Upside volatility and long term bonds

[AdamA]

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

I have been fascinated by the discussion of negative yields on LTT's that pops up on this site from time to time.  

Does anyone think this is possible?  

I use a Treasury Only MMF right now and essentially accept a negative yield (because of the expense ratio).  I do it for safety and convenience.  

What if at some point people were willing to do the same with longer dated bonds?  Maybe moving out of LTT's would be a mistake at that point...

I realize that this is very far-fetched, but it's fun to discuss.

[Tortoise]

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

I have been fascinated by the discussion of negative yields on LTT's that pops up on this site from time to time. 

Does anyone think this is possible? 

Yes, I think it's possible. But I also think it would be historically unprecedented (or nearly so). I suppose there's a first time for everything, so why not for negative long-term bond yields? And if it's possible, I suppose an investor wanting to protect against the worst-case scenario might want to allow for it in his portfolio allocation. Then again, maybe not. Who knows.

I use a Treasury Only MMF right now and essentially accept a negative yield (because of the expense ratio).  I do it for safety and convenience. 

What if at some point people were willing to do the same with longer dated bonds?  Maybe moving out of LTT's would be a mistake at that point...

I realize that this is very far-fetched, but it's fun to discuss.

Accepting negative yield on short bonds can make sense if you expect danger ahead or deflation for the next couple of years. Accepting negative yield on long bonds requires a much gloomier outlook since it encompasses the next 30 years (!!).

But who am I to argue with reality? Even Japan hasn't yet experienced a 30-year period of net deflation, but if things continue along their current trajectory, they might eventually get there. And so may the U.S.

If 30-year yields go negative, I would imagine short bond yields would be even more negative, thus providing at least some relative incentive to invest in long vs. short. And if money 30 years from now is expected to have more purchasing power than money today has (i.e., net deflation over 30 years)... well then, maybe a slightly negative yield on long bonds wouldn't be such an unreasonable thing to accept.

[Lone Wolf]

I have been fascinated by the discussion of negative yields on LTT's that pops up on this site from time to time.  

Does anyone think this is possible?  

It's certainly an interesting idea but I just can't see it happening.  Once you get to 0%, you start competing with the physical currency that I keep stored in a titanium safe atop a craggy Himalayan mountain, guarded by a vicious drop bear.

Once the LT bonds have the same return as the physical cash, all they offer you is interest rate risk.  For that reason I think that trying to get LT bonds to truly hit 0% is like trying to get the "north" sides of two magnets to come together.

[AdamA]

It's certainly an interesting idea but I just can't see it happening.  Once you get to 0%, you start competing with the physical currency that I keep stored in a titanium safe atop a craggy Himalayan mountain, guarded by a vicious drop bear.

But that's kind of the point.  If you had a lot of money, you'd probably be better off taking a small negative return than you would be storing it in the Himalayas. 

I think a negative return on 30 year bonds would kind of be a polite form of default. 

[Lone Wolf]

But that's kind of the point.  If you had a lot of money, you'd probably be better off taking a small negative return than you would be storing it in the Himalayas.  

Dude, I have a drop bear.  This eliminates virtually all risk of theft.  :)

In the end, you're weighing the risk of theft against the risk of interest rates rising or inflation taking hold.  If an LT bond is offering both a negative rate and very high interest rate risk, physical cash (with no interest rate risk but a zero return) begins to look like a great investment.

In other words, that small negative return can work for short-term T-bills.  I can't see it holding up against physical money once you add in that huge pile of interest rate risk.  I think that it's just a bridge too far.  IMO, at least.

Edit: To expand just a bit, if you've got LT rates at -1%, I imagine that you'd lose something like half your money (or more?) if they climbed back up to just 2-3%.  It seems a lot safer to just rent a few safe deposit boxes and stuff cash in them.  The risk of loss (compared to the LT bonds, where you could realistically lose half or more of your money) would be minimal and the costs quite low.

It seems to me that this would create a real barrier to LT rates dropping below 0%.  Is there an angle I might be missing?

[AdamA]

Is there an angle I might be missing?

I have no idea, but I do like the drop bear idea.  Can you buy drop bear futures?

[MachineGhost]

Of course yields can go negative.  They're negative in Italy right now as people prefer the government to be holding their "money" instead of the banks and will pay for the privilege.

MG

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]

But that's kind of the point.  If you had a lot of money, you'd probably be better off taking a small negative return than you would be storing it in the Himalayas.  

Dude, I have a drop bear.  This eliminates virtually all risk of theft.  :)

What keeps the drop bear from stealing it?

It's not like you could just go ask for it back.

LoneWolf: Um, drop bear, can I have my money back?

Drop Bear: As a drop bear, you know what I'm capable of, right?  Do you know about the pain and destruction that flow from my ferocious teeth and claws?

