I don't understand the case for EE bonds

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Re: I don't understand the case for EE bonds

Post by market timer » Sun Apr 23, 2017 7:31 pm

NiceUnparticularMan wrote:
market timer wrote: 1. Optionality: I can redeem my EE bonds if interest rates go up. It's like owning a 3.5% 20-year Treasury with a free put option.
But you lose the 3.5% if you redeem them early.

It's more like owning a 20-year CD with a severe withdrawal penalty.
Sure, you could also view EE bonds as 20-year CDs with variable and potentially large withdrawal penalties. In either case, they offer better optionality than typical long term bonds. The EE bond holder always has the option of earning the 3.5% 20-year zero coupon return or redeeming early, whichever has the highest expected payoff. Clearly, this option is more valuable in the first few years, after which redemption is increasingly unlikely to be preferred.

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Re: I don't understand the case for EE bonds

Post by willthrill81 » Sun Apr 23, 2017 7:40 pm

NiceUnparticularMan wrote:My concern, though, is that perhaps some people are committing to a bond allocation percentages for risk-management reasons, then seeking higher yield because of the current pretty dismal yields, then forgetting why they had bonds in the first place and selling out the relevant attributes in the effort to squeeze out more yield. And I do wonder how these people will feel in practice if inflation and/or rates go up, or alternatively there is a deflationary scenario where they can't make use of their EE bonds without a severe penalty.
I share your thoughts.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: I don't understand the case for EE bonds

Post by NiceUnparticularMan » Sun Apr 23, 2017 7:47 pm

market timer wrote:Sure, you could also view EE bonds as 20-year CDs with variable and potentially large withdrawal penalties.
How are they only "potentially" large?

A typical early withdrawal penalty on a decent 5 year CD is 6 months interest. The early withdrawal penalty on EE bonds is almost all of your anticipated interest.
In either case, they offer better optionality than typical long term bonds.
That makes no sense to me. A typical long bond holder can also just hold them to maturity. Or they can sell them at any time, and keep all the interest to date. Unlike with EE bonds, doing so will not trigger a severe early withdrawal penalty.

Or if you like, you can put this as that at any time, you can convert them to basically being no better than having held paper money under your mattress. That's not much of an option.
Clearly, this option is more valuable in the first few years, after which redemption is increasingly unlikely to be preferred.
Theoretically, an EE bond you redeemed within six months would be less punitive than a 5 year CD with a 6 month interest penalty. Problem is you can't redeem them before 1 year. By that point, the penalty is already much worse.

But yes, the penalty does get more and more severe the longer you hold them.

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Re: I don't understand the case for EE bonds

Post by willthrill81 » Sun Apr 23, 2017 8:00 pm

market timer wrote:Whether stocks might return more than bonds over this period is also beside the point.
No, it's not beside the point at all unless your end goal is something other than maximizing the amount of money left in your hand when all the chips are down. Bonds are not a goal in and of themselves.

Of course the past could look very different from the future, but let's take a look at the most recent 20 year returns of the TSM, the period from 1996 to 2016. This obviously includes two bear markets and a lot of turbulence. The CAGR for the TSM was a nominal 8.43%, so if you had put $10k into this in 1996, you'd now have $54,733. Regardless of taxes, that beats the pants off of $20,000.

Regardless as to what the future actually turns out to be, if you put any value on historical data (for inflation, stocks, etc.), the opportunity cost of EE bonds is very high.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: I don't understand the case for EE bonds

Post by letsgobobby » Sun Apr 23, 2017 8:14 pm

you are really and repeatedly missing the point. if my goal was to maximize the amount of money in my hand when the chips are down, or whatever you said, I would invest exclusively in ultra micro cap deep value emerging market stocks, or some such. By the plain fact that I hold 40% bonds you should immediately recognize that "maximizing money" is not my goal, nor the goal of every investor. apparently it's not even your goal, because you also own some bonds.

several of you could have saved us all a lot of trouble if you'd just argued against holding any long bonds, or any bonds at all, rather than focusing on EE Bonds, which turn out to be just a red herring in this discussion. I didn't think it was necessary to make the disclaimer that for me, who already has decided to own some bonds, and some long bonds at that, that EE bonds fit the bill quite nicely.

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Re: I don't understand the case for EE bonds

Post by Kevin M » Sun Apr 23, 2017 8:27 pm

NiceUnparticularMan wrote:
Kevin M wrote:Although they have unique characteristics compared to the long-term Treasuries held in something like a total bond market fund (TBM), some of those unique characteristics are positive (higher yield, limited downside in nominal terms), and I can see how someone would conclude that those positives outweigh the negatives (only 0.1% if held for less than 20 years) for a portion of their fixed income.
Ordinary long-term Treasuries have the same lack of downside in nominal terms if held to maturity.
That's obviously not what I was talking about.

If rates really spike in the first few years of the 20-year term, your 20-year Treasuries will drop a lot in value. With an EE bond, you essentially have a put option, limiting your "loss" to a 0.1% return minus the early withdrawal penalty if redeemed within five years. So in this scenario, you could sell your EE bond and reinvest at a higher rate for an overall higher 20-year return, which you cannot do with the long-term Treasury. This is a unique risk/return profile that some may consider to be a valuable diversifier for the fixed-income portion of their portfolio.

I get the same benefit with my direct CDs with low early withdrawal penalties, but I don't get the same guaranteed nominal 20-year return. I accept this tradeoff.
So it seems to me it is really a question of whether the little bit of extra yield is worth the severe penalty in case you want to use them within 20 years.
First, I think "a little bit of extra yield" is a misnomer. With the level of yields we're talking about, over 90 basis points is significant--3.53% is 35% higher than 2.61%. The lack of tax deferral for the 20-year Treasury cuts into the return some more, and you end up with $14,736 vs. $17,500 with the EE bond at a 25% constant tax rate. So with the EE bond you end up with almost 20% more terminal after-tax value.

Second, as mentioned already, the penalty could be even more severe for the long-term Treasury in a rising rate environment.

Third, the people here buying EE bonds are not buying them for any part of their portfolio that them might want or need to liquidate in less than 20 years, unless rates were to increase enough to justify doing so. So although I personally don't hold EE bonds, this particular argument you're making does not impress me at all.
I don't see that making sense from a risk-management perspective, but I agree that if you are thinking nominal bonds might outperform stocks even over the long run, then perhaps.
EE bonds are perfectly sensible from a risk-management perspective. You're hedging a particular "risk"--a 20-year period of low nominal and real fixed-income returns and nominal stock returns less than 3.5%--in a way that's hard if not impossible to do with any other security. Of course you acknowledge this in the second part of your sentence.
My concern, though, is that perhaps some people are committing to a bond allocation percentages for risk-management reasons, then seeking higher yield because of the current pretty dismal yields, then forgetting why they had bonds in the first place and selling out the relevant attributes in the effort to squeeze out more yield. And I do wonder how these people will feel in practice if inflation and/or rates go up, or alternatively there is a deflationary scenario where they can't make use of their EE bonds without a severe penalty.
I think some of the posters supporting their EE bond allocations have made very rational arguments indicating that they know what they're doing.

I've already pointed out that if rates go high enough quickly enough, you'd be worse off with long-term Treasures than with EE bonds. People who want to benefit more from, or hedge against, a deflationary scenario that doesn't last 20 years should hold some long-term Treasuries to hedge that risk, just like they should hold some long-term Treasuries if they want to hedge against, or benefit from, the risk of a financial crisis like 2008. The posters holding EE bonds have pointed out that they comprise only one component of their fixed-income allocations, and count on other components to provide them the benefits of fixed income that EE bonds don't provide.

