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Investing Blog Roundup: iShares Defined-Maturity TIPS ETFs

If you want to know, in advance, that you’ll have a specific amount of purchasing power available on a specific date in the future, Treasury Inflation-Protected Securities (TIPS) are the tool for the job.

And if you want to know, in advance, that you’ll have a specific amount of purchasing power available each year for many years, a ladder of TIPS is the right tool for the job.

TIPS mutual funds, while they can be a useful tool, generally can’t do either of those jobs. That’s because TIPS mutual funds keep buying new bonds. So if you were to plan to sell your shares of the TIPS mutual fund at any specific date in the future, there’s no way to know what price you’ll get (because you’re essentially selling bonds prior to maturity).

Earlier this year, Allan Roth challenged the fund industry to implement a fund that could be used as a TIPS ladder. John Rekenthaler of Morningstar argued in favor of the idea as well.

And last month, BlackRock released a lineup of TIPS ETFs that can be used in such a way. They’re called iShares iBonds ETFs. (I hate the name due to the obvious potential for confusion with Treasury I Bonds. But BlackRock didn’t ask me, and the name is of course not the most important point here.)

The idea is that each ETF basically just buys bonds that mature in a specific year — and only that year — and then holds those bonds to maturity. And that’s it. So each ETF can essentially act as a stand-in for one rung of a bond ladder.

It’s a neat idea. I’m happy that they exist. I’d love to see BlackRock extend the lineup out beyond the current 10-year limit. And I’d really be interested to see a fund that actually implements a whole ladder for you.

Other Recommended Reading

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Should I Sell Bonds to Prepay My Mortgage?

A reader writes in, asking:

“We bought a home recently, when rates were high though not as high as they are now. Without having any idea of whether home prices and interest rates will decline or continue to rise, how does one determine whether it’s a worthwhile tradeoff to sell some or all of our bond funds to payoff, or pay down, our mortgage?”

Changes in the Home’s Value Don’t Matter (For This Decision)

Firstly, the decision of whether to prepay the mortgage has nothing to do with the price of the home.

Example: Bob borrowed $400,000 to purchase a $500,000 home (i.e., making a 20% down payment of $100,000). If the home goes up in value by $50,000, Bob’s balance sheet will now include a $550,000 home. And that’s true regardless of whether he prepaid his mortgage or not. Similarly, if the home declines in value by $50,000, it’s now a $450,000 home, regardless of whether he prepaid the mortgage.

If you bought a home, you now own that home. You will experience 100% of the home value fluctuations, even if you only have, for example, 20% equity in the home. Point being, the amount by which the home goes up or down in value is unaffected by the decisions you make about the mortgage. And in turn, the decisions you make about prepaying the mortgage should be unaffected by your expectations for how the home’s value will change over time.

Yield on Bonds vs. Mortgage Interest Rate

The comparison to make is the interest rate of the bonds you would be selling as compared to the interest rate of the mortgage. Specifically:

  • For bond funds, we want to look at the SEC yield.
  • For individual bonds, we’d look at the yield-to-maturity.
  • If the bonds are in a taxable account (as opposed to a retirement account such as a 401(k) or IRA), we need to calculate their after-tax yield.
  • Similarly, for the mortgage, we’re concerned with the after-tax interest rate (i.e., after accounting for any tax savings you get as a result of the itemized deduction for home mortgage interest).

As of this writing, Vanguard Total Bond Market ETF (BND) has an SEC yield of 4.82%. If you owned that ETF in a taxable account, we’d have to multiply by [1 minus your marginal tax rate] in order to find the after tax yield (e.g., 4.82% x 0.75 if you have a 25% marginal tax rate).

If your mortgage is from several years ago and has a 3% interest rate (which is likely less than 3% after accounting for the itemized deduction for mortgage interest), selling bonds that yield 4.82% in order to pay down a 3% mortgage doesn’t seem all that appealing, from a purely financial point of view. (Some people may still choose to do it, because eliminating the mortgage gives them psychological benefits.)

On the other hand, if your mortgage is newer, with a 6% or 7% interest rate, selling those 4.82% bonds does look pretty attractive.

A complicating factor is that interest rates change over time. If for some reason you are convinced that interest rates are about to fall or rise, that would have an impact on whether or not you should sell your bonds at this time. (Bond prices move in the opposite direction of interest rates. So if you are convinced that your bond values are about to rise or fall in the near future, that would be either a point in favor or against selling right now.)

Personally, I have not seen any evidence that interest rate movements are easier to predict than short-term stock market movements. So rather than making guesses, I prefer to make decisions based on today’s rates.

Other Tax Considerations

Another important factor is: what type of account is it that you would ultimately be drawing these assets from, in order to prepay the mortgage?

If you would be using assets from a taxable brokerage account, we want to account for the capital gains tax (if any) that you would have to pay as a result of selling the holdings in question.

