The legions of new investors jumping into capital markets throughout the pandemic walked into a wild ride: cheap debt, wild speculation, and abundant free time made markets as fun (and volatile) as a rollercoaster ride.
Those retail traders and investors, whether they walked into 2022 unscathed with their capital intact (many didn’t), were still spoiled by one of the rarest, once-in-a-lifetime market events possible that made nearly any equity investment profitable: no matter how weak or structurally unsound the underlying company fundamentals were.
Options strategies and massive margin made the market even more of an emotionally exhilarating ride, so it’s no wonder that, today, many of those same investors feel existential fatigue when logging onto their brokerages and face a sea of red interspersed with volatility that inevitably moves against retail traders’ speculative positions.
Much like our collective shortened attention spans make simple nature walks an exercise in tedium, these traders and investors consider fixed-income investments fundamentally dull. Fixed income lacks the emotional excitement and physical dopamine hit of hopping in and out of trades buoyed by substantial leverage and seeing (relative) fortunes won and lost as a series of filled orders in a trade journal.
But these traders are missing out on a different brand of excitement filled with high-stakes auctions, the anticipation of new rates posting, and a new level of strategic analysis that challenges these investors by forcing them to think multiple moves ahead, fighting through both time and space in a chess game balancing monetary policy with in-depth economic analysis amid bank collapses, inflation, and more.
Source: FRED
We’re laddering bonds.
Fixed-Income Functions
First, many newer traders focused on high-risk/high-return strategies don’t functionally understand bonds or, worse yet, see them as a less-useful birthday check from Grandma that they can’t even use for decades.
Incidentally, this was my first exposure to bonds: a slip of paper that said $50 on it that my seven-year-old self was disappointed to hear wouldn’t be worth that ‘til I was nearly thirty. I was wrong, though, and that little guy was worth $54.36 when I cashed it in after sitting on it until it was old enough to drink.
Ok, that’s neither exciting nor profitable.
But bond buying is more complex, exciting, and potentially lucrative than that. Here’s a quick crash course for those utterly new to the concept.
Bonds 101
Buying Bonds
Bonds are available directly from the US government through the Treasury Direct website, but traders and investors can also buy them on secondary markets (from other bondholders) or buy new-issue bonds before the auction from most major brokerages.
“New issue” bonds are those that are, well, new. When you pick a new issue, you pledge the amount you want to spend and get that many bonds at a rate dictated by the competitive bidders (big boys and institutional investors with complex modeling that breaks bids into fractions of a percent). The US Treasury schedules bond auctions monthly, and you can usually enroll until the day of the auction.
Building a Bond
Bond components include:
Par value: the face value of the security, par is the amount you’re guaranteed to get back at maturity. So, if you buy a $1,000 par value bond that matures in twenty years, the government guarantees repayment of that principal at that point.
Maturity: is when the security “expires” and gets paid back in full. Even though we tend to call all US government fixed-income securities bonds, there are three categories defined by maturity:
- Treasury Bills (T-Bills, bills): some are as short as a few days but usually mature one month to one year from the issue date. They’re generally referred to by weeks until maturity, i.e., 4-Week Bill or 52-Week Bill, and all in between.
- Treasury Notes (T-Notes, notes): 2, 3, 5, 7, or 10 years until maturity.
- Treasury Bonds (bonds): 20- or 30-year maturities. For this article, we’re excluding Savings Bonds like Series EE or I-Bonds, because they aren’t liquid (can’t trade on secondary markets) and fundamentally different from Treasury Bonds.
Coupon rate: the coupon rate is the bond’s interest payment, usually a semiannual (twice a year) payment described as an annual rate. So, for a $1,000 par value bond with a 5% coupon rate, the holder would get $50 every six months until maturity, then they’d get their $1,000 initial investment.
Yield-to-maturity (YTM): since bonds are tradable on secondary markets, investors also consider the YTM, a function of how much cash the security generates until it matures. YTM is critical in understanding zero-coupon securities, which we’ll examine as part of our primary topic.
