A reader writes in, asking:

“Have you encountered the ‘Inflation-Linked Distributing Ladder’ ETFs from Northern Trust? It looks to me that they create an entire TIPS ladder for you, and all you have to do is just buy a single fund. Too good to be true?”

Yes, the ETFs in question do create an entire TIPS ladder for you. But there is a catch. We’ll get to that in a moment.

Firstly, I want to note that these are very different from iShares’ target-maturity TIPS ETFs. The ETFs from iShares each buy TIPS maturing in a single year (i.e., each of the ETFs could serve as a single rung in a ladder, rather than being a ladder on its own).

In contrast, the Inflation-Linked Distributing Ladder ETFs from Northern Trust each own an entire TIPS ladder (with the final year being the year in the fund’s name). Here are the options so far:

• Northern Trust 2030 Inflation-Linked Distributing Ladder ETF (TIPA)
• Northern Trust 2031 Inflation-Linked Distributing Ladder ETF (TIPE)
• Northern Trust 2035 Inflation-Linked Distributing Ladder ETF (TIPB)
• Northern Trust 2036 Inflation-Linked Distributing Ladder ETF (TIPF)
• Northern Trust 2045 Inflation-Linked Distributing Ladder ETF (TIPC)
• Northern Trust 2046 Inflation-Linked Distributing Ladder ETF (TIPG)
• Northern Trust 2055 Inflation-Linked Distributing Ladder ETF (TIPD)
• Northern Trust 2056 Inflation-Linked Distributing Ladder ETF (TIPH)

They started with the 2030, 2035, 2045, and 2055 funds last year, and added the other funds this year. It seems likely that next year they’ll launch another four funds (i.e., 2032, 2037, 2047, 2057).

The idea is that, for each fund, as the bonds mature or make interest payments, the fund distributes cash. And when the final bonds mature, the fund distributes its remaining assets and then closes. So, yes, each of these ETFs really is an entire TIPS ladder via a single fund.

And they’re low-cost as well, with expense ratios of just 0.10%.

The catch: the distribution policy makes no sense (at least in my opinion). The funds distribute cash when bonds pay interest or mature, which makes sense. But they also distribute the inflation adjustments as they occur. What that means is that, in order for your holding to actually go up along with inflation (which is generally the idea of a TIPS ladder), you’d have to manually reinvest the distributions that are the result of inflation adjustments. And you can’t just set it to automatically reinvest all distributions, otherwise you’d be reinvesting the other distributions as well.

So these ETFs are much less work to set up than a DIY ladder of individual TIPS, but they involve ongoing management work, whereas a ladder of individual TIPS is generally just left alone once it has been put it place.

They’re so close to being a major convenience upgrade. But as it stands, they’re just trading work now for work later. For some people that might still be a desirable tradeoff. For me, it puts them in the “neat idea, but no thank you” category.

One other point: so far, the funds are tiny, in terms of assets managed. I hope they catch on. But I hope even more that somebody eventually creates a product that really is a set-it-and-forget-it TIPS ladder all in a single fund.

A reader writes in, asking:

“I have question about your VT + TIPS choice. Will you maintain that two fund portfolio throughout your life? Was wondering if your choice reflects a personal judgement about holding BND in a portfolio. BND has certainly not been a stellar performer for several years. Makes me wonder if going with TIPS only for the non-stock portion of our portfolio is also the right choice for us. Currently looking at a 50/50 BND/TIPS for fixed income as I start retirement next year, but your choice is making me doubt the wisdom of that approach.”

Bonds can perform two separate roles in a portfolio. In our household, we’re using them in a way that only individual TIPS held to maturity is really the right fit. But if they are being used as basically “the thing that’s less volatile than stocks, which will be rebalanced with the stock part of the portfolio” there are tons of options that would be fine. This article has more on that:

• What’s the Point of Bonds in a Portfolio? (And Why Individual TIPS, Held to Maturity, Are Unique)

Personally I have no significant qualms about a “total bond market” fund such as BND in that second role. Its performance in recent years is not anything strange or alarming. That’s just what happens when interest rates go up. And they went up, by a lot, from 2021-2022 (especially in 2022). If you find the fund on Vanguard, click to the performance section, then click the tab for “annually,” you’ll see the year-by-year returns. It’s really just those two years (especially 2022 with a -13.15% total return by NAV) that makes all of the performance figures look bad — and it’ll be that way until those years fall out of the various calculations. (Note that the fund’s 3-year performance is much better than 5-year performance for exactly this reason.)

And again, it’s not as if the fund did anything wrong over the 2021-2022 period. BND has an average duration of 5.8 years. That means that for every percentage point change in interest rates for bonds similar to those in the portfolio, the fund’s price should move in the opposite direction by about 5.8%. From the beginning of 2021 to the end of 2022, yields on 7-year Treasury bonds went from 0.64% to 3.96%, an increase of 3.32%. Multiplied by an average duration of 5.8, we’d expect a price decline of about 19% over the period, offset somewhat by the fund collecting some interest over those two years. (Also note that the fund holds corporate bonds as well as government-backed bonds, so the change in yield was a bit different than we see here.)

