Gyroscopic Investing

http://seekingalpha.com/article/992641- ... sury-bonds

I'm probably touching upon a topic debated here many times, namely "why should we buy LTTs now that the rates have nowhere to go but up". I know it might well happen that we face the Japan experience and the yields will go even lower in the next who-knows-how-many years. If not, then there should be a moment in the future when the Fed starts selling what the amassed over the course of unlimited QE pushing the rates higher and decimating the bond prices.

I'm not trying to analyze the LTTs in isolation which is not a smart way of discussing PP as we all know, I simply want to remove this uneasy feeling that I'm doing something stupid by buying more and more of a "fear asset". Ultimately, I want to keep my inner peace while doing "the right thing". 

As long as the yield is north of zero, I don't think it really matters what the yield actually is.  If it's north of zero it can go up or it can go down.

The greatest gains in 30 year treasuries usually come in the periods following articles like the one you posted.

We are in a period of secular deleveraging, which is deflationary, which means interest rates could stay low for a long time.  With the PP, if rates rise you are protected, so why worry?

Realistically, what would happen if interest rates spiked tomorrow?  The economy would probably tip back into recession, which would place fresh downward pressure on rates.

MediumTex wrote: As long as the yield is north of zero, I don't think it really matters what the yield actually is.  If it's north of zero it can go up or it can go down.

The greatest gains in 30 year treasuries usually come in the periods following articles like the one you posted.

We are in a period of secular deleveraging, which is deflationary, which means interest rates could stay low for a long time.  With the PP, if rates rise you are protected, so why worry?

Realistically, what would happen if interest rates spiked tomorrow?  The economy would probably tip back into recession, which would place fresh downward pressure on rates.

What if the rates won't spike but will be creeping higher over time?

Every time I question LTT's in my portfolio, such as last week, a day like today happens.  Dow drops 121 points and my portfolio is up .3%.  Will this continue?  Who knows but I guess we'll find out.

foglifter wrote:

MediumTex wrote: As long as the yield is north of zero, I don't think it really matters what the yield actually is.  If it's north of zero it can go up or it can go down.

The greatest gains in 30 year treasuries usually come in the periods following articles like the one you posted.

We are in a period of secular deleveraging, which is deflationary, which means interest rates could stay low for a long time.  With the PP, if rates rise you are protected, so why worry?

Realistically, what would happen if interest rates spiked tomorrow?  The economy would probably tip back into recession, which would place fresh downward pressure on rates.

What if the rates won't spike but will be creeping higher over time?

But what's the catalyst for the upward creep?

To me, treasury yields can rise for one of two reasons: 

(1) They are competing with another asset such as stocks and they must pay higher rates to lure money away from the other asset,

or

(2) There are expectations of future inflation and bond holders want to be compensated for that risk.

I see neither of these catalysts right now, and every time either situation above begins to present itself in recent years it is revealed to be a cyclical phenomenon and not a new secular one.

This will, of course, change some day and we will get inflation and we will get rising bond yields, but who knows when that will be?  It could be five years, ten years, or longer. 

Who would have believed you in 2002 if you had told them that a decade later 30 year treasury bonds would be yielding less than half what they were yielding in 2002, while gold would have quintupled in value?  People would have said that something like that was ridiculous, but that's what happened.





Weird stuff like that happens all the time.  Don't be surprised, just have exposure to every economic condition and then you can enjoy the ride.

The thing that is hard to convey to people is that treasury bonds sounded just as dumb as they do today when they were at 6%, 5%, and 4%, and people made exactly the same arguments they are making today about why it would be foolish to own them.

Alanw wrote: Every time I question LTT's in my portfolio, such as last week, a day like today happens.  Dow drops 121 points and my portfolio is up .3%.  Will this continue?  Who knows but I guess we'll find out.

But does this really matter until the gains are realized? I see my LTTs go up, but until they hit a rebalancing band, I do not feel like I really gained anything. They will likely just go back down again at some point.

Which brings me to a related point. Many months ago someone showed that, below a certain yield, there is little/no chance of hitting a rebalancing band and realizing gains (and then the discussion went off on whether LTT yields could go negative, which I kind of find ludicrous). If true, this would contradict your assertion, MT, that any yield north of zero is equally valuable in the portfolio. Anyone remember this thread? Any thoughts?

