a better price for the risk you take; a slightly higher equity percentage with government-backed bonds will generally outperform at the same level of risk.
    - jterenzio 8y ago
      Is there a good link to learn more about that?
      - ThrustVectoring 8y ago
        Not that I can easily find or remember.
mvilim 8y ago
No, bond ladders are not strictly better than a bond fund. In theory, they are equivalent. In a bond fund, you simply see your loss on rising interest rates more directly. Scenario 1 (holding bonds to maturity, i.e. bond ladder): Let's imagine you invest in a $100 1yr bond at a 2% rate. You will be paid $102 in a year's time. Immediately after you buy the bond, the rate goes to 3%. You are locked into the bond, so you can't switch to the higher rate (i.e. you've lost out on a potential $1). Scenario 2 (bond funds, ignoring reinvestment): Instead imagine that you invest $100 in a fund that currently holds 1yr bonds at a 2% rate. You expect to be able to sell this fund in a year's time for $102. Now the rate changes to 3%. You are not locked into the fund, but the fund is locked into the bonds that they bought. If you can sell your shares in the fund for $100, you could then buy the new 3% rate bonds directly (i.e. you have avoided the loss due to the interest rate change). This would be a risk-free arbitrage between the fund and the new bonds. The price of the fund needs to drop to ~$99 to be "fair" (to be precise, it's 1.02/1.03, not exactly 99). If you sell at ~$99 and buy new 3% bonds directly, you will receive $102 in a year's time, just like scenario 1. In short, the bond fund loses value because you maintain the optionality to withdraw whenever you want (and invest at higher rates if rates go up). The expected value between bond funds and bond ladders is still the same. In essence, the difference is between holding bonds to maturity and having the possibility of selling them, which doesn't change the expected value.
- jterenzio 8y ago
  In theory that's true if you hold the fund forever but take the example of VGSH from another comment thread. If you bought that fund exactly 1 year ago and sold today you would have realized a return of less than 2% because while the yield is currently about 2.5% the price decrease over that time was about 1.5%. Your return would have been less than buying a single treasury yielding 2% a year ago and letting it mature.
  - mvilim 8y ago
    I don't think this has anything to do with how long you hold the fund. In essence, the original comment was using bond ladders as a proxy for holding bonds till expiration and using bond funds as a proxy for always liquidating your bonds and reinvesting at the new rate on any rate change. The question is really about holding vs liquidating bonds, not funds vs ladders (which theoretically could hold or liquidate, depending on their implementation). If the market is fairly priced, then there is no expected value difference between holding and liquidating. In the example I gave above, the value of the fund in a year is still $102 (independent of whether they hold the bonds to maturity or whether they sell at the fair market value and reinvest at the higher rate). In your example, buying and holding a treasury would only be better than VGSH if the market on average underestimated the future interest rate over that time period (so that as VGSH rolled (i.e. liquidated and reinvested) its bonds at an average rate of less than 2%). This has less to do with holding vs liquidating than it has to do with fair pricing of the interest rate. The main difference between holding to maturity and rolling the bonds is this: if you hold to maturity you make a single large bet on the interest rate; if you roll your bonds, you make several smaller bets on the interest rate. Yes, as you say, holding a bond instead of rolling it can lead to a different return (when the market expectation of the future rate is wrong). But for most people this is irrelevant, as they won't be better at valuing interest rates than the rest of the market.
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snikeris 8y ago

From the article: > 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). You can avoid selling the bond at a loss; however, you are still holding a bond that earns less interest than current bonds are earning. As far as I know, holding to maturity doesn't improve your returns in the face of rising interest rates despite what the author seems to be implying.

Retric 8y ago
Don’t forget transaction fees. If you sell bond X that pays out 100$ in 1 year for bond Y which pays out 100$ in one year you gained nothing.
jterenzio 8y ago
What holding does is lock your returns and sets a floor. When you buy a bond and hold it you will be guaranteed to receive the return. Sure if rates rise afterwards you have opportunity cost because you can't invest that money at a higher rate, but that's what ladders help you do. You get the current rate when you add new bonds to the end. What alternatives exist? You can buy a bond fund which might decline in value if rates rise or just sit on cash but those don't seem optimal.
cirgue 8y ago
Yeah, the idea is that at any give price, holding any bond or selling it and using the proceeds to purchase bonds at the current rate are equivalent from a return perspective.

frgtpsswrdlame 8y ago

>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? Yes they converge in the long-term. A treasury bond fund is just a ladder (albeit maybe weighted a little differently) that reinvests in a convenient wrapper. The case being made here is that if you may need to pull money from the bond strategy then the ladder is good because there is always a bond that is very close to maturity.

jterenzio 8y ago

You are correct in rising interest rate environments where you believe the rates will continue to rise. With bond funds you can get the same yield as the ladder (interest payments) if you hold forever and never sell, but if you sell you may take a hit because the price has gone down. That doesn't happen with ladders since you always get paid out the face value.

