Maximum Bond Upside

Discussion of the Bond portion of the Permanent Portfolio

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MachineGhost
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Maximum Bond Upside

Post by MachineGhost » Wed Jan 07, 2015 5:13 am

I may be rehashing a previous thread, but I'm wondering how much upside bonds have in terms of capital gains at current yields to reach 0%?  Since stocks are about 75% above where they need to be to reach a secular bear market low, I'm suddenly curious if bonds have enough upside juice left to offer complete protection.  Anyone?
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Re: Maximum Bond Upside

Post by Lang » Wed Jan 07, 2015 5:25 am

It depends on the maturity and the coupon rate. A rough approximation is given by duration- if the bond's duration is 5 years and YTM is 2%, then the capital gain on that bond will be roughly 5x2=10% if its YTM were to drop to 0%. I usually use quotenet.com to find such data.

To see the precise relationship between the bond's yield and its price, you can use a price/yield calculator, e.g. Fidelity's: https://powertools.fidelity.com/fixedincome/yield.do
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Re: Maximum Bond Upside

Post by MachineGhost » Wed Jan 07, 2015 5:55 am

Lang wrote: It depends on the maturity and the coupon rate. A rough approximation is given by duration- if the bond's duration is 5 years and YTM is 2%, then the capital gain on that bond will be roughly 5x2=10% if its YTM were to drop to 0%. I usually use quotenet.com to find such data.

To see the precise relationship between the bond's yield and its price, you can use a price/yield calculator, e.g. Fidelity's: https://powertools.fidelity.com/fixedincome/yield.do
Looks like its roughly 40-50% upside gain left.  17 * 2.5% = 42.5% or the calculator shows it around 50% extrapolated.  That's very interesting!  There's not actually enough juice left.  So long as it doesn't happen all in one year, although I'm not sure how rebalancing into even lower yields along the way would improve the situation.
Last edited by MachineGhost on Wed Jan 07, 2015 6:01 am, edited 1 time in total.
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Re: Maximum Bond Upside

Post by Lang » Wed Jan 07, 2015 7:37 am

That's how it is everywhere. Some countries, like Canada and the UK, have recently issued ultra-long 50 year government bonds. These have higher duration than 30 year bonds and therefore carry more "juice" within them.

There was some talk last year that the US Treasury might issue ultra-long bonds, but as far as I know, this hasn't happened so far. Some US Corporates, such as Microsoft and Ford, have recently issued ultra-long bonds. But from what I see, almost all of these bonds are callable, so their effective duration is actually poorer than 30 year Treasuries.
Last edited by Lang on Wed Jan 07, 2015 7:45 am, edited 1 time in total.
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Re: Maximum Bond Upside

Post by Reub » Wed Jan 07, 2015 2:19 pm

Can't US bonds go past zero into negative territory too?
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Re: Maximum Bond Upside

Post by Reub » Wed Jan 07, 2015 2:31 pm

Have you noticed how today's bond "correction" was barely down at all even though we've had a massive move up preceding it? IMHO I would not rebalance out of long bonds unless or until you actually hit the rebalance band.....and not before that.
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Re: Maximum Bond Upside

Post by Alanw » Wed Jan 07, 2015 2:35 pm

US 10 year yield = 1.95,  Spain 10 year yield = 1.71. Where would you rather invest? We could have a long way to go.
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Re: Maximum Bond Upside

Post by moda0306 » Wed Jan 07, 2015 2:46 pm

WHAT?

When the hell did Spain's yields recover... weren't they like a Greece Jr. a couple years ago?
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Re: Maximum Bond Upside

Post by Alanw » Wed Jan 07, 2015 2:52 pm

Just checked Euro bond yields on CNBC web site. UK = 1.6, Germany = .47, even Italy = 1.88. Go figure.
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Re: Maximum Bond Upside

Post by barrett » Wed Jan 07, 2015 3:22 pm

moda0306 wrote: WHAT?

When the hell did Spain's yields recover... weren't they like a Greece Jr. a couple years ago?
I think even when Spanish yields were "high" they were only at about 6%, no? Damn! I knew I should have gone long on Spain!