Zeroes for Heroes
Rather than issue coupons, because they’re short-term securities, nearly all bills instead are zero-coupon, which means the yield is a function of competitive bidding, which sets the sale price despite par value. That probably makes zero sense (pun intended), so let’s look at a real-world example from a recent auction:
It isn’t practical, for many reasons, for the government to issue coupon payments on a four-week (28-day) bill. Instead, the bill is zero coupon and trades at a discount from par (in this case, $100). So an investor pledging $1,000 to the auction (10 bills) pays less than par, then gets par when the bill matures. The difference between the discount and par is the yield and the rate of return the investor receives. In this case:
- Par: $100
- Price paid: $99.67
- Yield: 4.23%
So our investor bought a bond for $99.67 and got $100 back in a few weeks. Remember that we’re looking at yield as an annual expression, so we’re dividing the yield by varied time frames to calculate anything maturing in less than a year (i.e., daily or monthly returns).
The yield, after the auction, fluctuates based on secondary market conditions and whether a seller finds a buyer, so the only way to guarantee the total 4.23% return is by holding the bill until maturity.
Climbing the Ladder
Bond laddering describes staggering your investment amount into fixed-income securities with different maturities. Historically, this happened over several years, and investors would buy a series of 2-year, 5-year, 10-year, and 20-year bonds to generate predictable cash flow and manage interest rate risk.
Today, the landscape is a little different and instead makes laddering short-term bills a winning play.
Long-term bonds were preferred laddering assets because, in general, long-term bonds have better interest rates (yields) than short-term ones because of the increased risk of longer investments. Today, though, the yield curve remains inverted and short-term bills outperform bonds on an annual yield basis. From this month’s auctions:
- 13-week bill: 4.81%
- 1-year bill: 4.62%
- 5-year note: 3.625%
- 20-year: 3.875%
While not unprecedented, this is unusual: increased risk today makes competitive bidders demand a greater return for their capital investment, so short-term yields outperform long-term holdings.
How can we capitalize on this misalignment?
Stocks are in rough shape, still, and cash is losing value daily as inflation is stickier than expected and remains high. So, instead of stacking cash in a closet or under a mattress, you can build short-term ladders with 13-week and 26-week (3- and 6-month) maturities and generate guaranteed returns while you wait for a rebound.
Here’s how that could play out with past pricing, assuming a $100 initial investment in each ladder rung. For our initial 13-week bill, we bought:
- Issue date: January 3rd, 2022
- Maturity: April 7th, 2022
- Price Per $100: $99.977
Our 26-week bill was:
- Issue date: January 3rd, 2022
- Maturity: July 7th, 2022
- Price Per $100: $99.88
Now, each time a bill expires, we use the principal to buy a new 26-week bill because the initial one (bought on January 3rd, 2022) matures in 13 weeks.
Flipping the principal back to 26 weeks bought two more rungs on the ladder at $98.64 and $97.63 per $100, each, with the next maturity and repurchase in July 2023. This ladder locked in cashflow every three months with a guaranteed $3.87return for each $100 invested, but look even closer: the investment rate started at less than 1% to hit nearly 5% on the most recent rung.
We don’t know what happens next, but laddering short-term notes over the past year returned more than the S&P 500, which lost almost 19% over the same period, keeping your cash working and ready to redeploy on a rebound.
Source: FRED
But rates are continuing to climb, and the Fed hasn’t indicated they plan to back off soon – meaning that, in the short term, flat or even higher new issue T-bill rates are nearly guaranteed.
And, yes, some high-yield-savings-accounts are pushing between 3.5% and 4% APR, but those banks are investing in the same notes you are – they’re just taking a little off the top themselves, so you may as well go directly to the source and ladder them yourself.
Ultimately an even more significant benefit for newer investors used to out-of-control equities and outsized valuations is the intangible benefit of learning a new market. Learning laddering not only exposes investors to a new asset class but actively managing laddered portfolio forces you to understand monetary policy and tune into Fed announcements, as well as understand the underpinnings behind bank collapses like we saw recently with Silicon Valley Bank – caused, in part, by some of the fixed-income functions we covered above!
Debt market capital far exceeds equities and has gone tragically overlooked over the past decade. Hopefully, building a ladder establishes a sturdy foundation within an unfamiliar part of the US economy while helping preserve capital while you wait for a stock market reversal.
