John Terenzio > Blog > Building a Treasury Bond Ladder

A US treasury bond ladder is a great alternative to a high-yield savings account or CDs to invest short-term funds that you don't want to put at risk. Treasury bills, notes, and bonds (treasuries) are US government debt securities that may pay interest and return the principle at a specific time. While not FDIC insured, treasuries are backed by full faith and credit of the U.S. government in a similar sense.

There are a lot of mutual funds and ETFs that allow you to invest in many treasuries at once, but in a rising interest rate environment like we have now, the price of these funds may decrease over time and wipe out some or all of your gains in the short term. Bond prices fall as interest rates rise. You can avoid this by buying individual bonds and holding them until they mature (pay out their full value). Also, if you keep your ladder going over time you will benefit from the rising rates as each new treasury you purchase will have the current rate.

Interest rates for 1 year treasuries as of August 2018 are as high as 2.45% and some brokerages (such as Fidelity) do not charge any commissions for buying and selling treasuries either on the new or secondary market. Also, importantly, the interest from treasury bonds is tax free at the state level, which is not the case with interest from savings accounts or CDs. If you live in a high-tax state like New York or California this can help boost your returns. These rates also generally beat high-yield savings accounts and CDs. Lastly, treasuries are much more liquid than CDs, you can sell at any time in a matter of seconds (during market hours) if you need to liquidate early. However, as we'll see, selling early is not ideal and you will cut into your gains if you do this.

Bonds 101

Let's quickly review bond basics. Bonds (which are part of a family of securities called fixed income) are debt. You can consider them as a promise from someone (ex. the US government, Southwest Airlines, AT&T, etc.) to pay you a fixed sum of money on a certain date called the maturity date. This is called the par value (or face value) and is usually in $100 or $1,000 increments depending on your platform. Bonds also have a coupon, which is the interest rate per year that they pay out. US treasury bonds pay interest twice per year at 6-month intervals and this interest goes into your brokerage account as cash. The coupon is not the percent per interest payment, it's the total percent per year. So if you buy $10,000 worth of treasuries (at face value) and the coupon is 2%, you will receive two payments of $100 six months apart, plus $10,000 on the maturity date.

When you buy a bond, you also may pay more or less than the face value. If interest rates are higher today then they were when the bond was issued, the price will probably be discounted to compensate for the lower relative interest rate. The market will drive all bonds that mature on a given date to yield roughly the same return when you combine their premium or discount and their coupon interest payments. For example, a treasury with a 10% coupon that matures 12/31/18 and one with a 1% coupon that matures 12/31/18 will give you around the same return when purchased today. While the interest payments from the first bond will be 10x greater than the other one, you will pay well above par to own this bond and in the end it will be a wash (there is a real example below).

Example treasury: 2% coupon maturing on 12/31/18 and $10,000 par value purchased on 12/31/17 at a discount at $9,992.

12/31/17 - debit from your account of $9,992 06/30/17 - interest payment of $100 (1%) 12/31/18 - interest payment of $100 (1%) 12/31/18 - principle payment of $10,000

Total gain: $100 + $100 in interest, plus $8 due to the discount price = $208. The full $208 is state-tax-free since market discount gains (the $8) are treated as interest by default by the IRS.

Why ladder?

Let's say you have $50,000 that you think you'll need all of within 3 years but you want to invest in treasuries and earn 2.4% state-tax-free. There are two approaches. In the first you could buy a single bond with $50,000 face value that matures in 3 years. This will lock in the highest possible rate now since interest rates go higher as the maturity date goes further into the future. This is to compensate you for the time risk (maybe the US government will implode in 3 years).

The issue with the single-bond approach is that you must be sure you won't need any of it early. When rates are rising, the price of this bond on the secondary market will decrease over the time you own it. If you hold it until it matures, it doesn't matter as you will always get the principal at the end, but if you sell it early and the current rates have gone up you will not get the full return and may even lose some money.

An alternative approach is called a ladder. In this approach you break your principle ($50,000) into many installments and you buy bonds spread over time. For example, if you wanted to target the 1 year interest rate, meaning that you want the rate of bonds that mature around 8/31/19, then you can break your $50,000 into 10 chunks of $5,000 each and then buy 5 bonds that mature before that date and 5 that mature after.

Example: I have $50,000, I think I'll need it within 3 years, but not sure, let's aim for the one-year rate of 2.45% by laddering over approximately 20 months. Today is 8/31/18... I can buy:

$5,000 maturing 10/31/18 $5,000 maturing 12/31/18 $5,000 maturing 02/28/19 $5,000 maturing 04/30/19 $5,000 maturing 06/30/19 $5,000 maturing 08/31/19 <- target rate, rates above will be lower, rates below higher $5,000 maturing 10/31/19 $5,000 maturing 12/31/19 $5,000 maturing 02/29/20 $5,000 maturing 04/30/19

In this setup, you now get about the 1-year rate on average but you've created a cash flow that pays you $5,000 every 2 months. If you have more than a 2-month cushion in your other bank accounts then this should be safe. If you end up needing some or all of the next $5,000 payment you can use it when it matures, otherwise you buy a new bond and put at the end of the ladder. In the table above, if 10/31/18 rolls around and you don't need the $5,000 then you can buy a single new bond for 6/30/19 and put it back in the ladder. Basically now you have a conveyor belt of bonds, constantly paying you every two months and earning good interest, and as you put more bonds in the back you're average interest rate goes up over time if the overall interest rate is rising.

