Treasuries vs Treasury Funds

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GuitarXM
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Treasuries vs Treasury Funds

Post by GuitarXM » Mon Dec 03, 2018 3:37 am

I was reading online that the returns on Individual Treasuries are the same as returns on Treasury Funds.

The argument is that when say interest rates rise, funds sell the treasuries at a discount and reinvest in current higher interest rate Treasuries.
This will lead to the same return as if holding an individual Treasury to Maturity.

However I can't seem to verify that in actual returns.
For example lets look at VSBSX (Vanguard Short Term Treasury Index). Average duration is around 2 years.

The yearly return for an Individual 2 year treasury is 1.75%
The yearly return for VSBSX is 0.7%

That is a huge difference. So how are Individual bonds and and comparable bond funds the same?

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oldcomputerguy
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Re: Treasuries vs Treasury Funds

Post by oldcomputerguy » Mon Dec 03, 2018 5:53 am

Just a guess, I"d say that the lower return on the fund includes capital losses from selling holdings in a rising interest rate environment. Just as an exercise, what would happen if you sold your individual two-year bond one year after buying it?
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typical.investor
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Re: Treasuries vs Treasury Funds

Post by typical.investor » Mon Dec 03, 2018 6:14 am

GuitarXM wrote:
Mon Dec 03, 2018 3:37 am

The yearly return for an Individual 2 year treasury is 1.75%
The yearly return for VSBSX is 0.7%
The yield on a 2 year treasury is now about 2.84 so the treasuries in VSBSX are returning about 2.84%. However, the NAV of VSBSX was marked lower to do so. That's why the yearly return is only showing 0.7%.

In the case of your Individual 2 year treasury at 1.75%, you haven't adjusted their NAV to account for the fact that new bonds are yielding higher. If you did, they'd be similar to VSBSX.

UpperNwGuy
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Re: Treasuries vs Treasury Funds

Post by UpperNwGuy » Mon Dec 03, 2018 6:19 am

typical.investor wrote:
Mon Dec 03, 2018 6:14 am
GuitarXM wrote:
Mon Dec 03, 2018 3:37 am

The yearly return for an Individual 2 year treasury is 1.75%
The yearly return for VSBSX is 0.7%
The yield on a 2 year treasury is now about 2.84 so the treasuries in VSBSX are returning about 2.84%. However, the NAV of VSBSX was marked lower to do so. That's why the yearly return is only showing 0.7%.

In the case of your Individual 2 year treasury at 1.75%, you haven't adjusted their NAV to account for the fact that new bonds are yielding higher. If you did, they'd be similar to VSBSX.
^^^ This is the key to understanding what's happening. (The same concept applies to certificates of deposit. They seem better than bonds until you adjust the NAV to account for the fact that new ones yield higher.)

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Doc
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Re: Treasuries vs Treasury Funds

Post by Doc » Mon Dec 03, 2018 1:17 pm

GuitarXM wrote:
Mon Dec 03, 2018 3:37 am
The argument is that when say interest rates rise, funds sell the treasuries at a discount and reinvest in current higher interest rate Treasuries.
This will lead to the same return as if holding an individual Treasury to Maturity.
There is more to the argument than that.

Funds normally do not hold Treasuries to maturity. They may sell with one year left or three or five or whatever depending on their prospectus.

They may have a capital gain or loss depending on how the shape of the yield curve changes during the time they have held the security. If the yield curve is positively sloped and remains constant they will have a gain. This is the "normal" case. (Goggle "riding the yield curve" for an explanation.)

This added capital gain gives the fund an advantage over a security held to maturity. That gain is somewhat offset by the funds e/r.
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Phineas J. Whoopee
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Re: Treasuries vs Treasury Funds

Post by Phineas J. Whoopee » Mon Dec 03, 2018 4:10 pm

It's far less complex than that. OP, you're talking about yield, but frequently here the term is mistaken to mean coupon.

A ten-year $1000 face value Treasury bond with a 5% coupon (set by original auction, not the Fed or the Treasury) will pay $25 every six months, and $1000 at maturity. Barring default, and a US Treasury default is highly unlikely (cue people saying not impossible), it will pay that many dollars on the originally scheduled dates.

The coupon is $50 per year. It doesn't change for the life of the bond.

Yields, on the other hand, take current market values into account. Unless otherwise specified yield is normally taken to mean Yield to Maturity, YTM. It includes the coupons, reinvestment of coupons, and the inevitable convergence of a bond's market price with its face value as it approaches maturity. Who would pay much more, or accept much less, than $1000 for a $1000 face value bond that matures tomorrow?

