Flattening Yield Curve (10Y vs 30Y)

[buddtholomew]

At what interest rate variance does it make sense to reduce fixed income duration and hold the 10-year note over the 30-year bond? Speaking strictly from a traditional 4x25 HBPP perspective, do we still purchase the longest duration bond even if the curve is flattening?

10-Year Yield: 2.38%
30-Year Yield: 3.09%

Variance: 0.71%

[barrett]

Yeah, I am interested in this one as well. The reasoning I keep coming back to which favors holding onto the 30-year bonds is more or less as follows...

Let's say that the yield on the 30-year bond goes all the way down to 1.5% - 2% and stays there for a few years. That would only happen in a deflationary environment, correct? At those levels I would think that most people would be balancing out of LTTs and into something else. If that is the case, you would be holding fewer bonds but they would be giving you a nice real return. For example, most of the bonds I have are 3.75% issues maturing 11/15/43. If the economy is contracting, those payments would be beating inflation by a hefty margin.

I have put this argument forward one or two other times only to be told that we hold bonds for their volatility and not their interest payments. To me that seems like one of those statements that is true until it isn't anymore.

I'd love to get some other views on this as I can easily see myself jumping out of 30-year bonds and into 50% cash at a certain point. Holding cash when rates are extremely low would seem to me to be a better option than holding 10-years notes.

[buddtholomew]

I have put this argument forward one or two other times only to be told that we hold bonds for their volatility and not their interest payments. To me that seems like one of those statements that is true until it isn't anymore.

If we hold bonds for their volatility and there is a flattening yield curve, at what point does the 10 year and 30-year respond similarly enough to hold the shorter duration note? I too recall Harry Browne recommending that we sell treasuries with 20-years remaining and purchasing the longest duration bond available. Not sure if there were comments related to a flattening yield curve and whether the extra duration is necessary.

[dualstow]

Not to be a dogmatic follower of Harry, but it seems like this would have come up by now if we could just discard long-term bonds in the face of a flattening yield curve. That said, if long bonds really go down to 2% as in Barrett's scenario, I will probably get the hell out of LTTs.

[rickb]

Not to be a dogmatic follower of Harry, but it seems like this would have come up by now if we could just discard long-term bonds in the face of a flattening yield curve. That said, if long bonds really go down to 2% as in Barrett's scenario, I will probably get the hell out of LTTs.

... and get back in exactly when?

[dualstow]

Good question, rickb. I'll cross that bridge when I come to it, but I honestly don't know. If the ^TYX really went down to 2% for long enough, I would happily take profits but if it stayed low for years I'd feel stuck. Would probably have to abandon the pp and have something like a boglehead 60/40 portfolio, but with room for gold. Something like my vp. If it shot up to, say, 3.5% or 4% I would buy, because the yield alone would be worth something to me.

Even now, I wish treasuries would go up to 4% or 5% so that I could stock up, because they've done so well. I curse the assets that are low because they look like they won't recover, and I curse the assets that are flying high because I didn't have a chance to buy more.

[sophie]

I'd be hesitant to jump out of LTTs too soon.  I don't understand bonds well enough to understand differences in duration between a 10Y and 30Y bond when the yield curve is flattening.  There were periods in the past when yield curves flattened or reversed, and there was never a suggestion to shorten bond duration.  And the PP managed just fine through those periods.

The difference between 10 and 30 year bonds may not be much in absolute terms, but percentage wise it's pretty big yet.  Wait and see what happens but I doubt the yield curve is truly going flat.  One month T bills are still < 0.01.

[buddtholomew]

Appreciate the comments. I manage AVG duration (years required to hold the bond in the event of a one-time interest rate loss to break-even, including reinvested dividends) with additional cash, so I do not intend to sell long-term treasuries.

TLT has an AVG duration of 16.92 years, yield 3.05%
IEF has an AVG duration of 7.64 years, yield 2.33%

So, if yields increase/decrease by 1% across the yield curve, TLT would lose/gain 16.92% and IEF 7.64%. I guess that's all that matters for the PP.

The almost insignificant difference in yield between the two maturities (.72%) is therefore irrelevant, even if it falls to zero (flat curve). Is that what we are all saying?

[iwealth]

Yeah the yield is irrelevant, it's all about the asset price volatility which is related to the effective duration of the bond fund per your calculations. At least that's my understanding of it.

[Pointedstick]

Yeah the yield is irrelevant, it's all about the asset price volatility which is related to the effective duration of the bond fund per your calculations. At least that's my understanding of it.

True, but unlike stocks or gold, bonds have an upper bound. There's a point where the only volatility is down--at 0%. Of course, a good point to "get out" is somewhere between where we are now and there, and nobody knows what it is or when to get back in!

[dualstow]

..
unlike stocks or gold, bonds have an upper bound. There's a point where the only volatility is down--at 0%. Of course, a good point to "get out" is somewhere between where we are now and there, and nobody knows what it is or when to get back in!

It would be easier to get out if there were something to get into.
Stocks? They seem high.
Cash? Bleah. No yield.
Gold? I don't trust it to come back in my lifetime.

[Pointedstick]

..
unlike stocks or gold, bonds have an upper bound. There's a point where the only volatility is down--at 0%. Of course, a good point to "get out" is somewhere between where we are now and there, and nobody knows what it is or when to get back in!

It would be easier to get out if there were something to get into.
Stocks? They seem high.
Cash? Bleah. No yield.
Gold? I don't trust it to come back in my lifetime.

"Prettiest horse in the glue factory!" I believe MT was fond of saying.