LoneWolf: Yeah, I know about that...remember when I interviewed you for the security job?  The point is that I really want my money back.

Drop Bear: Ha!  I'll bet you do, but unless you've got a pack of chupacabras I don't know about, you're SOL.

[MachineGhost]

Deflation (that many confuse with disinflation) is when the absolute rate of change in inflation is negative, i.e. below 0.  In theory, you could have positive nominal interest rates along with a absolutely negative inflation rate though what kind of economic environment that would be escapes me at the moment.

MG

Can't deflationary periods extend to more than ten years? I don't know the correct definition/interpretation of deflation, but I do know that since 1992's in Japan they've had very low inflation or negative inflation % figures - yearly % values of :

[moda0306]

LW,

I think the only way to imagine LONG yields going negative is if short yields are even moreso.  That, and other assets were appearing very high risk in the face of a strong deflation.  Of course, then comes the question if you simply want to hold green-backs, but for some a 1%-2% nominal loss every year is worth it for SOME of their money to be stored from theft.

Can you imagine a billionaire trying to withdraw all his money?  Or at least the portion he wants in very low-risk assets?  Holding on to $1 Billion in cash is a lot scarier to some than putting it at the fed's bank, and having $990 Million at the end of the year.

I think most of us regular folks would start pulling cash out (as our bank accounts become riddled with "storage fees."  The rich don't have it so easy.

All in all, I think the real thing that would prevent long rates from going below zero is that once short rates (which are used to determine long rates based on future expectations) get beyond -2% interest, one would think that even billionaires would start figuring out how to get their money out, significantly decreasing the supply of loanable funds in the bank, and therefore keeping rates up from being too negative.

Negative rates are basically a wealth-storage fee that some are willing to pay for reliable, but decaying, storage.  Eventually that becomes too expensive.  I wonder if the gov't will ever try to limit our ability to hold physical cash, as they see it as 1) being obsolete, and 2) eliminates their ability to more easily manipulate the money supply and prevent deflation.  Limiting us to $100 bills is one thing... not much, but it keeps things bulky.  What if they cut it back to $10 bills?  What if the banks are limited in allowing cash withdrawals in excess of $x,xxx?  What if the gov't requires banks to set up 1% fees on withdrawals of cash?  What if they simply made a statement that it's illegal to hold more than $10k in greenbacks... that we have to get it into the banking system?

It seems to me that there are ways that the gov't could make it very difficult to hold cash as technology makes it more "obsolete" (or so they say).

[Lone Wolf]

What keeps the drop bear from stealing it?
...
Drop Bear: Ha!  I'll bet you do, but unless you've got a pack of chupacabras I don't know about, you're SOL.

Oh my word... outplayed by my own employee.  Perhaps there's some support group that Gus Fring and I can join.

When you start factoring in the costs of hiring a yeti with good references to manage the drop bear-based security staff, this stuff starts getting expensive.

Nice teeth on that drop bear, by the way.

I wonder if the gov't will ever try to limit our ability to hold physical cash, as they see it as 1) being obsolete, and 2) eliminates their ability to more easily manipulate the money supply and prevent deflation.  Limiting us to $100 bills is one thing... not much, but it keeps things bulky.
...
It seems to me that there are ways that the gov't could make it very difficult to hold cash as technology makes it more "obsolete" (or so they say).

You're right.  Such extreme measures as outlawing physical cash would change the entire calculus of what's possible with LT interest rates.  (Also, not a very pleasant world to imagine!)

[AdamA]

Deflation (that many confuse with disinflation) is when the absolute rate of change in inflation is negative, i.e. below 0.

I get what you're saying, but why is the distinction important? 

[AdamA]

...factoring in the costs of hiring a yeti with good references to manage the drop bear-based security staff, this stuff starts getting expensive.

I've had nothing but bad experiences with yetis, no matter how good their references have been. 

[D1984]

Clive,

I have two questions as regards your chart of the Japanese PP vs the 15-15-70:

One, why use the 15% US market (in yen) instead of a mix of say 60% EAFE ex-Japan in yen and 40% US market in yen for the 15% stock exposure (so 9% EAFE ex-Japan and 6% US TSM for a total of 15% )? Using only the US market seems kind of unusual; also why would a Japanese investor in 1975 (not knowing what was going to happen after 1989 because he obviously couldn't predict the future) choose all US stocks and no Japanese stocks (I could understand why an Icelandic or Zimbabwean investor might choose another nation's TSM as their stock holdings but Japan was a large 1st-world economy by this time with its own well-developed capital markets)? It's obvious in hindsight but in 1975 probably no one would have guessed the future for Japanese stocks was a huge bubble and a 20+ year deflationary slide.

Two, does your chart not include Nikkei dividends (I ask because it say "exc dividends" ) for the Japanese PP? If so that unfairly slants things against the PP; even a 0.75% or 0.90% dividend yield (I don't know what the Nikkei's yield was for each year but I can't imagine it was much less than that) means something in a deflationary environment.

