Maximum Bond Upside

[craigr]

How much will we make when long bonds reach -1%?

Well, I went ahead and updated my previous chart to include negative yields.  The red dot represents current market conditions in the US, 30-year bond yield ~ 2.5%, price 100.  If yield drops to -1%, then price is 222.



*bond pricing calculations performed as described here:
http://www.investopedia.com/university/ ... dbond2.asp

The two words all Treasury bond investors should know: positive convexity.

In this blog post I discuss the concept along with a couple useful links:

https://web.archive.org/web/20160324133 ... y-and-you/

Links that discuss this concept further:

http://financetrain.com/bond-duration-a ... rt-1-of-2/
http://financetrain.com/bond-duration-a ... rt-2-of-2/

Now the next question is if I would personally buy long bonds in negative yield territory? No, I wouldn't. But as others have stated some institutional investors don't have an option.

[Pet Hog]

MediumTex provided a similar response here:

http://gyroscopicinvesting.com/forum/pe ... #msg140483

The message seems to be that changes in yield will lead to greater volatility in bond prices in low-interest-rate environments, and that this effect is a good thing for a PP.  I'm going to play devil's advocate and look at it the other way.  A change in bond value will have less of an effect on yields when interest rates are low than when they are high.  For example, a trillion-dollar change in the value of 30-year treasuries will have a much larger effect on the yield when interest rates are high than when they are low.  And it's this change in bond value that will affect the PP the most, regardless of the state of interest rates.  In other words, a low-interest-rate environment will lead to lower volatility in yields than a high-interest-rate environment (there's just less room to move), but their effects on the PP will ultimately be the same, so there is no need to worry about interest rates when implementing a PP.

Thoughts?

[Lang]

Switzerland's 50 year bond (to be precise, it's actually 48 years, due 2064) yield today fell to an all time low of 0.32%.

Yes, if you want to lend Switzerland money for the next 50 years, you're only going to get 0.32% interest per year.

[craigr]

Switzerland's 50 year bond (to be precise, it's actually 48 years, due 2064) yield today fell to an all time low of 0.32%.

Yes, if you want to lend Switzerland money for the next 50 years, you're only going to get 0.32% interest per year.

Clearly at some point investors should just not be buying bonds.

In the case of the Permanent Portfolio, you'd have a hard time getting me to buy long term bonds under 1%. I say this knowing that it breaks the model. But I'd also say that 30 year bonds paying under 1% the risk is just far too high. 50 year bonds under 1% is an absurdly bad deal as well. Investors would be better in cash.

[Lang]

By the way, the maximum bond upside of that Switzerland bond is now just 11%. Of course, this assumes that its yield won't go negative, but would you buy a 50 year bond with a negative yield?

[craigr]

By the way, the maximum bond upside of that Switzerland bond is now just 11%. Of course, this assumes that its yield won't go negative, but would you buy a 50 year bond with a negative yield?

No. I won't buy any long bonds under 1%.

At some point the risk is just too high. Even with negative yields it's not worth it because long-term negative yields are not stable and will revert.

It's an interesting discussion because obviously the Permanent Portfolio holds long-term bonds. But at some point dogma needs to relent to reality.

Personally if long term bond rates go below 1% in the U.S. I'll strongly consider selling them and going to cash for that allocation until they rise again.

If I'm in Europe staring at long term bonds that are negative, I'd probably sell them and hold cash.

This is all very new territory for investors and options start getting really limited.

[Reub]

Is there no history of LTT's being this low? If it has happened before how did it end?

[craigr]

Is there no history of LTT's being this low? If it has happened before how did it end?

In the 1930s they supposedly hit around 1% or so. But it's hard to compare eras like this to each other. The banking system back then was far different than today still being on a gold standard and of course economies were much different.

But regardless of the era, long term bonds paying less than 1% is never a good deal.

[ochotona]

If banks start charging retail consumers to hold their money, then probably all of us with cash should become microlenders, I'm serious. Or loan sharks, however you want to characterize it.

[dualstow]

Craig, your comments make sense to me, but they also make me want to sell my bonds "too soon." I don't get this feeling from stocks which I can hold onto during a bubble, and just wait for my 30 or 35% band. I'm kind of tempted to quietly sweep all my anti-timing words under the rug, exchange long bonds for two-year notes, and just suffer the low yields while counting my modest profits.

[quote="craigr"]

No. I won't buy any long bonds under 1%.

At some point the risk is just too high. Even with negative yields it's not worth it because long-term negative yields are not stable and will revert.

It's an interesting discussion because obviously the Permanent Portfolio holds long-term bonds. But at some point dogma needs to relent to reality.

Personally if long term bond rates go below 1% in the U.S. I'll strongly consider selling them and going to cash for that allocation until they rise again.

[ochotona]

Craig, your comments make sense to me, but they also make me want to sell my bonds "too soon." I don't get this feeling from stocks which I can hold onto during a bubble, and just wait for my 30 or 35% band. I'm kind of tempted to quietly sweep all my anti-timing words under the rug, exchange long bonds for two-year notes, and just suffer the low yields while counting my modest profits.

