Treasuries, CDs, and Munis reconsidered

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stlutz
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Treasuries, CDs, and Munis reconsidered

Post by stlutz » Tue Jun 25, 2013 11:11 pm

Amidst all of the panic threads about bonds of late, I thought I'd add in the results of some number crunching I've been doing.

I'd like to question a couple of points that have become the conventional view around here of late:

a) CDs represent a free lunch over a Treasury bond fund--higher return and less risk
b) In a taxable account, a muni bond fund offers significantly higher returns than a Treasury bond fund, which is either a free lunch or reveals hidden risks in the muni market.

Let's look at these further:

First, 5 year CDs are considered a great deal right now. Right now at depositaccounts.com, the highest nationally available rate is 2.00%. .

Second, there is the Treasury bond fund. To simplify things, let's take the Stlutz Intermediate Term Treasury Fund. Its strategy is to buy a T-note of just over 5 years in maturity, hold it for 1 year and then replace it with a new bond. Right now, this fund holds the 9/30/2018 bond yielding 1.54% and priced at 99.188. It has a coupon rate of 1.375% The common assumption is that the "expected" return on this fund is therefore 1.54%. However, funds like mine and VG Intermediate Term Treasury don't do this. They buy bonds, hold them for a while, and then sell them well before maturity (VG IT Treasury basically turns over its entire portfolio each year). Thus, if one assumes that the yield curve remains the same for the next year, my bond will then be a 4 year bond yielding 1.23%. That would mean the price would have gone up to 100.590. Thus, my return would be as follows:

the coupon 1.375% / 99.188 (the bond price) = 1.39%
capital appreciation from 99.188 to 100.592 = 1.42%
Total expected return for the next year = 2.80%

Thus, the intermediate term treasury fund has a higher expected return than the CD if one assumes that the yield curve will basically stay like it is for the next year.

I know many people here think rates will continue to skyrocket, so this assumption wouldn't hold if that is your view. However, if you are like me and you have no idea what the future holds, then it is usually assumed that the best forecast of the future yield curve is simply the current curve.

Regardless, the CD is no longer a free lunch--you are accepting a guaranteed return that is lower than the expected but uncertain T-bond return. That doesn't mean the CD is a bad idea--it just means that there is no free lunch.

Now lets add in munis and look at after tax returns.

Because the muni market is much less liquid than the Treasury market, a muni bond fund like VG IT-TE resembles a rolling bond ladder as opposed to the buying and selling that goes on with the Treasury fund--most bonds are held to maturity. VG IT-TE turns over about 10-15% of its portfolio each year. When bonds are held to maturity, the SEC Yield of the fund basically represents your expected return, as that cacluation assumes bonds held to maturity. The SEC yield of the Vanguard fund is currently 2.04%.

So, let's look at after tax returns. I'll assume a 28% federal tax rate and a 5% state tax rate:

CD: 2.0% return - 33% taxes = 1.34%
Muni Fund: 2.04% - 5% taxes = 1.94%
Treasury Fund: 1.39% coupon - 28% taxes = 1.00%
+ 1.42% cap. gain - 20% taxes (15 federal, 5 state) = 1.14%
total = 2.14%

Thus, even after taxes the Treasury fund has the highest expected return of these three options.

In short, I think the assumption that Treasuries are simply a horrible investment compared to the alternatives should be reconsidered.

I'm thinking out loud here, so please make additions/subtractions/correction to my logic as needed.
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EDIT: I later reconsidered my view/calculation on bond ladders (e.g. the muni fund example). See page 2 for more....
Last edited by stlutz on Tue Jul 23, 2013 10:35 pm, edited 1 time in total.

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Re: Treasuries, CDs, and Munis reconsidered

Post by ogd » Tue Jun 25, 2013 11:20 pm

Really quickly, what jumped at me:
stlutz wrote: Total expected return for the next year = 2.80%
VGIT has a yield of 1.07%. I don't know how you got 2.8 (can't go through the price calculation right now), but I think you might be double-counting the yield.
stlutz wrote: Muni Fund: 2.04% - 5% taxes = 1.94%
For some of us, the state muni fund saves about 50% in taxes...

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Re: Treasuries, CDs, and Munis reconsidered

Post by stlutz » Tue Jun 25, 2013 11:36 pm

VGIT has a yield of 1.07%. I don't know how you got 2.8
The SEC Yield isn't a snapshot--it's an average of the past 30 days. As of 5/31, VGIT reported a portfolio YTM of 1.1%, which was about the yield of a 5 year T-note on that date. Now, the 5 year yields 1.49%

The rest of the "expected" return comes from the capital appreciation that would occur if you held the bond for 1 year and sold it as a lower-yielding 4 year bond.

However, your post does make me think that I have underestimated the yield of the Tax Exempt fund, as the SEC Yield of that will also be understated because of the 30 day averaging issue. Once that is taken into account, the muni probably does promise higher after-tax expected returns than the Treasury.

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Re: Treasuries, CDs, and Munis reconsidered

Post by ogd » Wed Jun 26, 2013 12:09 am

stlutz wrote:The SEC Yield isn't a snapshot--it's an average of the past 30 days. As of 5/31, VGIT reported a portfolio YTM of 1.1%, which was about the yield of a 5 year T-note on that date. Now, the 5 year yields 1.49%
The SEC yield has priced in the decline in NAV, so it's current.
stlutz wrote:The rest of the "expected" return comes from the capital appreciation that would occur if you held the bond for 1 year and sold it as a lower-yielding 4 year bond.
According to my bond calculator, the 4 year bond yielding 1.375 will be worth $99.32 next year, assuming rate stays 1.54%. Your calculation, I think, essentially double-counts the yield.

And it figures, because your train of thought would have ended with a bond at maturity worth $105 or something :) This gave me pause the first time around too.

Ouch, scratch that. Your calculation is right, I just don't understand how you can extract 2.80% yield from that bond, or why VGIT yield is so immensely hurt by its maturity curve. I'll have a better handle on this in the morning.
stlutz wrote:However, your post does make me think that I have underestimated the yield of the Tax Exempt fund, as the SEC Yield of that will also be understated because of the 30 day averaging issue. Once that is taken into account, the muni probably does promise higher after-tax expected returns than the Treasury.
I don't think you need to do that. I was only asking for some high tax bracket consideratios :)

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Re: Treasuries, CDs, and Munis reconsidered

Post by Kevin M » Wed Jun 26, 2013 1:00 am

This is much simpler than you're making it. Simply compare a 5-year treasury to a 5-year CD. Yield on 5-year treasury is about 1.5% vs. your stated 2% on the CD. The choice is easy for me. To somehow turn a 1.5% known nominal return into a 2.8% nominal return is your mythical free lunch. You simply cannot be comparing apples to apples here.

Then on top of that, you can't simply ignore the CD early withdrawal option, which caps your downside risk to 1% with an EWP of 180 days of interest. You can argue that there's a risk that the early withdrawal will be disallowed, or that the terms will be changed, but to simply ignore the option is not rational.

