Gyroscopic Investing

I went to a seminar on retirement tax planning (aka, selling annuities) the other day just to get the free meal (which wasn't that good).

The guy told an interesting story however. He said that back in the late 70's and early 80's you could buy LTT's with a yield of 14% that are only now maturing after 30 years. Amazingly however, he said this was one of the least-sold bonds of all time and the reason was because you could buy bank CD's starting at 15% and going as high as 18%. I didn't know about the 14% LTT's but I did know about the CD's because my parents were among those chasing the CD returns (an addiction they carried the rest of their lives and which they are only now starting to realize might not have been the best financial strategy).

This got me thinking about what apparently is the standard practice I have read about here of selling LTT's every 5 years and buying new ones. I think I understand that the PP play is related more to what bonds are currently selling for on the open market than the yield, but in the unlikely event you had 30 year bonds at a rate of 14% would you still sell them after 5 years and buy new ones?

Damn. I've never seen a post of mine get so many views in such a short amount of time.

So here is a follow-up question. If you could buy LTT's at 14% today, how many PPer's would dump the whole idea and bet all their money on the full faith and credit of the U.S. government instead?

notsheigetz wrote:
but in the unlikely event you had 30 year bonds at a rate of 14% would you still sell them after 5 years and buy new ones?

Yes.  

Who's to say the rate wouldn't keep climbing?  

What if the rate stayed range bound for several years?  

notsheigetz wrote: Damn. I've never seen a post of mine get so many views in such a short amount of time.

So here is a follow-up question. If you could buy LTT's at 14% today, how many PPer's would dump the whole idea and bet all their money on the full faith and credit of the U.S. government instead?

If any bond is paying 14% interest, there's a reason for it.  I would definitely not go all in. 

notsheigetz wrote: I went to a seminar on retirement tax planning (aka, selling annuities) the other day just to get the free meal (which wasn't that good).

The guy told an interesting story however. He said that back in the late 70's and early 80's you could buy LTT's with a yield of 14% that are only now maturing after 30 years. Amazingly however, he said this was one of the least-sold bonds of all time and the reason was because you could buy bank CD's starting at 15% and going as high as 18%. I didn't know about the 14% LTT's but I did know about the CD's because my parents were among those chasing the CD returns (an addiction they carried the rest of their lives and which they are only now starting to realize might not have been the best financial strategy).

First off, this is a good topic and one that I had a hard time with as well.

The reason why everyone hated LTT in 1980 was because they "knew" that inflation would continue to be high over the next 30 years.  Only madmen would buy LTT when inflation was clearly going to increase or at least remain high.  Better buy gold.  This type of thinking falls into "the recent past will be the future".

notsheigetz wrote: This got me thinking about what apparently is the standard practice I have read about here of selling LTT's every 5 years and buying new ones. I think I understand that the PP play is related more to what bonds are currently selling for on the open market than the yield, but in the unlikely event you had 30 year bonds at a rate of 14% would you still sell them after 5 years and buy new ones?

You're falling into the same trap as the dividend people with the yield-on-cost.  The LTT's bought 30 years ago are not currently yielding 14%, they are yielding the current rate of 2.8%.  The reason for this is the price of the old 30 year LTT has increased to the point where its coupon is yielding only 2.8%.  The 14% is based on the original purchase price and does not account for the current price of the LTT.

It makes no difference if you sell a LTT with a coupon of 14% and buy a new LTT with a coupon of 2.8%.  The underlying price of the LTT's will ensure that they are both yielding the same amount.

But don't get me wrong, buying LTT's in 1980 was a brilliant move and has paid off very well.  However it is important to understand that as interest rates (and inflation) decreased, the yield on the LTT also decreased, while the price increased, and the coupon remained constant.

Gosso wrote: You're falling into the same trap as the dividend people with the yield-on-cost.  The LTT's bought 30 years ago are not currently yielding 14%, they are yielding the current rate of 2.8%.  The reason for this is the price of the old 30 year LTT has increased to the point where its coupon is yielding only 2.8%.  The 14% is based on the original purchase price and does not account for the current price of the LTT.