Because the yield calculation includes current market price, as the price goes down the yield goes up, and the other way around as well. In fact, yield and price are mathematically related and express the same thing. If you know one you can calculate the other.

But the coupon is still $25 every six months, and the final payoff $1000. It goes to whoever happens to own the bond at the time.

Yes, bond funds buy and sell to maintain the credit quality and duration characteristics they're targeting, but that's not why yields go up when prices fall.

Does that help?

PJW

GuitarXM
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Re: Treasuries vs Treasury Funds

Post by GuitarXM » Mon Dec 03, 2018 6:41 pm

Phineas J. Whoopee wrote:
Mon Dec 03, 2018 4:10 pm
It's far less complex than that. OP, you're talking about yield, but frequently here the term is mistaken to mean coupon.

A ten-year $1000 face value Treasury bond with a 5% coupon (set by original auction, not the Fed or the Treasury) will pay $25 every six months, and $1000 at maturity. Barring default, and a US Treasury default is highly unlikely (cue people saying not impossible), it will pay that many dollars on the originally scheduled dates.

The coupon is $50 per year. It doesn't change for the life of the bond.

Yields, on the other hand, take current market values into account. Unless otherwise specified yield is normally taken to mean Yield to Maturity, YTM. It includes the coupons, reinvestment of coupons, and the inevitable convergence of a bond's market price with its face value as it approaches maturity. Who would pay much more, or accept much less, than $1000 for a $1000 face value bond that matures tomorrow?

Because the yield calculation includes current market price, as the price goes down the yield goes up, and the other way around as well. In fact, yield and price are mathematically related and express the same thing. If you know one you can calculate the other.

But the coupon is still $25 every six months, and the final payoff $1000. It goes to whoever happens to own the bond at the time.

Yes, bond funds buy and sell to maintain the credit quality and duration characteristics they're targeting, but that's not why yields go up when prices fall.

Does that help?

PJW
Im not talking about the coupon. I'm talking about the total return which is the yield and comparing the yield of an individual treasury and similar fund. Isn't that precisely why Yields go up? They go up because prices fall to match the returns on the current new bonds being offered with higher interest rates.

But that wasn't my questions. What I'm getting at is that the fund return is way different from the individual treasury return when comparing a 2 year treasury with VSBSX

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Phineas J. Whoopee
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Re: Treasuries vs Treasury Funds

Post by Phineas J. Whoopee » Mon Dec 03, 2018 6:56 pm

GuitarXM wrote:
Mon Dec 03, 2018 6:41 pm
...
But that wasn't my questions. What I'm getting at is that the fund return is way different from the individual treasury return when comparing a 2 year treasury with VSBSX
A bond fund is nothing more nor less than a vehicle by which to own its underlying portfolio of bonds.

If you compare a two-year note with a mutual fund that consists of anything other than two-year notes with a declining duration, naturally you will observe a different return.

If you held the same bonds in the same proportion as those held by a mutual fund their prices would fluctuate just as much, and your returns would be the same, plus a little for the expense ratio, but less a little because a large fund will be able to trade at a lower cost than you.

The market value of your portfolio would change in concert with the fund's net asset value.

Now, if your desired fixed income portfolio is different than that of any available inexpensive mutual fund then of course your portfolio, hypothetical or otherwise, will perform differently.

I am not telling you what, if any, fixed income portfolio you should own.

PJW

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vineviz
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Re: Treasuries vs Treasury Funds

Post by vineviz » Mon Dec 03, 2018 7:40 pm

GuitarXM wrote:
Mon Dec 03, 2018 6:41 pm
What I'm getting at is that the fund return is way different from the individual treasury return when comparing a 2 year treasury with VSBSX
As others have observed, a bond fund typically is managed to maintain a relatively constant duration and/or maturity whereas an individual bond has continually declining yield and/or maturity.

What was a two-year Treasury note on 11/30/2016 has morphed into cash by now. VSBSX was a short-term bond fund on 11/30/2016 and is still a short-term bond fund today.