[MediumTex]

...factoring in the costs of hiring a yeti with good references to manage the drop bear-based security staff, this stuff starts getting expensive.

I've had nothing but bad experiences with yetis, no matter how good their references have been. 

I swore them off after seeing "The Empire Strikes Back."

[AdamA]

...factoring in the costs of hiring a yeti with good references to manage the drop bear-based security staff, this stuff starts getting expensive.

I've had nothing but bad experiences with yetis, no matter how good their references have been. 

I swore them off after seeing "The Empire Strikes Back."

The last one I used turned out to be a Tibetan Blue Bear who spray painted himself white.  He tore up my garden and ran off with my wife.  Plus I got fined by U.S. Fish and Wildlife Services for employing an endangered species. 

[MediumTex]

I've had nothing but bad experiences with yetis, no matter how good their references have been. 

I swore them off after seeing "The Empire Strikes Back."

The last one I used turned out to be a Tibetan Blue Bear who spray painted himself white.  He tore up my garden and ran off with my wife.  Plus I got fined by U.S. Fish and Wildlife Services for employing an endangered species. 

Be glad you didn't get in trouble with the INS for employing an illegal alien.

I'm assuming the blue bear did not have a green card.

[AdamA]

Be glad you didn't get in trouble with the INS for employing an illegal alien.

I'm assuming the blue bear did not have a green card.

Texas law is actually pretty clear about this.  You may hire endangered, fictitious, or mythical species/creatures without a a green card or workers visa as long as you complain publicly about how it's ruining the economy and talking jobs from able-bodied Americans, especially if you're ever interviewed by the local news.  

[6 Iron]

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.

Tex, this was exactly the kind of feedback that I was looking for, but after seeing Tortoise's potential yields with rate drops, I would be inclined to modify your decision points up one rung (e.g., trim exposure at 1.5 %, and convert all to T bills at 0.75%). Something that I appreciate the most about the PP are the concrete bands of rebalancing and allocation that it prescribes. But while stocks and gold have a potentially limitless upside, long term bonds clearly do not, and I would prefer to make these decisions now, rather than in a panic, should need arise.

[BearBones]

Tex, this was exactly the kind of feedback that I was looking for, but after seeing Tortoise's potential yields with rate drops, I would be inclined to modify your decision points up one rung (e.g., trim exposure at 1.5 %, and convert all to T bills at 0.75%). Something that I appreciate the most about the PP are the concrete bands of rebalancing and allocation that it prescribes. But while stocks and gold have a potentially limitless upside, long term bonds clearly do not, and I would prefer to make these decisions now, rather than in a panic, should need arise.

Seems to me that the risk is progressively greater than the benefit as the yield approaches zero. So I'm thinking something more like:
>4%  25% LTTs
3.5-4  20% LTT/5%STT
3-3.5  15% LTT/10%STT
2.5-3  10% LTT/15%STT
2-2.5  5% LTT/20% STT
<2      25% STT

[AdamA]

Tex, this was exactly the kind of feedback that I was looking for, but after seeing Tortoise's potential yields with rate drops, I would be inclined to modify your decision points up one rung (e.g., trim exposure at 1.5 %, and convert all to T bills at 0.75%). Something that I appreciate the most about the PP are the concrete bands of rebalancing and allocation that it prescribes. But while stocks and gold have a potentially limitless upside, long term bonds clearly do not, and I would prefer to make these decisions now, rather than in a panic, should need arise.

Seems to me that the risk is progressively greater than the benefit as the yield approaches zero. So I'm thinking something more like:
>4%   25% LTTs
3.5-4   20% LTT/5%STT
3-3.5   15% LTT/10%STT
2.5-3   10% LTT/15%STT
2-2.5   5% LTT/20% STT
<2      25% STT

Who knows what kind of odd things would be happening in this bizarro world of negative long term interest rates...

I would stick to the 25% x 4 and see what happened.  Could be the investment world's big joke on us...we sell all our LTT's at 0% and 5 years later they're at -2%.  I mean, if they actually got to 0%, it wouldn't surprise me to see them get negative.  

[Gumby]

... [Deleted for inaccuracies]

[moda0306]

Gumby,

I am almost positive that chart is wrong.  I am On my phone now, though, so I dont have the flexibility to do a detailed analysis.  A zero coupon 30 year treasury would be worth a cumulative $1,000 after 30 years.  A 3% coupon bond will pay out $900 in its lifetime.  I have trouble believing there could be that big of a difference in price.

[Gumby]

So, which calculator is correct?

[moda0306]

Gumby,

Your calculator seems to be doubling the value of the bond for every halving in yield.

That would indicate, to me, a hypothetical "forever bond," definitely not a 30.