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Just posting my recent thoughts on these competing investments.

CD Ladder:
Total return=the interest rate. Cap gains/loss is irrelevant.


Bond Ladder (or Tradable CD Ladder):
If interest rates rise, you hold til maturity. Identical to a CD Ladder. If interest rates fall, you may choose to sell, realizing a cap gain. However when you reinvest your new rate will be proportionally lower, offsetting your cap gain. Thus, unless you plan on spending the money or investing in another asset class, there is no benefit to realizing the cap gain, except that you can take advantage of the lower cap gains tax rate or to realize a cap loss.


Bond Fund:
Once you've owned the fund until the bonds that were in the fund when you bought it mature, it's identical to the Bond Ladder (except you can't selectively realize cap gains). However, when you buy into the fund, you're getting a bond basket that isn't trading at par. With the ladders above, all of your investments were trading at par initially, so you're never in a situation when you paid $15,000 for the bond, but only got $10,000 when it matured.

Take for example Vanguard's Intermediate Treasury fund, VFITX. The average coupon is 5.3%, and the Yield To Maturity is only 2.9%. You are therefore paying a significant premium for the bonds in the fund. This is offset, of course, by the higher coupon these bonds pay. The question is: Does this matter? When all the high yielding bonds are flushed out (assuming interest rates stay low), how will total return be affected?

Nick
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"Bond Ladder (or Tradable CD Ladder): . . . unless you plan on spending the money or investing in another asset class, there is no benefit to realizing the cap gain."

I agree, Nick. It makes no sense to sell a bond unless you have identified an attractive alternative investment. A reasonable way to do this is to keep track of your yield based on cost and your yield based on market value.

The market value number tells you when you can sell that bond at a profit and make better returns in other investments--even though you bought it well and are getting a nice yield based on cost.

Still, most individuals do poorly selling bonds prior to maturity. Its better to keep them unless something threatens their security.
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Nick,

Here's how I look at it.

A CD ladder and a bond ladder (let's assume treasuries to ignore different risks) are similar, if you hold to maturity. Bonds have the advantage if you buy them when interest rates are comparatively high, in that you can sell them for a gain, though the point that you may not find anywhere good enough to put the money to make taking the gain worth while is well taken.

The reason I now prefer the CD ladder approach is that treasuries are paying less than CDs (even taking state tax advantage into account) for equivalent maturities, and if you start looking at 15-30 year bonds, my expectation is rolling over CDs will be a better way of handling changing interest rates. If you can lock in high rates for long term treasuries, more power to you—if Shrub gets his way on the national debt, we may have that chance.

With bond funds, I think you underestimate interest rate risk. It's not that you will lose money on a bond fund if you hold long enough, but that if you sustain a capital loss, it will eat up enough of your interest return that you are better off with a CD ladder. If you can't find a bond fund (of similar risk) that pays better interest than a CD ladder with similar average duration, the CD ladder should give a better total return.

Take a short term treasury fund currently yielding 2% with average duration of 2 years (I'm making up the numbers). If in two years, the fund is still yielding 2%, I get my 2% yield with no capital loss. If the fund is yielding 3%, and averaged 2.5%, I end up with a 5% interest gain over 2 years, with a 2% capital loss, or an average total return on 1.5% (ignoring taxes). If the fund yield goes to 4%, I have a 6% interest return over 2 years, with a 4% capital loss, or an average 1% return. If I can buy a 2 year CD with a 2% yield, chances are that will be the better choice. Even if the fund's yields went to 1%, so I got a 2% capital gain to go with an average 1.5% yield, my total annualized return would be only 2.5%. On the other hand, the fund's yield could go up to 6% (not likely, but neither is 1%), in which case my total return would be zilch.
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With bond funds, I think you underestimate interest rate risk. It's not that you will lose money on a bond fund if you hold long enough, but that if you sustain a capital loss, it will eat up enough of your interest return that you are better off with a CD ladder. If you can't find a bond fund (of similar risk) that pays better interest than a CD ladder with similar average duration, the CD ladder should give a better total return.


I think it's a zero sum game. Collectively, the cost of capital is set by people with far more power than you and me. One asset class is not going to perform better than another (for very long), because as soon as it did, enough people would swoop up to capture the arbitrage spread.

Of course, this applies only to people with a very long time horizon who can ride out the economic cycles. Obviously in the very short term, CD's might not lose capital while a bond fund could. But keep in mind, too, that the same scenario in which interest rates rise and cause bond funds to dcline also would most likely coincide with higher inflation and a decline in purchasing power, so even the "safe" return on the CD's might be less than one might otherwise think strictly by looking at the % return.