It makes no difference if you sell a LTT with a coupon of 14% and buy a new LTT with a coupon of 2.8%.  The underlying price of the LTT's will ensure that they are both yielding the same amount.

But don't get me wrong, buying LTT's in 1980 was a brilliant move and has paid off very well.  However it is important to understand that as interest rates (and inflation) decreased, the yield on the LTT also decreased, while the price increased, and the coupon remained constant.

I may be a bit dense, could could you explain this a bit more? Is the 2.8% figure derived by dividing the coupon by the present value of the bond rather than the original purchase price? If so, then even though the yield-on-cost has dropped, aren't you still in the very fortunate situation of owning an extremely desirable, valuable bond?

Sure; it's worth more now than what you paid for it.  Sounds like a good time to sell!

If a person bought a 30 year bond paying 12% and the next year yields were at 14%, he might feel like an idiot.

While we're on the subject of going against the herd, how about those crazy people who were buying gold for $250 an ounce back in 2000?

These things tend to hide in plain sight.  The PP forces you to buy what no one else wants and to sell when everyone is certain that prices can only go up.

The PP can make an investor look very smart.  It actually makes you feel smart, but it's really just a matter of seeing clearly (maybe for the first time) some very basic market truths that for whatever reason a lot of people don't want to face.

Pointedstick wrote:

Gosso wrote: You're falling into the same trap as the dividend people with the yield-on-cost.  The LTT's bought 30 years ago are not currently yielding 14%, they are yielding the current rate of 2.8%.  The reason for this is the price of the old 30 year LTT has increased to the point where its coupon is yielding only 2.8%.  The 14% is based on the original purchase price and does not account for the current price of the LTT.

It makes no difference if you sell a LTT with a coupon of 14% and buy a new LTT with a coupon of 2.8%.  The underlying price of the LTT's will ensure that they are both yielding the same amount.

But don't get me wrong, buying LTT's in 1980 was a brilliant move and has paid off very well.  However it is important to understand that as interest rates (and inflation) decreased, the yield on the LTT also decreased, while the price increased, and the coupon remained constant.

I may be a bit dense, could could you explain this a bit more? Is the 2.8% figure derived by dividing the coupon by the present value of the bond rather than the original purchase price? If so, then even though the yield-on-cost has dropped, aren't you still in the very fortunate situation of owning an extremely desirable, valuable bond?

Sure.  Maybe an example would help.  I pulled these off my brokers bond desk:

Issuer                             Coupon                 Maturity            Price          Yield
CANADA (GOVERNMENT)  8.000                 2023/06/01   159.012    1.854
CANADA (GOVERNMENT)  1.500                 2023/06/01    96.226    1.894

As you can see, bonds with the same maturity date will have roughly the same yield, regardless of their coupon.  So even though it may feel like the 8% coupon is a sweet deal, it is actually no different than the 1.5% coupon.  The market will price these bonds appropriately based on the current market rate and the amount and number of coupon payments remaining on the bond.

notsheigetz wrote: I went to a seminar on retirement tax planning (aka, selling annuities) the other day just to get the free meal (which wasn't that good).

The guy told an interesting story however. He said that back in the late 70's and early 80's you could buy LTT's with a yield of 14% that are only now maturing after 30 years. Amazingly however, he said this was one of the least-sold bonds of all time and the reason was because you could buy bank CD's starting at 15% and going as high as 18%. I didn't know about the 14% LTT's but I did know about the CD's because my parents were among those chasing the CD returns (an addiction they carried the rest of their lives and which they are only now starting to realize might not have been the best financial strategy).

Most points already addressed, but again back then when inflation was raging not many people wanted LTTs. Prime rate peaked over 21% in the early 1980s!

Also many of those issued high interest bonds actually had call provisions on them later. Many did not make it to maturity before being called back.

This got me thinking about what apparently is the standard practice I have read about here of selling LTT's every 5 years and buying new ones. I think I understand that the PP play is related more to what bonds are currently selling for on the open market than the yield, but in the unlikely event you had 30 year bonds at a rate of 14% would you still sell them after 5 years and buy new ones?