Essentially, any intermediate-term bond fund (and especially long-term bond funds) had a terrible year in 2022. That’s just the math of what happens when yields go up. For instance:

• Vanguard Intermediate-Term Treasury ETF was down by 10.67% in 2022.
• Vanguard Inflation-Protected Securities Fund was down by 11.85%.
• Vanguard Intermediate-Term Investment-Grade Fund was down by 13.78%.

The flip side of course is that all of those funds look much more attractive now, with their higher yields.

In our specific household, we aren’t using bonds as “a thing to rebalance with stocks.” Rather, we’re just planning to hold the bonds until they mature, then spend the money. So we want individual TIPS for that. And with long-term TIPS yields well over 2% (very close to 3% in fact), we’re very happy to have the bond part of our portfolio earn inflation plus 2.X% for the next 20-30 years — especially given that for most of our careers, TIPS yields were practically zero and at some times even negative.

In March of this year, Vanguard released a new line of Target Maturity Corporate Bond ETFs. (Prospectus here.) The line currently consists of Vanguard Target Maturity 2027 Corporate Bond ETF (VBCA) through Vanguard Target Maturity 2036 Corporate Bond ETF (VBCJ). In other words, one fund for each year, up to ten years in the future.

The funds do pretty much what you’d expect from the name:

• Each fund holds (domestic) investment-grade corporate bonds that mature (or are expected to be called) in the year in question. For example, the Vanguard Target Maturity 2029 Corporate Bond ETF holds bonds that mature or are expected to be called in 2029.
• Each month, the fund distributes whatever income the underlying bonds paid.
• And then once all the bonds have matured, the fund makes a final distribution of the entire net asset value.

The idea, broadly, is that these funds could be used to create a corporate bond ladder, extending up to 10 years in the future. Vanguard even released a neat “BondBuilder Laddering Tool” to go along with the funds.

If you’re going to own corporate bonds, diversification among issuers is critical, for exactly the same reason why diversification is critical when owning stocks: you don’t want to have a disaster if any one company goes out of business.

So if you want to build a ladder of corporate bonds, using funds like these is much easier than buying individual bonds from a whole bunch of different issuers.

But do you want to build a ladder of corporate bonds?

I don’t, particularly.

To be clear, there’s nothing at all wrong with doing so. But most of the time if I’m considering a bond ladder, it’s specifically for asset-liability matching. That is, the point is the safety that a ladder can provide (due to holding bonds until maturity), relative to most funds (which maintain a steady average maturity and thus if you ever want to sell shares to raise cash, you’re always selling bonds prior to maturity). And if the goal is safety, then I specifically want the ladder to be Treasury Inflation-Protected Securities (TIPS).

Again, there’s nothing at all wrong with these funds. They’re low-cost, and I expect they’ll do a great job of doing what they say they’ll do. If you want a corporate bond ladder, these are a good choice (for up to 10 years of ladder rungs, that is).

It’s also worth noting that iShares has offered target-maturity investment-grade corporate bond ETFs since 2016. They are also low-cost and do basically the same thing. So the idea isn’t new. This is just Vanguard also offering a product in this category. (iShares also offers target-maturity ETFs of nominal Treasury bonds, TIPS, municipal bonds, and high-yield corporate bonds.)

Broadly speaking, bonds can be used to perform either of two distinct roles in a portfolio.

The first role: they are the “thing in the portfolio that’s safer than stocks but which still generally provides more return than cash.”

And for that role, as long as you stay away from bonds that are so risky that they actually aren’t safer than stocks (i.e., bonds with super long durations or extremely poor credit ratings), just about any bonds can do the trick. You can use individual bonds or a bond fund. And as long as it’s low-cost, any of several different types of bond fund would be fine:

• Short-term Treasury fund,
• Intermediate-term Treasury fund,
• Total bond market fund,
• Short-term TIPS fund, or
• Intermediate-term TIPS fund.

Any of those will work. The intermediate-term funds are riskier than the short-term funds, and a “total bond” fund is riskier than a Treasury fund, but that, in itself, is neither good nor bad. We can adjust the overall risk level to whatever we want it to be by adjusting the overall stock/bond allocation as needed.

The second role that bonds can play is that they can be used to offset specific costs at a specific date in the future. (“Asset-liability matching” is the technical term for this concept.) For instance, if I expect my first year of retirement to be 10 years from now, and I want to have $60,000 of spending power available in that year, I could buy bonds that mature in that year, to provide me with a very safe way of satisfying that spending.

But here’s the key point: for this purpose (asset-liability matching), it is only individual TIPS, held to maturity, that can do the job.

It has to be TIPS* (rather than “nominal” bonds, which are not adjusted for inflation), because we want a certain amount of purchasing power at some point in the future, rather than a certain dollar amount.

And it must be individual TIPS, rather than a TIPS fund.** And that’s because the only way to have a certain amount of known spending power at some specific date in the future is to hold the TIPS to maturity. With a typical bond fund, the fund is constantly buying new bonds. (It must. Otherwise it would eventually hold nothing but cash as the bonds matured.) And as a result, whenever you sell shares of a bond fund, you’re effectively selling bonds prior to maturity. And so, at the time you buy the fund, you don’t know what it will be worth when you eventually sell it. (For example, if I knew that I wanted to have $10,000 of spending power 10 years from now, a TIPS fund doesn’t achieve that goal for me, because I don’t know what the fund will be worth 10 years from now.)

