Doc wrote:Kevin M wrote:So you are counting on what I'm now calling speculative returns with all of your intermediate-term and long-term Treasuries, as well as with all of your corporate bonds, which is the majority of your fixed-income portfolio! CDs provide a higher safe return than Treasuries or corporate bonds, providing much higher yields than Treasuries of same maturities, much less term risk than intermediate-term or long-term Treasuries, and no credit risk as you have in corporate bonds.
Now you are misunderstanding me. I don't own any long term bonds of any stripe. (I might go long TIPS if the real yield was very good.)
You're responding to the tree and ignoring the forest. Simply strike long-term Treasuries from the what I said, and the basic argument is the same. Intermediate-term Treasuries have much more term risk than direct CDs of same maturity.
Doc wrote:I agree that CD's likely produce higher returns than comparable duration Treasuries. But if you cannot hold them to maturity you need to consider the EWP as well as liquidity and tax considerations.
Of course you do. So knock off 20 basis points from the 2% CD yield for a 10% state tax, and you're still looking at a huge yield premium. And I don't look at the EWP as a negative; rather I look at it as a small price to pay (maybe) to reinvest at a higher rate if rates increase, or even if a better CD deal comes along. Contrast that to the much higher loss on a 5-year Treasury if rates increase by as little as one percentage point. And you're not going to find a much better 5-year Treasury deal (as you might with CDs) without paying a much larger price in the form of capital loss due to higher yields.
Doc wrote:Kevin M wrote:Your repeated justification for holding Treasuries is the speculative component that you might receive if we have another financial crisis on the order of 2008 in our lifetimes
We've had two in the first eight years of this century. I intend to live longer than eight years even at my advanced age. My house hasn't burned down in 40 years either but I am still going to buy fire insurance. In the world of investing in stocks and bonds the bonds at least in part are the fire insurance.
I don't think that the last eight years is necessarily a good statistical sampling, and even the chart you shared showed that corporate bonds held up well in the first of these two crises.
The fire-insurance analogy is horrible on multiple levels. It doesn't take much thought to see why. About the only thing that is comparable is thinking of the guaranteed return you're giving up in choosing Treasuries over CDs as the insurance premium. There's much more to it than that.
What's the analogy to the capital loss suffered in Treasuries when yields increase? With fire insurance you're not trading off one risk for another, which is what you're doing with Treasuries. With Treasuries you take the risk of loss due to rising rates in return for mitigating the risk of stock losses a bit better than with cash or CDs. It's not like cash or CDs don't mitigate stock risk at all. So it's not like having fire insurance or not having it.
And historically US and global stocks have recovered from their losses. Your house doesn't rebuild itself after a fire.
Horrible analogy.
Doc wrote:If you're going to price the cost of insurance you need to have some consideration to the possible plusses for Treasuries that CD's don't have.
Of course you do (despite the horrible analogy), which is why I keep saying that I can see holding a dollop of Treasuries for the exact reasons you champion on top of having the bulk of your fixed income in higher yielding
AND safer CDs.
Doc wrote:Just ignoring the EWP because it may never happen is not realistic. Likewise ignoring state taxes if your insurance is in a taxable account is akin to cherry picking.
I do not ignore the EWP, since the early withdrawal option is one of the key benefits to direct CDs, and the possibility of paying the EWP only comes into play for me if the reward of higher yield outweighs the cost of the EWP. Benefit, not downside. And although I don't talk about state taxes much, they just aren't a big enough concern to have significant impact on the huge yield advantage of CDs, and of course are not a factor at all in a tax-advantaged account.
Doc wrote:Kevin M wrote:With the corporate bonds we are simply being rewarded (perhaps) for taking credit risk, which has worked out OK in recent years (yay!), but as Larry points out has not been rewarded enough over longer time periods to justify taking the extra risk. You and I both go against the grain on this one, but I limit my exposure here to 20%-25% of fixed income, whereas you pile the credit risk on top of the term risk you are taking in Treasuries.
