EE Bonds for the Accumulation Phase

[moda0306]

I have been very tempted lately to make a PP tweak centered around the fact that while EE bonds aren't marketable at FMV nor are they long-term enough in duration, that they are still maybe worthwhile adding to the PP during accumulation and attribute them to some ratio mix between cash and bonds.  I highly doubt that things could get so crazy that the rest of my long-bonds (tlt or direct) would be insufficient for rebalance if it ever even came to that during accumulation.

Right now 20-30 year bonds are sitting between 2.6% and 2.9% while EE's have a 3.53% implied 20 year return with no principal risk if rates rise.  It seems to me that someone early in their accumulation phase could afford to load up on these as part of their bond portion of the pp, weighted partially to cash due to its shorter duration.  Many pp accumulators are probably foregoing some of their EE bond limit and piling into tlt.  While I'd never put all your bonds into EE's, they could probably function as some good "deep bonds" that you hold to "maturity," slowly converting its value in increments to deep cash along the way.  I really think its a shame for younger people to ignore the opportunity these give us if used in the right doses.

I just feel like a dupe buying tlt at such low rates when I can get a better return and lower risk by making some moderate tweaks.

Sound off.

[melveyr]

I think I will treat them as cash, and then if their phantom rate (thank you for that thread) becomes speculatively enticing I will conceptualize them as part of my VP and totally exclude them from my PP.

But back to your proposed strategy. When one buys an EE bond would they value it as (20/30) 66% bond-like and 33% cash-like when adding up values in their tracking spreadsheet?

And then when there is only 10 years left to maturity it would be (10/30) 33% bond-like and 66% cash-like?

[moda0306]

Melveyr,

You've got it about right.  If you think about it, rebalances out of bonds are probably few and far between.  This indicates that while their volatility is helpful in terms of rebalances and peace of mind (think 2008), we still are relying on them, for the most part, as a fixed annuity-esque income stream.

If this is their major role, then I think accumulators should consider letting a portion of their bonds exist as EE bonds... Allocated in a similar fashion to what you posted of course.

[melveyr]

Hmmmmm. This is a very interesting concept. I have a decent income right now, but no 401(k) because I am just an intern. This leaves me hunting for any tax efficiency I can find after maxing out my roth. I might follow your proposal. You have given me something to ponder...  :)

[melveyr]

Wow. Based on market 20 year yields the PV of 5,000 dollars in savings bonds is $5,620. A nice deal. Not to mention the tax efficiency. And if yields spike to the point where my phantom rate is lower than the market rate (after taxes) then I get a free ticket out.

Holy crap. I am definitely doing this (with the allocation methodology I posted before).

[MachineGhost]

What is so great about EE bonds over the I bonds?  The inflation return on EE has always been pathetic.  In either case, no portion of these bonds are to be considered part of the LT bond allocation as they have no secondary market and do not move in response to disinflation.

MG

Wow. Based on market 20 year yields the PV of 5,000 dollars in savings bonds is $5,620. A nice deal. Not to mention the tax efficiency. And if yields spike to the point where my phantom rate is lower than the market rate (after taxes) then I get a free ticket out.

Holy crap. I am definitely doing this (with the allocation methodology I posted before).

[moda0306]

MG,

Yes, the fixed rates of EE bonds aren't that great, but they're still better than most short-term treasury debt, and are behind I-bonds as another option for cash.

Where EE bonds become interesting, to me, is as a deep-pocket bond alternative.  I-bonds don't have that guaranteed doubling that implies 3.53% return for 20 years.  They are awesome instruments, but different than EE's.

I kind of tried to explain this above.  Most accumulators will go through a very large chunk of their life with minimal Bond rebalances, which indicates that its volatility gives us peace of mind, yes, but limited actual utility... I said limited, not nonexistent.  This indicates that MOST of the LTT value comes in annuity-type payments that won't decrease to zero like short-bonds as soon as the fed says "QE."

Since this is the case, for young guys like melveyr and myself with years to accumulate and collect interest we don't need to use for spending, a 20-year bond accruing interest at 3.53% is better as PART of the bond portfolio (you still want marketable LTT's or TLT making up the majority of your bond holdings) than 2.6%-2.9% securities for 20-30 years that can fall in value if rates rise.

EE's have a "put option" to sell at face value plus accrued fixed interest that more than makes up for them not being marketable at their true value if rates don't rise... because you're holding most of your bonds for a long time anyway.

[TripleB]

EE Bonds or I Bonds are horrible for the bond allocation of the PP. Just really really really bad.

The bond portion of the PP is not there to make a higher rate of interest than cash through the use of extended durations. The bond portion of the PP is designed to respond to deflation.

In 2008, LTTs jumped 30% when the stock market dipped 40%. EE Bonds gained 1% (or a phantom 3.5% if you are guaranteed to hold 20 years).

You specifically want volatility in the Bonds section. You want as much volatility as possible. I'd buy 10,000-year Treasury bonds if they existed that moved 1,000% every time interest rates swung 0.01%.

Feel free to use EE Bonds or IBonds as the cash "deep" position because cash is supposed to have the stable NAV par price.