BearBones wrote:

Alanw wrote: Every time I question LTT's in my portfolio, such as last week, a day like today happens.  Dow drops 121 points and my portfolio is up .3%.  Will this continue?  Who knows but I guess we'll find out.

But does this really matter until the gains are realized? I see my LTTs go up, but until they hit a rebalancing band, I do not feel like I really gained anything. They will likely just go back down again at some point.

Isn't that equally true of any asset we hold?

BearBones wrote:

Alanw wrote: Every time I question LTT's in my portfolio, such as last week, a day like today happens.  Dow drops 121 points and my portfolio is up .3%.  Will this continue?  Who knows but I guess we'll find out.

But does this really matter until the gains are realized? I see my LTTs go up, but until they hit a rebalancing band, I do not feel like I really gained anything. They will likely just go back down again at some point.

Is that really true?

Which brings me to a related point. Many months ago someone showed that, below a certain yield, there is little/no chance of hitting a rebalancing band and realizing gains (and then the discussion went off on whether LTT yields could go negative, which I kind of find ludicrous). If true, this would contradict your assertion, MT, that any yield north of zero is equally valuable in the portfolio. Anyone remember this thread? Any thoughts?

Well, you are now backing into the argument for tighter rebalancing bands when the asset you like least is performing well.  It's okay to do that, as long as you understand what you are doing.

There is nothing wrong with letting any asset run, even if you hate it.  LT bonds have had monster gains in two of the last four years when everyone thought they were the last asset you would want to own.

I agree that it would be harder for long term treasuries to double in value right now than it would be for gold or stocks to double in value, but the potential for large gains is still there.

With all that said, there is nothing wrong with 20/30 rebalancing bands, and that would probably be a complete solution to your concerns that long term bonds don't have enough upside potential at this point.

I'm sort of agnostic about the whole thing.

Pointedstick wrote: Isn't that equally true of any asset we hold?

Yes, but my concern about LTTs is that they are like a tight rubber band. The closer the yield gets to zero, the tighter it gets, and the more force it takes to push lower. At some point, the probabilities become much higher that you will be rebalancing into LTTs than out (and realizing gains).

In other words, at lower yields, it seems intuitive to me that there is a higher risk of hitting the 15% band than hitting the 35% one. I do not see this with the other asset classes (unless gold prices neared the cost of extraction).

MediumTex wrote: Well, you are now backing into the argument for tighter rebalancing bands when the asset you like least is performing well.  It's okay to do that, as long as you understand what you are doing.

There is nothing wrong with letting any asset run, even if you hate it.  LT bonds have had monster gains in two of the last four years when everyone thought they were the last asset you would want to own.

Good points. I am additionally biased against LTTs since I made a decision 2 years ago to move into the PP over a 2 year period. So, I have been buying LTTs as they have gone down in yields, and my gut tells me that once I am all done, they will go back up again. I'm gonna hang in there, but my agnosticism is not nearly as strong as yours since I am jumping in so late and so gradually.

Hey, what would happen to a PP in which you used 20/30 rebalancing bands for only one asset and 15/35 for the others?

BearBones wrote:

Pointedstick wrote: Isn't that equally true of any asset we hold?

Yes, but my concern about LTTs is that they are like a tight rubber band. The closer the yield gets to zero, the tighter it gets, and the more force it takes to push lower. At some point, the probabilities become much higher that you will be rebalancing into LTTs than out (and realizing gains).

In other words, at lower yields, it seems intuitive to me that there is a higher risk of hitting the 15% band than hitting the 35% one. I do not see this with the other asset classes (unless gold prices neared the cost of extraction).

There was a thread somewhere about yield curve convexity.  The relationship between bond prices and yields is nonlinear; as the yields approach zero, the change required to produce a fixed change in bond price becomes smaller and smaller.  So there may well be plenty of room for LTTs to make big gains.  I think the consensus in that thread was that it wouldn't be unreasonable to switch to short or intermediate term treasuries if the yield were to dip below 1.5% or so.  On the other hand, who's to say that negative Treasury yields are impossible?