If we get into negative long interest rate territory, and it suddenly starts to get less negative, and the price of TLT or TLO crosses back under its 10 or 12 month moving average, you'll know it's time to get out, and you'd better not delay at that point.

[Reub]

Get out? PP holders don't get out. We hold all four assets because they work in tandem. I could see rebalancing but not totally getting out of one of the assets.

[ochotona]

Get out? PP holders don't get out. We hold all four assets because they work in tandem. I could see rebalancing but not totally getting out of one of the assets.

If interested in trend-following the PP, follow this thread.

[bedraggled]

Craig,  MT,

Is it possible to hold Treasuries in your hands, like a person can hold gold coins?  I reread the bond section in the book.  I did not see info on taking possession but I may have missed the statement.  Treasury Direct may be easier but, as was said about TLT being a bunch of "1"s and "0"s recently, not the safest route.

My father loved taking possession of stock certificates and even gave me some as a gift.  He did not want to leave them with the broker, despite assurances.

[All are welcome to jump in.  I had the authors' book at hand].

Thanks.

[Kriegsspiel]

If the yield on 30 year bonds is negative, how much more negative would the yield on cash be? How would you know we wouldn't have negative yields for years? You might lose out on not losing money while rates are negative.

[Lang]

Well, in Switzerland the 30 year rate is currently 0.25%, while the cash rate is -0.75%, so that's a 1% differential.

[dualstow]

Craig, your comments make sense to me, but they also make me want to sell my bonds "too soon."
~

If we get into negative long interest rate territory, and it suddenly starts to get less negative, and the price of TLT or TLO crosses back under its 10 or 12 month moving average, you'll know it's time to get out, and you'd better not delay at that point.

I'm just not a moving avg kind of guy, ocho. However, but when the author of the Permanent Portfolio update says he would personally sell his bonds if rates went negative, it definitely gives me pause.

(Kriegsspiel)
If the yield on 30 year bonds is negative, how much more negative would the yield on cash be? How would you know we wouldn't have negative yields for years? You might lose out on not losing money while rates are negative.

We don't know. But while bad yields suck, I could sleep at night vs wondering when the value of my holdings would be cut in half or even decimated.

I love long bonds because they do their job in the portfolio, but they are also the asset I feel queasiest about. The only thing that bugs me about gold is the markup and the anguish of transporting it physically in a city of thieves. The only thing that worries me about gold is the longshot probability that we will synthesize gold or mine it from an asteroid. That certainly doesn't keep me up at night.

The fact that we're supposed to sell bonds when they have twenty years left on them regardless of their value or what share of the pp they make up- that bothers me.

So as rates go downward, I've been hanging on to MT's metaphor about a game of tennis becoming a game of ping pong. It's just that every time I don't sell when TLT rises above 130, I feel regret when it comes back down.

Well, I'm not selling today. I'll just grin and bear it for now. The rise in bond value may turn out to be what keeps the pp's overall value up.

[Austen Heller]

It is interesting that people have different risk tolerance levels for bond yields, much like Bogleheads have different risk tolerance levels for stocks.  Some Bogleheads use 'age in bonds', or 'age-10' or just '60:40' stocks:bonds.  There is no right answer, it just depends on the individual.  However, with the PP, you are expected to be 25% long bonds, there is no alternative, or else you don't have a PP.

For myself, I bailed out of the long-term bonds back in 2014, when rates were around 3%, because I could not justify owning them at yields below that level, in spite of the fact that there is further upside potential as the rates drop.  3% is my 'magic number'.  For craigr, it sounds like 1% is his number, and I'm sure others don't have a number, they will hold the bonds no matter what.  If you have a 'magic number', what is your plan when the yields get there?

When I bailed out of the long-bonds, I combined the cash and LT bond positions into a one big position in short-to-intermediate bonds, with maturity around 2-5 years.  This is the steepest part of the yield curve, so there is some capital gains benefits as the bonds get closer to maturity (riding the yield curve).  So, if LT bond yields get below your 'magic number', consider this alternative approach.

[goodasgold]

Craig,  MT,
Treasury Direct may be easier but, as was said about TLT being a bunch of "1"s and "0"s recently, not the safest route.

Personally, I have had no problems with TD, but other people have.

But I do worry about some hackers in Russia, China or  ______  breaking into the TD system and sending my LTTs to a post office box in Nigeria. It seems that no computer system is safe nowadays, no matter how complex the security. And there is always the danger of an inside job, too. The NY Times recently had an article on a major upsurge in bank fraud carried out by crooked bank tellers with access to their employers' online system.

[Kriegsspiel]

It is interesting that people have different risk tolerance levels for bond yields, much like Bogleheads have different risk tolerance levels for stocks.  Some Bogleheads use 'age in bonds', or 'age-10' or just '60:40' stocks:bonds.  There is no right answer, it just depends on the individual.  However, with the PP, you are expected to be 25% long bonds, there is no alternative, or else you don't have a PP.

For myself, I bailed out of the long-term bonds back in 2014, when rates were around 3%, because I could not justify owning them at yields below that level, in spite of the fact that there is further upside potential as the rates drop.  3% is my 'magic number'.  For craigr, it sounds like 1% is his number, and I'm sure others don't have a number, they will hold the bonds no matter what.  If you have a 'magic number', what is your plan when the yields get there?