Kevin
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Re: I don't understand the case for EE bonds

Post by market timer » Sun Apr 23, 2017 8:28 pm

NiceUnparticularMan wrote:
market timer wrote:In either case, they offer better optionality than typical long term bonds.
That makes no sense to me. A typical long bond holder can also just hold them to maturity. Or they can sell them at any time, and keep all the interest to date. Unlike with EE bonds, doing so will not trigger a severe early withdrawal penalty.

Or if you like, you can put this as that at any time, you can convert them to basically being no better than having held paper money under your mattress. That's not much of an option.
This is the crux of our disagreement here, so I've excluded the rest.

The logic here is really just set theory. An EE bond contains the payoff of a 20-year zero coupon at the same or lower yield held to maturity. Therefore, it is at least as good. In fact, it is better, because we have the option to redeem and buy higher yielding long term bonds if rates increase. To make it very clear, suppose EE bonds and 20-year zero coupons start at the same 3.5% yield. Holding both for 20 years gives the same return. However, if the zero coupon ever trades at a discount to its issue price, we could redeem the EE bond and buy more zero coupons than we could initially afford.

Now, you could argue that the long term bond has potential that the EE bond does not due to its liquidity. If interest rates decline sharply, you could sell the long term bond at a profit and reinvest in something else (say, the S&P 500). I would argue that you can do this synthetically with EE bonds by short selling Treasury futures and going long S&P 500 futures, while continuing to hold the EE bonds until they double. I believe the potential to construct this type of swap makes liquidity a non-issue for EE bonds.

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Re: I don't understand the case for EE bonds

Post by willthrill81 » Sun Apr 23, 2017 8:29 pm

letsgobobby wrote:you are really and repeatedly missing the point. if my goal was to maximize the amount of money in my hand when the chips are down, or whatever you said, I would invest exclusively in ultra micro cap deep value emerging market stocks, or some such. By the plain fact that I hold 40% bonds you should immediately recognize that "maximizing money" is not my goal, nor the goal of every investor. apparently it's not even your goal, because you also own some bonds.

several of you could have saved us all a lot of trouble if you'd just argued against holding any long bonds, or any bonds at all, rather than focusing on EE Bonds, which turn out to be just a red herring in this discussion. I didn't think it was necessary to make the disclaimer that for me, who already has decided to own some bonds, and some long bonds at that, that EE bonds fit the bill quite nicely.
Okay, I'll bite one more time.

I do hold bonds, but only in my EF because I want stability and liquidity for those funds. For my retirement portfolio, I'm currently 100% equities due to my risk tolerance and investment horizon, but I'll move into about 30% bonds when I get closer to retirement.

Bonds are not a problem at all. But bonds that cannot be sold, cannot be liquidated without relinquishing virtually all interest and realizing a real loss due to inflation, have a low (in relation to inflation, both historic and Fed-target) interest rate, and must be held for two decades to get the stated return are not typical 'long' bonds. EE bonds provide stability and a guarantee (of very little) but no liquidity of returns and a high opportunity cost. That's why Bogleheads aren't flocking to them in droves.

If someone doesn't want to maximize their money (risk-adjusted of course), then they should just stick their cash under their mattress. I have family members who might as well have done this, so I'm not trying to be facetious at all.
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Re: I don't understand the case for EE bonds

Post by NiceUnparticularMan » Sun Apr 23, 2017 8:33 pm

letsgobobby wrote:several of you could have saved us all a lot of trouble if you'd just argued against holding any long bonds, or any bonds at all, rather than focusing on EE Bonds, which turn out to be just a red herring in this discussion. I didn't think it was necessary to make the disclaimer that for me, who already has decided to own some bonds, and some long bonds at that, that EE bonds fit the bill quite nicely.
Well, I see bonds as potentially useful risk management tools, and potentially nominal long bonds as well (although I personally don't hold any).

But from my perspective, the punitive early withdrawal structure of EE bonds rather ruins the risk-managing potential of holding nominal long bonds.

I don't think of that as a red herring, I think of that as a valid distinction between EE bonds and other nominal long bonds which undermines the case for including them in a long-term investment portfolio.

But again, I recognize this is coming from the perspective that the utility of bonds is based on their risk management ability. If you are interested in holding bonds for some other purpose, maybe EE bonds make more sense.

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Re: I don't understand the case for EE bonds

Post by NiceUnparticularMan » Sun Apr 23, 2017 8:42 pm

market timer wrote:I would argue that you can do this synthetically with EE bonds by short selling Treasury futures and going long S&P 500 futures, while continuing to hold the EE bonds until they double. I believe the potential to construct this type of swap makes liquidity a non-issue for EE bonds.
Walk me through this. I invest in a 20-year Treasury. 10 years in, an unexpected deflationary scenario hits, and rates go down. I can now sell this bond for a real profit and use that money as I see fit.

As I understand it, your idea is instead of doing that, I short sell Treasury futures and go long S&P 500 futures. Explain to me when I did this, what it cost me, and how it turns into a profit when this deflationary scenario hits.

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Re: I don't understand the case for EE bonds

Post by willthrill81 » Sun Apr 23, 2017 8:47 pm

Kevin M wrote:If rates really spike in the first few years of the 20-year term, your 20-year Treasuries will drop a lot in value. With an EE bond, you essentially have a put option, limiting your "loss" to a 0.1% return minus the early withdrawal penalty if redeemed within five years. So in this scenario, you could sell your EE bond and reinvest at a higher rate for an overall higher 20-year return, which you cannot do with the long-term Treasury. This is a unique risk/return profile that some may consider to be a valuable diversifier for the fixed-income portion of their portfolio.
Intriguingly, from my perspective, you make a more convincing argument for EE bonds that those who actually hold them.

That being said, while long bonds like these can, theoretically, be useful in certain situations (very minimally on the upside I still think), this reminds me of thoroughly researched, well thought at quote.

"It’s more efficient to take the risk on the equity side."
-Larry Swedroe

http://www.etf.com/sections/index-inves ... nopaging=1
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Re: I don't understand the case for EE bonds

Post by market timer » Sun Apr 23, 2017 9:01 pm

NiceUnparticularMan wrote:
market timer wrote:I would argue that you can do this synthetically with EE bonds by short selling Treasury futures and going long S&P 500 futures, while continuing to hold the EE bonds until they double. I believe the potential to construct this type of swap makes liquidity a non-issue for EE bonds.
Walk me through this. I invest in a 20-year Treasury. 10 years in, an unexpected deflationary scenario hits, and rates go down. I can now sell this bond for a real profit and use that money as I see fit.

As I understand it, your idea is instead of doing that, I short sell Treasury futures and go long S&P 500 futures. Explain to me when I did this, what it cost me, and how it turns into a profit when this deflationary scenario hits.
I'm assuming your trade in 10 years is to sell $100-150K of 10-year Treasuries and buy $100-150K of the S&P 500. First, I'd note this is market timing and not typically done here. That said, I did something similar at the time of Brexit.

The easiest way to make this change is to make the trade using other bonds in your portfolio. If you hold non-EE bonds, sell those first and convert to stocks. If you only hold EE bonds, then there are several ways to short duration, including short selling Treasury futures. You could either short sell the US Treasury bond future (ticker ZB), which has a notional value around $150K and a duration slightly over 10 years, or short sell the 10-year T-note future (ticker ZN), which has a notional value around $125K and a duration slightly less than 10 years. You could pair this trade with going long the E-mini S&P 500 future (ticker ES), which has a notional value around $120K. The transaction costs for this pair trade are minimal: $10 in commissions and $30-50 roundtrip for bid/offer spread. Presumably, you'd have similar transaction costs if you went the non-synthetic route. You can even do this in a retirement account if you don't want to worry about taxes.
Last edited by market timer on Sun Apr 23, 2017 9:03 pm, edited 1 time in total.