BearBones wrote: Hey, what would happen to a PP in which you used 20/30 rebalancing bands for only one asset and 15/35 for the others?

It would probably do about the same as a regular PP.

It's also okay for one of the PP assets to go down.  Just let it fall.  There will probably be one or more other assets in the portfolio that will be taking care of you.

The mental obstacle one must overcome to really embrace the PP are WAY larger than many people appreciate.  It's just really, really, really hard to put aside your instincts and intuitions that serve you so well in other areas of life. 

To me, the key to just letting go in the context of the PP is to really internalize the concept that the markets are designed to use your instincts and intuitions against you, and thus to be successful you must ignore them.  The easiest way to do this, in my experience, is not to develop nerves of steel, but rather to just train your mind not to focus at all on the internal workings of the portfolio.

sophie wrote: There was a thread somewhere about yield curve convexity.  The relationship between bond prices and yields is nonlinear; as the yields approach zero, the change required to produce a fixed change in bond price becomes smaller and smaller.  So there may well be plenty of room for LTTs to make big gains. 

It's like a game of tennis turning into a ping pong match.

There is still plenty of action on the smaller court (if not more).

MediumTex wrote: To me, the key to just letting go in the context of the PP is to really internalize the concept that the markets are designed to use your instincts and intuitions against you, and thus to be successful you must ignore them.  The easiest way to do this, in my experience, is not to develop nerves of steel, but rather to just train your mind not to focus at all on the internal workings of the portfolio.

Kind of ironic that so much of this forum is devoted to trying to understand the economy. As a pragmatist, the main reason I want to understand the economy (and investing strategies) is to predict. But if I really thought I could predict, I would not believe in the the PP concept, right?

So, the sensible side of me is saying, "have some faith, let the PP work in the background, get off of the damn computer, and get out and enjoy life more fully."

Treasuries have potentially unlimited upside.



Any PP investor worth their salt is concerned about real (inflation adjusted returns). Now, we are used to making this adjustment in a way that decreases our real returns. But in a deflationary environment the real adjustment can give you a higher inflation adjusted return. There is no clear limit to how bad a deflation can get; it depends on credit conditions and fiscal policy. If we entered a depression where economy wide prices fell by 10%, a 30 year bond that simply maintained its nominal value would have 10% real return. However the upside would probably be greater than that because interest rates would likely have fallen, increasing the value of your bond.

So when someone says that Treasury bonds have limited upside and unlimited downside, that may be true in nominal terms, but is less certain when adjusting for inflation/deflation.

BearBones wrote:

MediumTex wrote: To me, the key to just letting go in the context of the PP is to really internalize the concept that the markets are designed to use your instincts and intuitions against you, and thus to be successful you must ignore them.  The easiest way to do this, in my experience, is not to develop nerves of steel, but rather to just train your mind not to focus at all on the internal workings of the portfolio.

Kind of ironic that so much of this forum is devoted to trying to understand the economy. As a pragmatist, the main reason I want to understand the economy (and investing strategies) is to predict. But if I really thought I could predict, I would not believe in the the PP concept, right?

So, the sensible side of me is saying, "have some faith, let the PP work in the background, get off of the damn computer, and get out and enjoy life more fully."

If I thought I could predict the future consistently and successfully, I would.  I have discovered, however, that I can't and most others can't either.  Thus, I need a strategy that is realistic about this inability to predict the future.

I don't think that a profound ignorance of the future is a reason not to study economics and finance.  That would be like saying it's not worth following your favorite team because you aren't sure which games they will win and which games they will lose.

melveyr wrote: Treasuries have potentially unlimited upside.

I love that.

Watching his mind get blown over and over is sort of hypnotic.

melveyr wrote: If we entered a depression where economy wide prices fell by 10%, a 30 year bond that simply maintained its nominal value would have 10% real return. However the upside would probably be greater than that because interest rates would likely have fallen, increasing the value of your bond.

So when someone says that Treasury bonds have limited upside and unlimited downside, that may be true in nominal terms, but is less certain when adjusting for inflation/deflation.

I get your point, Melveyr. But in the same way, cash has unlimited upside potential in a deflationary environment, doesn't it?  As LTT yields approach zero, why take all of the upside risk instead of just shifting to cash?