I am guessing that the fact these countries are part of the EU has some kind of mitigating effect on bond prices. Anyone care to explain if this is true?
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Re: Maximum Bond Upside

Post by MachineGhost » Wed Jan 07, 2015 11:30 pm

barrett wrote: I am guessing that the fact these countries are part of the EU has some kind of mitigating effect on bond prices. Anyone care to explain if this is true?
It is.  Germany subsidizes the irresponsible members.  Watch for Greece to flip the EU the bird and exit.  They really have no choice as some of the Greek are literally starving to death due to EU-imposed austerity.  Madness.

So I guess there is hope if the Treasury issues longer-duration bonds.  So 50-years at 1% would be equivalent to 30-years at 2.5%?  They could keep issuing longer and longer durations and keep pushing rates back to 0% over and over.  That sure sounds like a literal "pushing on a string" to me!

Yes, it seems obvious now Keynesianism is imploding around the world.  The weird thing is it seems to be a "soft default" except for Europe which has no printing press.
Last edited by MachineGhost on Wed Jan 07, 2015 11:37 pm, edited 1 time in total.
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Re: Maximum Bond Upside

Post by MachineGhost » Wed Jan 07, 2015 11:37 pm

Reub wrote: Can't US bonds go past zero into negative territory too?
Do we still get capital gains in negative yield territory?  It does make sort of sense because without a gold standard, something has got to give and it should be negative yields rather than a peg.
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Re: Maximum Bond Upside

Post by MediumTex » Thu Jan 08, 2015 1:03 am

If you look at TLT's biggest years, it has always been when rates were ultra low.

It's counterintuitive, but the largest fortunes in bonds have probably been made when rates were very low because the effect of each basis point move is amplified the closer you get to 0%.

I don't think that you realistically every get to 0% on a long bond on a sustained basis, but I think that you can easily bounce between 1% an 2% for many years, as Japan has done, and make a lot of money trading that range.
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Re: Maximum Bond Upside

Post by MachineGhost » Thu Jan 08, 2015 1:52 am

MediumTex wrote: It's counterintuitive, but the largest fortunes in bonds have probably been made when rates were very low because the effect of each basis point move is amplified the closer you get to 0%.
What do you mean?  It's not linear?  Is this related to the convexity issue?
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Re: Maximum Bond Upside

Post by MediumTex » Thu Jan 08, 2015 2:11 am

MachineGhost wrote:
MediumTex wrote: It's counterintuitive, but the largest fortunes in bonds have probably been made when rates were very low because the effect of each basis point move is amplified the closer you get to 0%.
What do you mean?  It's not linear?  Is this related to the convexity issue?
Of course it's not linear.

If bond yields go from 9.9% to 9.8%, it will trigger a smaller move in the bond price than if yields go from 2.4% to 2.3%.

Price moves are dramatically amplified as you get closer to 0%.

Look at the huge returns TLT has provided in its up years in the 2008-2014 period.  All of those returns were driven by 100-200 basis point moves in yield (basically bouncing around in the 2.3%-4.3% range).  You wouldn't see anything like those gains in a market where LT rates were fluctuating between 9% and 11%.
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Re: Maximum Bond Upside

Post by MachineGhost » Thu Jan 08, 2015 2:32 am

MediumTex wrote: Look at the huge returns TLT has provided in its up years in the 2008-2014 period.  All of those returns were driven by 100-200 basis point moves in yield (basically bouncing around in the 2.3%-4.3% range).  You wouldn't see anything like those gains in a market where LT rates were fluctuating between 9% and 11%.
I think I see what you're saying.  Are you saying that the leverage factor actually increases with lower yields so that you're actually making more dollars in absolute terms than at higher yields?  Because gains in percentages are useless if they don't match the losses of equites and/or gold in absolute dollar terms.
Last edited by MachineGhost on Thu Jan 08, 2015 2:34 am, edited 1 time in total.
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Re: Maximum Bond Upside

Post by MediumTex » Thu Jan 08, 2015 2:40 am

MachineGhost wrote:
MediumTex wrote: Look at the huge returns TLT has provided in its up years in the 2008-2014 period.  All of those returns were driven by 100-200 basis point moves in yield (basically bouncing around in the 2.3%-4.3% range).  You wouldn't see anything like those gains in a market where LT rates were fluctuating between 9% and 11%.
I think I see what you're saying.  Are you saying that the leverage factor actually increases with lower yields so that you're actually making more dollars in absolute terms than at higher yields?  Because percentage terms are useless if they don't match the losses of equites and/or gold in absolute dollar terms.
Yes.

