Investing in T-bills (Part 14)

In the fourth paragraph of Part 12, I mentioned creation of a bond (T-bill) ladder without explaining the what or why.

Bond laddering involves buying bonds with different maturity dates thereby enabling the investor to respond relatively quickly to interest rate changes. Investing in bonds maturing on the same date carries high reinvestment risk: being forced to roll over a large capital allocation of maturing bonds into similar fixed-income products with a much lower interest rate. The ladder therefore facilitates a steadier stream of cash flows throughout.

Reducing reinvestment risk and smoothing out interest payments is of limited importance to me since my T-bills mature within months. The Fed usually decides whether to raise/lower interest rates during its eight scheduled meetings per year (and rarely by more than 50 basis points at a time). Over 3-4 months, drastic interest rate changes have seldom been seen. T-notes (T-bonds) mature in 2-10 (20-30) years—periods of time over which large rate changes are more likely.

Limiting price risk is another benefit of bond laddering that doesn’t apply much to my short-dated T-bills. When interest rates rise, bond prices fall; this affects longer-dated more than shorter-dated bonds.* A worst-case scenario would be large portfolio allocation to long-dated bonds at the unexpected start of a rising interest rate environment followed by a catastrophic life emergency forcing bond sale at a substantially lower price to raise cash. Contrast this with an initial outlay of five equal tranches of capital to bonds maturing in 2, 6, 10, 20, and 30 years. The rising interest rates would not hurt the 2-, 6-, and 10-year T-notes nearly as much as the 30-year T-bonds.

One final benefit to bond laddering is liquidity improvement [of a fixed-income portfolio]. Although Treasurys tend to trade on a relatively liquid secondary market, bonds by their nature are not generally liquid investments and cannot be cashed in anytime without penalty. In the example just given, 20% of the total allocation matures after 2, 6, 10, 20, and 30 years making cash available in a relatively short period rather than having to wait 30 years for any (all) of it.

Liquidity improvement is the main reason I use a bond ladder. Should the stock market move sharply against me, I may need cash to close losing positions. Every week I get a cash-balance infusion when T-bills mature. Rather than reinvest, I can skip a T-bill purchase(s) and use the cash to manage option positions. In combination with the 10% cash buffer (see last two full paragraphs of Part 13), I will hopefully avoid having to borrow funds from my brokerage and paying high margin interest.

I will continue next time.

* — Duration is a bond’s change in price per 1% increase in rates.