With respect to munis and treasuries, I trust that the bond market is quite efficient, so I don't think there's generally a free lunch with either. Munis clearly have more credit risk than treasuries; the market prices this risk accordingly. There may be some inefficiencies from time to time, such as the muni bond fund scare a couple of years ago, and the muni bond ETF market price discount to NAV recently. Calm, rational investors may be able to take advantage of these inefficiencies, but nothing is certain.

Incidentally, I don't think the common view is that CDs are a free lunch vs. treasuries--certainly not vs. bond funds in general. I think those of us who see a clear advantage in CDs are in the minority. I see many, many more posts suggesting to "stay the course", and continue to hold bond funds rather consider CDs as an alternative. I have to admit this puzzles me somewhat, but it is what it is.

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Re: Treasuries, CDs, and Munis reconsidered

Post by SimpleGift » Wed Jun 26, 2013 8:28 am

Kevin M wrote:Incidentally, I don't think the common view is that CDs are a free lunch vs. treasuries--certainly not vs. bond funds in general. I think those of us who see a clear advantage in CDs are in the minority. I see many, many more posts suggesting to "stay the course", and continue to hold bond funds rather consider CDs as an alternative. I have to admit this puzzles me somewhat, but it is what it is.
Kevin, please pardon this naive question about the rolling CD strategy in place of a bond fund allocation: Are rolling CDs designed to be a permanent asset allocation in one's portfolio, to be executed throughout the rest of one's investing career? Or are they just a "placeholder strategy" during this period of low interest rates and relatively high bond prices, a temporary substitute for bond funds?

If it's just a placeholder strategy, it would seem to present a market timing dilemma. In other words, how does one know when interest rates have risen sufficiently that it's time to abandon CDs and start reinvesting in bond funds again? What's the decision-making process about when to risk one's capital again to the vagaries of bond market interest rate changes? And how does one determine when to switch back again to the safety of CDs?

Since these two strategies (rolling CDs versus bond funds) are so different, it seems one would constantly be faced with the problem of market timing back and forth between them — unless I'm missing something. Thanks.
Last edited by SimpleGift on Wed Jun 26, 2013 8:42 am, edited 2 times in total.

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Re: Treasuries, CDs, and Munis reconsidered

Post by richard » Wed Jun 26, 2013 8:37 am

ogd wrote:Ouch, scratch that. Your calculation is right, I just don't understand how you can extract 2.80% yield from that bond, or why VGIT yield is so immensely hurt by its maturity curve. I'll have a better handle on this in the morning.
He's not getting 2.8% yield. He's getting about 1.4% in capital appreciation by "riding the yield curve." Longer term bonds typically have a higher yield shorter term bonds. Over time, longer bonds become shorter term, so their higher yield is equalized by an increase in price.

For example, after 4 years a 5 year bond is a 1 year bond, yet it has a higher coupon than new 1 year bonds. Therefore, if yields don't change, the 5 year, now 1 year, bond will sell at a premium.

Is this a free lunch? Of course not. The strategy often works, but has risk. Google "riding the yield curve" for more info.

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Re: Treasuries, CDs, and Munis reconsidered

Post by gerrym51 » Wed Jun 26, 2013 8:39 am

since this is a cd thread(sort of). How many people here consistently break CD's. i know we talk constantly about having the ability to break a CD but who actually does and does the bank you do it to try to talk you out of it.

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Re: Treasuries, CDs, and Munis reconsidered

Post by Epsilon Delta » Wed Jun 26, 2013 8:53 am

stlutz wrote:First, 5 year CDs are considered a great deal right now. Right now at depositaccounts.com, the highest nationally available rate is 2.00%. .

Second, there is the Treasury bond fund. To simplify things, let's take the Stlutz Intermediate Term Treasury Fund. Its strategy is to buy a T-note of just over 5 years in maturity, hold it for 1 year and then replace it with a new bond.
Over time, the average duration of the maturing CD is about 2.5 years, while the average duration of SITTF is about 4.5 years. This means there is extra risk in SITTF, which explains some or all of the extra return.

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Re: Treasuries, CDs, and Munis reconsidered

Post by Sidney » Wed Jun 26, 2013 8:56 am

CDs have a scale problem.
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Re: Treasuries, CDs, and Munis reconsidered

Post by richard » Wed Jun 26, 2013 9:06 am

Sidney wrote:CDs have a scale problem.
Only if you care about risk. :P

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Re: Treasuries, CDs, and Munis reconsidered

Post by Sidney » Wed Jun 26, 2013 9:13 am

richard wrote:
Sidney wrote:CDs have a scale problem.
Only if you care about risk. :P
True! and I should note, most of the references to "treasuries" didn't specify which country. :wink:
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Re: Treasuries, CDs, and Munis reconsidered

Post by Doc » Wed Jun 26, 2013 9:15 am

richard wrote: He's not getting 2.8% yield. He's getting about 1.4% in capital appreciation by "riding the yield curve." Longer term bonds typically have a higher yield shorter term bonds. Over time, longer bonds become shorter term, so their higher yield is equalized by an increase in price.
As I understand it riding the yield curve is based on the slope of the yield curve and the fund's transaction costs. If the slope is positive and the cost are low enough there is gain to be made. How much to be gained depends on what the future yield curve looks like but it has been said that the best predictor of the future yield curve is the present one albeit not a very good one.

Note this is not necessarily active management. It is just a fund following a particular index.

As an example the Vanguard short TIPS fund follows a 0-5 index while the PIMCO short TIPS ETF follows the 1-5 index. Given PIMCO's size and expertise in bonds I suspect that their transaction costs are lower and therefore have more potential to be gained in "riding the yield curve" than Vg.
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Re: Treasuries, CDs, and Munis reconsidered

Post by nimo956 » Wed Jun 26, 2013 9:28 am

Kevin M wrote:With respect to munis and treasuries, I trust that the bond market is quite efficient, so I don't think there's generally a free lunch with either. Munis clearly have more credit risk than treasuries; the market prices this risk accordingly. There may be some inefficiencies from time to time, such as the muni bond fund scare a couple of years ago, and the muni bond ETF market price discount to NAV recently. Calm, rational investors may be able to take advantage of these inefficiencies, but nothing is certain.
Aren't most munis callable, whereas treasuries are not? Do taxable investors tend to overlook this risk when deciding between munis and treasuries? In my mind, callable bonds are a lose-lose proposition. The price of the bond goes down if interest rates rise, and the bond gets called if interest rates fall, so you have to invest at a lower rate.

There's also default risk as well. I don't really accept that there's a default risk for treasuries since the US gov can always print more money. Municipalities, however, cannot print more money or raise taxes to generate additional revenue as needed.
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Re: Treasuries, CDs, and Munis reconsidered

Post by stlutz » Wed Jun 26, 2013 10:34 am

Over time, the average duration of the maturing CD is about 2.5 years, while the average duration of SITTF is about 4.5 years
Duration of a non-brokered CD is really more like 0, as they are immune from interest rates hikes and drops. I would absolutely agree that there is less risk in a CD than in an intermediate-treasury fund.
As I understand it riding the yield curve is based on the slope of the yield curve and the fund's transaction costs. If the slope is positive and the cost are low enough there is gain to be made
Yes, which is why riding the yield curve isn't really a viable strategy for a muni bond fund where trading costs are high.