One note about this: If you know for a fact that you need the entire $50,000 on a certain date, then this might not be the best strategy. In that case you might want to buy one big bond that matures just before that date if you don't need anything early. The ladder approach is better if you don't anticipate needing a ton of money on a specific date. Later, if you start to see that becomes the case, like you start planning on buying a house, then you start letting the ladder burn down like a candle and keep the payouts in a shorter-term ladder or regular savings account. You can also make your ladder a bit shorter and tighter so the end is not 20 months in the future, but maybe 15...

And if you really, really need to sell early, under conditions like today you probably won't lose more than you put in if you received at least one interest payment, but you will reduce your gains to mediocre savings account levels instead of 2.4% (unless the interest rate really fallas unexpectedly). Also note that you can sell in increments of $1,000, so if you just need a little bit don't have to sell the entire amount.

Here's what a real 20-month ladder looks like in Fidelity (8/18, 12/18, 4/19, 8/19, 12/19, 4/20, picture is not in order). Also notice the discount on all of these bonds (the current value) which is due to interest rates rising since they were issued. The top number is the CUSIP, which is like a stock ticker symbol for bonds.

Real bond ladder

Secondary market vs. primary

In many brokerages, such as Fidelity, you can buy treasuries on the primary or secondary market. The primary market is much less flexible as you are buying new bonds directly from the government on the day they are issued. You probably won't find all the bonds to create your ladder in the primary market, if you find any suitable ones at all.

The secondary market is where people trade existing bonds that can be issued any time in the past. They say this is the most liquid market in the world and in here you can find bonds that mature in any given month going out many years into the future. Some will have coupons that are higher or lower, but following the rule above they will yield roughly the same. Most treasuries mature on either the 15th or last day of the month.

In Fidelity you can see rough yields of all kinds of bonds. To get to this page, click "News & Research" at the top and then "Fixed income, bonds & CDs".

Interest table

To buy a bond, click the "Bonds" tab on the page above, which defaults on the secondary treasury market.

Secondary market

In the picture above we are looking for a bond for our ladder that matures in 1 year, August 2019. There seem to be eight. Let's click "see 8 CUSIPs".

Pricing table

Buying a bond

Now we see all treasury bonds on the secondary market that mature next August. Here it's a good idea to sort by "yield to worst" descending, so the bonds with the highest returns are on top. Notice that last bond, it has a huge coupon of 8.125% which means it was probably issued a long time ago when interest rates were high. You will earn big semi-annual payments off that, but you'll need to pay $1,057.33 for each $1,000 in face value, which knocks close to 6% off your return. Generally, even though the rates are close, it's better to buy the lower-coupon bonds. As you can see the winner has a total yield of 2.463% which comes from its 1.625% coupon and the discount. It only costs $991.37 for $1,000 worth of face value. There are also what are called zero-coupon bonds in this example. These bonds don't pay any interest and all the gains come from the market discount (the difference in price between when you buy and maturity). Since no interest gets paid they have a lower premium but you have to wait until the end (versus every 6 months) to get any interest payments.

Note: Look at the different prices for the same bond in the "bid" column and the "ask" column. $0.36 per $1,000 of bonds. The gap there is called the bid/ask spread. It's the average distance between buyers' willingness to pay and sellers' willingness to sell. You can see here that if you buy a bond and sell it right back a minute later, you will lose money due to this spread. For 5 units of $1,000 you'd eat $1.80. This is also part of why selling early can hurt you (in addition to the interest rate rising which will also lower your bond's value).

Keep in mind that depending on how much you buy you might not get the rates listed on this page. The rate for the top bond assumes you can buy 25,000 units (which is 2.5 million worth). If you are only buying 5 units you'll get a slightly lower return which is auto-filled on the next page. Let's buy that top bond by clicking "buy" to the right.

On the next page, you specify how much you want. This is in increments of $1,000 so you would put "5" to buy $5,000 of face value (the total due today will vary depending on the premium/discount). The price is filled in for you already. "Fill or kill" means that you don't want a partial order to execute (ie. you only get 2 bonds) you want either 5 or 0 bonds.

Order page

Next you get your final order preview before you place the order.

Order page 2

On this page you see the final, actual yield you will get if you keep this bond until it matures. 2.407% in this case, a little lower than the advertised rate because you are a smaller player.

Also, note that since the bond has predictable interest payments you also have the pay the seller for interest that is accrued but not yet paid out. If you are buying a bond close to an interest payment then this number will be high. If you buy a bond close to a day it paid out interest, then this will be low. It doesn't matter that much. At the end of August you will be getting a payment of ((1.625% * $5,000) / 2) which is about $40.63. So you'll get this accrued interest back soon. The "mark-up" is the fee Fidelity charges, which for treasuries is zero but does kick in with corporate and municipal bonds.

When you click "place order" the bond order will show up in your orders tab similar to a stock. The bond market is a bit slower and it can take a few minutes for the order to complete. It's also possible that a movement in the market prevents your limit price from being reached, and the order fails. In this case just repeat the buy order again and the let the price auto-fill.

Happy bond buying! When you are finished the bonds will show up in your account like in the first screenshot. Remember that you can sell any time in a similar flow to buying but only when the bond market is open (weekdays during trading hours). Bonds in Fidelity also take 1 day to settle meaning that if you sell on Monday you can't withdraw the cash until Tuesday morning.

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