For example, a drop in yield from 4% to 3% might result in a 25% increase in the price of a bond, but a drop in yield from 3% to 2% might result in a 30% increase in the price of the same bond.

Picture a game of tennis turning into a game of ping pong.  It doesn't get boring--it gets more exciting because the game gets much faster as the effect of small moves becomes much more important.
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Re: Maximum Bond Upside

Post by MachineGhost » Thu Jan 08, 2015 2:53 am

MediumTex wrote: For example, a drop in yield from 4% to 3% might result in a 25% increase in the price of a bond, but a drop in yield from 3% to 2% might result in a 30% increase in the price of the same bond.

Picture a game of tennis turning into a game of ping pong.  It doesn't get boring--it gets more exciting because the game gets much faster as the effect of small moves becomes much more important.
Wow, that's really pretty cool!  So in theory bonds should infinitely never reach zero?  How is it that Switzerland can be having negative yields then?  If all it takes is a bidder bidding yields down to negative, how does that affect your premise?
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Re: Maximum Bond Upside

Post by Lang » Thu Jan 08, 2015 5:56 am

There are two factors in play here:
1. When the yield on a bond decreases, its duration increases. When its yield increases, its duration decreases. Therefore, like MediumTex said, a drop in yield from 2.4% to 2.3% will have a bigger impact on a bond's price than a drop from 9.9% to 9.8%.
2. Two bonds with the same maturity and the same yield but with different coupon rates will have different durations. The one with a lower coupon rate will have higher duration. As T-Bond yields go down, new T-Bonds are issued with a lower coupon rate (equal to the current market yield for a bond with the same maturity). For example, in July 2012, when yields on Treasuries went extremely low, several 30 year bonds were issued with a 2.58% coupon rate.

Here's a simple example: you have two bonds, A and B, both with a 30 year maturity and a 3% annual coupon rate. Bond A trades at a YTM of 2.5% and bond B is trading at a YTM of 1%. Then bond A has a duration of 20.45 years and bond B has a duration of 22.22 years (I used an online calculator to get this). But it is not true that bond B has more "juice" than bond A. Bond A can potentially drop from a 2.75% yield to 0% and this will result in a capital gain of around 20.45x2.75=56.24% (actually higher, because the duration approximation always underestimates). Bond B, on the other hand, can potentially drop from a 1% yield to 0% and this will result in a capital gain of around 20.22x1=20.22%. So bond A has a higher potential capital gain as well as a smaller potential capital loss (if the yield goes up by 1%, the bond's price drops roughly by its duration).

Imagine it like this- you bought a 30 year bond for 100$ and you intend to hold it until maturity. Each year you get 1$ (coupon payments) and in the last year you also get your 100$ back (the principle). If the bond's price were to rise to 130$ then there would be no point in buying it, because the total gain from it would be:

-130+1x30+100=0

So the bond's price should never rise above 130$. Actually this is a bit imprecise because you may be able to reinvest the coupons into the same bond at a more attractive price, or maybe into an entirely different bond. This way you might get a tiny positive gain. But if you spend the coupons as you receive them then this doesn't matter to you.
If the bond's price is above 130$ then it effectively has a negative yield. If you manage to find a sucker who will buy the bond from you for 140$ then yay, you just got 10$ in profit. ;) But why would anyone do such a thing? Well, I guess one might do that if he thinks he can find a greater sucker who will buy the bond from him for 150$, but my gut feeling tells me that Treasury bonds aren't going to become a Ponzi scheme. ;D

Regarding the negative yields in Switzerland, this is really strange and I have no explanation for it. In Europe it sort of makes sense because the ECB imposed a penalty rate of 0.2% on commercial bank reserves held in its deposit facility. So a bond with a yield of -0.1% looks relatively attractive (smaller loss). But really, no idea about Switzerland.
Last edited by Lang on Thu Jan 08, 2015 6:05 am, edited 1 time in total.
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Re: Maximum Bond Upside