*I Bonds also work, though they have two major limitations in that they cannot be purchased inside retirement accounts and you’re limited to $10,000 per purchaser per year.

**One exception: BlackRock does offer ETFs that hold TIPS to maturity. For example, iShares iBonds Oct 2028 Term TIPS ETF (IBIE) owns nothing other than TIPS maturing in 2028. And the ETF will hold those TIPS until they mature, and then the fund will liquidate, distributing cash to shareholders. So it works very similarly to just buying 2028 TIPS on your own and holding to maturity.

A reader writes in, asking:

“I am aware that bonds and bond funds with longer duration have greater price changes in response to interest rate moves than shorter-term bonds do. And given that, I understand that longer-term bonds generally have higher yields because of that higher risk. That makes perfect sense.

What I have never been able to wrap my head around is why do the prices of longer duration bonds fluctuate more severely?”

A bond’s market price is really just the result of a net present value calculation. That is, the price of a bond at any given time is the sum of the present values of each of the cash flows from the bond (i.e., the present value of each interest payment plus the present value of the payment upon maturity).

(See this article if you haven’t encountered the concept of present value before. It’s worth a read, as it’s one of the most fundamental concepts in finance.)

As a reminder, the present value of a given cash flow is calculated as follows:

PV = FV / (1 + r)^n

where:

PV = present value
FV = future value (i.e., the dollar amount of the cash flow in question)
r = annual discount rate
n = number of years before the cash flow is received

The greater the number of years, the greater the impact of the discount rate. Compare the two following examples.

Example 1: Given a discount rate of 2%, the present value of a $1,000 cash flow to be received one year from now is $980. If we raise the discount rate to 3%, the present value falls to $971, a change of $9.

Example 2: Given a discount rate of 2%, the present value of a $1,000 cash flow to be received five years from now is $906. If we raise the discount rate to 3%, the present value falls to $863, a change of $43.

Point being, a 1% increase in the discount rate had a much larger effect on the cash flow that was further in the future.

When we’re calculating the present value of a bond, the discount rate is the return that investors could expect to earn from other bonds with similar risk (i.e., other bonds with the same credit rating and same duration).

So when interest rates change, the discount rate changes. And the further in the future the cash flow is to be received, the greater the change in present value (i.e., market price).

So, the longer the duration of a bond (i.e., the further in the future its cash flows will be received, on average), the greater the change in present value (i.e., market price) when interest rates change.

A reader writes in, asking:

“Do bond prices work like stock prices in that interest rate expectations are “priced in” in the same way that expectations for the company are “priced in” to the price of the stock? I guess what I’m asking is if everybody expects interest rates to rise and then they do rise, should I still expect my bonds to go down in value? Or does the change in interest rates have to be unexpected or bigger than expected in order for my bond prices to fall?”

As a bit of background for readers unfamiliar with the concept, a stock’s price at any given time reflects the market’s expectations for the underlying company. For example, if everybody expects a given company to have huge growth in profits over the foreseeable future, those expectations are built into the price of the stock. And the stock will only earn above average returns if the company’s profits turn out to be even greater than the market had expected.

In other words, the performance of a stock is not a function of how well the underlying company performs, but rather how well the company performs relative to the market’s expectations.

With regard to the reader’s question (i.e., whether it needs to be an unexpected change in interest rates in order to change bond prices), the answer is “it depends.” Specifically, it depends which interest rates we’re talking about.

A Bond’s Yield and Price Are Mathematically Linked

For typical nominal bonds, short of defaulting, there is no way for the interest rate to change without the price changing. A change in the price is how that the interest rate changes.

Example: If a bond with a $1,000 face value pays $40 of interest per year, that $40 is fixed. It doesn’t change. So the only way that the bond’s yield can be higher or lower than 4% is if the price is different from $1,000. In other words, the only way for the interest rate to change is for the price to change. Said yet another way, a change in the interest rate on this bond is literally the same thing as a change in its price (e.g., the bond price has gone up to $1,020 and now therefore has a yield of less than 4%, because you have to pay $1,020 to get that $40 of annual interest rather than just paying $1,000).

So if you own, for example, a 5-year Treasury bond and interest rates go up for 5-year Treasury bonds, the price of your bond will go down at the same time.

Expectations about Other Rates Might be “Priced in”

Bonds come with a variety of credit ratings and maturities, and there are different interest rates for each of those rating/maturity combinations. In addition, there are other interest rates that play important roles in the economy, such as the prime rate or the federal funds target rate.

And the interest rate on any given type of bond is based, to some extent, on expectations about various other interest rates (i.e., interest rates for other types of bonds or interest rates for things other than bonds). For example, bonds may at any given time be priced on the assumption that the Federal Reserve will raise the federal funds target rate by a certain amount. And therefore if the Fed does raise the rate by that amount, it won’t have much effect on bond prices, because that change was already “priced in.”