And you know what? The PP is still doing fine despite it all. I feel bad for everyone else, though. The people who've piled into stocks, desperate for yield. The people cowering in cash, slowly getting eaten away by inflation. The people so afraid of hyperinflation evaporating their life savings that they're letting gold do it instead. Bad times.

[buddtholomew]

Don't forget that interest rates can go negative. At that point, I will be either happy, sad or both.

[Pointedstick]

Don't forget that interest rates can go negative. At that point, I will be either happy, sad or both.

And they could always make 0% look like a bargain by instituting "expiring currency."

[buddtholomew]

Don't forget that interest rates can go negative. At that point, I will be either happy, sad or both.

And they could always make 0% look like a bargain by instituting "expiring currency."

Thats insane. I couldn't even fathom such a concept.

[dualstow]

And they could always make 0% look like a bargain by instituting "expiring currency."

Thats insane. I couldn't even fathom such a concept.

That would be an outrage! That would be like....inflation!

[Pointedstick]

And they could always make 0% look like a bargain by instituting "expiring currency."

Thats insane. I couldn't even fathom such a concept.

I can't either, but there are some loonies on the far left who are advocating for it. An "anti-hoarding" measure, or some such populist crap. I see a lot of people in my generation falling for it. They're broke, saddled with seemingly endless student loans, and eager to find a man to stick it to. They're easy for prey for liberal class warfare.

[Tortoise]

[...] unlike stocks or gold, bonds have an upper bound. There's a point where the only volatility is down--at 0%. Of course, a good point to "get out" is somewhere between where we are now and there, and nobody knows what it is or when to get back in!

Yup. I think it would be very "anti-PP" to time the market when trying to decide when to get out of long bonds and when to get back in. (For example, "I'll wait to see what I feel like doing when interest rates get really low.")

By contrast, if one were to set firm interest rate bands ahead of time--say, get out at 2% and go back in at 3%--and adhere to those bands mechanically, it wouldn't be market timing since it is based purely on risk assessment and not on emotion or prediction. Similar to rebalancing bands.

I'm still not sure if I'm going to apply such bands to my long bonds or just hold on to them no matter what long-term rates do. It's a question I'm having a hard time answering for myself.

All-PP-all-the-time is a very tempting strategy due to its simplicity. I always liked Craig's "firewalls" analogy. Four 25% firewalls are pretty simple and elegant, are they not? Because no matter what happens to even the biggest stinker of an asset, it's always completely walled off from the other 75% of the portfolio.

[iwealth]

By contrast, if one were to set firm interest rate bands ahead of time--say, get out at 2% and go back in at 3%--and adhere to those bands mechanically, it wouldn't be market timing since it is based purely on risk assessment and not on emotion or prediction. Similar to rebalancing bands.

That's an interesting interpretation of what is and what is not market timing. And I agree. It's no different than using a 200-day moving average or any other indicator so long as you follow your plan mechanically and ignore emotion.

And backtests prove these systems work very well.

[dualstow]

... If the ^TYX really went down to 2% for long enough, I would happily take profits but if it stayed low for years I'd feel stuck.
...

I'd be hesitant to jump out of LTTs too soon.

Future brass plaque on my wall:
I made all of my money getting out of LTTs too soon.

[Kbg]

Volatility of the assets in the PP and how they interrelate...what doesn't suck in a PP at some point in time? If you are having a bond discussion open up three other discussions and all four miss the entire point and theory of the PP.

[buddtholomew]

Volatility of the assets in the PP and how they interrelate...what doesn't suck in a PP at some point in time? If you are having a bond discussion open up three other discussions and all four miss the entire point and theory of the PP.

True, but it makes for interesting conversation as we each have our favorite asset/s.

As I've said before I manage duration to 5.6 years. If interest rates rise by 1%, I expect LTT to fall by approximately 17% and CD's/Cash to gain a minimal amount. Looking at the FI portion of the portfolio as a whole, I only expect to lose approximately 6%. Fixed income duration will fall and I will be required to purchase additional LTT's to restore the duration to 5.6 years.

[Kbg]

Volatility of the assets in the PP and how they interrelate...what doesn't suck in a PP at some point in time? If you are having a bond discussion open up three other discussions and all four miss the entire point and theory of the PP.

True, but it makes for interesting conversation as we each have our favorite asset/s.

As I've said before I manage duration to 5.6 years. If interest rates rise by 1%, I expect LTT to fall by approximately 17% and CD's/Cash to gain a minimal amount. Looking at the FI portion of the portfolio as a whole, I only expect to lose approximately 6%. Fixed income duration will fall and I will be required to purchase additional LTT's to restore the duration to 5.6 years.

I'll stick with my statement, but I think there is a rather easy and tested method in reality to deal with it. Use a momentum sort between say TLT, IEV and SHY. Most likely you will either forfeit or reduce or cause a mistime of the shock dampening effect of TLT and stocks.  And, it will probably end up being a rotation between TLT and SHY in reality.

Which evil? Increased volatility or poorer performance.

[Reub]

It sure seems that when the four different lines on the chart compress is when we have our stock market crashes. Am I wrong? Thankfully the lines seem relatively spaced right now.

[barrett]

...what doesn't suck in a PP at some point in time? If you are having a bond discussion open up three other discussions and all four miss the entire point and theory of the PP.

Not sure how I missed this post the first time but it's a great one.

I guess I've never looked before, but I will admit to being surprised at how yields have generally not been that different for different maturity periods.

Yeah, me too (surprised, that is). Interesting point that Reub makes as well. It doesn't seem that the different lines coalesce exactly at the right time, but it sure seems to be the case for both 2000 and 2008. Looks like everything got pretty compact in 1996 without any major stock selloff.

The Reub Bond Indicator? RBI?