Yes. Because if we get that prime rate above 20% again it could mean very bad inflation. History doesn't repeat. Those bonds at 14% could still get killed if there was a very bad monetary crisis there. It's best to have a mechanical strategy about this.

Also if anything, at 14% yields, chances are when you are rebalancing it will be things like gold that will have gone through the roof, not the bonds. So you'll probably be selling gold and buying those high yield bonds most likely for something higher yielding perhaps.

Another way of looking at this is to assume the LTT is a 30 year CD that cannot be sold.  If you place $100 into a 30 year CD yielding 14%, then it will yield 14% per year since it is assumed the value of the $100 will not change.

However, once you allow the value of the $100 to float then the yield will change as well.

Lets assume that the market yield on the LTT drops from 14% down to 7% after a year.  If you think of the LTT as a CD then this doesn't matter, but if you think of LTT as a LTT then the price of the LTT would have increased by roughly 100%.  So now you have $200 yielding 7%, which is roughly equivalent to $100 yielding 14%.

notsheigetz wrote: Damn. I've never seen a post of mine get so many views in such a short amount of time.

So here is a follow-up question. If you could buy LTT's at 14% today, how many PPer's would dump the whole idea and bet all their money on the full faith and credit of the U.S. government instead?

No I wouldn't abandon the PP. On the other hand, given that the historic CAGR for the PP over the last 40 years is a little over 9%, a guaranteed 14% return that is exempt from state and local taxes might be tempting in the context of the VP.

Pointedstick wrote: I may be a bit dense, could could you explain this a bit more? Is the 2.8% figure derived by dividing the coupon by the present value of the bond rather than the original purchase price? If so, then even though the yield-on-cost has dropped, aren't you still in the very fortunate situation of owning an extremely desirable, valuable bond?

https://en.wikipedia.org/wiki/Yield_to_maturity

If we were all magically transported back to 1980, would the discussion be the same?  Or would there be people urging you to get rid of the bonds and buy gold instead?

If I thought that inflation would be winding down, I'd consider moving the bonds to the VP instead of selling.  Except that I'd probably be too afraid that it would work out badly if interest rates stayed high or went up further, and I'd end up selling anyway.

sophie wrote: If we were all magically transported back to 1980, would the discussion be the same?  Or would there be people urging you to get rid of the bonds and buy gold instead?

If I thought that inflation would be winding down, I'd consider moving the bonds to the VP instead of selling.  Except that I'd probably be too afraid that it would work out badly if interest rates stayed high or went up further, and I'd end up selling anyway.

If I found myself in 1980 (presumably with no memory of the future) I think it would take a lot of intestinal fortitude to buy LTTs. Probably more than I have. The PP did not have forty years of back testing behind it at that point.

You would have needed some kind of market timing strategy, even if it was just noticing that Ronald Reagan won the election and Volcker was going to "break the back of inflation" by jacking up interest rates.  But, I really doubt any of us would have been that smart back then.

So if we flip that scenario around for today, it should be easy to know when the Fed is going to be forced to raise rates and lessen our exposure to bonds.  Only two situations can prompt it: a recovering economy near maximum capacity utilization (excess demand vs supply) or an increase in the velocity of the money supply (low demand vs supply).

MediumTex wrote: While we're on the subject of going against the herd, how about those crazy people who were buying gold for $250 an ounce back in 2000?

I signed up for a meeting with the gentleman at the seminar because I was too embarrassed not to after getting a free meal (worse prime rib I ever ate at Flamestone grill, BTW). I'm not sure that I will keep it as I have a dentist appointment on the same day but if I do I think it might actually be fun to let him see my whole PP strategy just so he can tell me about all the terrible and foolish mistakes I'm making.

He brought up the 14% LTT's so it would really be interesting to see his reaction to what you are saying about gold if I decide to go for it. Could be fun (although he's obviously about getting money out of my pocket and into his, he did seem like a decent human being so I'll resist slugging him in the face).

notsheigetz wrote:

MediumTex wrote: While we're on the subject of going against the herd, how about those crazy people who were buying gold for $250 an ounce back in 2000?