[moda0306]

EE Bonds or I Bonds are horrible for the bond allocation of the PP. Just really really really bad.

I-bonds are bad.  EE bonds aren't bad as a 10-30% portion of bonds for the reasons I mentioned above.

The bond portion of the PP is not there to make a higher rate of interest than cash through the use of extended durations. The bond portion of the PP is designed to respond to deflation.

You are right and wrong.  Yes, we want our bonds to react strongly in price, but rarely do we ever rebalance out of them.  This indicates that the high interest payment is the majority of how long-term treasuries have contributed to the PP over the last 40 years.

Even if some of our bonds (the EE bond portion) aren't marketable, they still have a higher value to us as holders as they offer higher interest rates.  Of course, we keep this as a small-enough portion of our bond portfolio so in the event of a deflationary shock we still have plenty of long-term treasuries to sell.

In 2008, LTTs jumped 30% when the stock market dipped 40%. EE Bonds gained 1% (or a phantom 3.5% if you are guaranteed to hold 20 years).

You specifically want volatility in the Bonds section. You want as much volatility as possible. I'd buy 10,000-year Treasury bonds if they existed that moved 1,000% every time interest rates swung 0.01%.

This marketable volatility does offer us peace of mind and liquidity at that high FMV they might acquire as rates rise, but think of an accumulator for a second... the volatility is only useful to them to the degree it helps them rebalance, historically.... otherwise it's just a big wash.

I guess, if rates continue to fall over the 20 years you hold the i-bond down to the 1% realm then you could be left with poor return at 3.5% vs the increasing price, but being realistic, the volatility in price really only serves us in rebalancing, which is much less important in accumulation and much more important in drawdown.

If you can point to me where a 80/20 bond allocation of TLT and EE bonds will come back to bite me please explain it to me.  At 2.5-2.8% on 20-30 year treasuries and being relatively young and accumulating to prevent the need of income and less need to rebalance, I think I'll take my chances with 3.53% over the next 20 years without rebalances as a portion of my bond portfolio.

[TripleB]

If you can point to me where a 80/20 bond allocation of TLT and EE bonds will come back to bite me please explain it to me.

It would have in 2008. LTTs gained about 30% and the overall PP was about 0% for the year using rough numbers.

If you diluted your LTT into an 80/20 mixture of LTT and EE Bonds, then you'd have only gained about 25% in your LTT allocation. That would have changed your total PP return from 0% down to -1%.

Big difference? No. Negative difference? Yes.

What you essentially did is shift the PP to 20% LTT, 30% Cash, 25% Gold and 25% stocks. Does that really affect returns? Not really. But don't consider EE Bonds as LTTs.

Since I started the PP a few years ago, the principal appreciation of my LTTs have been about 35%. The interest rate appreciation has been about 8%. The actual yield of the bonds only accounted for about 1/5 of my LTT gains in the last few years. Had I been in EE Bonds, I'd have lost 80% of the gains in that asset.

[stone]

moda perhaps falling bond yields are an inevitable long term consequence of the type of fiat currency we have I'm not saying that is true, I'm just saying it might be true. It will be interesting to see what happens in Japan as perhaps they are like us but a decade ahead.

[moda0306]

stone,

I'm a deflationist, so I'm the first person to agree that yields could likely drop.  Obviously that makes my plan less attractive, but I still think it offers you a bit of arbitrage to have a 3.53% 20-year return with a put option.

I never thought they'd get to 2.8% in 2011 though... I thought maybe a 4.5%-to-3.5% drop over a few years.

This is unreal, but I can't say I'm entirely bearish on these things... Japan's got a "different" type of deflation we do (deleveraging in the corporate sector while their households had great balance sheets... we're the opposite), but I don't know how that difference will play out in the bond market.

[stone]

moda perhaps the EE bonds should be thought of as a variable portfolio speculation . Or you could have them under "cash" just so long as it is possible to move your money out of them into real cash if we get 18% STT yields or whatever. If that is prohibited, then they definately don't sit in the PP.

[melveyr]

Triple B,

Here is how I would use an EE bond. I pay $1,000 dollars today and get back $2,000 dollars in 20 years. It is basically a 20 year zero coupon bond. However, this zero coupon bond doesn't trade, I have to hold it to maturity.

It still protects me from falling interest rates because the present value of the bond increases. I have a higher yielding bond than the market place, therefore its PV moves up to reflect that change. Even though I can't liquidate it at the PV, it is still worth more to me.

EE-bonds are a creation of government that do not trade at there efficient market price, which is why I see them as attractive for part of the bond allocation. If you don't need the money for 20 years it is a total free lunch, compliments of Uncle Sam.

[moda0306]

It is basically a 20 year zero coupon bond. However, this zero coupon bond doesn't trade, I have to hold it to maturity.

It still protects me from falling interest rates because the present value of the bond increases. I have a higher yielding bond than the market place, therefore its PV moves up to reflect that change. Even though I can't liquidate it at the PV, it is still worth more to me.

