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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35367  
Subject: Re: CD Ladders vs Bonds vs Bond Funds Date: 4/24/2003 4:07 PM
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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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