Upside volatility and long term bonds

[6 Iron]

Is there a yield point where the potential upside volatility of long term bonds is so blunted that it is insufficient to counter the downside volatility of the other assets in a deflationary period? Where we would be, in effect, operating without a true permanent portfolio, and subject to a much bumpier ride?

As an aside, let me say that I take much more than I give in terms of knowledge and advice from this forum, and my thanks to you all.

[moda0306]

Shhhhh.... you're disturbing my PP calm!

JK... it's a legit question I've asked myself a lot but in a different manner... at what point is the upside of whatever limited deflation protection you could get with a hypothetical 2% yield on a 30-year bond not worth the risk of insane loss of principal if rates go up?

At some point, if we're truly in a crazy deflation, simply burying your wealth in cash & ST bonds seems to be a better option than trying to chase a little bit of yield with little upside and huge downside risk.

[6 Iron]

Shhhhh.... you're disturbing my PP calm!

JK... it's a legit question I've asked myself a lot but in a different manner... at what point is the upside of whatever limited deflation protection you could get with a hypothetical 2% yield on a 30-year bond not worth the risk of insane loss of principal if rates go up?

At some point, if we're truly in a crazy deflation, simply burying your wealth in cash & ST bonds seems to be a better option than trying to chase a little bit of yield with little upside and huge downside risk.

I hate to harsh a mellow. Still, things feel a little "black swanny" and I have grown fond of our smooth sailing with the PP; I think my problem is that I have the day off, and too much time to read the news.

[moda0306]

6 Iron,

I'm always looking to tweak the PP away from cash, but I wouldn't be surprised at all if the next year or two were very weak for the PP.  We've had three excellent years in a row, the last two of which have ben especially great (about 14% each).  History shows that the PP tends to zig and zag between 0% gains and 20% gains annually, with a tendency to revert to a mean.  This is probably especially strong a force back towards a mean with yields being so incredibly low nowadays (even though gold likes to react to those negative real interest rates).

All in all, I wouldn't pick now as a time to jump into a 3x33 PP, and maybe if I were a tinkerer I'd hoard into cash a bit more than 25% and let the PP ride out what I expect to be a pretty weak year.

[murphy_p_t]

speaking of reversion to mean, look @ chart for  Treasury Yield 30 Years (Chicago Options: ^TYX ) since 1980 ...seems reversion to mean might be in order?

(i don't know how to post that chart)

[stone]

Clive, if that ECB "unlimited liquidity" scenario does play out, then I wonder whether Italian etc bonds will suddenly become such a bull market that everything else (stocks, gold, UK and US and Japanese treasuries etc etc) will get dropped to buy them Only once the club med bonds have the same yields as other government bonds, will other asset prices re-inflate

[stone]

I suppose if Germany were to leave the euro and the ECB were to QE down to say 2% yields, then that would probably be the most orderly conclusion and would not impact us too badly in the UK. The 6% to 2% shift in club med bond yields would be compensated for by the devaluation of the non-German euro so that would not suck in all global money. German exports would be curtailed by the strong Mark, Germans would be better off and so buy more stuff from the rest of europe. Unemployment would fall in the rest of europe so they would buy more stuff despite the euro being weaker. German banks etc would be less awash with excess USD, GBP etc to ineptly stuff into the latest destructive bubble. Better all round

[Tortoise]

Is there a yield point where the potential upside volatility of long term bonds is so blunted that it is insufficient to counter the downside volatility of the other assets in a deflationary period? Where we would be, in effect, operating without a true permanent portfolio, and subject to a much bumpier ride?

As an aside, let me say that I take much more than I give in terms of knowledge and advice from this forum, and my thanks to you all.

Revisiting this thread because I don't think the basic question in 6 Iron's OP was adequately answered.

There are two possibilities for long-term bond yields: (a) they will always remain positive, or (b) they will go negative at some point.

In situation (a), the upside volatility of long-term bonds is certainly limited: the price is limited to F + C, where F is the bond's face value and C is the sum of the remaining coupon payments. Any price above F + C implies a negative yield.

By contrast, in situation (b) the upside volatility of long-term bonds is unlimited. The more negative the yield, the higher the price.

Therefore, the way I see it, the answer to 6 Iron's basic question about long-term bonds' upside volatility hinges critically on whether one believes long-term bond yields will or will not ever go negative. I'd be interested in hearing some ideas on that.

[murphy_p_t]

is there any precedent for negative rates on LTT? Did this happen in Great Depression I ? Or in other countries?