Perfect... it still has the value as long as liquidity isn't a concern (money in our HSA, IRA, and even Roth earnings have a lot of the same concerns).  One could say that rebalancing isn't the only concern... that if you actually need to access your wealth the EE's won't be sufficient, but I think this is no more risky than money that many of us surely have in an IRA.

If we have LT treasuries in an IRA, and they go from a value of $10k to $15k over a couple years, if we need that money, between federal, state and penalty tax rates, we could likely be losing 40%-50% of that assets value to taxes.

This would be much less likely during the low income of retirement, which is why we contribute to IRA's so much in the first place.

[TripleB]

If we have LT treasuries in an IRA, and they go from a value of $10k to $15k over a couple years, if we need that money, between federal, state and penalty tax rates, we could likely be losing 40%-50% of that assets value to taxes.

OR... you could sell the LTTs within the IRA, keep the money in the IRA and then within the IRA buy stocks, tbills, or gold, to rebalance and lose 0% of the assets to taxes.

[moda0306]

I guess you are right if we're talking small amounts, but let's be honest... most of us, with the use of IRA's and 401(k)'s, set up most of our wealth with a box of quasi-illiquidity.

I would say most people keep the vast majority of their financial asset wealth inside a tax-deferred account that, if taken out in highest earning years, you get absolutely slammed by taxes.

Looking at EE bonds in that context, they don't seem much of a risk to me.  We make sure we have different pots with liquidity and tax situations... I see no reason to leave EE's on the table as bonds in a world where we're acknowledging that we aren't going to use that whole pot to go out and liquidate at once, and in that context bonds truly do play their biggest role in the long run by paying out guaranteed interest.

[stone]

moda, some of you US based people on here have said that most bankruptcies in the US are due to medical expenses for people who actually have medical insurance. That makes it sound as though there really is a tail risk that a US person might unexpectedly have to sell off their entire PP. In such a tail risk scenario I guess the difference between "implied value" and marketable value would bite. Compared to the tail risks you are guarding against by putting cash in a safe rather than a bank; getting cancer or mental illness or whatever -and having everything turned upside down by that- sounds fairly normal to me.

I realize that rates might rise and I don't think those EE bonds sound stupid as a variable portfolio thing but to me a crucial aspect of the PP is that it could ALL be sold off with minimal loss at anytime.

[moda0306]

stone,

That's a great point and certain observations like that are huge in terms of how we should allocate our portfolios.

I think I'm maybe playing a little fast and loose with the PP, but it may make some for some young guys like melveyr and myself willing to bend the rules a bit.

I think this suggestion if anything is bringing out some great concerns about liquidity that should be a part of our PP discussion no matter what.

Maybe we in the US should be putting a much higher value on 1) getting properly insured, and 2) staying as liquid as we can with our wealth without sacrificing other factors too much.

[stone]

moda, another thing that sounds crazily far fetched is war/sectarian strife etc. People who felt that they were living in their own homeland have had to up sticks and flee on many many occasions over the last 100 years. Indian Partition, the Balkans, the holocaust, Ruwanda etc etc.
If you want an example of people who might have expected to be safe where they had lived for thousands of years and were economically and politically at the heart of things but then all had to leave:
http://en.wikipedia.org/wiki/History_of ... ws_in_Iraq

[melveyr]

It's just so damn enticing. Based on market rates for the 20 year, $5000 dollars in savings bonds have a PV of over $6000. A 20% discount plus I get tax deferred interest.

Also if the PV ever falls below my redemption value (if rates spike), I can hop off the train.

The main risk is that if I need the money 10-19 years from now, the gap between the redemption value and the PV will be sizable. I am okay with this because I will have a sizable Roth by then. The savings bonds would be my bucket of last resort.

[TripleB]

Here's another reason why this is a bad idea for the bonds section. HB recommends that one does not hold LTTs to maturity, but rather to sell them when they hit 20 years left. This strategy is essentially requiring one to hold a 20 year bond to maturity.

[moda0306]

TB,

That's why you consider only a portion of it bonds in relation to its yield-to-maturity.... The rest would count as deep cash much like I bonds.

This fits with the idea that a ladder isn't wholly inappropriate for cash/bonds, and durations between 3 and 20 years, while not ideal, can be considered a mix of both cash & bonds and get you very close to where you want to be.

[MachineGhost]

I'm still unclear as to what the advantage of the EE bond is.  Does it serve as a deflationary hedge like T-Bonds or does it serve as an inflation hedge like I-Bonds?  If it is guarnateed to earn 100% in 20 years, what does the inflation rate do to that guarantee?

MG

TB,

That's why you consider only a portion of it bonds in relation to its yield-to-maturity.... The rest would count as deep cash much like I bonds.

This fits with the idea that a ladder isn't wholly inappropriate for cash/bonds, and durations between 3 and 20 years, while not ideal, can be considered a mix of both cash & bonds and get you very close to where you want to be.

[moda0306]

MG,

I don't know where it was said that there was some inflation benefit to EE bonds... maybe there was some sort of miscommunication.

The value of EE bonds, besides as an alternative to cash, is that they offer deflation protection, especially for those in the accumulation stage for whom 20 years isn't pushing them too far into illiquidity.