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Re: I don't understand the case for EE bonds

Post by NiceUnparticularMan » Sun Apr 23, 2017 9:03 pm

willthrill81 wrote:Intriguingly, from my perspective, you make a more convincing argument for EE bonds that those who actually hold them.
Just keep in mind you have to keep track of what has happened with yield and duration. X years in, the normal long bond has already generated a bunch of yield, and duration has decreased. An increase in rates will drop the market value of the bond, but only as per its current duration, and you would still have that yield (which we should consider to be re-invested) to offset that market value loss.

Now the question is whether you would be better off giving up all that yield to get back your original investment. Maybe, but it is not a definite yes.

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Re: I don't understand the case for EE bonds

Post by NiceUnparticularMan » Sun Apr 23, 2017 9:07 pm

market timer wrote:I'm assuming your trade in 10 years is to sell $100-150K of 10-year Treasuries and buy $100-150K of the S&P 500.
How does this give me more money to use during the deflationary event?

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Re: I don't understand the case for EE bonds

Post by willthrill81 » Sun Apr 23, 2017 9:16 pm

NiceUnparticularMan wrote:
willthrill81 wrote:Intriguingly, from my perspective, you make a more convincing argument for EE bonds that those who actually hold them.
Just keep in mind you have to keep track of what has happened with yield and duration. X years in, the normal long bond has already generated a bunch of yield, and duration has decreased. An increase in rates will drop the market value of the bond, but only as per its current duration, and you would still have that yield (which we should consider to be re-invested) to offset that market value loss.

Now the question is whether you would be better off giving up all that yield to get back your original investment. Maybe, but it is not a definite yes.
Don't misunderstand me. I'm not putting a penny into EE bonds at current yields. :wink:
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Re: I don't understand the case for EE bonds

Post by market timer » Mon Apr 24, 2017 7:54 am

NiceUnparticularMan wrote:
market timer wrote:I'm assuming your trade in 10 years is to sell $100-150K of 10-year Treasuries and buy $100-150K of the S&P 500.
How does this give me more money to use during the deflationary event?
Sorry, I thought you had in mind a plan to sell the bonds and reinvest in equities. If you would like to sell bonds and use the money for consumption, I would suggest shorting Treasuries (to reduce duration) and borrowing from other investments.

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Re: I don't understand the case for EE bonds

Post by Kevin M » Mon Apr 24, 2017 9:48 am

NiceUnparticularMan wrote:
willthrill81 wrote:Intriguingly, from my perspective, you make a more convincing argument for EE bonds that those who actually hold them.
Just keep in mind you have to keep track of what has happened with yield and duration. X years in, the normal long bond has already generated a bunch of yield, and duration has decreased. An increase in rates will drop the market value of the bond, but only as per its current duration, and you would still have that yield (which we should consider to be re-invested) to offset that market value loss.

Now the question is whether you would be better off giving up all that yield to get back your original investment. Maybe, but it is not a definite yes.
This is what these comments are referring to:
Kevin M wrote:If rates really spike in the first few years of the 20-year term, your 20-year Treasuries will drop a lot in value. With an EE bond, you essentially have a put option, limiting your "loss" to a 0.1% return minus the early withdrawal penalty if redeemed within five years. So in this scenario, you could sell your EE bond and reinvest at a higher rate for an overall higher 20-year return, which you cannot do with the long-term Treasury. This is a unique risk/return profile that some may consider to be a valuable diversifier for the fixed-income portion of their portfolio.
So let's put some numbers to it.

Say the 15-year Treasury yield is 5% in 5 years. The price of a 20-year Treasury bought at par (100) at today's yield of 2.61%, which would then be a 15-year Treasury with 2.61% coupon at 5% yield, would be 75.19.

Without considering reinvestment, you would have collected 13.05 in coupon payments (for every 100 of original investment). Assuming you were able to reinvest the coupons at the average of the original 20-year yield of 2.61% and the 15-year yield in five years of 5%, you would have 14.08 of cumulative interest.

Adding the price and the cumulative interest gives you a range of 88.24 - 89.27 of total return, which in percentage terms is a range of -11.76% to -10.73%.

By contrast, redeeming your EE bond after five years would give you a total return of +0.5%.

Kevin
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Re: I don't understand the case for EE bonds

Post by willthrill81 » Mon Apr 24, 2017 10:12 am

Kevin M wrote:So let's put some numbers to it.

Say the 15-year Treasury yield is 5% in 5 years. The price of a 20-year Treasury bought at par (100) at today's yield of 2.61%, which would then be a 15-year Treasury with 2.61% coupon at 5% yield, would be 75.19.

Without considering reinvestment, you would have collected 13.05 in coupon payments (for every 100 of original investment). Assuming you were able to reinvest the coupons at the average of the original 20-year yield of 2.61% and the 15-year yield in five years of 5%, you would have 14.08 of cumulative interest.

Adding the price and the cumulative interest gives you a range of 88.24 - 89.27 of total return, which in percentage terms is a range of -11.76% to -10.73%.

By contrast, redeeming your EE bond after five years would give you a total return of +0.5%.

Kevin
As another contrast, if you bought a 5 year CD with Capital One 360 today, you would have a guaranteed annual return of 2.30%.
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Re: I don't understand the case for EE bonds

Post by Kevin M » Mon Apr 24, 2017 10:44 am

willthrill81 wrote:
Kevin M wrote:So let's put some numbers to it.

Say the 15-year Treasury yield is 5% in 5 years. The price of a 20-year Treasury bought at par (100) at today's yield of 2.61%, which would then be a 15-year Treasury with 2.61% coupon at 5% yield, would be 75.19.

Without considering reinvestment, you would have collected 13.05 in coupon payments (for every 100 of original investment). Assuming you were able to reinvest the coupons at the average of the original 20-year yield of 2.61% and the 15-year yield in five years of 5%, you would have 14.08 of cumulative interest.

Adding the price and the cumulative interest gives you a range of 88.24 - 89.27 of total return, which in percentage terms is a range of -11.76% to -10.73%.

By contrast, redeeming your EE bond after five years would give you a total return of +0.5%.

Kevin
As another contrast, if you bought a 5 year CD with Capital One 360 today, you would have a guaranteed annual return of 2.30%.
Yes, I really short-changed CDs in this comment:
Kevin M wrote: I get the same benefit with my direct CDs with low early withdrawal penalties, but I don't get the same guaranteed nominal 20-year return. I accept this tradeoff.
I thought another direct CD fan might call me on it, but since not ...

With a good direct CD, you get the added benefit of a significantly higher return if you do an early withdrawal. For example, the 7-year CD at 3% I bought last year has an early withdrawal penalty (EWP) of six months of interest, so basically you lose 1.5% in doing an early withdrawal. Unlike an EE bond for which the EWP essentially increases as time passes, the CD EWP is fixed.

So if doing an early withdrawal after five years, I'd end up with 114.23 (for every 100 of original value), so that's a +14.23% cumulative return compared to +0.5% for the EE bond and -11% to -12% for the 20-year Treasury. So the CD really is the best hedge against rising rates.

I'd come out slightly better with the 5-year CD I could buy today at 2.75% with an EWP of six months of interest, since I wouldn't have to pay any EWP after five years. I'd end up with a +14.53% cumulative return.

If we take each of these alternatives, and assume we buy the 15-year Treasury in five years with the proceeds of our EE bond or CD, we get these total 20-year annualized returns:

EE bond + 15-year Treasury: 3.75%
7-year CD + 15-year Treasury: 4.42%
5-year CD + 15-year Treasury: 4.43%

Of course with the 20-year Treasury there would be no pure return benefit in selling after five years to buy a 15-year Treasury, so you'd just hold the 20-year for your 2.61% return. There might be a tax-loss harvesting benefit though.