More broadly on "riding the yield curve": This is a variable maturity strategy where you always own the bonds at the point where the yield curve is the steepest. This usually occurs in the ~2-3 year range. In recent years, it's been much further out. A fund like Vanguard IT-Treasury doesn't really vary its duration--it's always been 5 and 5.5. In more normal times, the capital gain from buying a bond and selling it a year later would be ~.25%/yr. Right now, however, the capital gain portion is a disproportionally large part of the returns on a fund like this.

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Re: Treasuries, CDs, and Munis reconsidered

Post by ogd » Wed Jun 26, 2013 10:42 am

richard wrote:He's not getting 2.8% yield. He's getting about 1.4% in capital appreciation by "riding the yield curve." Longer term bonds typically have a higher yield shorter term bonds. Over time, longer bonds become shorter term, so their higher yield is equalized by an increase in price.
Thanks, I got it. It all makes sense in the morning. The large difference is about the maturity over time.

Code: Select all

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5-year T, rolled over             5-year fund, idealized
at maturity                       
The strategy on the left makes 1.54%. It makes sense that the strategy on the right is rewarded for the additional interest rate risk, the missing upper half of the seesaw. Not exactly double because the diagonals are not straight when translated into yield curves, but it's in that ballpark.

Part of this was me refusing to believe that SEC yields are so far off base (from what actually I want to know). I knew that it's the best for comparisons between funds, but I didn't quite understand that it assumes bonds are held to maturity and the implications thereof. So the SEC yield represents the strategy on the left rather than what the fund is actually doing. :oops:

The distribution yield is more like it, but it has other reliability problems. Will somebody, anybody, please, tell me what my fund will be making if nothing else changes? I want the "stlutz" yield :)

Thanks, stlutz! This has been most illuminating. I've never tried to roll bonds by hand before.

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Re: Treasuries, CDs, and Munis reconsidered

Post by Doc » Wed Jun 26, 2013 11:48 am

ogd wrote:
The distribution yield is more like it, but it has other reliability problems. Will somebody, anybody, please, tell me what my fund will be making if nothing else changes? I want the "stlutz" yield :)
If both the yield curve and the funds strategy remain constant you will get the SEC yield for the "duration".

b) You want something like IEI IShares Bar Cap 3-7 year Treasury. (This is just an example of an Index fund/ETF that takes advantage of the riding the yield curve concept. There are others.)
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Re: Treasuries, CDs, and Munis reconsidered

Post by neurosphere » Wed Jun 26, 2013 12:02 pm

Doc wrote: If both the yield curve and the funds strategy remain constant you will get the SEC yield for the "duration".
Is this statement generally true? --> When interest rates are actively rising, the SEC yield will underestimate the actual yield which will be earned by the investor in the bond fund.

I.e. The vanguard long-term new york tax exempt fund shows an SEC yield today of 2.48%. If that represents the average of the past 30 days, then can't one assume that as of TODAY, shares owned by the fund will likely earn MORE than 2.48%, because we know that interest rates have risen during that 30 day period? If rates stay unchanged for the NEXT 30 days, then the SEC yield will steadily increase until the "moving average" represented by the SEC yield catches up with a new steady state baseline (again, assuming that interest rates for the next 30 days are unchanged).

Do I have this right?
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Re: Treasuries, CDs, and Munis reconsidered

Post by ogd » Wed Jun 26, 2013 12:14 pm

Doc wrote:
ogd wrote:
The distribution yield is more like it, but it has other reliability problems. Will somebody, anybody, please, tell me what my fund will be making if nothing else changes? I want the "stlutz" yield :)
If both the yield curve and the funds strategy remain constant you will get the SEC yield for the "duration".
That's what I used to think, but is it true? It seems to represent what happens if the fund's portfolio stays completely unchanged and is allowed to "taper" to cash by the time duration elapses. In other words, it's the equivalent of a bond's YTM. This is not what the fund does.

Otherwise, how do you explain the huge discrepancy between VGIT's yield and the rolled 5 year treasury like in stlutz's scenario?

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Re: Treasuries, CDs, and Munis reconsidered

Post by Doc » Wed Jun 26, 2013 12:41 pm

neurosphere wrote:
Doc wrote: If both the yield curve and the funds strategy remain constant you will get the SEC yield for the "duration".
Is this statement generally true? --> When interest rates are actively rising, the SEC yield will underestimate the actual yield which will be earned by the investor in the bond fund.
"When interest rates are actively rising" the yield curve is not constant.
ogd wrote:It seems to represent what happens if the fund's portfolio stays completely unchanged and is allowed to "taper" to cash by the time duration elapses.
This is true but if you reinvest all cash flows in exactly the same portfolio you essentially wind up with a zero with infinite maturity so the SEC yield remains constant forever which is usually longer than the original duration. (At least I think so but I'm breaking a cardinal rule to not do discounted cash flow calculations in my head.) :beer

When you do a YTM you can use the present value formulas (taper) or a future value formula assuming all cash flows are reinvested at the same YTM. The equations are the same except for dividing (multiplying?) by (1+i)^n or something like that anyway. I think the B-schoolers tend to use present value because they want to know much money they have now and retail investors use the future value because they want to know how much money they will have when they retire. In any case the YTM is the same.

We are way off topic and I am going to shut up.
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Re: Treasuries, CDs, and Munis reconsidered

Post by neurosphere » Wed Jun 26, 2013 12:59 pm

Doc wrote:
neurosphere wrote:
Doc wrote: If both the yield curve and the funds strategy remain constant you will get the SEC yield for the "duration".
Is this statement generally true? -->When interest rates are actively rising, the SEC yield will underestimate the actual yield which will be earned by the investor in the bond fund.
"When interest rates are actively rising" the yield curve is not constant.
Ok. New statement --> If interest rates have risen at some point during the previous 30 days , the SEC yield will underestimate the actual yield which will be earned by the investor in the bond fund assuming no additional changes to interest rates or fund strategy.

Better? :D
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Re: Treasuries, CDs, and Munis reconsidered

Post by ogd » Wed Jun 26, 2013 1:10 pm

Doc wrote:When you do a YTM you can use the present value formulas (taper) or a future value formula assuming all cash flows are reinvested at the same YTM. The equations are the same except for dividing (multiplying?) by (1+i)^n or something like that anyway. I think the B-schoolers tend to use present value because they want to know much money they have now and retail investors use the future value because they want to know how much money they will have when they retire. In any case the YTM is the same.
Yes but the reinvested cash flows can't possibly account for much at the current rates. E.g. in the single Treasury maturity graph I did above it would make the slope slightly gentler (to the tune of ~0.075 years of maturity / year), still leaving a drastically lower duration on average. So it still seems to me that the SEC yield is an underestimation of what the fund will actually pay out without any changes in rates / strategy.
Doc wrote:We are way off topic and I am going to shut up.
As far as I'm concerned, we're on topic (maybe the OP can chime in as well). Many such CD/bonds comparisons have been made recently based on SEC yields so I'd like to understand whether they are underestimating bond returns for investors without a defined horizon. Your insights are much appreciated.