Huh? Our portfolio is currently 25.7% corporates. And the duration is 4.3 years. The longest duration asset we own is a ten year TIPS with a 2% coupon. The next highest duration asset is 6.5 years.
The point still applies, since you're still taking much more term risk with your Treasuries than I'm taking with my CDs. So I'm only taking credit risk OR significant term risk with 20%-25% of my fixed income.
Earlier you had mentioned using a 50/50 corporate/Treasury benchmark, and talked about adding 20% of diversified bond funds in Treasuries to the 30% you hold directly. That leaves about 50% in corporate bonds. Are you switching between talking about percentages of fixed income and percentages of portfolio? This is just a detail, and is not significant to the conceptual risk/return tradeoffs we're discussing; it impacts the magnitude but not the nature of the risks.
Doc wrote:I do need to look at CD's vs corporate yield. But since almost all of the intermediate corporates are in tax advantaged and I tend to use them for TLH to avoid wash sales using direct CD's is problematic. And that part in taxable is the "car" fund that gets new investments every month.
Practical issues definitely come into play. People who have most of their portfolios in a 401k or 403b don't even have the option of holding direct CDs, and very probably don't even have the option of holding just Treasuries, as they may only have one or two diversified bond funds to choose from.
Regarding corporate bonds vs. CDs, you can get a quick, rough overview by looking at the Fidelity or
Vanguard fixed income overview. What I see at Vanguard is 1.43% for 5-year "Corporates highest grade", 1.95% for 5-year "Corporates high grade", up to 3.72% for 5-year "Corporates investment grade". So unsurprisingly you get an increasing yield premium for increasing credit risk, with a good direct 5-year CD at 2% or better still having a slight yield premium over "corporates high grade". So CDs have a higher risk-adjusted yield, as must be the case as long as we consider credit risk a real risk.
Doc wrote:The reason we go around in circles is that you look at your FI as a source of return and I look it only as a source of risk reduction.
How in the world do you come to this conclusion??? I always talk about the risk/return trade-off of CDs in discussing their advantages over bonds or bond funds, so I do look at the risk-mitigation aspects of CDs in addition to the return aspects. The beauty of direct CDs is that they provide a higher
guaranteed return (ignoring potential speculative return) than Treasuries while being exposed to even less term risk due to the early withdrawal option. So risk reduction is a huge component of what I look for in my fixed income.
The only thing I give up is the possible slight reduction in portfolio loss over a relatively short time period (at least historically). So if you define risk as maximum portfolio drawdown over a one or two-year period, then yeah, Treasuries have been a winner in recent times, with long-term Treasuries (which you don't like) being the best of all. But as I've shown, this benefit has evaporated if you look at slightly longer time periods of recent history, with corporate bonds doing almost as well if you increase your investment horizon to as little as five years surrounding the 2008 crisis.
Doc wrote:As I have said before we never had these types of discussions before the Fed ran the real interest rate to zero. I don't think we should have discussions like this now. More important perhaps is that if we decide that interest rates are not going to return to "normal" in ten years or so then do we need to rethink our whole asset allocation not just our bond sectors. I think that would be a more productive discussion.
The Fed did not drive the real interest rate to zero, the economy did, but that's another discussion (see Bernanke's blog posts on this). We are living in the times we're living in, so I think it's great that we're having discussions relevant to our time.
Maybe you couldn't get the yield premiums we're seeing for CDs ten years ago, but you can now, and now is the only time we can make investment decisions that matter.
Since no one has demonstrated any consistent ability to accurately predict interest rates, I don't see much point in speculating much on that. If rates remain low, we do the best we can to get an edge, and as long as FDIC-insured deposit accounts give us yield premiums of 100 basis points, that's an edge for the retail investor.
Kevin
If I make a calculation error, #Cruncher probably will let me know.