Kevin
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Re: I don't understand the case for EE bonds

Post by NiceUnparticularMan » Mon Apr 24, 2017 11:33 am

market timer wrote:Sorry, I thought you had in mind a plan to sell the bonds and reinvest in equities.
What you seem to be saying is if my desire in a deflationary scenario is to sell nominal bonds at a profit and invest in equities, then if I have also invested other money in nominal bonds then I can sell those at a profit and invest in equities, as long as I have enough invested in those other bonds I am willing to sell so as to satisfy my desire to invest more in equities.

I would suggest that is always going to "worK" as an answer to a liquidity issue--just assume more money which was invested in something liquid which is sufficient to satisfy whatever you need money for now. But really that isn't answering the issue, just assuming it away. Which in turn leaves me wondering exactly what the EE bonds did for you in this case--it would seem like nothing. There was no clever swap to get around the EE bonds' punitive early redemption rules, just using other money and other assets to solve the problem.
If you would like to sell bonds and use the money for consumption, I would suggest shorting Treasuries (to reduce duration) and borrowing from other investments.
Right, the scenario is something like I have lost my job in deflationary event 10 years into owning the EE bonds. I need to sell some of my portfolio to provide me with some income. If I invested enough other money in my portfolio in normal nominal bonds, selling them may satisfy my needs. But that just means the EE bonds were irrelevant, not useful, in this scenario, because I needed to invest other money in other things to make this work.

So now walk me through this latest plan. I'm borrowing Treasuries from other people to sell them? How does this produce a profit I can use? Are you suggesting I can borrow them for free and not have to close them for the ten years as I am waiting for the EE bonds to be redeemable? How is this different from hypothesizing someone will just give me a loan for the money I need and decide not to charge me any interest until it all comes due at once conveniently right when by EE bonds are redeemable? And isn't that 10-year loan actually going to cost me something in terms of present value?

Maybe I am missing something, but I see no clever swaps here. I just see ways you could use other money in the event you needed money, and the EE bonds are simply irrelevant to what your are imagining you could do.

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Re: I don't understand the case for EE bonds

Post by NiceUnparticularMan » Mon Apr 24, 2017 11:46 am

Kevin M wrote:So let's put some numbers to it.
I don't disagree with your analysis, but I would suggest they are putting the emphasis on "really spike" and "the first few years". For example, I think if you changed your time period to 10 years instead of 5 for the rate increase, the traditional bond would come out ahead.

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Re: I don't understand the case for EE bonds

Post by Chuck » Mon Apr 24, 2017 12:03 pm

This is a really interesting discussion. Here are a couple more ways to think of it:
  • EE bonds are "illiquid" only in the sense that you can't bear to give up the remaining expected interest. If you're 10 years in, and the "effective" interest rate for the remaining 10 years is 7%, then just get a HELOC or margin loan or something if you need money. But you have to be pretty tapped out if the value of your EE bonds is what you're going after.
  • If you don't plan to spend 95% of your portfolio in 20 years, then having 5% of your portfolio in EE bonds or anything "illiquid" is no big deal.
  • If you have a $1MM or $2MM retirement portfolio, having a $10K or $20K EE bond mature will be a cute little surprise from your past self.
Since no one is going to be destitute as a result of investing in, or avoiding EE bonds, it's definitely a personal preference thing, and depends mostly on "willlingness to hold."

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Re: I don't understand the case for EE bonds

Post by Kevin M » Mon Apr 24, 2017 12:30 pm

NiceUnparticularMan wrote:
Kevin M wrote:So let's put some numbers to it.
I don't disagree with your analysis, but I would suggest they are putting the emphasis on "really spike" and "the first few years". For example, I think if you changed your time period to 10 years instead of 5 for the rate increase, the traditional bond would come out ahead.
Sure, you can always find a scenario where one does better than the other. That's why we diversify and hold investments that will do better than others in certain scenarios.

Seems to me that there's too much all or none thinking in this thread.

If we're going to own any fixed income for a holding period of 20 years, then we either think there's a chance that fixed income will outperform stocks, or we think that we'll get enough of a rebalancing bonus by holding both that our stock/fixed portfolio will outperform 100% stocks.

If we're going to hold more than one kind of fixed income, then it seems that we must believe that there are different future scenarios in which each kind would do better. In the scenario I outlined, direct CDs do better than EE bonds, which do better than long-term Treasuries. In the deflationary scenario that you outline, long-term Treasuries would do better. In a scenario where you just hold your fixed income to maturity, EE bonds do better than 20-year Treasuries, and we don't know how rolling 5-year CDs will do. In a scenario where stocks have a 20-year annualized return of less than 3.5% but greater than 2.6% for 20 years, EE bonds beat stocks, which beat Treasuries, and we don't know how rolling 5-year CDs will do.

Over the last 6+ years during which I shifted fixed income from mostly bond funds to mostly direct CDs, my stocks have beat my intermediate-term investment grade bonds, which have beat my CDs, which have beat an intermediate-term Treasury fund. Over the next 6+ years that order could be reversed, but I'm placing a bigger bet on CDs, a smaller bet on stocks, and even smaller bet on investment-grade and muni bonds, and no bet on Treasuries (other than the small amount held in the investment-grade bond funds) or EE bonds (although I see some benefits to both).

I think the odds are that stocks will win, but since they could lose by a lot (even based on historical returns for rolling 6-year periods), and since I don't need to take the extra risk for the extra expected return, I limit my exposure to the high-risk, high-expected-return asset class. If I can earn a higher expected return with the same or less risk in the fixed-income space, as I can with direct CDs, I'll take advantage of that.

For me, I could see more of an argument for adding some EE bonds than for increasing my allocation to stocks at the present time, considering my ability, willingness and need to take risk, but at my age, 20-years seems like too long to lock money up at 3.5%.

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Re: I don't understand the case for EE bonds

Post by NiceUnparticularMan » Mon Apr 24, 2017 1:36 pm

Chuck wrote:EE bonds are "illiquid" only in the sense that you can't bear to give up the remaining expected interest. If you're 10 years in, and the "effective" interest rate for the remaining 10 years is 7%, then just get a HELOC or margin loan or something if you need money. But you have to be pretty tapped out if the value of your EE bonds is what you're going after.
Right, meaning they are useless as a provision against withdrawals, planned or unexpected, during most of the 20 years, and also useless for rebalancing. This alone wipes out many of the reasons people tend to give for investing in bonds. The last major one is reducing portfolio volatility for psychological/behavioral/social/relational reasons. But the only reason that might work in favor of EE bonds is you are tricking yourself into not thinking about the real value of your EE bonds over time, precisely because you can't market them for their real value anyway (and if you are good enough at forgetting about your EE bonds, you might even get a "cute surprise"!).
If you don't plan to spend 95% of your portfolio in 20 years, then having 5% of your portfolio in EE bonds or anything "illiquid" is no big deal.
Taking out 5% of your portfolio in cash and then burning it to heat your home is probably also no big deal, but not necessarily a good idea. But you are helping heat your home, so one could call it a preference thing I suppose.

Generally people invest in bonds for a reason. Generally the reasons involve things EE bonds don't provide. It is therefore fair to ask why EE bonds, since they can't do what people normally want bonds to do. "It probably won't make much difference" isn't really an answer.

So the answer does seem to come down to some sort of "it makes me happy" argument. Which is fine if it works, but I continue to wonder if they really will make investors happy in the event it becomes clear they were a bad investment. Even if it doesn't ruin the investor's overall plan, I am skeptical that they will not care at all, seeing as how they cared in the first place.

