Gyroscopic Investing

TLT just broke through resistance. Dividend-adjusted $122.26 on 12/15/2008 and $122.32 on 12/12/2011. That's supposed to be very bullish.

It looks like treasury yields are now decisively below the levels they reached during the depths of the 2008 financial crisis.

I remember people saying back then that the 2008 lows in treasury yields were definitely the end of the multi-decade secular bull market for treasuries.

They were wrong.

MediumTex wrote: It looks like treasury yields are now decisively below the levels they reached during the depths of the 2008 financial crisis.

I remember people saying back then that the 2008 lows in treasury yields were definitely the end of the multi-decade secular bull market for treasuries.

They were wrong.

Agree with all. I am excited that I hold LTTs in the same way that I am excited when any of my assets appreciate. But as the yields lower, are not LTTs less capable of protection from future deflationary events? It seems intuitive to me that rates approach 0 only as an increasingly improbable asymptote. There has been discussion of rates turning negative, but why would one ever tie up $ for 30 yrs when one could get a better rate from cash under the mattress? So, the lower yields go, the more I am concerned that LTTs cannot hold up the PP in their favored economic condition.

Please educate me. My bond IQ is less than 70.

BearBones wrote:

MediumTex wrote: It looks like treasury yields are now decisively below the levels they reached during the depths of the 2008 financial crisis.

I remember people saying back then that the 2008 lows in treasury yields were definitely the end of the multi-decade secular bull market for treasuries.

They were wrong.

Agree with all. I am excited that I hold LTTs in the same way that I am excited when any of my assets appreciate. But as the yields lower, are not LTTs less capable of protection from future deflationary events? It seems intuitive to me that rates approach 0 only as an increasingly improbable asymptote. There has been discussion of rates turning negative, but why would one ever tie up $ for 30 yrs when one could get a better rate from cash under the mattress? So, the lower yields go, the more I am concerned that LTTs cannot hold up the PP in their favored economic condition.

Please educate me. My bond IQ is less than 70.

When you shrink a game of tennis you have a game of ping pong that is more, not less, exciting than tennis.  That's what happens as bond yields approach 0%.

It is true that yields must stop at 0%, but a lot can happen between here and there.

A person could make a fortune buying bonds that yield 3% and selling them when yields hit 2% and then buying them back when yields went to 3% and repeating the process.

I think that's what Japanese bond traders have been doing for years.

Low yields doesn't mean that there aren't tremendous opportunities in the bond market.

Another thing is that with non-callable bonds you have something called "positive convexity" which unfortunately is overlooked when people buy callable bonds. With positive convexity, the lower interest rates go the longer the duration becomes. When duration goes up, the price movements of bonds becomes much more volatile. In essence, as rates go lower the convexity makes them go up in price faster. When rates go up, the bond duration shortens and price movements are less pronounced.

This is an involved topic, but the reason like Tex said we see this big swings in bond prices is because the rates are so low. That will really exaggerate price movements. Here is a good primer on this topic:

http://www.investopedia.com/university/ ... dbond6.asp

BearBones wrote:

MediumTex wrote: It looks like treasury yields are now decisively below the levels they reached during the depths of the 2008 financial crisis.

I remember people saying back then that the 2008 lows in treasury yields were definitely the end of the multi-decade secular bull market for treasuries.

They were wrong.

Agree with all. I am excited that I hold LTTs in the same way that I am excited when any of my assets appreciate. But as the yields lower, are not LTTs less capable of protection from future deflationary events? It seems intuitive to me that rates approach 0 only as an increasingly improbable asymptote. There has been discussion of rates turning negative, but why would one ever tie up $ for 30 yrs when one could get a better rate from cash under the mattress? So, the lower yields go, the more I am concerned that LTTs cannot hold up the PP in their favored economic condition.

Please educate me. My bond IQ is less than 70.

At these really low low rates, I think the game becomes about selling bonds when the rate falls and buying them when it rises, and not so much actually using the bonds for income. If going from a 10% interest rate to a 9% interest rate makes your bond 10% more valuable, think about what rates falling to 1% would do to your 2% bonds.