[6 Iron]

I have a hard time getting my head around a world where I would pay Uncle Sam for the privilege of loaning him my money with a 30 year note.

[AdamA]

I have a hard time getting my head around a world where I would pay Uncle Sam for the privilege of loaning him my money with a 30 year note.

Me too.

But...what if you had a 10 million dollar portfolio.  That would mean that you'd have $5 million to put in cash and bonds.  What would you do with all of this money if you weren't going to use T-bills and LTT's?  Would you buy just stocks and gold?  Would you keep $5 million in the bank?  Would you keep it under your mattress?  Safe deposit box?

[MachineGhost]

My way of dealing with this LT Bond risk is to use market timing along with a permament position for "Black Swans".  I believe the ratio is about 70%/30%.  If anyone has a better suggestion, I'm all eyes.

MG

Shhhhh.... you're disturbing my PP calm!

JK... it's a legit question I've asked myself a lot but in a different manner... at what point is the upside of whatever limited deflation protection you could get with a hypothetical 2% yield on a 30-year bond not worth the risk of insane loss of principal if rates go up?

At some point, if we're truly in a crazy deflation, simply burying your wealth in cash & ST bonds seems to be a better option than trying to chase a little bit of yield with little upside and huge downside risk.

[moda0306]

AdamA,

I think the point you're getting at is great, and probably lost on most of us, intuitively, that don't have masses of wealth that we wish to preserve.

For the uber-wealthy, as well as foreign nations, simply storing wealth is a large concern.  Many would take a -2-3% real hit every year if they simply knew that their wealth was relatively safe. 

In fact, I'd almost go so far as to say that treasury bonds are simply a cash-like wealth storage mechanism, subject to whatever swings in inflation that their interest income doesn't beat.  They aren't guaranteed to keep up with inflation, but they are sure not to default on their obligation to pay $$'s back to you givent their terms, and that makes them practically like cash anyway...

The idea that yields could one day go negative makes me even more encouraged about savings bonds.  Sometimes it's nice not to be a bajillionaire.

[rickb]

According to http://www.exceleverywhere.com/calculat ... ulator.asp, the following would be the price changes for a 30 year bond with various interest rate changes:

3% -> 2%: +21.9%
3% -> 1%: +50%
2% -> 1%: +25%
1% -> 0.5%: +13.4%

3% -> 4%: -17.1%
3% -> 5%: -30.5%

At 3% it seems to me there's still plenty of oomph left.  If rates get to 1% the story changes.  We're not there yet, but it's an interesting "what if" question.  Personally, if the LT rate drops below 2.5% I think I'd consider adjusting the target allocation to LT bonds to perhaps 10x the LT rate, moving the rest to ST.  Harry's comments on this sort of scenario would be interesting.

[Tortoise]

If investors accept a negative yield on 30-year bonds, doesn't that effectively mean they expect either extreme market uncertainty or net deflation over the next 30 years?

Expecting extreme uncertainty or net deflation over the next few years is one thing; expecting it over the next 30 years is a whole different ball game.

[moda0306]

Tortoise,

I tend to think that investors predicting much beyond 10 years is a bit much.  I think what happens is that we have a pretty good vision of what issues might be over the next 5 years, and less so for the 5 years after that.

I think after that first 10 year yield curve is set based on those expectations, the 20- and 30-year just build off of that.  If peoples' expectations of 0-5 year rates are lower than years 6-10, then I would assume that investors would simply tend to carry that expectation into 20-30 year yields, rewarding investors willing to go out that far.

This is all my guess... I mean I have to think that one of the main considerations is what similar securities of shorter durations... eventually you get back to 5-10 year rates, which we just "wing it" and use to give us our best guess as to what somebody should get for going out another 10-20 years in duration.

[MediumTex]

If investors accept a negative yield on 30-year bonds, doesn't that effectively mean they expect either extreme market uncertainty or net deflation over the next 30 years?

Expecting extreme uncertainty or net deflation over the next few years is one thing; expecting it over the next 30 years is a whole different ball game.

People have a tendency to think that the way they feel right now is the way they will always feel.

That's part of the reason people commit suicide or a couple gets married shortly after meeting one another.

I think it's the same with investing.  It seems crazy that people wouldn't be able to conceptualize market conditions being dramatically different in a few years compared to now, but that's what happens.

Look at where 30 year bond yields were in the late 1970s/early 1980s.  Did those people really think that U.S. inflation would be out of control for the next 30 years?