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Re: I don't understand the case for EE bonds

Post by NiceUnparticularMan » Mon Apr 24, 2017 2:24 pm

Kevin M wrote:Sure, you can always find a scenario where one does better than the other. That's why we diversify and hold investments that will do better than others in certain scenarios. Seems to me that there's too much all or none thinking in this thread.
Well, I think it is worth understanding under what circumstances this EE bond feature would actually be useful. And at the end of the day, it is common for certain possible investments to not make the final cut in an "efficient" portfolio, because there is some other combination of investments that does the same job better.

So I was in fact interested in understanding better when this option made sense. But between the narrow window and the manifest superiority of something like CDs during that window--I'm still skeptical inclusion for this reason is really warranted.
If we're going to own any fixed income for a holding period of 20 years, then we either think there's a chance that fixed income will outperform stocks, or we think that we'll get enough of a rebalancing bonus by holding both that our stock/fixed portfolio will outperform 100% stocks.
So my framework is the main common reasons to hold bonds are:

(1) To provide for planned withdrawals;

(2) To provide for possible unplanned withdrawals;

(3) To use for rebalancing;

(4) Behavioral/emotional/psychological/social/relational reasons;

(5) Because you think they might outperform stocks (and other bonds) over the same period if held to maturity.

Holding aside (4), we seem to be agreeing the case for EE bonds would otherwise really have to be made on the basis of (5). Interestingly, though, it seems the proponents are mostly ending up focusing on (4).

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Re: I don't understand the case for EE bonds

Post by lazyday » Mon Apr 24, 2017 3:01 pm

I imagine EE bonds could make good sense to someone buying them for a Liability Matching Portfolio, when there's a high yield spread over Treasuries of the same duration. Such as Summer of 2016, when the spread reached something like 175 basis points.

CDs with generous yield spreads can be a challenge to buy in IRAs before the yield promotion ends. If you've already bought I bonds, then it's very easy to buy EE bonds.

But if CDs have the same yield spread, the case for EE might be hard to make. Because they both have nominal yield, I'm not sure there's a huge benefit to matching the liability timing. Rolling CDs might increase reinvestment risk, but it would seem to reduce inflation risk.

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Re: I don't understand the case for EE bonds

Post by NiceUnparticularMan » Mon Apr 24, 2017 3:12 pm

lazyday wrote:I imagine EE bonds could make good sense to someone buying them for a Liability Matching Portfolio, when there's a high yield spread over Treasuries of the same duration. Such as Summer of 2016, when the spread reached something like 175 basis points.
As an aside, isn't that sort of the purpose of them, where the liability in question is future education spending?

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Re: I don't understand the case for EE bonds

Post by mhop » Mon Apr 24, 2017 4:27 pm

NiceUnparticularMan wrote:
lazyday wrote:I imagine EE bonds could make good sense to someone buying them for a Liability Matching Portfolio, when there's a high yield spread over Treasuries of the same duration. Such as Summer of 2016, when the spread reached something like 175 basis points.
As an aside, isn't that sort of the purpose of them, where the liability in question is future education spending?
Along the same vein, would anyone consider EE's vs. an accelerated mortgage paydown if you were carrying something like a 15-yr at 2.875% or a 30-yr at 3.5%? Granted, you could take that money and invest in stock as well or possibly use a mix.

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Re: I don't understand the case for EE bonds

Post by lazyday » Mon Apr 24, 2017 4:35 pm

Well now that you have to hold for 20 years to get much return, I doubt EE are very useful for education. Maybe if your babies WILL grow up to be doctors? :)

I was thinking retirement. $10k I + $10K EE per person per year could be enough for modest living until social security starts, and the risk portfolio could be for luxuries. Or something like that, I'm not much of an LMP person.

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Re: I don't understand the case for EE bonds

Post by letsgobobby » Mon Apr 24, 2017 5:08 pm

NiceUnparticularMan wrote:
Kevin M wrote:Sure, you can always find a scenario where one does better than the other. That's why we diversify and hold investments that will do better than others in certain scenarios. Seems to me that there's too much all or none thinking in this thread.
Well, I think it is worth understanding under what circumstances this EE bond feature would actually be useful. And at the end of the day, it is common for certain possible investments to not make the final cut in an "efficient" portfolio, because there is some other combination of investments that does the same job better.

So I was in fact interested in understanding better when this option made sense. But between the narrow window and the manifest superiority of something like CDs during that window--I'm still skeptical inclusion for this reason is really warranted.
If we're going to own any fixed income for a holding period of 20 years, then we either think there's a chance that fixed income will outperform stocks, or we think that we'll get enough of a rebalancing bonus by holding both that our stock/fixed portfolio will outperform 100% stocks.
So my framework is the main common reasons to hold bonds are:

(1) To provide for planned withdrawals;

(2) To provide for possible unplanned withdrawals;

(3) To use for rebalancing;

(4) Behavioral/emotional/psychological/social/relational reasons;

(5) Because you think they might outperform stocks (and other bonds) over the same period if held to maturity.

Holding aside (4), we seem to be agreeing the case for EE bonds would otherwise really have to be made on the basis of (5). Interestingly, though, it seems the proponents are mostly ending up focusing on (4).
I have been one of those proponents you allude to, and have never argued they are a behavioral or emotional salve. I have repeatedly stated to you and your fellow skeptic that items 1, 2, and 3 are completely irrelevant to me for this portion of my money. 5 is probably the closest reason I hold them, that is to say, anything is possible in the future and I want to be protected against tail risks of all kinds. EE bonds protect against a low inflation future better than any other instrument I know of.

Let me put it another way: Can you propose a cheaper way to guarantee me exactly $40,000 in 20 years? Right now the least expensive way I've found to achieve that is by buying $20,000 of EE bonds. If you know a cheaper way I'm all ears. Since this is in a taxable account, please don't forget to take taxes into consideration.

By the way, I also have an I bond annuity of sorts. Every year's purchase of I bonds guarantees me identical purchasing power, minus taxes, any time five or more years from now. I am not aware of a cheaper way to do that, either, especially in a taxable account (TIPS may do this to some extent but are subject to price swings and are not suitable for a taxable account).

The I and EE bonds contribute to what I call my 'early retirement travel annuity.'

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Re: I don't understand the case for EE bonds

Post by market timer » Mon Apr 24, 2017 5:31 pm

NiceUnparticularMan wrote:
If you would like to sell bonds and use the money for consumption, I would suggest shorting Treasuries (to reduce duration) and borrowing from other investments.
Right, the scenario is something like I have lost my job in deflationary event 10 years into owning the EE bonds. I need to sell some of my portfolio to provide me with some income. If I invested enough other money in my portfolio in normal nominal bonds, selling them may satisfy my needs. But that just means the EE bonds were irrelevant, not useful, in this scenario, because I needed to invest other money in other things to make this work.

So now walk me through this latest plan. I'm borrowing Treasuries from other people to sell them? How does this produce a profit I can use? Are you suggesting I can borrow them for free and not have to close them for the ten years as I am waiting for the EE bonds to be redeemable? How is this different from hypothesizing someone will just give me a loan for the money I need and decide not to charge me any interest until it all comes due at once conveniently right when by EE bonds are redeemable? And isn't that 10-year loan actually going to cost me something in terms of present value?

Maybe I am missing something, but I see no clever swaps here. I just see ways you could use other money in the event you needed money, and the EE bonds are simply irrelevant to what your are imagining you could do.
Yes, if you want to sell EE bonds synthetically after 10 years without really selling them, you would need to short Treasuries of comparable duration. On this short position, you would earn interest, which could be used to pay for short term borrowing costs to fund consumption spending until EE bonds maturity.