MediumTex wrote: A person could make a fortune buying bonds that yield 3% and selling them when yields hit 2% and then buying them back when yields went to 3% and repeating the process...
Low yields doesn't mean that there aren't tremendous opportunities in the bond market.

So, for one moving into the PP over a few years (as I have been doing) or adding large amounts each year compared to that already invested (as in growth stage of career), would this bouncing be much of an opportunity? As I see it, this movement b/w 2-3% is mainly helpful if one is in a position to sell as well as buy.

craigr wrote: Another thing is that with non-callable bonds you have something called "positive convexity" which unfortunately is overlooked when people buy callable bonds. With positive convexity, the lower interest rates go the longer the duration becomes. When duration goes up, the price movements of bonds becomes much more volatile. In essence, as rates go lower the convexity makes them go up in price faster. When rates go up, the bond duration shortens and price movements are less pronounced.

This is an involved topic, but the reason like Tex said we see this big swings in bond prices is because the rates are so low. That will really exaggerate price movements. Here is a good primer on this topic:

http://www.investopedia.com/university/ ... dbond6.asp

Thanks. VERY helpful concept in swallowing investment in LTTs at such low yields (so this would be good for your book).

So, because of these exaggerated price movements, is there more deflationary protection in LTTs with 2.8% yield as compared to 4+, for example? Do I have this backwards?

BearBones wrote:

craigr wrote: Another thing is that with non-callable bonds you have something called "positive convexity" which unfortunately is overlooked when people buy callable bonds. With positive convexity, the lower interest rates go the longer the duration becomes. When duration goes up, the price movements of bonds becomes much more volatile. In essence, as rates go lower the convexity makes them go up in price faster. When rates go up, the bond duration shortens and price movements are less pronounced.

This is an involved topic, but the reason like Tex said we see this big swings in bond prices is because the rates are so low. That will really exaggerate price movements. Here is a good primer on this topic:

http://www.investopedia.com/university/ ... dbond6.asp

Thanks. VERY helpful concept in swallowing investment in LTTs at such low yields (so this would be good for your book).

So, because of these exaggerated price movements, is there more deflationary protection in LTTs with 2.8% yield as compared to 4+, for example? Do I have this backwards?

If you look at the 5 best years for LT treasury performance in the last 30 years, 3 of them were with yields at or below 4%.

Low yields are really no problem.  The tennis match turns into a ping pong match.  If anything, things get more exciting.

MT and Craig have mentioned the increased volatility of LTTs at low yields, which is good in a sense since the PP thrives on volatility, but that's only the bright side. There's also a dark side to low LTT yields: ever-shrinking maximum upside and ever-growing maximum downside.

If we assume, for the sake of argument, that LTT yields would never drop below 0% nor rise higher than about 15% (their all-time high in the early 1980s), here are the max upsides and max downsides at different yields:
30-Yr Yield (%)  Max Upside (%)    Max Downside (%)
---------------  --------------    ----------------
    5                150                -66
    4                120                -72
    3                  90                -79
    2.7                81                -81
    2                  60                -86
    1                  30                -92
    0                  0                -99

The numbers above don't include interest payments, which of course would tend to offset losses to some degree, but only partly--and it would take a number of years. So I think those numbers are a decent ballpark figure.

Coincidentally, the yield at which the max downside first begins to exceed the max upside is 2.7%--which just so happens to be the yield we're at. Time to put our thinking caps on.

Not trying to be a wet blanket here. I just think that when a primary goal is to minimize risk (I think the PP falls in that category!) it's prudent to consider best-case and worst-case scenarios, not just short-term volatility.

If adhering to the HBPP, we should not consider max upside and max downside.  That, to me, would be market timing.  Re-balancing to take profits when LTT yields fall and prices rise should be all we need to do.

Alanw wrote: If adhering to the HBPP, we should not consider max upside and max downside.  That, to me, would be market timing.  Re-balancing to take profits when LTT yields fall and prices rise should be all we need to do.

In order for a 25% LTT allocation to hit a 35% rebalancing band, LTTs have to rise in price by 40%. The lowest LTT yield that supports a 40% increase in bond price is 1.3%. At yields below that, your max upside drops below 40%, so your LTTs would be increasingly unlikely to hit that rebalancing band to take profits.

Maybe sub-1% LTT yields might call for narrower LTT rebalancing bands to ensure that at least some of the profits are captured?