If you would be using dollars from a traditional IRA, what tax rate (including 10% penalty, if applicable) would you be paying on the distribution? And how does that compare to the tax rate you expect to face in the future (i.e., whenever these dollars would come out of the account later, if you don’t take them out now)? The higher the current tax rate that you would pay is, relative to the future tax rate that you anticipate, the less desirable it is to tap this account for any reason, including prepaying a mortgage.

If you would be using Roth IRA dollars, would you be paying tax (or penalty) on any of the distribution?

Risk Considerations

One point that trips many people up is the idea that by selling bonds to prepay the mortgage, they’ll be increasing their financial risk (because the portfolio will now have a higher percentage allocated to stock). In most cases, that’s not true. In most cases, it will not be a significant change in risk.

When you buy the home, you increase your risk. In our example above (Bob uses $100,000 of cash and a $400,000 mortgage to buy a $500,000 home), he now has $500,000 additional dollars of exposure to real estate (risky). He has a new $400,000 liability (risky). And he has $100,000 less cash (also an increase in risk). He has increased his economic risk in three different ways.

But once he has bought the home, those things have already happened. He has already taken on all of that additional risk.

Selling bonds to prepay a mortgage doesn’t affect how much exposure you have to real estate volatility (see the beginning of this article). Nor does it affect how many dollars you have exposed to stock market volatility. What it does do is:

  • Reduce your liabilities (thereby reducing your risk), and
  • Reduce your safe assets (thereby increasing your risk).

Net change in risk: roughly zero.

People often latch on to the percentage change in the asset allocation. But that’s a distraction. In our example above, imagine that after buying the home, Bob’s portfolio is $1,000,000, of which 60% is stocks and 40% is bonds (i.e., $600,000 in stocks, $400,000 in bonds).

If Bob were to use all $400,000 of his bonds to pay off the mortgage, he’d go from a 60%-stock portfolio to a 100%-stock portfolio. If we just look at the percentage, that’s a huge increase in risk. But in reality, he still has exactly $600,000 exposed to stock market risk. He didn’t increase his allocation to stocks at all. We just have a smaller denominator in our fraction ($600,000 total portfolio rather than $1,000,000).

Selling bonds to pay down a mortgage does not typically change the household risk level by very much. It is, mostly, just a decision of interest rates (after accounting for the various tax considerations).

Investing Blog Roundup: Automatically Adjusting Social Security Funding

Social Security’s funding problem has been known for decades, and yet nothing material has been done to fix it during my lifetime. The issue, of course, is that our two major political parties do not agree as to what the fixes should look like (i.e., primarily cuts in benefits or primarily increases in taxes).

Alicia Munnell (Director of the Center for Retirement Research at Boston College) recently proposed that any changes that are made should include a mechanism that would automatically make adjustments as needed going forward, in order to prevent such a situation from recurring.

Other Recommended Reading

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How Often to Rebalance a Portfolio

A reader writes in, asking:

“We are getting closer to retirement and beginning to adjust our asset allocation. Recently we rebalanced our asset allocation from 90/10 stocks/bonds to 70/30. It was the first time we rebalanced in about 7 years. We think given our time horizon we should consider 50/50 or even 40/60. It’s a very difficult decision.

In addition, we’re trying to figure out how often we should be rebalancing going forward as we move into retirement.

How do we figure out what is the best rebalancing frequency for our funds held at Vanguard: Total Stock Market Index Fund, Total Bond Market Index Fund and Intermediate Term Bond Index Fund? Those funds are our complete retirement portfolio…trying to make you proud…KISS. You helped us so much in the 10+ years that we have been following you.”

First a note on terminology, because it may cause some misunderstandings when reading the links I’m about to provide: the change that you describe having recently made is not rebalancing. Rebalancing is when you bring your allocation back to the intended (target) allocation. For example, if the target is a static 60/40 allocation and every quarter you make adjustments to bring the portfolio back to the 60/40 allocation, that’s rebalancing. If you change the target (e.g., deciding instead that a 40/60 allocation is the new target), that’s not rebalancing.

This is not to say that changing the target is a bad idea. Sometimes it’s a good idea — especially as your life circumstances change. I’m just belaboring this terminology point, because when reading about rebalancing in more technical writing, it’s important to know very specifically what is being discussed. (This is a common terminology mix-up, by the way. People get it wrong constantly on the Bogleheads forum for instance.)

And with that out of the way, the following are a few things you may want to read.

A takeaway from reading the three articles above is that rebalancing more often than annually is likely not a great idea. In very brief, the reason is that the stock market has historically exhibited a slight degree of momentum over periods shorter than a year. That is, if yesterday was a good day, today is more likely than usual to be a good day. And if yesterday was a bad day, today is more likely than usual to be a bad day. And the same goes for monthly periods.