I view the above as not a typical use case for EE bonds. The typical use case is for someone who has, say, a 70/30 portfolio, with $700K in stocks and $300K in bonds, of which $100K are EE bonds. In such a portfolio, EE bonds currently pay higher interest than other bonds, so would be the last to be liquidated. Rebalancing occurs with new investment contributions and by selling other bonds. In such a portfolio, the real question is whether EE bonds are more attractive than other bonds of similar duration. Those of us on the EE side think they are.

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Re: I don't understand the case for EE bonds

Post by DaftInvestor » Mon Apr 24, 2017 7:01 pm

This Bogleheads place is an interesting town - when someone asks "should I pay off my 3% mortgage" the majority of respondents jump in and say yes. But yet when someone asks if there is any point in a risk free investment that guarantees 3.5% over 20 years the result is entirely different. :)

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Re: I don't understand the case for EE bonds

Post by Kevin M » Mon Apr 24, 2017 8:05 pm

letsgobobby wrote: Let me put it another way: Can you propose a cheaper way to guarantee me exactly $40,000 in 20 years? Right now the least expensive way I've found to achieve that is by buying $20,000 of EE bonds.
Yes, I think this is the primary benefit of EE bonds--a guaranteed nominal 20-year return that is higher than anything else you can currently get with any other investment.
By the way, I also have an I bond annuity of sorts. Every year's purchase of I bonds guarantees me identical purchasing power, minus taxes, any time five or more years from now. I am not aware of a cheaper way to do that, either, especially in a taxable account (TIPS may do this to some extent but are subject to price swings and are not suitable for a taxable account).
But I disagree with this. Unlike EE bonds vs. nominal Treasuries, you can beat I Bonds with TIPS in a taxable account, and price swings don't matter if you target a maturity date, as you're essentially doing with EE bonds. Of course it depends on your personal tax arbitrage situation, and the realized inflation rate (and ignores the possible tax exemption for qualified educational expenses, which can tip things more in favor of I Bonds).

Five-year TIPS have just dropped to 0%, but were as high as 0.22% earlier in the month, and as high as 0.28% in mid-March. Currently you have to go to seven years to get a positive real return, at 0.18% (and 7-year TIPS were at 0.40% earlier this month, and as high as 0.54% in mid-March).

If we go with the 7-year at 0.18%, assume a constant 25% marginal tax rate and 2% average inflation, 10,000 invested in TIPS in taxable today grows to 11,204 in seven years after tax, and $10K in I Bonds grows to 11,176. If we see 7-year TIPS at 0.5% again soon, you'd end up with 11,395.

If you're really thinking in terms of an annuity, and extend the time period to 20 or 30 years, TIPS are even more advantageous. The 20-year yield is 0.80%, and has recently been as high as 0.91%, and the 30-year yield is 0.94%, and recently has been as high as 1.09%.

With a 20-year TIPS yield of 0.9%, you end up with 15,418 after 25% constant tax rate at an average 2% inflation rate in a taxable account, compared to 13,870 for the I Bond. With a 30-year TIPS at 1% you end up with 19,480 compared to 16,499 for the I Bond. You just can't make up for the large yield spread between long-term TIPS and I Bonds with tax deferral.

Even if you assume 35% tax rate on the TIPS and 25% on the I Bond (due to dropping into a lower tax bracket in retirement), the TIPS in taxable still wins at the yields and inflation rate mentioned.

I Bonds just make a lot less sense as long-term inflation hedges than long-term TIPS, unless you're betting on real yields rising enough to make it worthwhile to redeem your I Bonds and buy TIPS at higher yields (and since you'll lose your "tax deferred space" when you redeem the I Bonds, you can't replace them with more I Bonds unless you want to consume your annual purchase limit this way).

I think it's a bit hyperbolic to say that TIPS are not suitable for a taxable account.

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Re: I don't understand the case for EE bonds

Post by letsgobobby » Mon Apr 24, 2017 8:13 pm

Kevin M wrote:
I Bonds just make a lot less sense as long-term inflation hedges than long-term TIPS, unless you're betting on real yields rising enough to make it worthwhile to redeem your I Bonds and buy TIPS at higher yields (and since you'll lose your "tax deferred space" when you redeem the I Bonds, you can't replace them with more I Bonds unless you want to consume your annual purchase limit this way).

I think it's a bit hyperbolic to say that TIPS are not suitable for a taxable account.

Kevin
I ended up deciding that neither I bonds nor TIPS really were attractive enough as an inflation hedge, net of taxes, so for 2 years I have not bought either; so I admit my analysis did not really extend beyond that. Because I am still employed and plan to stay partly employed for some time, and have significant equity and real estate holdings, I decided I was not sensitive enough to inflation to bother with inflation-protected bonds, not at these rates.

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Re: I don't understand the case for EE bonds

Post by flamesabers » Mon Apr 24, 2017 9:05 pm

DaftInvestor wrote:This Bogleheads place is an interesting town - when someone asks "should I pay off my 3% mortgage" the majority of respondents jump in and say yes. But yet when someone asks if there is any point in a risk free investment that guarantees 3.5% over 20 years the result is entirely different. :)
I think one reason for the difference is the psychological benefits of being completely debt free. I'm not a homeowner, but I imagine it feels nice to not have to pay the bank anymore for a 15 or 30 year mortgage. Another difference is the amount of time it takes to recognize the rewards of either option. Paying down (or paying off entirely) a mortgage reduces the total amount of interest you'll be paying for your house. You don't have to wait 20 years before you get a reduction in the amount of interest you have to pay.

I'm not opposed to investing in EE Bonds, but with my finite amount of money, they're not the most compelling form of investment for me right now. If say I was able to max out my retirement account contributions along with I-Bonds, I might consider buying EE Bonds if my focus is on investing in tax-deferred investments.

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Re: I don't understand the case for EE bonds

Post by willthrill81 » Tue Apr 25, 2017 12:30 am

DaftInvestor wrote:This Bogleheads place is an interesting town - when someone asks "should I pay off my 3% mortgage" the majority of respondents jump in and say yes. But yet when someone asks if there is any point in a risk free investment that guarantees 3.5% over 20 years the result is entirely different. :)
I'll admit that that may not be the most logical position to take, but it's not comparing apples to apples. The consequences of failing to repay a mortgage are steep, whereas the consequences of earning 3.0% in the worst 20 year period of the stock market as opposed to a guaranteed 3.5% in EE bonds on a $10k is rather trivial. Granted, savings could potentially be used to repay a mortgage in the event of an extended job loss, but when most or all of those savings are in tax advantaged accounts, the penalties involved could be very steep.

But there's a big psychological benefit in owning your home free and clear (I anticipate this anyway).
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: I don't understand the case for EE bonds

Post by NiceUnparticularMan » Tue Apr 25, 2017 6:07 am

letsgobobby wrote:5 is probably the closest reason I hold them, that is to say, anything is possible in the future and I want to be protected against tail risks of all kinds. EE bonds protect against a low inflation future better than any other instrument I know of.
Not if there is a deflationary event before 20 years.

I recognize that if what you are imagining is just a slow steady 20 years of 1% inflation, then EE bonds, like all nominal long bonds bought under today's inflation expectations, will benefit. As I noted before, though, that is a rather unlikely scenario. Instead, if inflation only averages 1% for the next 20 years, likely there has been a significant deflationary event along the way. And in that case, my guess is for one of reasons (1) to (3), you would be better off with marketable long bonds.
Let me put it another way: Can you propose a cheaper way to guarantee me exactly $40,000 in 20 years?
What value does a guarantee of a certain NOMINAL amount of USD 20 years in the future have?

That's not guaranteed to have a certain amount of spending power, it is not guaranteed to be a good investment compared to other alternatives, and so on.

Indeed, suppose I told you I was investing in a copper future contract, in which 5 tons of copper wire would be delivered to me in 20 years, which I could then sell. You might reasonably ask me, why? And suppose my answer was, "What other investment would guarantee me exactly 5 tons of copper wire in 20 years?"