[Tortoise]

Look at where 30 year bond yields were in the late 1970s/early 1980s.  Did those people really think that U.S. inflation would be out of control for the next 30 years?

Evidently they did.

Their collective estimate of the level of inflation over the next 30 years may have been way off the mark, but they were correct that there would be net inflation over that period. There was plenty of precedent for 30-year periods of high inflation in the recorded history of fiat currencies. By contrast, when has there ever been a recorded 30-year period of net deflation?

Part of my motivation for coming back to the issue of negative yields on 30-year bonds is that some participants of this forum seem to mistakenly believe that if yields remain positive but continue to decrease exponentially (e.g., continually halve), bond prices will continue to increase without bound. That is simply not true. For each halving in yield, the corresponding price increase gets smaller and smaller until it eventually approaches zero. Unbounded increases in long-term bond prices eventually require negative yields. And negative yields on long-term bonds are (as far as I know) historically rare or even unprecedented.

So regarding 6 Iron's question in his OP, I do think there is a point beyond which the 25% LTT allocation ceases to have enough upside volatility to counter losses in the other PP assets. At the same time, though--and this may be the real answer to 6 Iron's question--if LTT yields ever get that low, the other PP assets will probably be poised to rise significantly since money always has to go somewhere. If it floods out of LTTs, at least some of it is likely to flood into stocks and/or gold. And that is why I will continue to own the entire 4 x 25% PP as a complete package.

[BearBones]

Part of my motivation for coming back to the issue of negative yields on 30-year bonds is that some participants of this forum seem to mistakenly believe that if yields remain positive but continue to decrease exponentially (e.g., continually halve), bond prices will continue to increase without bound. That is simply not true. For each halving in yield, the corresponding price increase gets smaller and smaller until it eventually approaches zero. Unbounded increases in long-term bond prices eventually require negative yields. And negative yields on long-term bonds are (as far as I know) historically rare or even unprecedented.

So regarding 6 Iron's question in his OP, I do think there is a point beyond which the 25% LTT allocation ceases to have enough upside volatility to counter losses in the other PP assets.

Thanks for pursuing this. I am interested in the discussion, since this is the only reason that I have not fully embraced the PP, and I maintain a separate VP without LTTs. But this may be very foolish.

Three questions:
1. Does anyone see a flaw in 6 Iron's original question or Tortoise's response?
2. Does the movement in LTT yields respond to market conditions fairly linearly, or does it become increasingly difficult/improbable for yields to approach zero. In other words, it would seem to me that the market conditions causing a movement in yields from 3 to 4% would be less severe than to move from 3 to 2. And the conditions for moving from 2 to 1 even more severe and improbable, as if it were an asymptotic curve approaching but never reaching zero.
3. How would LT yields ever go negative? Why would anyone choose LTTs over cash or T-bills?

[moda0306]

BearBones,

I'll just try to answer questions 2 & 3.

2) Yes, I would think that it would be harder and harder for yields to drop.

3) I would only imagine that 30-years could go negative if short-term yields were even MORE negative, and were believed to stay there for some time.

[AdamA]

3) I would only imagine that 30-years could go negative if short-term yields were even MORE negative, and were believed to stay there for some time.

What do you think would be happening with gold in this situation?

[BearBones]

What purpose do LTT's serve in the PP?

Thanks, Clive. I do undertand the basic purpose of LTTs in the PP. But I still wonder if 6 Iron, Moda, and Tortoise are on to something, namely that the benefit of holding LTTs in the PP declines exponentially as the yield approaches zero. And the risk increases. So, as the yield of LTTs approaches 2, for example, why not steadily substitute STTs for LTTs? Alternatively, one could maintain a separate VP which is shifted more toward cash and short term bonds as the LTT yields decrease in the PP (which is the strategy have chosen).

This is not something I am particularly knowledgeable in, so I appreciate everyone's opinion.

Part of my motivation for coming back to the issue of negative yields on 30-year bonds is that some participants of this forum seem to mistakenly believe that if yields remain positive but continue to decrease exponentially (e.g., continually halve), bond prices will continue to increase without bound. That is simply not true. For each halving in yield, the corresponding price increase gets smaller and smaller until it eventually approaches zero. Unbounded increases in long-term bond prices eventually require negative yields. And negative yields on long-term bonds are (as far as I know) historically rare or even unprecedented.

BearBones,...
2) Yes, I would think that it would be harder and harder for yields to drop.