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Re: Treasuries, CDs, and Munis reconsidered

Post by stlutz » Wed Jun 26, 2013 1:36 pm

As far as I'm concerned, we're on topic (maybe the OP can chime in as well). Many such CD/bonds comparisons have been made recently based on SEC yields so I'd like to understand whether they are underestimating bond returns for investors without a defined horizon
Yes--that was the goal of my illustration. Looking only at the SEC Yield underestimates your expected bond return as it does not include the capital appreciation that one can expect from yield curve riding, which is relatively significant currently for an intermediate term treasury fund/etf.

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Re: Treasuries, CDs, and Munis reconsidered

Post by stlutz » Wed Jun 26, 2013 1:42 pm

Ok. New statement --> If interest rates have risen at some point during the previous 30 days , the SEC yield will underestimate the actual yield which will be earned by the investor in the bond fund assuming no additional changes to interest rates or fund strategy.
Actually, looking at all of this has made me somewhat confused as to what exactly SEC Yield is. Someone was talking about the VGIT ETF which has a duration of about 5.1 years and as of 5/31 had a yield-to-maturity for its holding of 1.1%. (https://personal.vanguard.com/us/funds/ ... =INT#tab=2). 5 year rates have gone up about .4% since then, which means that I would estimate the new YTM to be 1.5%. If the SEC Yield is YTM - expenses, I would think the "yield" on this ETF would be 1.4%. Yet, the site shows 1.09%. I'm not clear on why there is such a gap.

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Re: Treasuries, CDs, and Munis reconsidered

Post by Kevin M » Wed Jun 26, 2013 1:48 pm

I saw a somewhat convincing argument in another post that SEC yield somewhat underestimates return over a period equal to average maturity (or duration, whichever is theoretically correct) assuming no change in yield curve, but as I recall, it wasn't a huge discrepancy. I've seen enough whacky things with changes in SEC yield and price to not assume the relationship is as precise as I used to think. However, based on lots and lots of inputs from the bond experts on this forum, I think SEC yield probably is much closer than distribution yield to estimate total return given the stated conditions.

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Re: Treasuries, CDs, and Munis reconsidered

Post by Kevin M » Wed Jun 26, 2013 2:21 pm

Simplegift wrote: Kevin, please pardon this naive question about the rolling CD strategy in place of a bond fund allocation: Are rolling CDs designed to be a permanent asset allocation in one's portfolio, to be executed throughout the rest of one's investing career? Or are they just a "placeholder strategy" during this period of low interest rates and relatively high bond prices, a temporary substitute for bond funds?

If it's just a placeholder strategy, it would seem to present a market timing dilemma. In other words, how does one know when interest rates have risen sufficiently that it's time to abandon CDs and start reinvesting in bond funds again? What's the decision-making process about when to risk one's capital again to the vagaries of bond market interest rate changes? And how does one determine when to switch back again to the safety of CDs?

Since these two strategies (rolling CDs versus bond funds) are so different, it seems one would constantly be faced with the problem of market timing back and forth between them — unless I'm missing something. Thanks.
Good questions. Thanks for prompting me to articulate some thoughts on this. :wink:

First, I don't use a "rolling CD" strategy. I have just gradually moved 2/3 of my fixed income into 5-year CDs with reasonable EWPs over the last two years. In other words I haven't intentionally created a ladder. But a bunch of my CDs are Ally Bank CDs, which I kind of consider the shorter rungs on a ladder, due to the very low EWP. Other than that, I guess I have ended up with something like a 3-5 year ladder at this point.

Is it a permanent strategy? Honestly, I don't know. Although I've owned brokered CDs previously (and still have a few 5%-ers that haven't matured yet), I only learned about the advantages of non-brokered CDs a couple of years ago. It may have been Allan Roth's blog that I first learned about it from; I can't really remember. If non-brokered CD rates remain competitive with bond fund rates, then it may well become a permanent strategy for me.

Remember that I still have 1/3 of my fixed income in bond funds, primarily intermediate-term investment-grade and tax-exempt (but also some long-term and high yield). So I'm hedging my bets a bit by taking more interest-rate risk and credit risk to get higher yields on a portion of my FI. It has occurred to me that I've ended up with something not so different from TBM, except having replaced the treasury/agency/mbs component with safer (IMO) and higher yielding CDs.

As long as the rate on a 5-year, federally-insured CD is higher than the rate on a 5-year treasury, I see no point in owning treasuries. With anything else, there is credit risk, and it's a judgment call as to whether or not it's worth it. I believe Larry Swedroe has presented evidence that credit risk generally has not been very highly rewarded historically, but I obviously don't follow his advice 100%.

As far as switching back to bond funds ... With the recent declines in bond fund prices, I have stopped even considering moving more to CDs. The only bond fund I'm currently watching to potentially add to is VG long-term inv-grade; I think if the SEC yield hits 5% (it's getting close), I will top off my holding back to the Admiral shares limit; VG may ask me to do so anyway at some point, and that would be a driver for me.

I don't have a strict policy for this yet, and of course that is not the Boglehead way, but I don't think that's so bad. I do have a policy for my stock/FI AA, which I think is more important. And I'm thinking generally that once a bond fund holding has declined by 10%-20% from the level at which I last pulled money out of it, or if the yield hits 5%, I will add enough to it to bring it back to the level at which I last pulled some out of it. But I may rethink this if at that point I can get 5% on a 5-year non-brokered CD with a reasonable EWP.

Kevin
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Re: Treasuries, CDs, and Munis reconsidered

Post by wesleymouch » Wed Jun 26, 2013 2:24 pm

stlutz wrote:Amidst all of the panic threads about bonds of late, I thought I'd add in the results of some number crunching I've been doing.

I'd like to question a couple of points that have become the conventional view around here of late:

a) CDs represent a free lunch over a Treasury bond fund--higher return and less risk
b) In a taxable account, a muni bond fund offers significantly higher returns than a Treasury bond fund, which is either a free lunch or reveals hidden risks in the muni market.

Let's look at these further:

First, 5 year CDs are considered a great deal right now. Right now at depositaccounts.com, the highest nationally available rate is 2.00%. .

Second, there is the Treasury bond fund. To simplify things, let's take the Stlutz Intermediate Term Treasury Fund. Its strategy is to buy a T-note of just over 5 years in maturity, hold it for 1 year and then replace it with a new bond. Right now, this fund holds the 9/30/2018 bond yielding 1.54% and priced at 99.188. It has a coupon rate of 1.375% The common assumption is that the "expected" return on this fund is therefore 1.54%. However, funds like mine and VG Intermediate Term Treasury don't do this. They buy bonds, hold them for a while, and then sell them well before maturity (VG IT Treasury basically turns over its entire portfolio each year). Thus, if one assumes that the yield curve remains the same for the next year, my bond will then be a 4 year bond yielding 1.23%. That would mean the price would have gone up to 100.590. Thus, my return would be as follows:

the coupon 1.375% / 99.188 (the bond price) = 1.39%
capital appreciation from 99.188 to 100.592 = 1.42%
Total expected return for the next year = 2.80%

Thus, the intermediate term treasury fund has a higher expected return than the CD if one assumes that the yield curve will basically stay like it is for the next year.