Well, no investment, I guess. But since the real value of 5 tons of copper wire in the future is not guaranteed, I think you would be reasonably skeptical about the value of a guarantee that I would have exactly 5 tons of copper wire.

To me, the guarantee of a certain nominal amount of USD in 20 years raises the exact same questions as my copper future contract.
Last edited by NiceUnparticularMan on Tue Apr 25, 2017 6:18 am, edited 1 time in total.

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Re: I don't understand the case for EE bonds

Post by NiceUnparticularMan » Tue Apr 25, 2017 6:16 am

market timer wrote:Yes, if you want to sell EE bonds synthetically after 10 years without really selling them, you would need to short Treasuries of comparable duration. On this short position, you would earn interest, which could be used to pay for short term borrowing costs to fund consumption spending until EE bonds maturity.
Again, I'm not following you here in practical terms. A short is just borrowing the asset from someone else and selling it, and eventually I have to return the asset to them and PAY interest to them as well. I could also just borrow money to spend and pay interest on that. I'm not following why you think the short is a better way of financing my current spending needs than borrowing. And none of this has anything to do with the EE bond.
The typical use case is for someone who has, say, a 70/30 portfolio, with $700K in stocks and $300K in bonds, of which $100K are EE bonds. In such a portfolio, EE bonds currently pay higher interest than other bonds, so would be the last to be liquidated. Rebalancing occurs with new investment contributions and by selling other bonds. In such a portfolio, the real question is whether EE bonds are more attractive than other bonds of similar duration.
No, the real question is why have 10% of your portfolio in bonds that you don't need for withdrawals, planned or emergency, and don't need for rebalancing. Exactly what purpose is it serving to put that 10% in bonds if it isn't one of those purposes?

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Re: I don't understand the case for EE bonds

Post by market timer » Tue Apr 25, 2017 8:34 am

NiceUnparticularMan wrote:
market timer wrote:Yes, if you want to sell EE bonds synthetically after 10 years without really selling them, you would need to short Treasuries of comparable duration. On this short position, you would earn interest, which could be used to pay for short term borrowing costs to fund consumption spending until EE bonds maturity.
Again, I'm not following you here in practical terms. A short is just borrowing the asset from someone else and selling it, and eventually I have to return the asset to them and PAY interest to them as well. I could also just borrow money to spend and pay interest on that. I'm not following why you think the short is a better way of financing my current spending needs than borrowing. And none of this has anything to do with the EE bond.
Think of it in terms of a balance sheet. You have some 10-year-to-maturity EE bonds with a yield-to-maturity of 7% (they will roughly double in the remaining 10 years) and you want to use them to buy a Mercedes. You don't want to redeem the bonds and give up the 7% yield, because 10-year interest rates are only 2.5%.

Ideally, you could take out a 10-year loan at the market rate of 2.5%, but this is not really possible for a retail investor. The main reason is that you have credit risk. One way around this is to collateralize the loan--a margin loan, for example. Margin loans are generally floating based on the overnight rate--I'm not aware of 10-year margin loans for retail investors. Therefore, even if you take out a margin loan to buy your Mercedes, your balance sheet has interest rate risk relative to selling EE bonds to buy a Mercedes. In particular, you are long 10-year rates and short the overnight rate. You are exposed to the risk that short term rates rise faster than expectations. The way to solve this is to short sell a 10-year Treasury, which is effectively borrowing at the 10-year rate and lending at the overnight rate. This is balance sheet neutral vs. selling EE bonds to buy a Mercedes. One last point: If you are concerned that your margin rate is nowhere near the risk-free rate, I suggest you change brokers or borrow implicitly via futures and options. One example of implicit borrowing is to sell equity holdings, withdraw some of the cash, and buy equity futures.
The typical use case is for someone who has, say, a 70/30 portfolio, with $700K in stocks and $300K in bonds, of which $100K are EE bonds. In such a portfolio, EE bonds currently pay higher interest than other bonds, so would be the last to be liquidated. Rebalancing occurs with new investment contributions and by selling other bonds. In such a portfolio, the real question is whether EE bonds are more attractive than other bonds of similar duration.
No, the real question is why have 10% of your portfolio in bonds that you don't need for withdrawals, planned or emergency, and don't need for rebalancing. Exactly what purpose is it serving to put that 10% in bonds if it isn't one of those purposes?
There is no guarantee equities will outperform bonds over 20 years. A 3.5% likely tax free return doesn't seem that bad to me.

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Re: I don't understand the case for EE bonds

Post by flamesabers » Tue Apr 25, 2017 8:51 am

market timer wrote:A 3.5% likely tax free return doesn't seem that bad to me.
Unless you're using the interest earned on qualified educational expenses, you'll have to pay federal taxes on the interest earned when the bond matures or is otherwise redeemed.

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Re: I don't understand the case for EE bonds

Post by NiceUnparticularMan » Tue Apr 25, 2017 9:28 am

market timer wrote:The way to solve this is to short sell a 10-year Treasury, which is effectively borrowing at the 10-year rate and lending at the overnight rate. This is balance sheet neutral vs. selling EE bonds to buy a Mercedes.
No it's not. You would actually have to borrow and sell a bond which had the same structure as your EE bond (basically zero coupon for 10 years then it doubles) for it to be truly balance sheet neutral.

Which is why the EE bond is irrelevant to all this. You've invested only in stocks, and a big rate drop increases the value of long nominal bonds, and you want to benefit from that even though you failed to buy long nominal bonds. So, you borrow a nominal bond and sell it. You say this is a clever way to borrow at the new lower market rates, and maybe it is, although I think you may be failing to account for the risks in such a scheme. But in any event, this great low-rate loan you think you just took out has nothing to do with your existing investments.
There is no guarantee equities will outperform bonds over 20 years. A 3.5% likely tax free return doesn't seem that bad to me.
Well, if you think 3.5% NOMINAL is actually likely to beat stocks over 20 years, then yes, an EE bond might look like a good investment.

If you think it is unlikely but possible, then you have to do some work to quantify how unlikely. Because it is unlikely but possible that lots of things could beat stocks over 20 years (anyone checked on tulip futures recently?). That doesn't mean we should invest in everything like that.

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Re: I don't understand the case for EE bonds

Post by dodecahedron » Tue Apr 25, 2017 9:37 am

NiceUnparticularMan wrote:
Well, if you think 3.5% NOMINAL is actually likely to beat stocks over 20 years, then yes, an EE bond might look like a good investment.

If you think it is unlikely but possible, then you have to do some work to quantify how unlikely. Because it is unlikely but possible that lots of things could beat stocks over 20 years (anyone checked on tulip futures recently?). That doesn't mean we should invest in everything like that.
Nobody (including market timer) is suggesting investing everything in EE bonds.

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Re: I don't understand the case for EE bonds

Post by willthrill81 » Tue Apr 25, 2017 9:48 am

dodecahedron wrote:
NiceUnparticularMan wrote:
Well, if you think 3.5% NOMINAL is actually likely to beat stocks over 20 years, then yes, an EE bond might look like a good investment.

If you think it is unlikely but possible, then you have to do some work to quantify how unlikely. Because it is unlikely but possible that lots of things could beat stocks over 20 years (anyone checked on tulip futures recently?). That doesn't mean we should invest in everything like that.
Nobody (including market timer) is suggesting investing everything in EE bonds.
Frankly, that's beside the point. It's akin to the logic used by those who buy lottery tickets with the spare change in their pocket. Granted, EE bonds are undoubtedly a better bet than that, but when compared to other long-term investments, inflation, etc., they are a poor bet in comparison.
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Re: I don't understand the case for EE bonds

Post by flamesabers » Tue Apr 25, 2017 10:10 am

willthrill81 wrote:
dodecahedron wrote:
NiceUnparticularMan wrote:
Well, if you think 3.5% NOMINAL is actually likely to beat stocks over 20 years, then yes, an EE bond might look like a good investment.

