Risk of creating bond ladder with few longer term maturity bonds vs typical ladder.

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Hector
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Risk of creating bond ladder with few longer term maturity bonds vs typical ladder.

Post by Hector »

Goal: 3 year average maturity with Treasuries

Daily Treasury Yield Curve Rates:

Code: Select all

Date		1 Mo	2 Mo	3 Mo	6 Mo	1 Yr	2 Yr	3 Yr	5 Yr	7 Yr	10 Yr	20 Yr	30 Yr
09/22/20	0.08	0.09	0.10	0.11	0.12	0.13	0.15	0.27	0.46	0.68	1.21	1.42
Method A:
5-1 ladder.
Roll return: = (((1+0.27/100)^5/(1+0.12/100)^1)^(1/(5-1))-1)*100 = 0.31
Total return = 0.31 + 0.27 = 0.58%

Method B:
8-1 ladder + 2-1 ladder.
Total return = (1.13 + 0.27) / 2 = 0.70%

Seems like Method B's return is higher than Method A`s. What are the risks?
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Doc
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Re: Risk of creating bond ladder with few longer term maturity bonds vs typical ladder.

Post by Doc »

One of the prime reasons for having a Treasury bond ladder is to capture the roll (down) yield that is achieved by selling before maturity. The amount of that extra you get by selling early depends on the shape of the yield curve. A 10-3 or 7-3 ladder was typical a few years ago before the yield curve flattened.

A 5-1 ladder is just a way to avoid the expense of mutual fund or ETF.

By comparing an 8-1 plus a 2-1 to a 5-1 I think is just giving you more return because you are taking on more risk.

If the yield curve becomes more normal in three years you are going to wish you hadn't been buying eights.

FWIW I currently have a 52-0 ladder due to the flatness of the yield curve.
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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Uncorrelated
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Re: Risk of creating bond ladder with few longer term maturity bonds vs typical ladder.

Post by Uncorrelated »

The yield curve reflects market participants best estimates about future yield plus a term premium, it cannot be used to estimate the future expected return of bonds. If you want to know the future expected return of bonds you need to know what the term premium is net of expected interest rate changes, but this cannot be observed from the yield curve.

There are two conflicting arguments that can be used to pick the best combination of bond durations:

The diversification argument. If you are diversified across the yield curve, that results in lower risk.

The bet-against-beta argument. Frazzini et all has shown that the sharpe ratio of bonds decreases as the duration increases. According to this argument, you should prefer lower duration bonds.


If you ask me, the correct answer is to stop wasting your time with micro-optimizing your bond allocation. Just buy total bond market and focus on the things that actually matter (in this order): stock/bond ratio and lifecycle investing models, international diversification with equities, understanding annuities, factor investing, international diversification with bonds.
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