Modelling TLT in an Era of Rising Rates, part 2

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europeanwizard
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Modelling TLT in an Era of Rising Rates, part 2

Postby europeanwizard » Sun Jul 16, 2017 4:13 am

So Kbg posted about an article in a previous topic, and it got a follow-up named How to Play US Treasury ETFs in an Era of Rising Rates.

I found it very interesting. I've been setting up an EU PP, and bought iShares Euro Government Bond 15-30yr UCITS ETF (IBGL) and it hasn't been sitting well with me.

So I did a couple of calculations. I'm not a smart mathy kind of guy, so this is all very simple Excel stuff. First I looked up the volatility of the EURIBOR interest rate; since its inception it has moved anywhere between 0 and 2 percent yearly. Then I created a table that shows that if I invest EUR 1000 in 30 year bonds that have a 1% yield, and the interest moves 2 percent up, it kills 46% of the bonds value.

We have extremely low yields on EU bonds, so it seems to me that any change is going to be upward, not downward. And any upward change in interest rates will quickly decimate the bonds part of your portfolio. I don't think the current environment is what Harry Browne thought of.

From the article:
If an investor intends to hold a US Treasury ETF for an extended period of time, shorter duration instruments may be superior to long. Returns may be higher (unlike in the past) and volatility will almost certainly be lower.

Have others moved from 30-year to 7-15 year bonds?
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Re: Modelling TLT in an Era of Rising Rates, part 2

Postby ochotona » Sun Jul 16, 2017 7:34 am

In all fairness, you need to consider cash and bonds as one block, even so, the results aren't pretty.

I am a big proponent of cash + 10 year Treasury, average duration about 5 years.
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Re: Modelling TLT in an Era of Rising Rates, part 2

Postby Tyler » Sun Jul 16, 2017 10:14 am

A few things to think about:

1) Modeling a 15-30 year bond fund by only looking at 30-year rates is inaccurate and will exaggerate the volatility of the fund. You need to account for the laddering in between.

2) The amount that bonds change in value due to a 2% rise in value is not constant. It may fall 46% moving from 1% to 3%, but the next 2% rise will not have the same level of effect.

3) You shouldn't assume that the rates will consistently go up. It never works that way, and intermediate drops even in a long-term upward trend can present plenty of profitable rebalancing opportunities.

4) You need to account for the interest payment in the fund return. When rates rise, your fund pays out more. So it's not all bad.

5) Its important to look at the portfolio as a whole rather than over-analyze each individual asset. If you hate bonds at current interest rates, you should probably also hate stocks at current valuations. But combining two bitter assets can create a more desirable result than any one asset in isolation. You evaluate the cake by tasting the final product, not by trying separate spoonfuls of sugar, flour, and eggs.
PortfolioCharts.com : a picture is worth a thousand calculations
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Re: Modelling TLT in an Era of Rising Rates, part 2

Postby europeanwizard » Sun Jul 16, 2017 1:14 pm

Tyler wrote:A few things to think about

Great pointers which I didn't consider.

As for point 3, yes that's something. However I feel somehow "caught" because I'm reading pretty horrible things in the news, and here on the forums as well.

This stuff just drives me nuts: European bonds rebound as ECB official say markets misjudged Draghi.

What is noise, and what is signal?
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Re: Modelling TLT in an Era of Rising Rates, part 2

Postby ochotona » Sun Jul 16, 2017 4:32 pm

Tyler wrote:3) You shouldn't assume that the rates will consistently go up. It never works that way, and intermediate drops even in a long-term upward trend can present plenty of profitable rebalancing opportunities.


We're all going to end up as bond traders... :(
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Re: Modelling TLT in an Era of Rising Rates, part 2

Postby thisisallen » Sun Jul 16, 2017 8:46 pm

ochotona wrote:In all fairness, you need to consider cash and bonds as one block, even so, the results aren't pretty.

I am a big proponent of cash + 10 year Treasury, average duration about 5 years.


