By Jonathan Ping, originally published at My Money Blog.
Most people worry about stock drama, but every so often, there is also bond drama. Bonds are debt, which means people worry when there’s an increased chance you won’t get paid back. However, the goal of my bond holdings is to have at least 5 years of expenses safely set aside so that I can comfortably ignore both stock market drama and bond market drama. If you assume a simple 4% withdrawal rate, that means roughly 20% of my portfolio should be in very safe bonds.
“Safe” means that my bonds should have both minimal default risk and interest rate risk. Minimal default risk means ideally either FDIC/NCUA-insured cash or certificates, or US Treasury bonds. Minimal interest rate risk means a relatively short duration.
In the idealized “mental model” of my bond portfolio, this is a ladder of 1-year, 2-year, 3-year, 4-year, and 5-year certificates of deposit. Each rung of the ladder is a year of expenses. As each year passes, the 5-year CD will now have 4 years left to mature, the 4-year CD will have 3 years left, and so on, with the 1-year maturing into a liquid savings account. Then, I will take money from my portfolio (mostly dividends and interest) and buy a new 5-year CD. Usually the yield curve is such that a 5-year CD will pay more interest than the savings account, so this ladder earns more interest overall than just keeping it all in the savings account.
In reality, right now US Treasury bonds with their state income tax exemption pay more interest (in my state situation) than other safe options. For example, right now, a 5-year Treasury bond pays ~4.8% interest, but that’s effectively ~5.3% with the state income tax exemption (assuming a 10% state tax rate). There are no 5-year bank CDs that pay ~5.3% a year, even if I went through the hassle of rate-chasing across different credit unions and banks around the nation.
I could build a manual ladder of Treasury bonds, but even better (lazier) is simply buying the Vanguard Short-Term Treasury ETF (VGSH), which maintains a basket of 100% Treasury bonds with an average maturity of 2 years and a low expense ratio of 0.03%. Not exactly the same, but a short-term Treasury ETF is practically very similar to a repeating ladder of US Treasuries of 1 to 5 years. 100% of the interest is considered US government obligations, and so I retain the full state income tax deduction.
For comparison, the 30-day SEC yield today on VGSH is ~4.4%, and with the state income tax exemption that’s an effective ~4.8% for me. Meanwhile, the popular Vanguard Total Bond Market ETF (BND) has a 4.8% 30-day SEC yield but also has higher default risk (holds corporate bonds) and higher interest rate risk (longer duration). BND is fine, but this is why I prefer VGSH. I’m getting the same after-tax return as BND with lower risk. VGIT (intermediate-term Treasury ETF) has a significantly higher average maturity of about ~6 years year, longer than I need and doesn’t pay much higher interest in return.
That’s my long-winded explanation of why ~20% of my portfolio is held in Vanguard Short-Term Treasury ETF (VGSH). The rest of my bond allocation is in TIPS because they guarantee a long-term real return and thus address another risk (inflation risk) directly, but that’s a different topic.
Jonathan Ping writes at My Money Blog. Read this article on their site.
