Why do bonds with low yields provide less insurance?

Discussion of the Bond portion of the Permanent Portfolio

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europeanwizard
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Why do bonds with low yields provide less insurance?

Postby europeanwizard » Thu Jun 29, 2017 8:15 am

So suppose I keep the usual 25% in my portfolio. I live in The Netherlands, so I buy the following, because that's the bond with the longest maturity date that my broker offers.
NL0000102234 NL 4.00% 2037/01/15

From what I understand, I now run the interest rate risk. This is clear and acceptable to me, because one doesn't hold bonds in the PP for yield or so I gather. Now as for my question: Here, MachineGhost says:

MachineGhost wrote:People forgot all too easily that the driver of the PP is Prosperity... everything else are HEDGES


This is clear to me. However, Craig then replies:

craigr wrote:But at 1% or lower long bonds provide little insurance


Why is this the case?
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Re: Why do bonds with low yields provide less insurance?

Postby Xan » Thu Jun 29, 2017 10:02 am

A bond's price moves inversely to its yield. So if the yield is extremely low, there's a low ceiling to how high the value of the bond can get.

My understanding is that there's debate about whether the yield can go negative. If it can, then the ceiling is higher.

And of course in a deflationary environment, your real return can still be pretty good, even with only small increases in the nominal value of your bonds.
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Re: Why do bonds with low yields provide less insurance?

Postby europeanwizard » Thu Jun 29, 2017 1:27 pm

Xan wrote:A bond's price moves inversely to its yield. So if the yield is extremely low, there's a low ceiling to how high the value of the bond can get.


So, the low-yielding bonds are a bad hedge for stocks, because the bond price can only get so high?

When stock prices would crash, where would investors then flock to, if not bonds?
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Re: Why do bonds with low yields provide less insurance?

Postby dualstow » Thu Jun 29, 2017 1:42 pm

Wizard, you probably already know this, but for others who come upon this thread:

Keep in mind that (A) Machine Ghost is very smart and very creative but not exactly a pp adherent and (B) I believe the context of Craig's comment was about extreme scenarios, and 30-year bond yields are already higher than they were then. I believe he also said he was reluctant to make the comment b/c he didn't want anyone blindly following what he was doing or thinking.

Sure, there's going to be massive interest rate risk with long bonds, always, but that's baked into the pp. Don't worry about that unless you scrap the pp and go 100% long bonds.
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Re: Why do bonds with low yields provide less insurance?

Postby Cortopassi » Thu Jun 29, 2017 1:50 pm

That is a good question. You'd look at a price/yield curve and think hey, this is asymptotic, going to infinity as it gets near zero.

Image

But I suppose not. Would be interesting to know, though.

If a bond yield drop from 2% to 1% (-50%) causes a bond to rise from 100 to 150 (50%), would a follow on drop from 1% to 0.5% result in a rise from 150 to 225, both 50% again?

Obviously it can't, because so many in the world have flipped to being negative interest rates.
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Re: Why do bonds with low yields provide less insurance?

Postby Pet Hog » Fri Jun 30, 2017 1:57 am

Cortopassi wrote:That is a good question. You'd look at a price/yield curve and think hey, this is asymptotic, going to infinity as it gets near zero.

Image

But I suppose not. Would be interesting to know, though.

If a bond yield drop from 2% to 1% (-50%) causes a bond to rise from 100 to 150 (50%), would a follow on drop from 1% to 0.5% result in a rise from 150 to 225, both 50% again?

Obviously it can't, because so many in the world have flipped to being negative interest rates.


Some rough calculations...

Consider a $1000 30-year bond with a 2% coupon. It pays out $20 per year, or $600 over the lifetime of the bond. So the value of the bond is $1600 after 30 years (ignoring compounding -- reasonable for such a low interest rate).

The day after you bought it, the yield plummets to 1%. Someone buying a $1000 30-year bond that day would be getting $10 a year for 30 years, or $300, giving a 1% bond a future value of $1300. In other words, it will be worth 1.3 times its cost in 30 years. That person might also consider buying your bond. It would be fair for the second buyer to pay you $1600/1.3 or $1230 for your bond. So that's how much your bond would be worth after the yield plummeted from 2 to 1%. It would go up 23%.

The next day the yield goes down further, to 0.5%. A third buyer of a $1000 bond enter the picture, expecting $5 per year for 30 years, or $150, making the future value of the 0.5% bond equal to $1150. At 1.15 times the cost, the third buyer might offer the second buyer $1300/1.15 or $1130 for the 1% bond. So the second bondholder would see a rise in bond price of 13%. (The third buyer might also buy your 2% bond at $1600/1.15 or $1390, again a 13% increase from the day before.)

If the yield goes to zero, $1000 today would be worth $1000 in 30 years. No growth. So a 2% bond having a future value of $1600 would have a price of $1600 today. A 60% increase over the price it was bought at a few days earlier -- not infinite. The 1% bond would have a price of $1300 and the 0.5% bond would have a price of $1150.

So:
2% to 1% causes the price to go up 23%;
1% to 0.5% causes the price to go up 13%;
0.5% to 0% causes the price to go up 15%;
1% to 0% causes the price to go up 30%.

