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Bond ETFs amid rising interest rates

Interest rates continue to rise, with the Federal Reserve recently raising its benchmark rate to a range of 5.25% to 5.5%. While borrowers may face higher costs, new investors in short-term Treasurys now realize these higher annual rates. However, investors in certain bond ETFs could also realize this rate with added liquidity, and convenience, while potentially avoiding state and local taxes.

US Treasury Bills are backed by the full faith and credit of the U.S. Government

Short-term investment options

There are several common approaches for investing in the short term, which we characterize as less than one year. Thankfully, these investments have zero default risk because the full faith and credit of the US Government backs them.

These investments include bank CDs, direct purchases of US short-term Treasury bills, money market funds, and certain Bond ETFs. Firstly, bank CDs and money market funds may be the most convenient for individual investors. Short-term bank CDs are currently yielding over 5%, and money market funds provide similar returns within most brokerage accounts. Unfortunately, both of these short-term investments are often subject to both state and federal income taxes. For residents of California, Hawaii, and New Jersey, the top state income tax rate exceeds 10%.

Bond ETFs for Tax-efficient investing in the short term

Alternatively, similar returns are possible if an investor chooses to purchase short-term Treasury bills from the U.S. Department of the Treasury. Or, an investor may purchase US Government Bonds ETFs. Both of these options are exempt from state taxes. However, treasury bills have maturity dates of 4, 8, 13, 26, or 52 weeks. So, at maturity, the investor receives back their investment plus interest. That means that an investor would need to regularly re-invest in treasuries at TreasuryDirect.gov.

To avoid the need to continually re-invest, and likely avoid state taxes, there are several short-term Bond ETFs to choose from. Here are just a few, that with reinvested dividends have returned 2.5-2.8% so far this year (e.g. from December 30, 2022, to July 28, 2023).

  • SPDR Bloomberg 1-3 Month T-Bill ETF (ticker: BIL)
  • iShares Short Treasury Bond ETF (ticker: SHV)
  • Goldman Sachs Access Treasury 0-1 Year ETF (ticker: GBIL)
  • iShares 0-3 Month Treasury Bond ETF (ticker: SGOV)
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The Arithmetic of Roth Conversions

In our recent posts from March, April, and May 2023, we highlighted some important considerations when making a Roth conversion. In this post, we continue this conversation with a recent article published in the May 2023 edition of the Journal of Financial Planning, entitled “The Arithmetic of Roth Conversions”. I was very fortunate to co-author this article with my colleague Dr. Edward McQuarrie, Emeritus Professor at Santa Clara University.


McQuarrie, Edward F., and James A. DiLellio. 2023. “The Arithmetic of Roth Conversions.” Journal of Financial Planning 36 (05): 72–89.

Executive Summary

• Roth conversions continue to vex planners. To clarify matters, this paper submits conventional rules of thumb to a strictly arithmetic analysis.

• The treatment shows that it must be optimal to pay tax outside the conversion with cash, confirming one common rule. But if tax must be paid to raise the cash used to pay the conversion tax, there will be an initial loss on the conversion and a subsequent breakeven point. This paper shows how to determine time to break even.

• By the same arithmetic, the paper refutes the common rule that future tax rates must be higher for a conversion to pay off. Given enough time, conversions can overcome moderately lower future tax rates and still produce a substantial payoff due to the power of compounding.

• Most Roth conversions will show a substantial payoff if the client’s planning horizon stretches over decades; however, shorter time frames may produce only a minimal payoff or even a loss.

• The paper gives practical advice regarding the optimum time to convert, points in the tax structure that favor or disfavor conversion, and the clients most and least likely to receive a substantial payoff from conversion.

Key points to consider when reviewing “The Arithmetic of Roth Conversions”

This article highlights the importance of the following key items:

  1. Current and future tax rates
  2. How time can help a conversion generate a positive payoff
  3. The type of retirees well suited and not suited for Roth conversions

We also encourage you to try our retirement income calculator. It was recently updated to include both optimal account drawdowns and Roth conversion analysis.

We hope you find this latest research article helpful in your own retirement planning or your financial planning practice!

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Roth Conversions with Optimal Withdrawals

In our posts from March and April, we discussed several aspects of Roth conversions. We showed that, if tax rates are higher in the future, Roth conversions can have a positive payoff. For tax-deferred assets, like pre-tax assets in a 401(k) or IRA, a retiree may pass some of these assets to an heir. The heir’s income tax rate determines the after-tax value of inheriting tax-deferred assets. This week’s post highlights the most recent software update made to our Optimal Retirement Income Calculator, which now includes Roth conversions and optimal withdrawals simultaneously!