I know many people here think rates will continue to skyrocket, so this assumption wouldn't hold if that is your view. However, if you are like me and you have no idea what the future holds, then it is usually assumed that the best forecast of the future yield curve is simply the current curve.

Regardless, the CD is no longer a free lunch--you are accepting a guaranteed return that is lower than the expected but uncertain T-bond return. That doesn't mean the CD is a bad idea--it just means that there is no free lunch.

Now lets add in munis and look at after tax returns.

Because the muni market is much less liquid than the Treasury market, a muni bond fund like VG IT-TE resembles a rolling bond ladder as opposed to the buying and selling that goes on with the Treasury fund--most bonds are held to maturity. VG IT-TE turns over about 10-15% of its portfolio each year. When bonds are held to maturity, the SEC Yield of the fund basically represents your expected return, as that cacluation assumes bonds held to maturity. The SEC yield of the Vanguard fund is currently 2.04%.

So, let's look at after tax returns. I'll assume a 28% federal tax rate and a 5% state tax rate:

CD: 2.0% return - 33% taxes = 1.34%
Muni Fund: 2.04% - 5% taxes = 1.94%
Treasury Fund: 1.39% coupon - 28% taxes = 1.00%
+ 1.42% cap. gain - 20% taxes (15 federal, 5 state) = 1.14%
total = 2.14%

Thus, even after taxes the Treasury fund has the highest expected return of these three options.

In short, I think the assumption that Treasuries are simply a horrible investment compared to the alternatives should be reconsidered.

I'm thinking out loud here, so please make additions/subtractions/correction to my logic as needed.
The big danger of CDs is a "bail in". This happened in Cyprus and has been discussed in Japan, Canada, European countries. You cannot exclude it happening in the US. Lots of risk for a marginal gain. Like bonds, CDs represent return free risk.

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Re: Treasuries, CDs, and Munis reconsidered

Post by ogd » Wed Jun 26, 2013 2:26 pm

Oh brother. Can we please start another thread about CDs and Cyprus and leave this one alone? That would be very much appreciated.

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Re: Treasuries, CDs, and Munis reconsidered

Post by Kevin M » Wed Jun 26, 2013 2:37 pm

ogd wrote:Oh brother. Can we please start another thread about CDs and Cyprus and leave this one alone? That would be very much appreciated.
:thumbsup
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Re: Treasuries, CDs, and Munis reconsidered

Post by SimpleGift » Wed Jun 26, 2013 2:56 pm

Kevin M wrote:I don't have a strict policy for this yet, and of course that is not the Boglehead way, but I don't think that's so bad. I do have a policy for my stock/FI AA, which I think is more important. And I'm thinking generally that once a bond fund holding has declined by 10%-20% from the level at which I last pulled money out of it, or if the yield hits 5%, I will add enough to it to bring it back to the level at which I last pulled some out of it. But I may rethink this if at that point I can get 5% on a 5-year non-brokered CD with a reasonable EWP.
Thanks for sharing more about your process, Kevin.

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Re: Treasuries, CDs, and Munis reconsidered

Post by Doc » Wed Jun 26, 2013 6:27 pm

stlutz wrote:
As far as I'm concerned, we're on topic (maybe the OP can chime in as well). Many such CD/bonds comparisons have been made recently based on SEC yields so I'd like to understand whether they are underestimating bond returns for investors without a defined horizon
Yes--that was the goal of my illustration. Looking only at the SEC Yield underestimates your expected bond return as it does not include the capital appreciation that one can expect from yield curve riding, which is relatively significant currently for an intermediate term treasury fund/etf.
1) I believe that the SEC yield is the regulators attempt to define a metric very similar to YTM that fund managers can't cheat on. Therefore I always equate SEC yield to YTM and ignore any possible subtle differences. (Bond traders may have a different outlook but then they don't typically invest in bond funds anyway.)

2) To the extent that a fund is riding the yield curve and not holding bonds to maturity I'm not sure what meaning to apply to Yield To Maturity or SEC yield. One of the reasons I chose a 1-5 TIPS over a 0-5 TIPS fund was because of the riding the yield curve effect but I never tried to quantify the difference.

The whole Treasury, CDs, TIPS, Muni discussion seems too fraught with each individuals risk, tax and credit union affiliation to have much certainty on any calculated result or opinion.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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Re: Treasuries, CDs, and Munis reconsidered

Post by john94549 » Wed Jun 26, 2013 8:59 pm

Unlike Kevin M, I've always been more of a CD ladder guy. I'm somewhat more skeptical about "break" strategies in a rapidly-rising rate environment, should we ever encounter one again. My ladder is sufficiently ancient that I still have one 5.75% CD which will cough up a nice yield until January of 2018. By then, I suspect I might be able to roll it with another CD at 5.5% or thereabouts. On average, my ladder overall still bests inflation by 100 bps, so it works for me.

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Re: Treasuries, CDs, and Munis reconsidered

Post by neurosphere » Thu Jul 04, 2013 11:32 am

Relevant to the discussion on this thread, and on many other threads, about what the SEC yield represents, whether it's forward looking, backward looking, and it's relationship to the NAV...

I hold the Long term New York Tax-Exempt Bond fund. The NAV has not changed in several days, but the SEC yield has steadily crept up. I assume that's because the full effect of interest rate changes in the during the last 30 days is not yet fully incorporated into the yield. So, assuming no more interest rate changes, the yield will continue to go up until the PREVIOUS interest rate changes are outside of the 30 day window.

Here is the date, NV and yield for the past 5 days. Not that the yield went up from 2.5% to 2.64%, with no change in the NAV:

Code: Select all

06/27/2013	$11.20	2.50%
06/28/2013	$11.20	2.53%
07/01/2013	$11.19	2.60%
07/02/2013	$11.20	2.61%
07/03/2013	$11.20	2.64%
So the purchase I made on 6/27 is now actually earning MORE than I thought on the date of purchase, but the NAV is the same.

This is relevant for those deciding between a CD and a bond fund, in that with the CD you get the rate advertised on the date of purchase. But the yield on the bond fund may not yet fully reflect the "current" or soon to be current rate on the bonds in the bond fund portfolio.
If you have to ask "Is a Target Date fund right for me?", the answer is "Yes".

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Re: Treasuries, CDs, and Munis reconsidered

Post by ogd » Thu Jul 04, 2013 11:46 am

The question remaining for me in this thread is whether the SEC yield underestimates (by design) the yield of the fund even if interest rates stay unchanged, by simulating current bonds held to maturity instead of curve riding.

This is based not only on stlutz' calculations but also on the SEC yield being always equated with the YtM of a single bond, which similarly does not involve any curve riding, only dividend reinvestment.