If you think it is unlikely but possible, then you have to do some work to quantify how unlikely. Because it is unlikely but possible that lots of things could beat stocks over 20 years (anyone checked on tulip futures recently?). That doesn't mean we should invest in everything like that.
Nobody (including market timer) is suggesting investing everything in EE bonds.
Frankly, that's beside the point. It's akin to the logic used by those who buy lottery tickets with the spare change in their pocket. Granted, EE bonds are undoubtedly a better bet than that, but when compared to other long-term investments, inflation, etc., they are a poor bet in comparison.
Ultimately I think it depends on what you're looking for in an investment. How many other investments (besides savings bonds) can you purchase that are tax-deferred, don't require earned income or a HDHP, has no fees, no income eligibility restrictions, has virtually no risk of default, is insured beyond the FDIC limits and isn't callable?

I don't think anyone will disagree that EE Bonds aren't a good investment if you're willing to take risk for higher gains and/or may need the money in less then 20 years. However, for those looking for investments that have the criteria I listed above, EE Bonds make more sense I think. Between the two, I would favor I-Bonds over EE Bonds. However, if someone wants to hedge the bet that I-Bonds will have relatively low rates over the next two decades, EE Bonds are a good counterweight I think.

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Re: I don't understand the case for EE bonds

Post by NiceUnparticularMan » Tue Apr 25, 2017 10:23 am

dodecahedron wrote:Nobody (including market timer) is suggesting investing everything in EE bonds.
Sure, but there are plenty of things I invest nothing in. I don't invest in collectible art, for example. I don't invest in copper wire futures. And so on. Sometimes no investment is in fact the right answer.

And I actually do think this process should start with asking why not put that money in your highest expected return investment. There are good reasons to not do that with all your money, but I think you do need such a reason, meaning the default should just be your highest expected return investment absent such a good reason.

And to me, the mere theoretical chance that an investment might out-return stocks is not typically not good enough without further explanation. Because that's true for collectible art, copper wire futures, and so on--anything MIGHT out-return stocks, so it proves too much to claim that is a good reason for holding any one thing that MIGHT out-return stocks.

I really do think a lot of the problem here (and with similar topics involving other higher-return/higher-risk bonds) is that people commit to a certain bond allocation as a risk-management device, and then grow dissatisfied with the low bond returns they are getting. So, they look to juice their bond returns. But in so doing, they may well be undermining the case for holding bonds at all.

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Re: I don't understand the case for EE bonds

Post by letsgobobby » Tue Apr 25, 2017 10:25 am

NiceUnparticularMan wrote:

If you think it is unlikely but possible, then you have to do some work to quantify how unlikely. Because it is unlikely but possible that lots of things could beat stocks over 20 years (anyone checked on tulip futures recently?). That doesn't mean we should invest in everything like that.
And you don't investing in anything like that; you've already said you are 100% stocks. But most investors are less confident in their ability to prophecy the future, so we invest in a diverse portfolio including lower-returning assets such as bonds. It's really that simple. Your skepticism about bonds in general is blinding you to the potential advantages of this instrument within the bond universe.
What value does a guarantee of a certain NOMINAL amount of USD 20 years in the future have?
The same value for which investors have paid for nominal bonds for centuries. Really, do I have to explain that to you?

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Re: I don't understand the case for EE bonds

Post by market timer » Tue Apr 25, 2017 10:28 am

NiceUnparticularMan wrote:
market timer wrote:The way to solve this is to short sell a 10-year Treasury, which is effectively borrowing at the 10-year rate and lending at the overnight rate. This is balance sheet neutral vs. selling EE bonds to buy a Mercedes.
No it's not. You would actually have to borrow and sell a bond which had the same structure as your EE bond (basically zero coupon for 10 years then it doubles) for it to be truly balance sheet neutral.

Which is why the EE bond is irrelevant to all this. You've invested only in stocks, and a big rate drop increases the value of long nominal bonds, and you want to benefit from that even though you failed to buy long nominal bonds. So, you borrow a nominal bond and sell it. You say this is a clever way to borrow at the new lower market rates, and maybe it is, although I think you may be failing to account for the risks in such a scheme. But in any event, this great low-rate loan you think you just took out has nothing to do with your existing investments.
What I've demonstrated is that an EE bond allows you to afford anything you could have afforded by investing in 20-year Treasuries of the same or lower yield for any future interest rate path--not just at the 20-year mark (trivial to show), but at any time prior to the doubling (via selling Treasuries and netting out at the 20-year mark). The only assumption I've relied on is access to collateral other than EE bonds.

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Re: I don't understand the case for EE bonds

Post by NiceUnparticularMan » Tue Apr 25, 2017 10:31 am

flamesabers wrote:How many other investments (besides savings bonds) can you purchase that are tax-deferred, don't require earned income or a HDHP, has no fees, no income eligibility restrictions, has virtually no risk of default, is insured beyond the FDIC limits and isn't callable?
Paper money?

To me this appears to be trying to reverse-engineer the problem. I want an EE bond allocation, now how do I justify it. Well, I try to define the unique characteristics of EE bonds to the point nothing else is like them, then claim that is valuable.

In my view, you have to start the other way around by defining what real world things you are actually trying to accomplish. Then you find assets that help you accomplish those real world things. Many assets will not be helpful, so you don't use them.

Hence I don't see a list of the attributes of EE bonds as a complete argument. To me, that isn't helpful unless you explain what it is you are trying to accomplish in the real world and how EE bonds are actually the best choice for that purpose.

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Re: I don't understand the case for EE bonds

Post by willthrill81 » Tue Apr 25, 2017 10:39 am

letsgobobby wrote:And you don't investing in anything like that; you've already said you are 100% stocks. But most investors are less confident in their ability to prophecy the future, so we invest in a diverse portfolio including lower-returning assets such as bonds. It's really that simple. Your skepticism about bonds in general is blinding you to the potential advantages of this instrument within the bond universe.
You act as though you taking a sure thing with EE bonds and those investing in something like stocks are the ones making a bet. But the truth is that you are still taking a gamble with EE bonds. Inflation could destroy the returns of EE bonds, and the opportunity cost could be equally detrimental. You say that you are hedging against deflation, but Bogleheads agree that there are many ways to hedge against like that, like paying off debt or buying Treasuries or I bonds, and none of them lock you in for twenty years.
viewtopic.php?t=149156

If you want the highest possible guaranteed nominal rate, then EE bonds seem to be the way to go. But buying them is still a gamble. All roads carry risk.
Last edited by willthrill81 on Tue Apr 25, 2017 10:43 am, edited 1 time in total.
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Re: I don't understand the case for EE bonds

Post by NiceUnparticularMan » Tue Apr 25, 2017 10:40 am

market timer wrote:What I've demonstrated is that an EE bond allows you to afford anything you could have afforded by investing in 20-year Treasuries of the same or lower yield for any future interest rate path
No, you've suggested shorting Treasuries is a good way to borrow money if rates are low.

The EE bond wasn't involved in any way in that transaction, meaning you could do it whether you did or did not have the EE bond.
(via selling Treasuries and netting out at the 20-year mark).
Netting out with what, exactly? If you borrow an ordinary Treasury, you have to return the same Treasury plus interest. At some later point, an EE bond might give you a return, but that has nothing to do with your short-as-loan plan.
The only assumption I've relied on is access to collateral other than EE bonds.
Exactly, the EE bond was totally irrelevant to this scheme.

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