How to model Roth conversions with Optimal Withdrawals

Roth conversions reduce tax-deferred assets by “converting” those assets in any year to a Roth account. Individuals performing a Roth conversion owe income taxes on the amount converted. But, the converted amount increases the individual’s Roth account assets, which a retiree can often access tax-free in retirement. One goal of generating tax-efficient retirement income is for optimal withdrawals to avoid large “spikes” in ordinary income. Our Optimal Retirement Income Calculator does this automatically and considers the tax rate of the heir under three distinct scenarios.

  1. A retiree has insufficient funds to satisfy retirement income
  2. A retiree has sufficient, but not excessive funds
  3. A retiree has excess retirement funds
Roth conversions and optimal withdrawals from Seeking Tax Alpha in Retirement Income
Source: “Seeking Tax Alpha in Retirement Income“, to appear in Financial Service Review (2023)

Excess retirement funds and the importance of your heir(s) tax rate

In scenarios 1 and 2, the top and middle portion of the image above, our calculator already finds the lowest marginal tax rate to efficiently distribute tax-deferred assets.  Consequently, our Optimal Retirement Income Calculator already provides a withdrawal strategy to utilize your tax-deferred assets efficiently. So, no additional tax-alpha is possible with a Roth conversion.  However, this is not the case in scenario 3 or the lower right portion of the image above.

When a retiree’s assets are far beyond what is needed to support their retirement income needs, many of their assets will eventually be passed to an heir. In this case, our Optimal Retirement Income Calculator previously left a significant amount of tax-deferred assets to an heir. With our latest software update, a new Roth Conversion Analysis includes converting tax-deferred assets to a Roth account “using up” the retiree’s tax brackets that are less or equal to those of the heir. For example, if your heir has an expected income tax rate of 25%, scenario 3 would perform a Roth conversion up to the 24% tax bracket. Doing so typically adds about 0.10% tax alpha. We encourage you to use our Optimal Retirement Income Calculator to evaluate possible situations for you or your clients. You can easily see if a Roth conversion with optimal withdrawals provides an additional benefit.

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Roth Conversions that Payoff

Roth conversions for retirees and individuals nearing retirement often confuse financial planners and individual investors. In this post, we discuss the pros and cons of converting a portion of tax-deferred assets to a Roth IRA. The insights I share here reflect early results from a recently conducted research initiative.

Why Convert to a Roth IRA?

Converting funds from a tax-deferred account, like a 401(k), 403(b), traditional IRA, or rollover IRA, may seem counterintuitive to many. Indeed, in my recent award-winning article on Seeking Tax Alpha in Retirement Income, which will soon appear in the Financial Services Review, I highlighted how many tax professionals, like CPAs, generally advocate deferring taxes for as long as possible. Converting funds to a Roth IRA imposes a current tax liability, contradicting this conventional wisdom. However, the communicative law of multiplication suggests otherwise for funds converted at the end of the year. A positive payoff occurs when the current marginal tax rate is less than the future marginal tax rate. Stated more simply:

Always seek the lowest marginal tax rate, either now, or in the future, when converting, or distributing tax-deferred assets.

Adapted from DiLellio and Ostrov (2017) “Optimal Strategies for Traditional versus Roth IRA/Roth 401(k) Consumption During Retirement”, Decision Sciences Journal. 48(2).

Tax Alpha from Converting to a Roth IRA

In my recent unpublished research results with Ed McQuerrie, we propose to show the benefit of Roth conversions in terms of tax alpha or the additional annual return realized by converting. If a distribution from the Roth IRA then pays the taxes, the figure below shows the tax alpha over a number of holding periods, from five to 40 years. We see that when future tax rates are higher, there is a significant benefit, but that tax alpha diminishes over time. Similarly, if an investor converts their tax-deferred assets and the future tax rates are lower, the negative payoff can be significant initially, but the loss will also diminish over time.