Tortoise wrote:

Alanw wrote: If adhering to the HBPP, we should not consider max upside and max downside.  That, to me, would be market timing.  Re-balancing to take profits when LTT yields fall and prices rise should be all we need to do.

In order for a 25% LTT allocation to hit a 35% rebalancing band, LTTs have to rise in price by 40%. The lowest LTT yield that supports a 40% increase in bond price is 1.3%. At yields below that, your max upside drops below 40%, so your LTTs would be increasingly unlikely to hit that rebalancing band to take profits.

Maybe sub-1% LTT yields might call for narrower LTT rebalancing bands to ensure that at least some of the profits are captured?

If rates fall that low, do we need to abandon the standard PP and revise with a lower percentage in LTT's or just hold 50% in short term treasuries or cash?

Alanw wrote:

Tortoise wrote:

Alanw wrote: If adhering to the HBPP, we should not consider max upside and max downside.  That, to me, would be market timing.  Re-balancing to take profits when LTT yields fall and prices rise should be all we need to do.

In order for a 25% LTT allocation to hit a 35% rebalancing band, LTTs have to rise in price by 40%. The lowest LTT yield that supports a 40% increase in bond price is 1.3%. At yields below that, your max upside drops below 40%, so your LTTs would be increasingly unlikely to hit that rebalancing band to take profits.

Maybe sub-1% LTT yields might call for narrower LTT rebalancing bands to ensure that at least some of the profits are captured?

If rates fall that low, do we need to abandon the standard PP and revise with a lower percentage in LTT's or just hold 50% in short term treasuries or cash?

Reducing the LTT allocation in proportion to the yield in a low-yield environment is an idea that has been tossed around in other threads here, and another idea Clive proposed was to keep the 25% LTT allocation but reduce the bonds' maturity in proportion to the yield. (For example, one might set the maturity equal to 10x the yield, so a 2% yield would mean don't go longer than 20-year bonds, 1% yield would mean don't go longer than 10-year bonds, etc.). But I haven't yet seen a consensus on this; it's still very much up for debate.

Despite my concerns about super-low LTT yields, I think I would be extremely reluctant to deviate from the HBPP formula no matter how low yields go. Can you imagine divesting out of LTTs into STTs as yields descend into the sub-1% range, only to see LTT yields bounce back and forth between 0% and 1% for the next 10 or 15 years? (It could happen!) An HBPP purist who held onto the 25% LTTs would be capturing that volatility the whole time, whereas someone with 50% STTs would just be sitting on the sidelines collecting microscopic interest payments.

craigr wrote: Another thing is that with non-callable bonds you have something called "positive convexity" which unfortunately is overlooked when people buy callable bonds. With positive convexity, the lower interest rates go the longer the duration becomes. When duration goes up, the price movements of bonds becomes much more volatile. In essence, as rates go lower the convexity makes them go up in price faster. When rates go up, the bond duration shortens and price movements are less pronounced.

This is an involved topic, but the reason like Tex said we see this big swings in bond prices is because the rates are so low. That will really exaggerate price movements. Here is a good primer on this topic:

http://www.investopedia.com/university/ ... dbond6.asp

Thanks, craig, this is very helpful information. 

Tortoise wrote: Reducing the LTT allocation in proportion to the yield in a low-yield environment is an idea that has been tossed around in other threads here, and another idea Clive proposed was to keep the 25% LTT allocation but reduce the bonds' maturity in proportion to the yield. (For example, one might set the maturity equal to 10x the yield, so a 2% yield would mean don't go longer than 20-year bonds, 1% yield would mean don't go longer than 10-year bonds, etc.). But I haven't yet seen a consensus on this; it's still very much up for debate.

It seems to me that an optimal strategy could be devised given certain yields and certain durations to maximize upside and minimize downside.  The concept could be developed on the Japanese 10-year bonds and then validated on Treasuries.

Tortoise wrote: Coincidentally, the yield at which the max downside first begins to exceed the max upside is 2.7%--which just so happens to be the yield we're at. Time to put our thinking caps on.

Great analysis.  This is why I don't want yields to go any lower -- I just don't like that yawning void to the downside, no matter how strong the forces pulling yields down seem to be.

