Long T-Bond Trading

[moda0306]

When diving into my EE-bond LTT substitution, I got thinking about the nature of the yield curve.  It's very often relatively flat, but with a slight upward slope, with I believe a ST/LT average differential of about 1%-1.5%.  If one though that gap would persist, all things being equal, it might be somewhat fun in a VP (in a tax-deferred account, of course), to play the game a bit.  If the yield curve appears especially steep, buy on the long, long end... if the yield curve is inverted, buy on the short end, but maybe with enough duration to have some "price bite" when yields drop... I'm thinking maybe a 3, 5, or maybe even 7 year, hoping that the natural yield curve is going to pull those yields down.

One other thing I noticed was that from sometime in mid-2008, the yield curve, while even more positively sloped than usual, actually had 20-year bonds at a higher rate than 30-year bonds.  I don't know why this is, because the rest of the yield curve was very steadily sloping upwards.

At year-end, 3 month rates were at .11%, 20 year rates were at 3.05%, and 30 year rates were at 2.69%.  That means, in a sharply positive sloping yield curve, you could get a .36% interest rate benefit on 20-year bonds vs 30.  Anyone else really surprised by this?  Now I know PP'ers hate to tinker, and this would have been a natural selling (not buying) point for LTT's, but I wonder if it would have been worth shortening the duration of your average LTT holding (especially if you didn't actually reach a rebalancing band by the end of 2008).  I don't think, during a sharply-positive sloping period on the yield curve and sub-3% interest rates, that I could have accepted holding a 30-year at a .36% penalty over a 20-year.  But that's probably the PP tinkerer in me trying to get out.

I just feel like irrespective of where we feel like rates may go, the yield curve has a tendency to revert to predictible means over time (not too unlike the PP itself, this is based on pretty solid macroeconomic fundamentals), and one could use the knowledge of that curve to play in their VP a bit.

[Greg]

That does seem a bit odd that 20 years at one point would be paying out a higher interest rate than 30 years. Now for this situation, correct me if I'm wrong, but were both of these 20 and 30 year bonds sold at auction with 20 year bonds having a higher interest rate? If so, I find that confusing. Otherwise 30 year bonds could be higher if interest rates started climbing if the 20 year bond was actually an aged-30 year bond.

On the plus side:
1.) this is the Variable Portfolio, so if you like to tinker, than tinker away.
2.) You're tinkering with something that still is "safe" in PP'ers eyes I would think. You're not buying a highly leveraged emerging mortgage bonds without call protection (just making things up) so it might not be too bad to potentially tink.

[moda0306]

Maybe I'm misinterpreting or wrong in my assumptions... isn't the yield curve historically quite often slightly upward sloping?

[MediumTex]

Maybe I'm misinterpreting or wrong in my assumptions... isn't the yield curve historically quite often slightly upward sloping?

Yes, though an inverted yield curve is supposed to be a signal of an upcoming economic downturn.

There are lots of theories on what drives changes in the shape of the yield curve.

[moda0306]

MT,

That's why I believe one could have some VP fun "riding the yield curve" as Clive puts it, buying into "lowish" duraton bonds that are short in duration enough to be more effected by the short end of the yield curve, but long-dated enough to give you nice gains when interest rates drop.

Moreso, though, opportunity could be identified on the long end of the yield curve, like in late 2008 when 20 year bonds were yielding quite a bit higher than 30's, even with strongly positively sloped yield curve... Not that treasuries were "the thing to own" at that point, but it would have been a good way of keeping a VP full of real estate & stocks relatively safe to toss some 20-year treasuries in there.

I tend to think that 20-30 years out is far enough out that the market just guesses as to what the yield curve will be based on the direction of the more-predictable years 5-10 durations or something.  I really have no idea why such a sharply positively sloped yield curve (almost 3% spread) would have had 20's be such a better deal than 30's.

Then again, that probably would have been a good time to buy some EE's (as a youngster) to protect against a snap-back in interest rates.

[moda0306]

The shape of the yield curve if fundamentally driven by estimations for future levels of inflation, and those estimations change over time.

Clive,

I tend to think that interest rates are driven more by the level that the fed is expected to set them at, which is more correlated with whether we're in a recession or achieving economic prosperity.  While inflation is related to those, I tend to think inflation is a secondary consideration to the fed's gauge of economic activity.

So when we see 10 year bonds at 1.75%, that doesn't mean people think this is higher than what we'll achieve in terms of inflation over the next 10 years, but moreso what an average of what people believe the fed will keep short rates (3 months-1 year) at for the next 10 years, given where the economy's at in terms of capacity, unemployment, and growth.

[moda0306]

Clive,

I'm honored to have the Wonk-in-chief (no offense to Wonk) "bow" to my understanding, but your knowledge of technical investing, (which yield-curve riding would probably fall under) is second to none on this forum as far as I can tell, so don't concede too fast... I'm definitely not 100% sure that the fed truly controls rates to the tight degree we think they might (maybe like 96%).  I was just seeing if there was an opportunity to get into another discussion/argument that might hijack this thread into MMR/MMT  :D... I kid.  How much future rates are a prediction of some mix of inflation & economic growth probably depends on the fed chief at the time, so you're probably just as right as I am.

You might be right about oil predictions, but that's sure a lot of detail to be working into 20-30 year projections (especially deciding that somewhere around the 20-year mark, the problem will be solved.... now that's some detail for you)... You'd think that the bond market would make sure that there weren't giant (relative) opportunities like that, though, so my instinct tells me there HAD to be some long-term projections that the market was buying into.  If something brought it about, then something else made it go away, cuz the yield curve speed bump is gone, so what was the projection, why did it come about, and why did it go away??!!

This is one little mystery I'm curious to solve, because if these are truly just errors of the market (which would amaze me with millisecond-trades happening on wall-street), then this presents a large opportunity to have some fund (oops... freudian misspelling of "fun") with the bond market.  If there was some actual reason for it, I'd love to know what kind of analysis could lock down the largest bond market in the world into creating a hiccup in the far (most unpredictable) end of the yield curve... I mean this is the same market that barely blinked at the debt-ceiling debate... do they really agree on 20/30 year projections on growth/inflation that would create a bump like that?

[lazyboy]

I know less about this subject than 89.765% of the known universe. But, I thought a simple explanation for 2008 yield difference between 20 and 30 year LTT was simply that investors were panic buying into the longest term U.S. Treasuries available. Because in a panic who can predict how far and for how long the stock market will fall? So, you might as well buy the safest longest duration bonds available. And when they are bought in high numbers the yield goes down. Does this sound right or am I missing something?

[MachineGhost]

I know less about this subject than 89.765% of the known universe. But, I thought a simple explanation for 2008 yield difference between 20 and 30 year LTT was simply that investors were panic buying into the longest term U.S. Treasuries available. Because in a panic who can predict how far and for how long the stock market will fall? So, you might as well buy the safest longest duration bonds available. And when they are bought in high numbers the yield goes down. Does this sound right or am I missing something?

The political vernacular at the time was China was distorting the long end of the curve with its rampant buying (the Fed was accused also, I believe).