Hopefully, everybody has been building a CD Step Stool or a Bond Step Stool (not a ladder). A Step Stool is the smarter approach because the short end of the yield curve has been rising faster than the long end.
The Fed Funds rate is the shortest of the short end, given it is the overnight interbank lending rate. The idea is that the more the Fed Funds rate increases, the higher yields should rise for longer duration lending rates due to the time value of money. With inflations expectations up, interest rates should continue to inch higher.
But the market controls longer term lending rates, and the market is currently telling the Fed to bugger off. Investors have found comfort in longer term bonds because their risk appetite has diminished. They don’t see inflation on the horizon nor do they see rosy good times.
To understand why buying shorter duration bonds and certificates of deposits is the optimal financial move for your cash, let’s take a look at a simple bond yield table.
Bond Yield Table Shows Why Shorter Is Better
First of all, can we give a moment of thanks now that we can generate a reasonable return on our cash? We’ve been able to grow our net worths tremendously since the 2008 – 2009 financial crisis. Now we get to protect our net worths with higher guaranteed rates. Pinch me silly!
The key is to create multi-generational wealth so that our kids never have to work again. With no student loans after college and one of our many fine homes to inhabit for free, their lives will be set. We just need to make sure we never tell them how wealthy we really are, lest they turn into insufferable early retiree bloggers.
Take a look at this bond yield table. You will see that riskier bonds pay more at every duration and longer durations pay higher yields than shorter durations.
Let’s zero in on U.S. Treasury bonds, the safest of the safest bonds you can buy. Unless you think the United States is going to default on its debt obligations, you will get your money back. Remember, the United States can simply print more money.
Based on the chart, you can lock your money up for one year and get a 2.74% return, state tax free. Alternatively, for 0.18% more, you can lock your money up for 10 years and get 2.92%. The 10-year bond yield is usually considered the risk-free rate of return, but the reality is that any of these Treasury bond durations can be considered the risk-free rate of return.
You would have to be a moron to tie your money up for 10 years for such a tiny premium.
And you would be a fool to own a 3-year or 5-year bond when you can own a 2-year bond with the same yield. Ok, not only morons and fools buy long duration bonds. So do extremely rich people who will never run out of money or institutional bond traders.
None of us can accurately predict where will we be 10 years from now. You might move for a job or want to buy a house during this time period. Some of us might even be dead, which would be such a waste of money. Further, even a slight uptick in inflation several years from now will wipe away any real returns you may have.
The savvy investor’s best move is to build a Bond Step Stool consisting of only 12-month duration bonds or shorter. For example, every month you can purchase a 6-month bond yielding 2.55%. After six months, you will always have liquidity to reinvest every month.
When the Fed is in the process of raising rates, you’ll maximize your cash returns because you’ll be able to more quickly take advantage with shorter lockups. The value of optionality increases in a rising interest rate environment full of uncertainty. When the Fed is in the process of lowering rates, you want to own longer duration bonds with higher yields to delay the inevitable drop.
Cash Is Growing More Attractive
It is my hope the yield curve (10-year minus 2-year bond or shorter) does not invert, even though the 5-year minus 2-year curve already has. An inversion would likely bring a recession within 12 – 18 months if history is any guide. Instead, I hope the yield curve slightly steepens so that equities don’t have to face such a huge headwind and the return on cash can continue to increase.
You’ve got to ask yourself after making so much money since the financial crisis: Does the peace of mind that comes with earning 2.5% – 3% risk-free outweigh the benefits of potentially making 10% or losing 10% in the stock market?
If the answer is yes, then overweight bonds or cash in your public investment portfolio. If not, then overweight equities and get accustomed to volatility and potentially losing money. It will help if you use real numbers.
Let’s say you have a $1,000,000 portfolio using the above return assumptions. You must compare earning $25,000 – $30,000 from your portfolio risk-free versus making $100,000 or losing $100,000. Is the extra $70,000 – $75,000 worth the risk of potentially losing $100,000? Only you can decide.
I would be surprised if the S&P 500 can make a 10% annual return any time over the next five years. A more reasonable return assumption is probably closer to +/- 5%, which makes owning Treasury bonds that much more attractive. The equity risk premium is simply not high enough to take on too much risk at this point.
Decide your financial fate with impunity. I’m happy with slow and steady returns as an unemployed person with a son to raise. A 3% – 4% risk-free return on my entire net worth each year sounds sweet to me. When you have the option of eliminating financial stress, do it.
Related: Liquid Courage: The Biggest Benefit Of Holding Cash
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Why invest in a bond step tool that you have to keep adjusting when you can easily invest in a treasury money market fund (such as Vanguard’s for example), which currently yields 2.25% and goes up automatically each time the Fed raises interest rates?
GenX FIRE says
I find both the article and the comments to equally helpful. I watched the 2008 recession as I had just started to have money then, and wasn’t hit too hard by it. I am still 10 to 15 years from retirement, which will put me in my mid to late 50s. That’s the plan anyway. The returns this decade will decide when that happens as much as my savings rate. The core question is what do do when this recession happens. My feelings were that it was coming soon when we got to the longest bull run last summer. We’ve had huge gains since then. The only thing I can think to do is to stay the course and wait for bargins like I did in 2008. I might tune down my investments and take some profit; rebalancing to bonds from stocks, and maybe even moving a bit more than that. Still, I’ll just be thinking this through. There are many things that could change this picture dramatically. Timing the market, though, in any serious sense is off the table for me.
Bond man says
A flat/inserted yield curve doesn’t necessarily mean that one should stick to shorter maturities like you suggest. Market participants are suggesting that there’s a chance that rates could be cut sometime in that 3-5 year horizon and would rather lock in a rate now than only living it in for 3 years and risk lower 2 year rates 3 years from now. For instance the last time the 2 year treasuries yield was the same as the 10 year yield was 2006 when both yielded about 4.8%, those who locked in their rate for 10 years did much better than those who only locked in their yield for two years and then got stuck with yields in the 2%’s for the next 8 years. We obviously don’t know where rates will be in the future and can only guess using forward curves. I think better advice is to match your maturity to when you think you’ll need the money rather than try to be a bond market timer.
It sounds like a genius when one goes to cash or CD on Jan 26 in 2018. Let me ask you all a question. Under what condition would you get back into the risk assets?
Financial Samurai says
Check out: Suggested Stock Allocation By Bond Yield For Logical Investors
I don’t have any back test data to support this idea but I would tend to think your whatever suggested stock/bond combination portfolio combined with a covered call strategy for both assets would outperform a straight stock/bond portfolio. If you are to use this allocation strategy, then why not get extra income every month from the short calls to reduce the cost basis of your assets. I believe it is a win-win strategy. I don’t have any statistics regarding the percentage of retirees who have used this strategy. I absolutely don’t understand why there are not more retirees would use this very simple strategy as it actually reduces the risks of just holding those assets straight up, and the portfolio volatility. We are not talking about using more complicated options strategy, such as long, short butterfly, ratio spreads, condors, etc. The only downside of this simple covered call strategy is one could cap the upside of the assets, but this is the price perhaps one has to accommodate for reducing risks. But then reducing risks after retirement is one of the more important goals, right?