Why is it necessary to consider cash and bonds as one block?
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Re: Modelling TLT in an Era of Rising Rates, part 2

Postby Mark Leavy » Mon Jul 17, 2017 9:27 am

thisisallen wrote:
ochotona wrote:In all fairness, you need to consider cash and bonds as one block, even so, the results aren't pretty.

I am a big proponent of cash + 10 year Treasury, average duration about 5 years.


Why is it necessary to consider cash and bonds as one block?


Not necessary, but a worthwhile mental model.

Cash and Bonds are all on a continuum of duration, yield, interest rates, etc. It's a smooth operator.

If you lump them all together, you get one yield/duration number. That is just math.

On the other hand, you can make an idealogical decision to separate them and call cash liquid and bonds something less liquid. That has some value. But it is religion, not math.
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Re: Modelling TLT in an Era of Rising Rates, part 2

Postby Desert » Mon Jul 17, 2017 1:54 pm

Mark Leavy wrote:
thisisallen wrote:
ochotona wrote:In all fairness, you need to consider cash and bonds as one block, even so, the results aren't pretty.

I am a big proponent of cash + 10 year Treasury, average duration about 5 years.


Why is it necessary to consider cash and bonds as one block?


Not necessary, but a worthwhile mental model.

Cash and Bonds are all on a continuum of duration, yield, interest rates, etc. It's a smooth operator.

If you lump them all together, you get one yield/duration number. That is just math.

On the other hand, you can make an idealogical decision to separate them and call cash liquid and bonds something less liquid. That has some value. But it is religion, not math.


:) True, true.
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Re: Modelling TLT in an Era of Rising Rates, part 2

Postby thisisallen » Mon Jul 17, 2017 2:26 pm

Mark Leavy wrote:
thisisallen wrote:
ochotona wrote:In all fairness, you need to consider cash and bonds as one block, even so, the results aren't pretty.

I am a big proponent of cash + 10 year Treasury, average duration about 5 years.


Why is it necessary to consider cash and bonds as one block?


Not necessary, but a worthwhile mental model.

Cash and Bonds are all on a continuum of duration, yield, interest rates, etc. It's a smooth operator.

If you lump them all together, you get one yield/duration number. That is just math.

On the other hand, you can make an idealogical decision to separate them and call cash liquid and bonds something less liquid. That has some value. But it is religion, not math.


Thx for the explanation.
In practice, is it that the person considering cash and bonds together has a different view of the PP? In other words, in the case of a person like Ochotona, who mentioned that he uses cash along with 10 yr bonds and so this combo has an average duration of 5 yrs., is his PP then

1. cash and bonds (25%)
2. stocks (25%)
3. gold (25%)
4. cash (25%)
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Re: Modelling TLT in an Era of Rising Rates, part 2

Postby Mark Leavy » Mon Jul 17, 2017 3:07 pm

The once and former King Melveyr spent some serious thought on the pluses and minuses of combining cash with bonds. The phrases to search for are "barbell" (cash and bonds separate) vs. "bullet" (cash and bonds combined as one asset).

https://www.gyroscopicinvesting.com/forum/viewtopic.php?f=1&t=3576
Here is his initial post - with comments by forum founders craigr and MediumTex

Here is his blog post on his personal website.
http://www.stableinvesting.com/2014/11/november-26-2014-bond-duration-as.html
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Re: Modelling TLT in an Era of Rising Rates, part 2

Postby buddtholomew » Mon Jul 17, 2017 3:40 pm

thisisallen wrote:
ochotona wrote:In all fairness, you need to consider cash and bonds as one block, even so, the results aren't pretty.

I am a big proponent of cash + 10 year Treasury, average duration about 5 years.


Why is it necessary to consider cash and bonds as one block?


When looking at the fixed income portion of the portfolio it is important to look at both Long and Short-Term treasuries as a whole.
Mixing the two investments together produces a duration closer to Intermediate Term bonds (loosely 7-8 year combined duration).
In other words, a 1% increase/decrease in interest rates would roughly result in a +/- 7-8% increase/decrease in this portion of your portfolio (4% overall).

Put things into perspective and its not so frightening after all...

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