I signed up for a meeting with the gentleman at the seminar because I was too embarrassed not to after getting a free meal (worse prime rib I ever ate at Flamestone grill, BTW). I'm not sure that I will keep it as I have a dentist appointment on the same day but if I do I think it might actually be fun to let him see my whole PP strategy just so he can tell me about all the terrible and foolish mistakes I'm making.

He brought up the 14% LTT's so it would really be interesting to see his reaction to what you are saying about gold if I decide to go for it. Could be fun (although he's obviously about getting money out of my pocket and into his, he did seem like a decent human being so I'll resist slugging him in the face).

Not all wizards are jerks.  I have met some very nice fortune tellers.

I have had frank discussions with people who work in asset management and when you get a few drinks in them they will often just come out and say: "Look, I'm just trying to make a living.  What am I supposed to tell people, that I don't know WTF is going to happen next in the markets and neither does anyone else?  People aren't going to pay you 150 basis points for that."

Gosso wrote:

Pointedstick wrote:

Gosso wrote: You're falling into the same trap as the dividend people with the yield-on-cost.  The LTT's bought 30 years ago are not currently yielding 14%, they are yielding the current rate of 2.8%.  The reason for this is the price of the old 30 year LTT has increased to the point where its coupon is yielding only 2.8%.  The 14% is based on the original purchase price and does not account for the current price of the LTT.

It makes no difference if you sell a LTT with a coupon of 14% and buy a new LTT with a coupon of 2.8%.  The underlying price of the LTT's will ensure that they are both yielding the same amount.

But don't get me wrong, buying LTT's in 1980 was a brilliant move and has paid off very well.  However it is important to understand that as interest rates (and inflation) decreased, the yield on the LTT also decreased, while the price increased, and the coupon remained constant.

I may be a bit dense, could could you explain this a bit more? Is the 2.8% figure derived by dividing the coupon by the present value of the bond rather than the original purchase price? If so, then even though the yield-on-cost has dropped, aren't you still in the very fortunate situation of owning an extremely desirable, valuable bond?

Sure.  Maybe an example would help.  I pulled these off my brokers bond desk:

Issuer                             Coupon                 Maturity            Price          Yield
CANADA (GOVERNMENT)  8.000                 2023/06/01   159.012    1.854
CANADA (GOVERNMENT)  1.500                 2023/06/01    96.226    1.894

As you can see, bonds with the same maturity date will have roughly the same yield, regardless of their coupon.  So even though it may feel like the 8% coupon is a sweet deal, it is actually no different than the 1.5% coupon.  The market will price these bonds appropriately based on the current market rate and the amount and number of coupon payments remaining on the bond.

The key takeaways for me are that:

1. A high-coupon bond will appreciate in value if market interest rates decrease
2. Selling the 8% bond and buying 1.6525 [159.012/96.226] 1.5% bonds will result in substantially the same return on investment.

In practice, if you buy a 14% bond and then market rates decrease, you can either hold the 14% bond or sell it for multiple lower rate bonds.  Because of the equivalent yields, your decision does not effect your rate of return!  However, the bond with the later maturity date should be the most volatile, which is the feature we want out of the LTTs.  Therefore, you should sell that 14% bond in accordance with your scheduled rebalancing from 20-year LTTs to 30-year LTTs.

jimbojones wrote: The key takeaways for me are that:

1. A high-coupon bond will appreciate in value if market interest rates decrease
2. Selling the 8% bond and buying 1.6525 [159.012/96.226] 1.5% bonds will result in substantially the same return on investment.

In practice, if you buy a 14% bond and then market rates decrease, you can either hold the 14% bond or sell it for multiple lower rate bonds.  Because of the equivalent yields, your decision does not effect your rate of return!  However, the bond with the later maturity date should be the most volatile, which is the feature we want out of the LTTs.  Therefore, you should sell that 14% bond in accordance with your scheduled rebalancing from 20-year LTTs to 30-year LTTs.

Looks like you got it!  It is a bit of a mind bender, especially when one has only dealt with CD's before.  It's best to ignore the coupon (except for volatility and tax considerations) when looking at the yield of the LTT.