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mywittyname 8y ago

When you buy the bonds directly, you're choosing an explicit exit date and you know exactly what your return will be. When you buy a bond fund, your principal is going to be reinvested, so there's a risk of interest rates going up right before you sell. Some firms offer target maturity bond funds which will is the best of both worlds.

pishpash 8y ago
Liability matching is strictly more optimal. If you know when you need money you can take that portion of the risk out of the equation. On the other hand, with reinvested funds, you are paid to take the risk of interest rates going up and the lack of a fixed maturity date, by the possibility that interest rates might go down (the so-called roll-yield).
jterenzio 8y ago
> Some firms offer target maturity bond funds which will is the best of both worlds. These are great for corporate bonds. Check out iShares iBonds if you want to include corporate bonds in your portfolio without building a ladder or taking on interest rate risk.
- ThrustVectoring 8y ago
  You don't want to include corporate bonds in your portfolio. Generally speaking, buying equities gets you a better price for the risk you take; a slightly higher equity percentage with government-backed bonds will generally outperform at the same level of risk.
  - jterenzio 8y ago
    Is there a good link to learn more about that?
    - ThrustVectoring 8y ago
      Not that I can easily find or remember.

mvilim 8y ago

No, bond ladders are not strictly better than a bond fund. In theory, they are equivalent. In a bond fund, you simply see your loss on rising interest rates more directly. Scenario 1 (holding bonds to maturity, i.e. bond ladder): Let's imagine you invest in a $100 1yr bond at a 2% rate. You will be paid $102 in a year's time. Immediately after you buy the bond, the rate goes to 3%. You are locked into the bond, so you can't switch to the higher rate (i.e. you've lost out on a potential $1). Scenario 2 (bond funds, ignoring reinvestment): Instead imagine that you invest $100 in a fund that currently holds 1yr bonds at a 2% rate. You expect to be able to sell this fund in a year's time for $102. Now the rate changes to 3%. You are not locked into the fund, but the fund is locked into the bonds that they bought. If you can sell your shares in the fund for $100, you could then buy the new 3% rate bonds directly (i.e. you have avoided the loss due to the interest rate change). This would be a risk-free arbitrage between the fund and the new bonds. The price of the fund needs to drop to ~$99 to be "fair" (to be precise, it's 1.02/1.03, not exactly 99). If you sell at ~$99 and buy new 3% bonds directly, you will receive $102 in a year's time, just like scenario 1. In short, the bond fund loses value because you maintain the optionality to withdraw whenever you want (and invest at higher rates if rates go up). The expected value between bond funds and bond ladders is still the same. In essence, the difference is between holding bonds to maturity and having the possibility of selling them, which doesn't change the expected value.

jterenzio 8y ago
In theory that's true if you hold the fund forever but take the example of VGSH from another comment thread. If you bought that fund exactly 1 year ago and sold today you would have realized a return of less than 2% because while the yield is currently about 2.5% the price decrease over that time was about 1.5%. Your return would have been less than buying a single treasury yielding 2% a year ago and letting it mature.
- mvilim 8y ago
  I don't think this has anything to do with how long you hold the fund. In essence, the original comment was using bond ladders as a proxy for holding bonds till expiration and using bond funds as a proxy for always liquidating your bonds and reinvesting at the new rate on any rate change. The question is really about holding vs liquidating bonds, not funds vs ladders (which theoretically could hold or liquidate, depending on their implementation). If the market is fairly priced, then there is no expected value difference between holding and liquidating. In the example I gave above, the value of the fund in a year is still $102 (independent of whether they hold the bonds to maturity or whether they sell at the fair market value and reinvest at the higher rate). In your example, buying and holding a treasury would only be better than VGSH if the market on average underestimated the future interest rate over that time period (so that as VGSH rolled (i.e. liquidated and reinvested) its bonds at an average rate of less than 2%). This has less to do with holding vs liquidating than it has to do with fair pricing of the interest rate. The main difference between holding to maturity and rolling the bonds is this: if you hold to maturity you make a single large bet on the interest rate; if you roll your bonds, you make several smaller bets on the interest rate. Yes, as you say, holding a bond instead of rolling it can lead to a different return (when the market expectation of the future rate is wrong). But for most people this is irrelevant, as they won't be better at valuing interest rates than the rest of the market.

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