So,

[MediumTex]

Note that LT treasury yields were about where they are now at the end of 2008.  After they bottomed at the end of 2008 they promptly went back up into the mid 4% range...and then came right back down to late 2008 levels at the end of 2011.

The point is that one can ride yields up and down and make money rebalancing along the way without having to speculate about what would or wouldn't happen to the PP strategy as we got closer to 0% on the long end of the yield curve.

The problem is that at any point in time we don't know whether we are at a low in yields or have farther to fall.  A Japanese investor would probably be licking his chopsticks at the opportunity to buy 30 year Japanese bonds at the levels 30 year treasuries are currently at.

I wouldn't invest too much energy in trying to figure out at what point it's time to bail on LT treasuries.  We are already WAY below yield levels that many people never believed were possible.  If rates can go this low, why can't they go lower?  If rates rise, won't your other PP assets protect you?

If you are protected if yields rise OR fall, then why worry? 

[Tortoise]

I wouldn't invest too much energy in trying to figure out at what point it's time to bail on LT treasuries.  We are already WAY below yield levels that many people never believed were possible.  If rates can go this low, why can't they go lower?  If rates rise, won't your other PP assets protect you?

If you are protected if yields rise OR fall, then why worry? 

So if someone were to say, "Heads it's a draw, tails you lose" you'd be eager to make a bet?

That's precisely the situation that arises as LTT yields approach zero. We're not talking speculation here. We're talking mathematics.

- If yields are at 3%, you stand to gain a maximum of 90% if yields drop all the way to 0%.
- If yields are at 2%, you stand to gain a maximum of 60% if yields drop all the way to 0%.
- If yields are at 1%, you stand to gain a maximum of 30% if yields drop all the way to 0%.
- If yields are at 0.1%, you stand to gain a maximum of 3% if yields drop all the way to 0%.
- If yields are at 0%, you stand to gain nothing if yields stay flat at 0%. But guess what happens if rates rise? Heads it's a draw, tails you lose.

If one's response to the above is that yields can potentially go negative, then that leads directly into the key question I posed a few posts back: Can LTT yields go negative, and if so, what is the reasoning? And has a 30-year net deflation ever occurred in recorded history?

Please don't misunderstand; I'm not attacking the PP strategy. I've been 100% in the PP for over a year. I'm just kicking the tires because I think the PP can handle it and will be stronger because of it. Somewhere in the philosophy underlying the PP there must be a good, logical answer as to why one should continue to keep 25% in LTTs even after the LTT croupier announces, "Heads it's a draw, tails you lose. Place your bets!"

[MediumTex]

I wouldn't invest too much energy in trying to figure out at what point it's time to bail on LT treasuries.  We are already WAY below yield levels that many people never believed were possible.  If rates can go this low, why can't they go lower?  If rates rise, won't your other PP assets protect you?

If you are protected if yields rise OR fall, then why worry? 

So if someone were to say, "Heads it's a draw, tails you lose" you'd be eager to make a bet?

That's precisely the situation that arises as LTT yields approach zero. We're not talking speculation here. We're talking mathematics.

- If yields are at 3%, you stand to gain a maximum of 90% if yields drop all the way to 0%.
- If yields are at 2%, you stand to gain a maximum of 60% if yields drop all the way to 0%.
- If yields are at 1%, you stand to gain a maximum of 30% if yields drop all the way to 0%.
- If yields are at 0.1%, you stand to gain a maximum of 3% if yields drop all the way to 0%.
- If yields are at 0%, you stand to gain nothing if yields stay flat at 0%. But guess what happens if rates rise? Heads it's a draw, tails you lose.

If one's response to the above is that yields can potentially go negative, then that leads directly into the key question I posed a few posts back: Can LTT yields go negative, and if so, what is the reasoning? And has a 30-year net deflation ever occurred in recorded history?

Please don't misunderstand; I'm not attacking the PP strategy. I've been 100% in the PP for over a year. I'm just kicking the tires because I think the PP can handle it and will be stronger because of it. Somewhere in the philosophy underlying the PP there must be a good, logical answer as to why one should continue to keep 25% in LTTs even after the LTT croupier announces, "Heads it's a draw, tails you lose. Place your bets!"

If 30 year yields reached 0%, then I would say move into t-bills for a while.

If 30 year yields reached .75%, I might say to trim LT bond exposure in the PP.

If 30 year yields reached 1.5%, I would probably say do nothing other than rebalance if you are near a rebalancing band.

At the current yield of around 3%, though, I don't think any change in LT bond exposure is called for.

Just my opinion, of course.