-hack
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Obviously in the very short term, CD's might not lose capital while a bond fund could. But keep in mind, too, that the same scenario in which interest rates rise and cause bond funds to dcline also would most likely coincide with higher inflation and a decline in purchasing power, so even the "safe" return on the CD's might be less than one might otherwise think strictly by looking at the % return.

Hack,

If inflation gets high, obviously CD interest may not keep up (which is the point of laddering, so you can renew CDs at higher interest). But the CD ladder will still do better than the bond fund, because even though the interest of the bonds in the fund goes up, unlike the CD, the capital loss more than makes up the difference. Try cruching the numbers with any durations on funds and any change in basis points: if you can get a CD for the same current interest rate as a fund for the same maturity/average duration, the only way the fund will do better is if interest rates go down.

It would be worth looking back a couple of years to see if CDs had lower yields than equivalent treasury funds. Of course, when interest rates were higher, there was a much better chance of interest rates going down than there is now, so even if the CD rate was higher, the bond find might have been the better bet, thanks to the possibility of a capital gain.
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It would be worth looking back a couple of years to see if CDs had lower yields than equivalent treasury funds. Of course, when interest rates were higher, there was a much better chance of interest rates going down than there is now, so even if the CD rate was higher, the bond find might have been the better bet, thanks to the possibility of a capital gain.


Loki-

I see your point, I just think a lot of this is minutae for anyone with a substantially long event horizon. Going far enough out, it is a zero sum game, (or better stated, it SHOULD be). There is a certain cost of capital. It doesn't vary (much) from one kind of government-backed instrument to another. Any small difference are likely ot be very small, and probably random. And if they weren't random, then start up a hedge fund and exploit it but don't tell anyone because the difference would soon become negligible again.

A lot of people spin their wheels on their own personal theories. Rise up above the forest and realize that the cost of money is a commodity, and neither you nor I are likely to have the tools necessary to truly exploit any market inefficiency.

This isn't meant as a rant, I just am commenting how frequently I see discussions like this on the boards, when everyone thinks they've figured out some way to jack up the return. Interest in government backed debt is a commodity - probably one of the largest commodities in the world. There is no way that one class of US govt backed debt is going to consistently perform substantially better than another. If you believe in indexing, then go with the Total Bond Index fund and spread out among maturities and risks in just one fund. If interest rate changes worry you, there are ways of hedging that (seldom discussed on this board though) - gold metal & futures & mining stocks, interest rate futures and swaps, shorting treasuries.

My thing against CDs is the limit. I don't want to have to keep adding new accounts to get around the 100k limit, and if we ever actually need that limit things will be far worse off than most of us could imagine anyway.

-hack
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Thanks for the great reponses, all. On the point zero sum game point, I agree with hack. If I own a bond fund for 5 years, and you own a CD ladder, who will have the higher return? If interest rates stay the same, so should our returns. If interest rates move, the bond fund may beat the CD or vice versa, but I don't think one has a better chance than the other.

That assumes, however, that the bond fund and the CD have the same initial interest rate. In reality, a CD should pay better than a similar bond since you give up liquidity. So if you're sure you don't need the cash for a year(s), the CD ladder might work out best.

Nick
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In the ladder once you own the investment, there are no further expenses. You collect the interest payments and eventually your return of principal. I assume your broker holds the bond and does not charge you a fee for doing so, because to some degree you are buying and selling stocks in the account.
In the bond fund there is a manager, and he gets paid, probably handsomely. There is an annual fee charged against your net asset value for this service.
Further, the bond fund has no maturity. Whether you get your principal back when you sell depends on whether interest rates are higher or lower than when you bought. They are now at historic lows, so if you are going to need the money in 5 years, chances are the NAV will be lower.
If you MUST own a bond fund, for goodness sake, Vanguard. At least the fees are lower than anywhere else.
Best wishes, Chris
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If I own a bond fund for 5 years, and you own a CD ladder, who will have the higher return? If interest rates stay the same, so should our returns. If interest rates move, the bond fund may beat the CD or vice versa, but I don't think one has a better chance than the other.

Nick,

The problem with this is that interest rates are now so low that the up-side risk is a lot more than the down-side gain.

The point of crunching the numbers is understanding that the increased yield on a fund as interest rates go up does not sufficiently compensate for loss in NAV to give as good a total return as a CD ladder with the same initial average yield and duration.
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