Gyroscopic Investing

It's been 20 years since I've tinkered with bond pricing and I'm trying to understand the interest rate risk of TLT at this point.  Figured I'd start here since you guys have been so helpful on other topics.  Today TLT was priced at about 123 and the yield on 30-years is something like 2.8%.

What would TLT go to if the 30 goes down to 2% or even 1%?  How about up to 4% or 5%?  Are there any good internet calculators or Excel templates for doing this sort of thing?

Thanks for your help!

Duration is the best way to measure a bond fund's volatility. Duration normally matches the amount +- it will move for each point in interest rate change.

For instance, TLT has a duration around 17 as of today. That means a 1% drop from here will have about a +17% gain in value. Inversely, a 1% interest rate rise from here could see a -17% drop in value from today. Cuts both ways.

Its interesting to see how the UK treasury 4% 2060 only goes up in price to £1.67 if yields fall to 1%. It currently costs £1.23. It sort of shows how falling rates might have much more scope for moving the gold price than they do for moving the bond price (but of course over the past few months the 50 year gilts have done very very well and gold has tanked).

stone wrote: Its interesting to see how the UK treasury 4% 2060 only goes up in price to £1.67 if yields fall to 1%. It currently costs £1.23.

That's a 36% duration. I wouldn't call the principal moving 36% for every 1% change in interest rates a small motion.

Triple B, I sort of meant that although 50 year UK treasuries have been great this year (gone from 91p to £1.23), there doesn't seem to be much scope for them doing as well for a long succession of years in the way that gold has over the past decade or stocks did during the 1980s and 1990s. Perhaps gold has a ceiling with the production cost being $800/ounce but I could sort of imagine the production cost creeping up. If in a few years time it costs $2000 to dig up an ounce of gold, perhaps gold might be at $4000/ounce but its hard for me to imagine LTT doubling in price.

I use Decision Moose to help me determine when to rebalance my PP. I think it is a useful method.

Reub wrote: I use Decision Moose to help me determine when to rebalance my PP. I think it is a useful method.

Do you have a formulaic way that you do this?  Do you rebalance if Decision Moose is in an asset that is currently underweight (under 25%) in your PP?

There is plenty of upside to TLT at this point.

Bond yields are sort of like a tennis game turning into a ping pong game as you get closer to 0% yield.  The price action is just as volatile, it just happens in a smaller space.

I'm sure there are Japanese bond traders who have made fortunes with bond yields lower than they currently are in the U.S.

Why don't they find a way to print more money?

Clive, Don's site seems a little bit complicated for me. Can you please explain how to cut through all of the multitude of charts and info and how use it? How does it compare with DM?

Thanks to everyone contributing to this thread, it's gone places I didn't anticipate and has been very informative!

However, I am interested in understanding the theoretical limit of the TLT price.  I'm not familiar with Japan's experience (although I'm digging into that now), but it's hard for me to imagine buying a long bond with a yield of 1%. 

Even if I were very confident that rates would stay low for a very long time, the interest rate risk would seem to dwarf any possible gains.  Maybe I'm missing something.  Is there a scenario where 1% long bonds would be an attractive, rational investment?

Thanks,
amp

amp wrote:Is there a scenario where 1% long bonds would be an attractive, rational investment?

None of the PP's assets would make "rational" investments on their own. Though, holding 4 irrational investments simultaneously actually makes a lot of sense — to me at least.

amp wrote: Even if I were very confident that rates would stay low for a very long time, the interest rate risk would seem to dwarf any possible gains.

That's an interesting point. Until now, I had never bothered to calculate the maximum possible capital gain for a 30-year bond (i.e., the capital gain resulting when the market yield drops to near-zero) as a function of the bond's coupon rate. But your comment motivated me to take a look. Using Excel's PRICE() formula, I calculate the following:

Coupon Rate (%)  Max Possible Cap. Gain (%)  Max Possible Cap. Loss (%)
10              300                        100
9                270                        100
8                240                        100
7                210                        100
6                180                        100
5                150                        100
4                120                        100
3.3              100                        100
3                90                          100
2                60                          100
1                30                          100
0.5              15                          100
0.1              3                          100

If these numbers are correct, the conclusion for 30-year bonds would seem to be that at coupon rates below about 3.3%, the max potential downside starts to exceed the max potential upside and eventually completely dominates it.

Even for smaller, realistic day-to-day interest rate movements, if we assume a small random movement of x has the same likelihood as a movement of 1/x (as in the log-normal distribution), then the expected capital gain appears to become negative below that same "magic" coupon rate of about 3.3%.