I think that MT is right on when he says that the LT bond game becomes a game of ping pong at the very low yields.  I just wish that I had ever seen the Permanent Portfolio play such a game of ping-pong before so that I could say definitively whether or not "it got game". 

BearBones wrote:Thanks. VERY helpful concept in swallowing investment in LTTs at such low yields (so this would be good for your book).

Thought about it, but it was too involved for the book. It could take most of the chapter explaining it and bonds are already (IMO) the most complicated asset in the portfolio due to the effects of interest rate, credit risk, currency, etc. Much more complicated to understand in many ways than other assets.

So, because of these exaggerated price movements, is there more deflationary protection in LTTs with 2.8% yield as compared to 4+, for example? Do I have this backwards?

At some point it will not be as good. But we are probably not there yet. Here is a bond convexity calculator to play with so you can see the effect of yield changes, duration and bond prices.

http://clem.mscd.edu/~mayest/Excel/ExcelStuff.htm

I would venture to guess that 60% or more of investment advisors don't understand bonds as well as avid PP followers do.

Love this...

US Interest Rates Have Made A Lot Of People Look Like Idiots Over The Past 10 Years

They dug up the best of the best blown interest rate calls over the past few years. Jim Rogers, Marc Faber, Bill Gross, Nassim Taleb, and many others make a nice appearance in the Bonus section too...

Gumby wrote: Love this...

US Interest Rates Have Made A Lot Of People Look Like Idiots Over The Past 10 Years

They dug up the best of the best blown interest rate calls over the past few years. Jim Rogers, Marc Faber, Bill Gross, Nassim Taleb, and many others make a nice appearance in the Bonus section too...

Dammit... Taleb made the list.  

Where's Peter Schiff on this thing?  Methinks within a year we need to declare him the next Art Laffer (who embarassingly, along with his utterly botched anti-housing bubble rant, has also claimed that our fiscal situation is going to push interest rates higher... that guy should just shut up at this point).

What bothers me isn't the idea of rates rising, so much as the certainty behind it.  I can respect any argument that at least takes an honest look at possible outcomes.

Gumby wrote: Love this...

US Interest Rates Have Made A Lot Of People Look Like Idiots Over The Past 10 Years

They dug up the best of the best blown interest rate calls over the past few years. Jim Rogers, Marc Faber, Bill Gross, Nassim Taleb, and many others make a nice appearance in the Bonus section too...

That's a pretty amusing infographic.  I'm not sure that the Faber call they used is quite fair since that appeared to be a call about "the next several years" but most of these are very clean hits.  The similar "nowhere to go" wording they all use is cute.

Anyway, glad we got that out of the way because it's time that you knuckleheads understood that at 2.7%, interest rates finally have nowhere to go but up.  Or down.  One of those, I'm nearly sure of it! 

Anyone ballsy enough to make the "interest rates have nowhere to go but down" counter-call?

does the saying "markets can stay irrational longer than you can stay solvent" apply here? (for those not doing a PP...of course)

Amazingly, we've had some great discussions here over the past year arguing why rates could have gone lower than they were back then. None of us knew for sure, but it sure was interesting to imagine the scenario... and here we are!

Fantastic thread.  The pointer to the page on convexity was much appreciated, although ... the curve described is a hyperbola (k/x, k = constant) not a Taylor series, which is not a curve formula.  It's a method of estimating the value of a function at zero using the first few terms of an infinite series that converges.  Most useful when you want to know the value of, say, an exponential but all you have is one of those little pocket solar calculators. That little snafu suggests to me that we need to find another source to verify the information.

The idea that bonds could become more volatile as yields drop lower never occurred to me, but it makes sense when you think about the price/yield relationship being a ratio rather than a linear correlation.  What happens to a ratio when the denominator approaches zero?  (Rhetorical question...to which we all know the answer.)  That idea, though, seems to fly in the face of the earlier suggestion that maximal upside is limited as yields decrease.  In fact, the idea of convexity predicts the opposite:  upside is if anything greater as yields approach zero.  Theoretically.

I guess there's only one way to find out, although perusing the equivalent of Fidelity's bond listing for Japanese or German bonds might be helpful.  Anyone know where that can be found?