Craig's comment about 1% 30-year bonds providing little insurance is borne out by these numbers. A stock market drop of 50% would not be compensated by a bond rise of just 30% (assuming yields don't go negative). A 2% bond could go up 60% in such a situation, so it would provide better insurance.
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Re: Why do bonds with low yields provide less insurance?

Postby europeanwizard » Fri Jun 30, 2017 2:37 am

Pet Hog wrote:2% to 1% causes the price to go up 23%;
1% to 0.5% causes the price to go up 13%;
0.5% to 0% causes the price to go up 15%;
1% to 0% causes the price to go up 30%.

Craig's comment about 1% 30-year bonds providing little insurance is borne out by these numbers.


The quarter has dropped :) Thank you very much for using easy to understand numbers, and forget about FV/PV calculations -- this enabled me to grab a notepad and just work along with your example.

Thus if I understand correctly, with lower bond yields, the Permanent Portfolio becomes riskier in the sense that it's more volatile. If the stocks portion sags, then the bonds part won't be able to provide as much help with lower yields.

I wonder if one could mitigate this problem by buying one of those bonds ETFs like IBGL. These carry French, German, and Dutch bonds, but also a bit of Italian and Spanish stuff (supposedly for yield). You'd then get more upside, but the bonds part of your portfolio becomes slightly more risky.
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Re: Why do bonds with low yields provide less insurance?

Postby barrett » Fri Jun 30, 2017 2:08 pm

europeanwizard wrote:Thus if I understand correctly, with lower bond yields, the Permanent Portfolio becomes riskier in the sense that it's more volatile. If the stocks portion sags, then the bonds part won't be able to provide as much help with lower yields.


Depending on the reason for a drop in stock prices (weaker currency, political upheaval, etc), gold might be the asset that comes to the rescue.
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Re: Why do bonds with low yields provide less insurance?

Postby Cortopassi » Fri Jun 30, 2017 2:17 pm

barrett wrote:
europeanwizard wrote:Thus if I understand correctly, with lower bond yields, the Permanent Portfolio becomes riskier in the sense that it's more volatile. If the stocks portion sags, then the bonds part won't be able to provide as much help with lower yields.


Depending on the reason for a drop in stock prices (weaker currency, political upheaval, etc), gold might be the asset that comes to the rescue.


Nah. Gold will never come to the rescue... >:(
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Re: Why do bonds with low yields provide less insurance?

Postby belgo » Fri Sep 08, 2017 3:30 am

I wonder if one could mitigate this problem by buying one of those bonds ETFs like IBGL. These carry French, German, and Dutch bonds, but also a bit of Italian and Spanish stuff (supposedly for yield). You'd then get more upside, but the bonds part of your portfolio becomes slightly more risky.


Hello, I am in the same boat as you being a European PP investor. My understanding of Harry Browne's PP is that it is crucial to have a Long Term Bond without any credit risk. Therefore I bought the 2046 Bund after a lot of hesitation given yield is so low. The idea is that your long term bond should offer you deflation risk protection while excluding any credit risk. It does look tempting to buy Italian and Spanish or French bonds as they offer a bit higher yield but we always see that in case of stress the spread with the German Bund immediately jumps. When there is a flight to quality money goes to the German Bund. The Dutch bond is fine in my opinion as an alternative to Germany but does not really offer much more yield. It is a strange situation with such low yields. But it is clear that many EU countries cannot afford higher interest rates; they cannot even avoid a deficit with interest rates close to zero. So I see the ECB continue to try and keep interest rates low for a lot longer than we think. Maybe one day it will all collapse and then I prefer to have the Bund and Gold to save us.
On a different topic, I was thinking of setting up a USD PP as a European investor but Harry was right again that the future cannot be predicted and that you should avoid currency risk: who would have thought the Euro would trade about 1.20 to the dollar? Back in January the specialists were predicting we would see EUR/USD parity soon...
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Re: Why do bonds with low yields provide less insurance?

Postby europeanwizard » Fri Sep 08, 2017 3:58 am

belgo wrote:My understanding of Harry Browne's PP is that it is crucial to have a Long Term Bond without any credit risk. Therefore I bought the 2046 Bund after a lot of hesitation given yield is so low. The idea is that your long term bond should offer you deflation risk protection while excluding any credit risk. It does look tempting to buy Italian and Spanish or French bonds as they offer a bit higher yield but we always see that in case of stress the spread with the German Bund immediately jumps.


Well, Browne advised those long term bonds in part because of their volatility. If you add up three high-volatility components thrown together in a portfolio, then the result is remarkably stable.

I don't think he foresaw LT bonds that offered < 1% yields, because although they can go down, they can hardly go up. And that is the problem, as I understood.

In the end, I shortened the duration, and got IBGM, a fund with 7-10 year duration bonds.
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Re: Why do bonds with low yields provide less insurance?

Postby Hal » Fri Sep 08, 2017 5:50 am

If they go for options like negative interest rates in the next crisis, bonds would look pretty good.....

But you are correct, I don't think HB would have envisaged the current situation.
Personally I would go with the minimum 15% allocation of long term bonds.

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