Tax Alpha from Roth Conversions if future marginal tax rates are 50%, 95%, or 150% of the current marginal tax rates
Tax alpha if future marginal tax rates are 50%, 95%, or 150% of the current marginal tax rates

The Challenge to Roth Conversions

The U.S. Congress sets tax rates. So, we can’t know future tax rates with certainty. But, a retiree is able to control the amount of ordinary income generated by distributions from tax-deferred accounts. Also, the results above assume the investor is at least 59 1/2 so they can avoid the tax penalty on early withdrawals to fund the tax liability. In our next post, we will highlight some beneficial results if an investor pays conversion taxes with a non-retirement account.

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A Presidential Cycle and the Markets

The stock and bond markets are off to a great start for 2023. This news is especially notable after a difficult 2022 for stock-based ETF investors. Including dividends and interest, the iShares Core S&P 500 ETF is up 6.3%, and the iShares Core Total US Bond ETF is up 3.3%. While a strong start can be helpful against losses later in the year, what may be more relevant is that we are now in the third year of a presidential cycle. In this article, we discuss this unusually strong relationship.

Data since 1933

According to a researcher at Charles Schwab using data from 1933 to 2015, the S&P 500 had average returns in the first, 2nd, 3rd, and 4th years of a presidential cycle of 6.7%, 5.8%, 16.3%, and 6.7%, respectively. So, in the third year of the presidential cycle, there was nearly a 10% increase in average returns. We revisited this data to include the end of the Obama administration, as well as the four years of the Trump administration and the first two years of the Biden administration. The results appear in the table below, which indicates that, even with the impact of the global coronavirus pandemic, the relationship still holds.

Presidential YearAverage Return (%)Sample Size
16.724
23.324
313.523
47.523
Average Returns of the S&P 500 from 1928 to 2022. Data Source: www.macrotrends.net

Clearly, we find that correlation is at play here, although the sample size is not very large. But, what could be the cause of this outperformance?

Possible Causes

A 2013 study at the University of Chicago attributed the effect of the 3rd year of a presidential cycle to increased future uncertainty of what a change of administration may cause. Others have argued that in the third year, the current administration has some momentum to start seeing the impact of their policies being implemented. But, it is always important to note that correlation is not causation, and there are likely many other factors at play that are producing this unusual market behavior. By the end of this year, we will see if the 3rd year of the Biden administration continues this outperformance.

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Inflation and ETFs

Inflation continues to persist higher than its long-term norm. Very few sectors of the U.S. economy have performed well. In this article, we discuss how ETFs designed with inflation in mind have fared in this current economic environment.

Historical rates of inflation

The U.S. Bureau of Labor Statistics (BLS) is an excellent free source of historical rates of inflation. The image below shows this data for the last 20 years. Clearly, the current inflation rate is above the norm of 2-3%. However, it does appear to be down somewhat from its high in June. Fortunately, we don’t see any recent “grey” area in this chart, which represents the U.S. in a recession, as determined by the National Bureau of Economic Research.

Inflation rates are still elevated above their long-term norm, but off of recent highs from June 2022

ETFs to protect against inflation

We chose three ETFs to show that not all ETFs are created equal in addressing inflation. Here, the acronym “TIPS” stands for “Treasury Inflation-Protected Securities”.

  • iShares Barclays TIPS ETF (ticker: TIP), $25B in assets
  • SPDR Bloomberg Barclays 1-10 Year TIPS ETF (ticker: TIPX), $1.4B in assets
  • Vanguard Short-term 0-5 year Inflation Protected ETF (ticker: VTIP), $17B in assets

    The most significant difference in these three ETFs is the term to maturity of the bonds contained within them. This difference has led to very different total returns for these three ETFs in 2022, as shown below.

    2022 Year-to-Date Total Return of Three ETFs offering inflation protection

    So, what’s going on?

    As one of my favorite writers at the Wall Street Journal recently wrote about, rising short-term interest rates are having greater impacts on the price of longer-dated bonds. This impact includes treasuries with inflation protection which each of these ETFs contains. The weighted average maturities for these three ETFs are 7.4 years, 4.7 years, and 2.5 years. By comparison, the broad-based iShares Core U.S. Aggregate Bond ETF has a weighted average maturity of 8.7 years and is down about 11% in 2022. So here, we see the limitation of a fund, like an ETF, that maintains a steady average maturity. Rising interest rates are offsetting the inflation benefit. Unfortunately, investors can avoid this with a bond ladder, but doing so requires investors to leave the relative ease of investing in ETFs.