Could it be that a sufficiently low coupon rate can mean that even the coupon payments themselves are no longer sufficient to offset the expected capital loss in the sub-3.3% range...?

The wierd thing though is that in terms of inflation adjusted real rates, Japanese bonds are actually quite favourable. Also because the Yen is a "flight to safety" currency, that gives an added punch to the inverse volatility with respect to stocks. It still seems extraordinary to buy LTT at 0.7% yields. Perhaps QE (or twisting) is a key part of this. Perhaps LTT get bought at crazy low yields on the anticipation/knowledge that the central bank will step in as the buyer. The central bank actually wants to get the ulgy side of the trade so as to sneak a handout to the finance industry.
Also I'm not sure about how much of the market for LTT is actually by institutions that are constructing risk free anuities and have no choice but to buy LTT at whatever price they are available at They wouldn't have the choice of buying 5year bonds rather than 30year. They have to commit to deliver the stated anuity for the next thirty years. LTT are the only way they can do that.

Again, thanks to everyone for their thoughts on this.  Unlike gold and stocks, there are real limits to how high bond prices can go and we are relatively close to those limits at current yields.  As MT suggested, clearly there will be trading opportunities based on price/interest rate fluctuations, but PP ain't a short-term trading strategy.

It seems we are in somewhat uncharted waters for 30-year treasuries and, based on risk and potential return of holding TLT vs. cash, I pulled way back on TLT (and EDV) holdings on Monday.  Yep, rates may very well go lower over the next couple of years, but that's not my time horizon.  My retirement target is 15 years away and, although I admittedly can't predict the future with any sort of accuracy, I just don't see rates staying at or below current levels for that period of time.  Can't see holding something that can't, at current prices, appreciate significantly over the long term and is yielding very little relative to cash.  Perhaps I'm wrong, but I'm pretty sure bond prices won't quadruple between now and 2026. 

Alright, now that I've alienated the PP faithful, please let me know why the above thinking is flawed!  And I know you think it's flawed or you would've done some selling too after a nice 30+ percent gain this year.

Amp,

I did exactly what you are doing when rates hit about 3.8 on the 30 year, down from about 4.5% where I bought in at. I moved everything into a five year ladder. It has been a tough number of months for me as I have watched rates continue to plummet. I haven't jumped back into LT bonds yet but I was tempted a few times when yields got back into the mid 3's a few months ago.

I look at it the same way as you. I am trying to avoid a big principal loss if rates rise. For the meantime, my 50% of assets in a five year ladder is yielding a little under a percentage point less than a 30 year / Tbill split.  which spread over the whole portfolio means that my cash flow from the portfolio has been reduced by about .5%.......which is acceptable to me.

Time will tell how this strategy turns out.

My greatest fear with the portfolio is that two of the assets...gld and LT bonds have been going up for many years. In addition when interest rates begin to rise I would expect both of these assets to come crashing down.

Everyone thus far has been operating under the assumption that rates cannot go below zero. It is unlikely that rates would go below zero, but certainly not impossible.

In a world where no one trust banks, a Treasury bond would simply be a vehicle for storing wealth. The negative rate would could be thought of as your storage fee. There would still be positive coupon payments of course, but the price you paid for the bond would make the YTM negative.

I am not predicting this of course, but I think it is important to not 100% rule it out as a possible outcome.

doodle wrote: Amp,

I did exactly what you are doing when rates hit about 3.8 on the 30 year, down from about 4.5% where I bought in at. I moved everything into a five year ladder. It has been a tough number of months for me as I have watched rates continue to plummet. I haven't jumped back into LT bonds yet but I was tempted a few times when yields got back into the mid 3's a few months ago.

I look at it the same way as you. I am trying to avoid a big principal loss if rates rise. For the meantime, my 50% of assets in a five year ladder is yielding a little under a percentage point less than a 30 year / Tbill split.  which spread over the whole portfolio means that my cash flow from the portfolio has been reduced by about .5%.......which is acceptable to me.

Time will tell how this strategy turns out.

My greatest fear with the portfolio is that two of the assets...gld and LT bonds have been going up for many years. In addition when interest rates begin to rise I would expect both of these assets to come crashing down.

You guys...

You're making things harder than they need to be.

Just buy the package and remove a huge burden from your mind.  It's hard to do, though.  I know that.

This business of endlessly trying to outguess the markets almost never ends well.  The PP is intended as a remedy to that, not a new opportunity to do it in a different way.