I completely understand that it might be impossible to define a metric that does take riding into account without being subject to manipulation by the fund managers. The SEC wanted a universal way to compare apples to apples when choosing a bond fund. I just wish I had that metric. Also, it's unfortunate that interest rates have been moving too much over the last few years to confirm the discrepancy from yield data we can easily access.

For now I will treat the SEC yield as a conservative lower bound, without expecting much more. It's nice to see it creeping up already.

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Re: Treasuries, CDs, and Munis reconsidered

Post by stlutz » Thu Jul 04, 2013 1:08 pm

The question remaining for me in this thread is whether the SEC yield underestimates (by design) the yield of the fund even if interest rates stay unchanged, by simulating current bonds held to maturity instead of curve riding.
I would say that SEC Yield correctly estimates the yield; however, when one is estimating the expected return of an intermediate-term Treasury bond fund, she should consider total return--the yield plus potential capital appreciation from yield curve riding.

Note that the current situation is somewhat unusual in that the yield curve is very steep several years out. Historically, the steeper part of the curve is in the 1-3 year range. What this means is that the benefits of yield curve riding are very large right now. However, if you take average rates for the past 60 years or so, the expected extra return from yield curve riding is only on the order of .3% per year.

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Re: Treasuries, CDs, and Munis reconsidered

Post by Epsilon Delta » Thu Jul 04, 2013 1:16 pm

Morningstar wrote: For the Pros

The formula for the SEC 30-day yield is as follows:

Yield = 2 {[(a-b)/cd + 1] ^ 6 - 1}

Where:
a = dividends and interest during the period
b = expenses accrued for the periods (net of reimbursements)
c = the average daily number of shares outstanding during the period, that were entitled to receive dividends
d = the maximum offering price per share on the last day of the period
neurosphere wrote: I hold the Long term New York Tax-Exempt Bond fund. The NAV has not changed in several days, but the SEC yield has steadily crept up.

Here is the date, NV and yield for the past 5 days. Not that the yield went up from 2.5% to 2.64%, with no change in the NAV:

Code: Select all

06/27/2013	$11.20	2.50%
06/28/2013	$11.20	2.53%
07/01/2013	$11.19	2.60%
07/02/2013	$11.20	2.61%
07/03/2013	$11.20	2.64%
If we look at the variables in the SEC yield formula we can see:
d (share price) did not change.
b (expenses) probably did not change.
a (interest)
The duration and maturity are about 6 years. So about 6/(6*365) of their assets matured during this period. This is about .27% of the assets. Interest rates would have to increase by a factor of 10 in this 6 day period for rolling over to new bonds with higher coupons to have that big an affect. It is possible that there are random issues with timing of dividend so that more or fewer payments fall into the 30 day window.
c (average shares outstanding)
A 5% sell-off of the fund could boost the SEC yield by the observed amount. Can anybody find the number of shares outstanding on a daily basis?

My bet would be the change is mostly due to changes in the total invested in the fund, with smaller contributions due random timing and possibly rounding errors, and a small contribution (about 10% of the total) from actual changes in interest rates.

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Re: Treasuries, CDs, and Munis reconsidered

Post by ogd » Thu Jul 04, 2013 1:28 pm

Epsilon Delta wrote:c (average shares outstanding)
A 5% sell-off of the fund could boost the SEC yield by the observed amount. Can anybody find the number of shares outstanding on a daily basis?
Actually, I think a and b also increase / drop with the number of shares, which makes a change neutral.

I agree that on a small scale of a few days, the timing of the dividend might make a big difference in the magnitude of the change. We should wait for a while before drawing conclusions.

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Re: Treasuries, CDs, and Munis reconsidered

Post by Epsilon Delta » Thu Jul 04, 2013 1:58 pm

ogd wrote:
Epsilon Delta wrote:c (average shares outstanding)
A 5% sell-off of the fund could boost the SEC yield by the observed amount. Can anybody find the number of shares outstanding on a daily basis?
Actually, I think a and b also increase / drop with the number of shares, which makes a change neutral.

I agree that on a small scale of a few days, the timing of the dividend might make a big difference in the magnitude of the change. We should wait for a while before drawing conclusions.
Consider an abrupt sell-off on July 1st. On June 30 you add the interest (and expenses) for June1 to June 30. On July 1st you use the interest for June 2 to July 1. Even if the interest on every single day is proportional to the invested assets the total interest over the last 30 days only drops by 1/30 of the change in assets and this will boost the SEC yield.

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Re: Treasuries, CDs, and Munis reconsidered

Post by ogd » Thu Jul 04, 2013 2:03 pm

Epsilon Delta wrote:Consider an abrupt sell-off on July 1st. On June 30 you add the interest (and expenses) for June1 to June 30. On July 1st you use the interest for June 2 to July 1. Even if the interest on every single day is proportional to the invested assets the total interest over the last 30 days only drops by 1/30 of the change in assets and this will boost the SEC yield.
I believe c is a daily average so it would also drop by only 1/30 of the July 1st change.

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Re: Treasuries, CDs, and Munis reconsidered

Post by Epsilon Delta » Thu Jul 04, 2013 2:53 pm

ogd wrote:
Epsilon Delta wrote:Consider an abrupt sell-off on July 1st. On June 30 you add the interest (and expenses) for June1 to June 30. On July 1st you use the interest for June 2 to July 1. Even if the interest on every single day is proportional to the invested assets the total interest over the last 30 days only drops by 1/30 of the change in assets and this will boost the SEC yield.
I believe c is a daily average so it would also drop by only 1/30 of the July 1st change.
:oops: Thanks for the correction.

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Re: Treasuries, CDs, and Munis reconsidered

Post by Kevin M » Thu Jul 04, 2013 4:51 pm

I still think there's something fundamentally wrong with the analysis in the OP. It occurred to me that if the hypothesis is correct, we should see it in actual fund returns. My thought is that distribution yields should reflect the OP hypothesis, but distributed cap gains and change in NAV must be accounted for.

Of course interest rates and the yield curve have not been constant, so we can't look at it exactly, but we can look at actual numbers and consider things like change in SEC yield to see if the hypothesis seems reasonable.

I looked at actual returns from 7/31/12 to 6/28/13 (12 months) for VFIUX (EDIT: corrected dates in table below):

Code: Select all

                  
Date               7/31/12    6/28/13
NAV                  11.85     11.32
SEC yield (%)         0.73      1.17
Dist yield (%)        1.24      1.50
Cap gain distributions: 0.086
Dividend distributions: 0.16661
Total distributions: 0.25261

% change in NAV adjusted for cap gains distributions: -3.75%
Theoretical price change based on duration of 5.4 years: -2.38%

Dividend distributions as % of start NAV: 1.41%
Cap gain distributions as % of start NAV: 0.73%
Total distributions as % of start NAV: 2.13%
Total return: -1.62%

Observations:
  • There are realized cap gains and unrealized appreciation in the fund, but I assume these are reflected in NAV--otherwise one could benefit by buying the fund and just waiting for these gains to be distributed.
  • The % change in NAV, adjusted for cap gain distributions, is quite a bit worse than that predicted by the duration of the fund and change in SEC yield--137 basis points worse.
  • The dividend distribution return of 1.41% is 68 basis points higher than the SEC yield of 0.73% at the beginning of the period, and 17 basis points higher than the starting distribution yield of 1.24%.
  • The higher distribution yield than one might have expected is much more than wiped out by the higher than predicted loss in NAV.
I just don't see a positive effect from this supposed riding the yield curve phenomenon. It seems to me that if anything we're seeing the opposite, since the higher than predicted loss in NAV more than wipes out the higher-than-SEC-yield distributions. In other words, I've adjusted for the increase in yield by evaluating the decrease in NAV.