And the result is that rebalancing daily or monthly would mean that, in a market downturn, you’re constantly buying more stocks as they keep falling, resulting in an overall loss that’s worse than if you hadn’t been rebalancing. And during upward markets, you’re constantly selling stocks, resulting in less of a gain than if you hadn’t been rebalancing.

The following two links are runs from PortfolioVisualizer, comparing monthly vs annual rebalancing, for a basic 3-fund portfolio using a “4% rule” spending strategy. Rebalancing annually worked out slightly better in terms of return, maximum drawdown, and standard deviation. (Note that I’m simply using the earliest start date available here, and letting it ride until today. If interested, you could instead test with rolling 30-year periods, for instance, to see how reliable this outcome is. You could also test with different target allocations or with different spending strategies.)

Plot Twist: Contrary Evidence

There’s also, however, a 2010 paper from Vanguard (no longer on their website, but here’s a Web Archive link), which found essentially no difference between rebalancing monthly, quarterly, or annually — other than the time (and potentially transaction costs) involved in doing so.

Also, as always, anything based on historical data — as all of the above is — should be treated with a healthy degree of skepticism. Sometimes, trends that persisted for a very long period, even many decades, eventually disappear, as the markets themselves change (e.g., as the participants in the market shift, as products available change, as laws/regulations change, etc.)

And indeed, per a 2022 paper, it appears that that’s exactly what has happened:

In this paper, the author found that the autocorrelation of stock returns (i.e., the correlation from yesterday’s returns to today’s returns) declined over the period 1960-2019 and actually became significantly negative in the second half of the sample. That is, yesterday being a good day would mean today is more likely than usual to be a bad day, and vice versa. And that would mean that rebalancing everyday (as you would see in a target-date or LifeStrategy fund) would actually be helpful.

So, where does all of this leave us?

Frankly, I really don’t know, other than to say that there’s some good evidence in favor of just about any option. My personal thinking at this point can be summarized as follows:

  • If you have a target-date fund, LifeStrategy fund, or anything similar which is rebalancing for you daily, that’s probably fine. (Though it can create tax costs in a taxable account.)
  • If you’re using a DIY allocation, and you want to rebalance quarterly, annually, or every two years (or “annually but only if the allocation is off-target by at least x%”), that’s probably fine too.
  • More frequent rebalancing means more work, if you’re doing the rebalancing yourself.
  • I wouldn’t worry too much about this topic overall. Nor would I put too much faith in Strategy A instead of Strategy B. It’s more along the lines of “pick one approach that seems reasonable, and stick with it.”

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Investing Blog Roundup: Roth Catch-Up Rule Delayed

One of the many changes made by the SECURE Act 2.0 was that, starting in 2024, catch-up contributions to 401(k), 403(b), and governmental 457(b) plans would have to be Roth (rather than tax-deferred) for any employee whose wages from the employer in question in the prior year were more than $145,000.

Many employers and plan administrators complained, arguing that they wouldn’t be able to implement the necessary systems in time. (Previously, catch-up contributions to such plans weren’t even allowed to be Roth, so there’s a bunch of software-related work to be done.)

The IRS recently agreed that more time was needed and announced that the new requirement won’t go into effect until 2026:

IRS Announces Administrative Transition Period for New Roth Catch Up Requirement from the IRS

Other Recommended Reading

Thanks for reading!

Why I Think International Diversification Is a Good Idea

A question that comes up, over and over in my email as well as on the Bogleheads forum is whether you really need international diversification, or whether sticking with only U.S. stocks is fine.

I’m a firm believer that it’s worthwhile to include an international stock fund in the portfolio.

The reason, however, has nothing to do with a rebalancing bonus, mean-variance optimization, or any particularly complicated math. As I’ve written elsewhere, I’m not optimistic about the possibility of creating a portfolio of assets with low correlation to each other, in such a way that they can reliably smooth out each other’s periods of poor performance. (And if you bother to look, international stocks and U.S. stocks actually have reliably high correlation with each other.)

For me, including international stocks in my portfolio is about diversification in a very fundamental, basic way: if I include international stocks, I have more stocks in my portfolio. This is diversification in the sense that your great, great grandparents would still have intuitively understood.

If any one stock has terrible performance, it has less of an impact on me. That’s a good thing. Because companies blow up sometimes.

And diversification is helpful from the other perspective as well: not just in terms of minimizing harm (from a company failing) but in terms of minimizing the likelihood of missed returns from failing to include a shooting star.

In the 20-30 years I’ve been learning about investing, the finding that stunned me the most was that most stocks actually have lower lifetime returns than 1-month Treasury bills. It’s a relatively small handful of very high-performing stocks that account for the entirety of stocks’ collective outperformance over safer assets. (When looking at the US stock market, if you eliminate the best-performing 4% of stocks, the remainder of the stock market has only matched Treasury bill performance.)

I don’t have any method for reliably picking those superstar stocks. (If I did, I would not be using mutual funds at all.) I want to own all the stocks, to be sure that I own those 4%. And that means owning international stocks also.

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