I don't buy the PP because I think rates are going to continue falling, or gold is going to continue rising, or any other asset-specific reason.  I buy it because it works as a package.  If you aren't willing to accept the basic premise that it is a package and only really works as a package, you can easily drive yourself crazy trying to apply old habits to a new allocation method that really can't be improved upon through speculative tweaking within each asset class.

It's not that I care that people choose to step outside the PP lines.  What sort of bugs me is that people seem to consistently step outside the lines and then report back that the tweaking didn't work out very well, but then they start talking about their new tweaking plan, as if it is going to work out better than the last one.  I just don't understand the logic that goes into that kind of decision making.  It's like Wall Street has put some people under a spell that causes them to make bad investment decisions that they perceive to be good decisions when they are making them.  As much as the PP is designed to break this spell, if you don't follow the strategy you can't enjoy the freedom and peace of mind that it offers.

melveyr wrote: Everyone thus far has been operating under the assumption that rates cannot go below zero. It is unlikely that rates would go below zero, but certainly not impossible.

I agree that it's a nonzero chance but the odds seem vanishingly small for the 30-year to get there.  There are some really strong upward pressures on LT interest rates once they approach zero.  All of these securities start competing with mattress and\or safety deposit box.

Physical cash will always yield 0%.  I have, incidentally, heard some bizarre (bordering on insane) ideas about how this could be driven down by canceling certain blocks of bills at random.  Anyway, fortunately nothing that crazy is every likely to happen.

LW,

How would the Serial Number cancellation work in the real world?  Would grocery store tellers be taking your $100 bill and looking at a list of 10,000 numbers to compare it to?

moda0306 wrote: How would the Serial Number cancellation work in the real world?  Would grocery store tellers be taking your $100 bill and looking at a list of 10,000 numbers to compare it to?

The idea is so goofy that I always assumed that it was proposed in a tongue in cheek fashion.  But then again, I thought the same thing about... er, certain very strange ideas that I will not bring up for further discussion. 

The proposal was to announce that all bills ending with a certain serial number to no longer be legal tender.  When someone hands you a bill, it's only good if it doesn't end with, say, an 8.  Instant ~10% devaluation to any pile of physical cash.

Pretty asinine, of course, and kind of shows just how nutty you have to get to drive physical cash below 0%.

As Harry Browne pointed out, though, T-bills did briefly dip below 0% during the Great Depression when trust in banks was at an all-time low.  I can't see that happening to the 30-year, though.

It is called demurrage and has been done in the past. 
http://en.wikipedia.org/wiki/Demurrage_(currency)
"Bernard Lietaer also documents in his book Mysterium Geld the use of demurrage currency systems in Europe's High Middle Ages' bracteate systems and ancient Egypt's ostraka - dated receipts for the storage of grain - and credits these currency systems with the great prosperity of these societies.
The major central banks' post-WWII policy of steady monetary inflation as proposed by Keynes was influenced by Gesell's idea of demurrage on currency,[2] but used inflation of the money supply rather than fees to effect the goal of increasing the velocity of money and expanding the economy."

http://en.wikipedia.org/wiki/Bracteate
"The bracteates were usually called back regularly, about one or twice a year, and could be exchanged for new coins with a deduction (Renovatio Monetae). This system worked like a demurrage: People wouldn't hoard their coins, because they lost their value. So this money was used more as a medium of exchange than for storing value. This increased the velocity of money and stimulated the economy."

Gold holdings also suffer demurrage if you consider the cost of storage (0.5% per year for GLD isn't it ?).

stone wrote: Gold holdings also suffer demurrage if you consider the cost of storage (0.5% per year for GLD isn't it ?).

You're close -- 0.40% for GLD.  I like IAU's 0.25% a bit better.

And obviously, physical gold can be stored in a bank safe deposit box for an extremely small annual fee.

http://www.dailymail.co.uk/news/article ... ables.html
"Barclays has admitted it has no idea where staff have misplaced a customer's safety deposit box containing almost £200,000 worth of valuables and cash."

Not so cheap in that instance

stone wrote: http://www.dailymail.co.uk/news/article ... ables.html
"Barclays has admitted it has no idea where staff have misplaced a customer's safety deposit box containing almost £200,000 worth of valuables and cash."

Hey, get this part:

that article wrote: He added: 'The bank has checked all of the 1,030 safety deposit boxes it has in storage and none of our belongings are in any of them.

This is all sounding really hinky to me.  Banks aren't even supposed to AFAIK be able to open a safe deposit box without their key and your key unless they drill it (at considerable expense.)  Are these safe deposit boxes less securely set up or did they seriously drill 1000+ boxes?