When I bailed out of the long-bonds, I combined the cash and LT bond positions into a one big position in short-to-intermediate bonds, with maturity around 2-5 years.  This is the steepest part of the yield curve, so there is some capital gains benefits as the bonds get closer to maturity (riding the yield curve).  So, if LT bond yields get below your 'magic number', consider this alternative approach.

So if yields on bonds went negative, you'd still own 50% bills, costing you even more to hold them?

I don't know man, I'd think that there isn't really any point in owning negative yield assets. Why not just own gold and stocks at that point, and wait until yields get back above 0?

[craigr]

Well yes I suppose there is a number for everyone. The bond number for me is 1% for sure. At that point I don't want them anymore. Under 2% I'm probably not buying them as a new investor, but if I already have them I'm not selling until 1% or so.

This is all highly subjective. But with bonds you kind of know what you're getting in terms of valuation. Stock P/E can change rapidly for a variety of reasons, but a long bond paying 0.50% is pretty much a known bad deal by most any measure I can come up with.

In terms of the Permanent Portfolio I know this would break the model, but sometimes dogma needs to step aside for reality. That reality for me is risk vs. reward for the bonds and the fact that at 1% it's just too rich for my blood and I'll go very short on the yield curve until they recover. But this of course puts investors in the unfortunate situation of asking: "When do I get back in?" And that I don't have an answer for yet. I'll cross that bridge if I'm forced to part ways with my bonds.

[Austen Heller]

So if yields on bonds went negative, you'd still own 50% bills, costing you even more to hold them?

I don't know man, I'd think that there isn't really any point in owning negative yield assets. Why not just own gold and stocks at that point, and wait until yields get back above 0?

In terms of the Permanent Portfolio I know this would break the model, but sometimes dogma needs to step aside for reality. That reality for me is risk vs. reward for the bonds and the fact that at 1% it's just too rich for my blood and I'll go very short on the yield curve until they recover.

As yields plummet, we will be faced with some tough questions.  If the yields are negative out to say, 10 years, as they are now in Japan, then it makes no sense as an individual investor to own them.  Then what do you do with your money?  I guess I would have to look at bank savings accounts or CDs, even though I'm leery of the FDIC.  Maybe by then, stocks will be so beaten down that they will seem like a great deal.

Even now, the 5-year US treasury is getting close to 1% (down from near 2% just a month ago), and it went as low as 0.5% just a few years ago.  My current plans to have a rolling ladder between out to 5 years would have to be re-thought as the yields get lower.

You can already feel the investor angst as yields are getting crazy low in Europe, best summarized in this post:

The fundamental issue with the EUR 30yr bonds 1% yield is this:
Does it reflect the market's view?
Is it a true market event or a central bank scam?

The answer should be clear.
It is not market participants buying deflation protection.
It is the central bank buying these bonds to the tune of 50 billion / month.

It is a scam. A farce. A hustle. A lie.
And I for one am not gonna be the bag holder.

http://gyroscopicinvesting.com/forum/pe ... #msg141005

[ochotona]

If the risk free rate is -1%, then a -0.5% yielding investment is better than the risk free rate? But who would invest in a -0.5% yielding investment? I can't get my head around any of it. Risk and reward would be gone. I think it would create more risk aversion, not less!

People can't see in the dark. A candle helps. 100,000 candlepower straight to your retina give you amazing sight, then! The logic kills me.

[craigr]

You can already feel the investor angst as yields are getting crazy low in Europe, best summarized in this post:

The fundamental issue with the EUR 30yr bonds 1% yield is this:
Does it reflect the market's view?
Is it a true market event or a central bank scam?

The answer should be clear.
It is not market participants buying deflation protection.
It is the central bank buying these bonds to the tune of 50 billion / month.

It is a scam. A farce. A hustle. A lie.
And I for one am not gonna be the bag holder.

http://gyroscopicinvesting.com/forum/pe ... #msg141005

Well certainly Pfanni has it right that central banks are a large cause of the problem. This is why I hold gold for when they blow everything up again.

Quantitative Easing was always a stupid idea. You can't make people spend money they don't have and governments spending money on their behalf is equally dumb.

Problem is a negative yielding bond is such a bad option on so many fronts that holding cash with a slightly worse negative yield is probably the best of the worst options.

[barrett]

I have to say that I am really happy to see super-low long-bond rates being discussed. In my mind I always think of this conundrum as "Pfanni's Dilemma" because he has been asking for feedback and not getting much. I know that belgo also had some related questions recently.

FWIW, I am also in the extra cash camp. As far as when to buy back in when/if rates rise, obviously that's an individual call, but I think we have to use our brains and, as Craig has stated, not rely on dogma. Right now with the rate on 30-year US debt being relatively high compared to what we see in Japan and Europe, I think we can reasonably guess that a further decline in rates here in the US is quite possible.

Lastly, I would probably go with a stutter-step approach somewhere between 2% and 1% and just hold fewer long bonds... not eliminate them altogether. Still pondering this though.