Kevin
Last edited by Kevin M on Fri Oct 10, 2014 1:14 pm, edited 1 time in total.
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Re: Treasuries, CDs, and Munis reconsidered

Post by stlutz » Thu Jul 04, 2013 6:19 pm

I still think there's something fundamentally wrong with the analysis in the OP.
Hi Kevin,

Please let me know where you disagree. Taking a completely hypothetical example:

--Suppose I buy a bond with 5 years to maturity today that yields 1.5%. The YTM of this bond would be 1.5% and the SEC Yield of a bond fund holding only this bond would be 1.5% minus the expense ratio. Correct?

--Suppose that four year bonds today are yielding 1.2%. If I held my bond for one year, *and* there were no interest rate changes, I would then have a 4 year bond yielding 1.2%. Given the YTM rate decline on my bond from 1.5% to 1.2%, the price of my bond will increase. I could sell it and have a capital gain that is over and above the coupon yield I got on the bond. Correct?

--This potential gain is not reflected in the original advertised YTM/SEC Yield when I bought it. Correct?

--Suppose that rates go up .5% over the next year. After a year my now-4-year bond yields 1.7%. If I sold it after one year, I would have a capital loss because the YTM on my bond went from 1.5% to 1.7%. Correct? (This is what actually happened to an intermediate term treasury fund over the past year).

--Suppose that rates actually go down .5% over the next year. My 4 year bond yields .7%. I get a larger capital gain that I originally expected.

The key assumption my my calculation is that interest rates do not change at all over the next year. This of course never happens--rates will either go up or do down. An expected return calculation like I performed is not a guaranteed return calculation. Assuming rates don't change is just a way to reflect that fact that I have no idea which way rates will move over the next year.

Best regards.

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Re: Treasuries, CDs, and Munis reconsidered

Post by Kevin M » Thu Jul 04, 2013 7:11 pm

Hi stlutz,

I'm not enough of a bond expert to evaluate your particular example. I just don't think it represents actual bond fund returns, which I think the data I presented illustrated.

A key point in the data is that NAV decreased MUCH more than would be predicted by the change in SEC yield and the bond fund duration. So the total return of the fund over the one-year period was lower than one would expect based on beginning SEC yield, while you're arguing that it should be higher. The actual data does not bear out your conclusion. Yes, interest rates went up, but in a sense I controlled for that by including change in NAV in the analysis.

One possible flaw in trying to apply your thinking to a bond fund is that a fund with a goal of maintaining a certain duration will not hold all of its bonds for anywhere close to one year; didn't you mention that the turnover for the IT Treasury fund is about 100%? The fund isn't likely to allow it's average maturity to drop from 5 years to 4 years over the period of one year, therefore the fund cannot take advantage of the effect your calculations seem to demonstrate.

For a positive yield curve, you will of course get higher returns by rolling a 5-year bond each year than holding a constant-maturity 4-year bond (which I think is the fundamental idea of riding the yield curve), but that higher return comes with higher risk. Again, I just don't think this applies to bond funds that are relatively passively managed (John Bogle has referred to Vanguard's actively managed bond funds as index-like, even though they are actively managed).

There's a video on the Vanguard site where Ken Volpert shows a graph indicating that yield historically has been a good predictor of bond returns over the subsequent 10-year period. Volpert also states that YTM is what bond managers are interested in, and that SEC yield is representative of YTM for a bond fund; i.e., SEC yield is the best predictor of future bond fund returns (even though it looks like it can be worse, or better, than that).

For me, the bottom line is that the actual 1-year distribution return on a bond fund with a 5-year duration is going to be somewhere between the SEC yield and the distribution yield if overall rates are fairly stable. But since I'm not good at timing and my investment horizon is much longer than one year, I don't care too much about the 1-year distribution return; the risk of loss due to rising interest rates swamps out the benefit of the currently higher distribution yields.

Based on everything I've learned, SEC yield is a reasonable indicator of longer-term returns. It may understate things slightly, but nowhere near the degree suggested by your example.

Thanks for your efforts. It's good to challenge our assumptions.

Kevin
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Re: Treasuries, CDs, and Munis reconsidered

Post by ogd » Thu Jul 04, 2013 7:55 pm

Kevin M wrote:I'm not enough of a bond expert to evaluate your particular example. I just don't think it represents actual bond fund returns, which I think the data I presented illustrated.

A key point in the data is that NAV decreased MUCH more than would be predicted by the change in SEC yield and the bond fund duration. So the total return of the fund over the one-year period was lower than one would expect based on beginning SEC yield, while you're arguing that it should be higher. The actual data does not bear out your conclusion. Yes, interest rates went up, but in a sense I controlled for that by including change in NAV in the analysis.
Kevin: I went over it several times, and the results are exactly what stlutz said. I too was skeptical at first. But it just makes sense if you think of the maturity over time "picture" that I posted earlier in the thread.

Here is the thing: the drop in NAV is quite close t owhat the yield differential in the 5-year Treasury would suggest: 0.8 x 5.4 = 4.37. The fund isn't exactly composed of 5-year Treasuries only, but it's a good first approximation. I think this means we just have to wait for the SEC yield (which is a 30-day average) to catch up.
Kevin M wrote:One possible flaw in trying to apply your thinking to a bond fund is that a fund with a goal of maintaining a certain duration will not hold all of its bonds for anywhere close to one year; didn't you mention that the turnover for the IT Treasury fund is about 100%? The fund isn't likely to allow it's average maturity to drop from 5 years to 4 years over the period of one year, therefore the fund cannot take advantage of the effect your calculations seem to demonstrate.
To me, turnover 100% suggests that the fund is in fact rolling over each bond every year, on average. I think the flaw in the above is that you're assuming the fund waits a year with no turnover (5 -> 4), then turns everything over at once. Instead, the 5 years is a steady state, with a few bonds being rolled over every day.
Kevin M wrote:For a positive yield curve, you will of course get higher returns by rolling a 5-year bond each year than holding a constant-maturity 4-year bond (which I think is the fundamental idea of riding the yield curve), but that higher return comes with higher risk.
Very true -- the risk averaged over time is higher than holding a 5-year T for 5 years, but the nice thing about it is that it's constant. With individual Treasuries, you sometimes have 5 years interest rate risk and sometimes 0.5 years. So you have to have a ladder of 10 years (-ish) to match that. At which point 20% of your money is earning less than checking accounts at the lower rungs of the ladder, which seems just wrong.