Post by Reub » Thu Jan 08, 2015 8:34 am

MediumTex it is great to read your posts again and I hope that you're doing well!
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Re: Maximum Bond Upside

Post by Lang » Fri Jan 09, 2015 1:17 am

I just got an idea. If you want Treasury bonds to give you more upside, look for "stripped" versions of them. A zero-coupon 30 year bond will respond more strongly to changes in yield than an ordinary 30 year bond.
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Re: Maximum Bond Upside

Post by MediumTex » Fri Jan 09, 2015 1:32 am

Lang wrote: I just got an idea. If you want Treasury bonds to give you more upside, look for "stripped" versions of them. A zero-coupon 30 year bond will respond more strongly to changes in yield than an ordinary 30 year bond.
Use EDV for convenience.
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Re: Maximum Bond Upside

Post by Austen Heller » Sat Jan 10, 2015 3:38 pm

MachineGhost wrote: Looks like its roughly 40-50% upside gain left.  17 * 2.5% = 42.5% or the calculator shows it around 50% extrapolated.  That's very interesting!  There's not actually enough juice left.
My calculations show approximately the same result.  Starting with today's 30-yr Treasury yield (2.53%), here is what the bond is worth as the market yield changes:

Image

If we are following Japan's playbook, then the 30-year could conceivably fall to their current yield of approx. 1%, which would give you an upside price gain of 40%.  On the other hand, if the yield goes back to 4% where it was last year in Jan 2014, the price drops 25%.  Who knows which direction yields are headed?  If I was forced to guess, I'd say they're going lower, that's the global trend.

It is interesting that the yield on the 30-year has gotten so low.  At 2.5%, you can almost get the same yield from a 5-yr CD, although with a much different risk profile. 

I have been taking the alternative 'bullet' approach of putting my bond+cash holdings together into a much larger position of shorter-term Treasury bonds.  The 5-year bonds give you decent yield (1.5%) plus weak deflation protection. You also get potential capital gains from 'riding the yield curve', since the yield curve is steep here; this is something you don't get from the 30-year bond, since the yield curve is pretty much flat there.  Of course, the yield curve is not static, so it's hard to make long-term investment decisions based on it's current shape.

Just for fun, I plotted the bond price changes for even lower starting bond yields, shown by the red dots.  Even if bond yields drop to the Japan level of 1%, you can still make 14% as the yield drops to the even lower Swiss level of 0.5%.

Image
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Re: Maximum Bond Upside

Post by barrett » Sat Jan 10, 2015 4:34 pm

Austen,

Thanks for posting that! Great info to have & much appreciated.
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Re: Maximum Bond Upside

Post by MachineGhost » Sat Jan 10, 2015 11:00 pm

Austen Heller wrote: I have been taking the alternative 'bullet' approach of putting my bond+cash holdings together into a much larger position of shorter-term Treasury bonds.  The 5-year bonds give you decent yield (1.5%) plus weak deflation protection. You also get potential capital gains from 'riding the yield curve', since the yield curve is steep here; this is something you don't get from the 30-year bond, since the yield curve is pretty much flat there.  Of course, the yield curve is not static, so it's hard to make long-term investment decisions based on it's current shape.
Excellent charts, thanks!

I have done similar with my duration risk because I'm looking at it from a long-term risk vs reward perspective (and because trendfollowing didn't work during the bear market).  But the problem with this approach is you lose the hedging potential.  If I recall, T-Bonds were up about 22% last year even though equities didn't correct.  If they had and you had a much lower duration, you would have taken on portfolio losses that the HBPP would have not.  This is a source of concern to me because I have certain Prosperity exposures that are not immediately liquid to sell in terms of negative trendfollowing (which also has its own emotional pitfalls just as buy and hold does).

Of course, the answer just came to me...  you definitely need to risk level the PP if you're going to lower the duration.  Fortunately, volatility seems to correspond to duration very well.
Last edited by MachineGhost on Sat Jan 10, 2015 11:04 pm, edited 1 time in total.
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