BearBones wrote:

melveyr wrote: If we entered a depression where economy wide prices fell by 10%, a 30 year bond that simply maintained its nominal value would have 10% real return. However the upside would probably be greater than that because interest rates would likely have fallen, increasing the value of your bond.

So when someone says that Treasury bonds have limited upside and unlimited downside, that may be true in nominal terms, but is less certain when adjusting for inflation/deflation.

I get your point, Melveyr. But in the same way, cash has unlimited upside potential in a deflationary environment, doesn't it?  As LTT yields approach zero, why take all of the upside risk instead of just shifting to cash?

That's a great point BearBones. You can make a strong case that theoretically 30 year bonds yield should never cross zero.

However, I would still rather have some yield than nothing. If broad price measures were expected to collapse over the next 30 years I would take a 0.5% 30 year bond over cash in a checking account.

Although Japan's 30 year is not at 0.5%, it is still pretty dang low at 2%. 40 years ago we would have a very hard time imagining that type of situation.

Things can always get worse 

Another potential argument against transitioning from LTTs to cash as yields approach zero is the possibility that yields will bounce back and forth between 0% and 2% for decades.

Cash wouldn't benefit much from a decades-long ping-pong match between 0% and 2%. But LTTs would, because you'd be capturing volatility at the lows and highs.

We like to think in terms of broad secular trends, but sometimes there is no trend for a long time--just random ups and downs. PP rebalancing provides a way to benefit from that.

melveyr wrote: However, I would still rather have some yield than nothing. If broad price measures were expected to collapse over the next 30 years I would take a 0.5% 30 year bond over cash in a checking account.

It would seem that the upside potential would be tangible but very small and the downside potential would be huge. If things get that bad, I would be very happy with the real return potential of cash alone rather than trying to squeeze another 0.5% by buying LTTs.

You use the word "expected" and I think you mean "known." If a 30 yr period of deflation were known, I'd make the same decision, of course.

Tortoise wrote: Cash wouldn't benefit much from a decades-long ping-pong match between 0% and 2%. But LTTs would, because you'd be capturing volatility at the lows and highs.

I kind of doubt that folks will be favoring LTTs over cash when yields are near zero. But, let's say that yields do bounce around between 1 and 2, how often would you reach rebalancing bands?

BearBones wrote: I kind of doubt that folks will be favoring LTTs over cash when yields are near zero. But, let's say that yields do bounce around between 1 and 2, how often would you reach rebalancing bands?

It all depends on what the rest of the portfolio is doing. If everything else zigs when LTTs zag, then LTT movements will cause you to hit rebalancing bands more often. If other assets are moving in tandem with LTTs, then LTT movements will cause you to hit rebalancing bands less often.

I'm still recovering from melveyr blowing my mind with his observation that "Treasuries have potentially unlimited upside." If that's true, then the simplest thing--just holding LTTs at all times--would be the right thing, and HB's timeless advice would be vindicated yet again. It wouldn't be the first time

Honestly, I see no problem with someone converting the STT/LTT to an intermediate bond holding with an average duration of 5 years.  Below are the real CAGR of a portfolio with 50% allocated to a bond fund with an average duration of 5 years (this can be replicated with a 10 year bond ladder), 25% stocks, 25% gold -- compared to the standard 4x25% PP:

                      25/25/50        4x25% PP
1972-1977 5.0%         4.9%
1977-1982 3.4%         3.5%
1982-1987 7.6%         7.9%
1987-1992 3.2%         2.9%
1992-1997 6.3%         6.4%
1997-2002 3.3%         3.2%
2002-2007 7.0%         7.0%
2007-2011 6.8%         7.1%
Overall              5.15%        5.17%

Data Source: Simba

LLT may provide a short-term reduction in volatility, but over a few years the overall returns are not significantly impacted.

I'll admit that I hate LTT, but I also understand that they are priced this way because stocks do not look promising and inflation is not on the radar.  But that can change.

Ultimately, it doesn't really matter, but if someone is more comfortable with intermediate bonds than the STT/LTT, then I'd say go with the intermediate bonds.

i have to say...this is a great discussion...complete w/ point and counterpoint

thank you.