I thought of one rationale for why curve riding cannot be possibly taken into account and reported: it's speculative. The yield curve might flatten and then you'd get less money, pretty much the SEC yield. Whereas the SEC yield itself is something that you're guaranteed that the current bonds in the fund are able to produce if held to maturity (which is an option). So it's a conservative lower bound.

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Re: Treasuries, CDs, and Munis reconsidered

Post by Kevin M » Thu Jul 04, 2013 8:29 pm

ogd wrote: To me, turnover 100% suggests that the fund is in fact rolling over each bond every year, on average. I think the flaw in the above is that you're assuming the fund waits a year with no turnover (5 -> 4), then turns everything over at once. Instead, the 5 years is a steady state, with a few bonds being rolled over every day.
This one's easy, so I'll respond to it now and maybe get back to some of your other points after looking at them more closely. I think we agree on this. I'm not assuming the fund waits a year and then rolls everything; what I'm saying is that's what they'd have to do to take advantage of the bond math presented by OP. I'm suggesting that the fact that they are constantly rolling their bonds prevents them from getting the benefit proposed in the OP.

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Re: Treasuries, CDs, and Munis reconsidered

Post by ogd » Thu Jul 04, 2013 8:33 pm

Kevin M wrote:This one's easy, so I'll respond to it now and maybe get back to some of your other points after looking at them more closely. I think we agree on this. I'm not assuming the fund waits a year and then rolls everything; what I'm saying is that's what they'd have to do to take advantage of the bond math presented by OP. I'm suggesting that the fact that they are constantly rolling their bonds prevents them from getting the benefit proposed in the OP.
I'm not sure we agree :happy If each bond, looked at in isolation, is held for exactly one year, yet the rollover times are staggered throughout the year, that would produce 100%/year turnover with constant avg maturity and stlutz' 1-year riding returns. More or less (they differ around the curve). Edit: do you mean that the OP's 5yr -> 4yr implies a maturity of 4.5 years? In that case, it's not very different if you slide up the curve a little bit.

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Re: Treasuries, CDs, and Munis reconsidered

Post by Kevin M » Thu Jul 04, 2013 8:53 pm

ogd wrote: Here is the thing: the drop in NAV is quite close t owhat the yield differential in the 5-year Treasury would suggest: 0.8 x 5.4 = 4.37. The fund isn't exactly composed of 5-year Treasuries only, but it's a good first approximation. I think this means we just have to wait for the SEC yield (which is a 30-day average) to catch up.
I don't know what you're saying here, but here's what I was saying.

The increase in SEC yield over the one-year period was 44 basis points. At a duration of 5.4 years, that would indicate a price drop of 5.4 x 0.44 = 2.38%. The actual cap gains distribution adjusted change in NAV was -3.75% (-4.47% unadjusted). Yes, since interest rates have risen over the last month, the SEC yield could increase as it "catches up", so maybe that gap will narrow.

The main point here is that this serves as kind of an adjustment for the fact that rates have increased, in terms of evaluating whether or not the SEC yield is grossly underestimating returns, which I'm suggesting it does not. If you roll all the numbers together, you don't see any hugely higher return as suggested in the OP.

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Re: Treasuries, CDs, and Munis reconsidered

Post by Kevin M » Thu Jul 04, 2013 9:11 pm

ogd wrote: If each bond, looked at in isolation, is held for exactly one year, yet the rollover times are staggered throughout the year, that would produce 100%/year turnover with constant avg maturity and stlutz' 1-year riding returns.
You can't have it both ways. Holding a constant maturity 5-year bond is not the same as holding a 5-year bond for one year, then selling and reinvesting in another 5-year bond; that's not constant maturity, and that doesn't represent how a bond fund works.

I'm not saying the bond math in the OP is wrong, I'm just saying that it's highly doubtful that it applies to bond funds to the extent implied.

I think it's important not to think that we can use a bit of math to come up with some magically superior bond fund yields when the folks running the bond funds are telling us that SEC yield is the most important number to pay attention to. Find me a paper on the Vanguard site that illustrates how their funds are likely to generate 100 basis points higher return than indicated by SEC yield, and I'll pay more attention.

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Re: Treasuries, CDs, and Munis reconsidered

Post by ogd » Thu Jul 04, 2013 9:14 pm

I was responding to the points in blue:
Kevin M wrote:A key point in the data is that NAV decreased MUCH more than would be predicted by the change in SEC yield and the bond fund duration. So the total return of the fund over the one-year period was lower than one would expect based on beginning SEC yield, while you're arguing that it should be higher.
Kevin M wrote:The higher distribution yield than one might have expected is much more than wiped out by the higher than predicted loss in NAV.
I am saying that the SEC yield is quite a bit lower than the 5-year yield and creeping steadily up. The 5-year T yield, updated constantly, jumped up much more, which puts the NAV drop in the right ballpark. We need to wait a bit before comparing SEC yields with the NAV drop and drawing any conclusions.

I am very confident that the SEC yield will not come even close to the curve riding return that stlutz computed. The numbers you posted suggest it will be in the neighborhood of 0.73 + 3.75 / 5.4 = 1.43 when things stabilize.

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Re: Treasuries, CDs, and Munis reconsidered

Post by ogd » Thu Jul 04, 2013 9:35 pm

Kevin M wrote:
ogd wrote: If each bond, looked at in isolation, is held for exactly one year, yet the rollover times are staggered throughout the year, that would produce 100%/year turnover with constant avg maturity and stlutz' 1-year riding returns.
You can't have it both ways. Holding a constant maturity 5-year bond is not the same as holding a 5-year bond for one year, then selling and reinvesting in another 5-year bond; that's not constant maturity, and that doesn't represent how a bond fund works.
I can have it both ways. Like so: I hold 365 6-year bonds, each maturing on a different day of the year. Every day, I roll over a bond maturing exactly 5 years from now into one maturing exactly 6 years from now. My average maturity stays 5.5 years, approximating VFIUX. If we go bi-weekly instead of daily, the average fluctuates a little bit more but still within 1% 4% (edit: oops: 1/52 times two).

The OP used 5->4 years, but looking at the yield curve the results will be similar for 6->5 years.

Are we talking about different things somehow, in a way I can't grasp?
Kevin M wrote:I think it's important not to think that we can use a bit of math to come up with some magically superior bond fund yields when the folks running the bond funds are telling us that SEC yield is the most important number to pay attention to. Find me a paper on the Vanguard site that illustrates how their funds are likely to generate 100 basis points higher return than indicated by SEC yield, and I'll pay more attention.
That would be nice, I agree. But this is all plausible if you consider the possibility that there is no reliable measure of the riding effect that a fund could post without getting in trouble with the SEC -- or that SEC itslef could choose.

For example, I used to think that this Morningstar article was just doing a p**s-poor job of explaining the SEC yields: http://news.morningstar.com/articlenet/ ... 471&part=1 , and that everyone should just be using those in return expectations. But perhaps it really is that complicated.

NB: distribution yield is known incorrect because of the capital loss effect of premium bonds returning to par, explained in the article. That one has always been clear to me.

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