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CD Ladder Or Bond Fund? My Thoughts

Tuesday, March 20, 2012 - 8:35 AM
For those who follow the Treasury Bond market, you might have noticed a marked increase in yield over the past three months. From 12/19/2011 to 3/19/2012, the 10-year yield went from 1.81 to 2.38 and the 30-year from 2.8 to 3.48. While CD rates have (regrettably) not at all kept pace (and, in some cases, have actually gone the "wrong" direction), the question some might ask is: "is now the time to buy a bond fund?"

Bond fund shares move inversely to the direction of interest rates. Bond funds with longer "durations" (i.e., which hold a basket of longer-maturities) are more impacted than those with shorter durations. In a rising-rate environment (my goodness, I never thought I'd say that again), the issue is whether the decrease in the NAV of the fund will be overcome by the rising yields on new bonds purchased, and, if so, when. For readers of this blog, the main issue is whether to roll new or maturing fixed-income money into a CD or a bond fund. Other fixed-income alternatives exist, but I'll keep it simple.

Let's look at the relative performance of a "long" Treasury-bond ETF (TLT), a "long" bond fund (VBLTX), and intermediate-term bond fund (VBTLX), over the last three months. As rates have gone up, TLT has lost roughly 10% of its value. This represents almost three years of current dividends on TLT. The "long" bond fund, VBLTX, has shed roughly 6.5%, which is about a year and a half of dividends. Even the intermediate-term bond fund (VBTLX) has taken a hit, albeit less (about -1.7%, representing a little more than a half year of current dividend yield).

Now let's look down the road. The SEC yield of VBTLX (think the yield of new bonds being purchased) is 2.18%. Since the "duration" of VBTLX is right about 5 years, you'd expect new money rolled into that fund, in five years, to be worth just about the same as a 5-year CD yielding 2.18%. Purists will dispute that analysis to a degree (it depends on how far and how fast interest rates change), but it's good for our purposes.

What does this tell us? First, if you have a five-year CD ladder, your "point of indifference" as between VBTLX and a 5-year CD is right around 2.2%. Second, you might experience some serious indigestion in bond funds if rates keep going up. You'll need to have patience and the fortitude to keep re-investing your bond fund dividends to do as well as if you were in an equivalent CD. Third, for those who have little patience (or can't abide the thought of seeing their fund value eat up the dividends) or need that fixed-income yield for expenses, a CD ladder might still be your best bet.

Bottom line: a 5-year CD at 2.2% is a fair deal for starting a ladder or renewing, and compares well to an intermediate-term bond fund. An additional plus: your CD ladder has zero credit risk (so long as you stay below FDIC or NCUA limits). The same cannot be said for the bond fund noted above (VBTLX), since it holds a mixture of government and non-government (i.e., corporate) debt.
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BozoBozo135 posts since
Feb 14, 2011
Rep Points: 917
1. Tuesday, March 20, 2012 - 5:05 PM
I got out of the bond fund investment 'heartburn' in 1994.  Couldn't bear watching the principal erode even with a decent yield. My laddered CD portfolio has done quite well since then, thank you. That is until now, due to the Bernanke effect.
1
ShorebreakShorebreak2,364 posts since
Apr 6, 2010
Rep Points: 12,574
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