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    Asset Correlations in 2022

    In 2022, many long-term trends in asset correlation appear to be changing. In this post, we discuss the longer-term trends in several popular asset class correlations and highlight recent changes that continued from the first half of the year.

    Short-Term Correlations and Long-Term Trends

    The stock and bond markets continued their downward slide this month. The iShares Core S&P 500 losses for 2022 reached 24%. In addition, the bond markets continue their losses for the year, with the iShares Core U.S. Aggregate Bond Market ETF down about 15%. This latter result is quite surprising, given the long-term correlation between the stock and bond market is 5%, but has recently grown to over 40%. Thus, the stock and bond market returns are more similar than they were in the past, so provide fewer diversification benefits. The chart below shows this upward trend in the correlation between the stock and bond markets in blue. The horizontal dotted line shows the long-term correlation from returns dating back to February 2004.

    90-Day Asset Correlation of Total Returns against the S&P 500 Index
    90-Day Asset Correlation of Total Returns against the S&P 500 Index

    Asset Correlation Among Other Sources

    The chart above also highlights the diminished effect of other sources on a portfolio’s diversification. For example, international equities are often sought for their diversification benefit. However, the long-term correlation of 88%, which also appears in this figures legend, hasn’t changed much this year. Bitcoin’s long-term correlation is 21%, but this correlation has steadily grown to over 60% this year. The one asset that has performed well this year is a direct investment in the U.S. Dollar ETF, ticker UUP. Long-term, the dollar has an insignificant correlation to the S&P 500. However, in 2022, the dollar’s correlation to the S&P 500 has grown significantly negative, as interest rate rises have increased demand for U.S. dollars. The chart below shows the total return of the five ETFs discussed here.

    2022 year to date returns of a variety of assets classes
    2022 Total Returns for ETFs associated with the S&P 500, Bonds, International, Bitcoin, and U.S. Dollars.

    Given the economic pressures creating these effects on the markets, the remainder of 2022 may continue to surprise investors. In particular, asset classes that formerly had low correlations to the stock market may continue to diverge from their long-term values.

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    Mitigating the effect of the Widow’s Penalty

    During our webinar earlier this year, we highlighted one of the retirement income challenges called “The Widow’s Penalty”. This situation occurs when the surviving spouse is filing taxes as a single, instead of married filing jointly. In this post, we elaborate on the effect of this penalty on a fictitious couple we call John and Jane and show that tax-efficient retirement income can help mitigate its effect.

    Case Study for John and Jane and the widow’s penalty

    The bulleted list here summarizes John and Jane’s situation at the start of their retirement.

    • John and Jane retired this year in a community property state.   
    • John is 65 and has a life expectancy of 80.  Jane is 62 and has a life expectancy of 82. 
    • Their after-tax retirement income needs are $150,000 per year, reduced to $140,000 per year for the surviving spouse. (Today’s dollars)
    • Both have RMDs starting at age 72. 
    • Their heir’s marginal income tax rate is 25%.
    • John and Jane both have retirement assets tax-deferred ($800k, $100k) and tax-exempt accounts ($400k, $50k). John owns a taxable account valued at $1M with a cost basis of $300k in stocks and $272k in bonds.
    • Their asset allocation is 60%/40% stock/bonds in all accounts, and they increase bond allocation by 1% each year. 
    • John and Jane have annual pension income starting at age 65 of $18,500 each, and social security income starting at age 67 of $11,000 each.

    As we showed in our previous post, if Jane is the surviving spouse, she can realize an additional 0.55% of investment return by drawing down from a mix of taxable, tax-deferred, and tax-exempt accounts. But, can this benefit still be realized if Jane lives longer?

    Tax efficiency for a longer-living surviving spouse

    In the example above, Jane lived for five years as a widow so needed to file her taxes as a single. Re-running our retirement income calculator and increasing Jane’s retirement horizon yields the following results.

    Widow's penalty and opportunity for tax-efficient retirement income
    Widow’s penalty and opportunity for tax-efficient retirement income

    So, these results show that Jane can still increase the inheritance for her heirs if she lives up to 15 years as a widow. If she lives 25 years as a widow, she will exhaust all of her savings but will be able to increase her portfolio longevity by 3.5 years. Either of these situations is possible by not following the common rule for retirement account drawdowns but instead using optimal account drawdown decisions.

    Want to see how the widow’s penalty may affect your retirement plan? We invite you to try out our calculator to see how your heir’s inheritance or your portfolio longevity may improve!