This constant-maturity feature of bond funds changes the risks slightly. It adds price risk (this is what's made the 2-year total return of VSBSX end up less than the total return of an individual 2-year Treasury note purchased on 11/30/2106) but reduces reinvestment risk. It's a tradeoff that sometimes benefits investors and sometimes reduces their return.
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JoMoney
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Re: Treasuries vs Treasury Funds

Post by JoMoney » Mon Dec 03, 2018 8:14 pm

A bond fund maintains a relatively constant target duration, if you gradually reduced the duration by mixing it with shorter term bond funds and cash you could simulate something close to a ladder of bonds maturing over time, not with the precision of a ladder of individual bonds, but close..
You can't simulate an individual bond with a typical bond fund (the exception being a few bond funds that have specific maturity dates), but you can simulate a ladder of bonds, provided you keep your bond fund portfolio's duration the same as what the equivalent ladder would be (which involves reducing it over time as bonds in the ladder mature and are cashed out).

Keep in mind that a fund with a average duration of 5.5 years is similar to a ladder going out 10 years (i.e. an average of bond maturing in 1,2,3,4,5,6,7,8,9, and 10 years)
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GuitarXM
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Re: Treasuries vs Treasury Funds

Post by GuitarXM » Mon Dec 03, 2018 9:15 pm

Yea I understand what you are saying.
I chose that particular fund because the average duration was close to 2 years.
When I compare it with the individual 2 year treasury it looks like the bond fund got 0.70% return over the last year while the 2 year treasury got a 1.75% return but because interested rates increased prices dropped by 1.2% so it looks like the 2 year treasury did worse totaling a 0.5% return.

This is crazy. I don't understand why someone would want to hold treasuries.
I was reading Larry Swedroe's books and he recommended holding short term treasuries no longer duration than 3 years due to interest rate risk.

If you are looking to hold fixed securities, wouldn't it just be better to hold a high yielding savings account or a CD.
Over the last year someone holding short term treasuries got a 0.7% return while someone at Ally got 1.9%

typical.investor
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Re: Treasuries vs Treasury Funds

Post by typical.investor » Tue Dec 04, 2018 5:04 am

GuitarXM wrote:
Mon Dec 03, 2018 9:15 pm
Yea I understand what you are saying.
I chose that particular fund because the average duration was close to 2 years.
When I compare it with the individual 2 year treasury it looks like the bond fund got 0.70% return over the last year while the 2 year treasury got a 1.75% return but because interested rates increased prices dropped by 1.2% so it looks like the 2 year treasury did worse totaling a 0.5% return.

This is crazy. I don't understand why someone would want to hold treasuries.
I was reading Larry Swedroe's books and he recommended holding short term treasuries no longer duration than 3 years due to interest rate risk.

If you are looking to hold fixed securities, wouldn't it just be better to hold a high yielding savings account or a CD.
Over the last year someone holding short term treasuries got a 0.7% return while someone at Ally got 1.9%
CDs are no different than treasuries. Brokered CDs are marked to a lower NAV when rates go up.

Bank CDs aren’t, and are sometimes preferred because you can get out for a small penalty (depends on CD terms) and then maybe back in again at better rates.

Treasuries will recover from NAV loss as maturity approaches. Funds will recover in about their duration. If rates continually go up, it’ll become twice the duration to recovery I believe.

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Phineas J. Whoopee
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Re: Treasuries vs Treasury Funds

Post by Phineas J. Whoopee » Tue Dec 04, 2018 3:11 pm

typical.investor wrote:
Tue Dec 04, 2018 5:04 am
...
Treasuries will recover from NAV loss as maturity approaches. Funds will recover in about their duration. If rates continually go up, it’ll become twice the duration to recovery I believe.
Under adverse circumstances, but barring defaults, yes approximately duration times two.

PJW

Carol88888
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Re: Treasuries vs Treasury Funds

Post by Carol88888 » Tue Dec 04, 2018 5:52 pm

You can buy individual treasuries from Vanguard without a commission, I believe. When you do this you are certain what you will get: the coupon plus the face amount back at maturity.

With funds, well, you don't have the same certainty. The only reason to hold a treasury fund in my opinion is the ease of reinvesting small amounts back into it.

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Phineas J. Whoopee
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Re: Treasuries vs Treasury Funds

Post by Phineas J. Whoopee » Wed Dec 05, 2018 8:34 pm

Carol88888 wrote:
Tue Dec 04, 2018 5:52 pm
You can buy individual treasuries from Vanguard without a commission, I believe. When you do this you are certain what you will get: the coupon plus the face amount back at maturity.

With funds, well, you don't have the same certainty. The only reason to hold a treasury fund in my opinion is the ease of reinvesting small amounts back into it.
If you own a portfolio of bonds equivalent to that of the fund, and manage it the same way, your returns and your market value fluctuations will be the same.

If you do something different than the fund of course your returns and fluctuations will be different.

Pretending bond market values don't change is fooling oneself.

PJW

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