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    Cryptocurrency in 2022

    It has been a very difficult year for cryptocurrency investors. Here, we will discuss the recent trend of cryptocurrency returns. Also, we will highlight the current cost of cryptocurrency mining, and share some thoughts on the future of this asset.

    Cryptocurrency returns in 2022

    Year-to-date returns of Bitcoin, Ethereum, and the first ETF that tracks bitcoin futures (ticker: BITO) appear below. Like the stock and bond markets, all three of these assets lost value in 2022. Also, in our previous post on the risks of cryptocurrencies, the volatility of all of these cryptocurrency assets was significantly higher than the long-term historical norm of 15-20% for the S&P 500.

    Total returns for the Grayscale Bitcoin Trust (GBTC), the Grayscale Ethereum Trust (ETHE) and the first ETF linked to bitcoin futures BITO.
    Total returns for the  Grayscale Bitcoin Trust  (GBTC), the Grayscale Ethereum Trust (ETHE), and the first ETF linked to bitcoin futures BITO.

    Bitcoin miners

    Like oil, natural gas, and precious metals, there is a cost to “mine” bitcoin. Economic theory for commodities suggests that, when demand is constant, rising prices should increase production, since even less efficient miners can operate profitably. However, as prices drop, less efficient producers will exit, and less production of a commodity will occur, thereby stabilizing prices. That may be occurring now, as the price to mine one bitcoin is in the $20,000 to $34,000 range. As of July 31, 2022, the price of one bitcoin was within this range, with a value of $23,819.

    Production cost of bitcoin, the most popular cryptocurrency. Source: TradingView
    Bitcoin production cost. Source: TradingView

    The Future of Cryptocurrency

    The future of cryptocurrency remains uncertain. However, few expect these new innovations in decentralized finance to go away. Instead, we may see longer-term price stabilization, as the investment in mining produces enough cryptocurrency to satisfy demand. Such price stabilization may not entice investors seeking outsize returns but could help cryptocurrency gain wider acceptance if its volatility can also be reduced.

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    Mid-year review of stock-based ETFs

    With the 1st half of 2022 now behind us, we devote this post to a mid-year review of ETFs in a variety of stock sectors. We also highlight some recent research on sectors that have historically held up well during periods of high inflation, and the benefit of time horizon when investing in stocks. We hope you find this mid-year review helpful!

    Record-breaking 1st half of 2022

    According to this MarketWatch article, the S&P 500 recorded its steepest 1st-half year loss in over 50 years. But, remember that the S&P 500 is a broad-based index consisting of many different companies across a variety of industries. In fact, there are 11 sectors in the S&P 500, which in order of size (and an ETF to represent them) are:

    • Information Technology (XLK)
    • Health Care (XLV)
    • Financials (XLF)
    • Consumer Discretionary (XLY)
    • Communication Services (XTL)
    • Industrials (XLI)
    • Consumer Staples (XLP)
    • Energy (XLE)
    • Utilities (XLU)
    • Real Estate (IYR)
    • Materials (XLB)

    Mid-year review of best and worst performing sector ETFs

    The chart below sorts the total return for the 11 ETFs identified above for 2022. As can be seen here, the biggest gains were among the energy sector (XLE) and the worst in consumer discretionary (XLY). Over this same period, the S&P 500 total return, measured by the iShares Core S&P 500 ETF (ticker: IVV) was -19.2%. Also, note that the energy sector was the only ETF here that saw a positive return, which is not surprising given the war in Ukraine and its impact on supply in the energy sector.

    Mid-year review of returns from 11 sector-ETFs in the S&P 500 Index
    Mid-year review of returns from 11 sector-ETFs in the S&P 500 Index

    Where will stocks go from here and what to do about it?

    Given the current high inflation rates, Derek Horstmeyer at George Mason University recently showed the following “inflation fighters” in his June 5th Wall Street Journal Article.

    Best performing sectors during periods of high inflation. Source: Derek Horstmeyer
    Best performing sectors during periods of high inflation. Source: Derek Horstmeyer

    Of course, the most prudent course of action may be to simply do nothing based on this mid-year review. Given longer investment horizons, the stock market is less likely to suffer losses. Based on Bank of America research, the chart below supports this fact.

    But, as this article notes, behavioral economists know that the pain of loss is greater than the pleasure of gains. So, the 2nd half of this year remains quite uncertain, as market volatility remains elevated.

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