boglerdude wrote: ↑Mon Jan 14, 2019 2:30 am
> The chances of a 1% (or even a .25%) decrease in rates is small
Predicting the future eh. How long will Japan's 10 year stay at 0
I don't have to predict the near-term future since the Fed is doing it for us. They've done exactly what they said they'd do with rate increases and while they may or may not follow through with the two further bumps planned for this year interest rate decreases are not on the horizon. Vis-a-vis Japan and the bigger picture, this excerpt from Todd Tresidder's excellent 2013 article "The Great Bond Bubble" still seems very timely:
"Further proving how extreme our current point in history really is, Timely Portfolios did a fascinating study on 10 Year U.S. Treasuries (constant maturity similar to IEF) evaluating what would happen if interest rates went to their theoretical minimum – zero.Are you ready – drum roll please – a paltry 17% gain. Shocking, but true.
That means that if interest rates went as far as they could theoretically go on the downside, the entire upside left on 10 Year Treasuries is a mere 17%.That’s not much considering it’s the mathematical extreme case limit for how far it could go. Your actual returns would depend on how long it took to reach this limit.
For example, Market Sci blog showed that if it took 4 years to reach zero percent interest rates, then the annualized return would be just 5%, and the total return would be 21.6%.
This may not sound too bad until you realize that 0% yield is not very likely. Given that Japan’s record low yield for their 10 Year Note was .47%, it’s interesting to note the maximum upside is reduced to a mere 13.8%.If it takes 4 years to get there, your annual return is just 4.1% with a total return of 17.6% – before inflation! If you net out inflation, the real return is minuscule at best.
The implication is clear – the upside potential in bonds makes no sense compared to the downside risk.
The problem is bond prices move inversely to interest rates, and interest rates are approaching their theoretical floor. In other words, as rates decline, bonds rise in value. As rates rise, bonds lose value. There is little room left for interest rates to fall, and tons of room for rates to rise, creating an unfavorable risk/reward ratio. This problem is further exacerbated by the fact that current low interest rates would cause a modest rise in rates to cause disproportionately large losses that could dwarf any income received in the interim.
For example, as of this writing, a mere 1% rise in interest rates on the Treasury long bond should equate to a roughly 20% price decline, wiping out 7 years of income at current interest rates.
Do you think it’s reasonable to expect a mere 1% increase in interest rates from these historically low levels over the next seven years as the above example illustrates? After all, far worse has occurred in the past when markets were less volatile.
For example, the 30 year Treasury yield rose 240 basis points in just 9 months back in 1994. Just imagine what a 2 – 3% rise (or more) would mean to investor portfolios given the above example.
This is critically important because fixed income’s traditional position within asset allocation is as a “safe investment“. In fact, we have entered one of those rare points in history where the risk/reward analysis on bonds could conceivably be more dangerous than equities, because the historically low coupon implies historically unprecedented volatility and downside price risk.
In other words, capital loss risk to bonds is highest when starting yields are lowest. Given that yields are at all time historical lows, many historical benchmarks for capital losses in bonds are unrealistically conservative. The future could easily be far worse than the past.
For example, according to Welton Investment Corporation the deepest (-15.3%) and longest (8+ years) Aaa corporate bond drawdown occurred from 1954-1963 because of a tiny 1.8% increase in interest rates – a hiccup by today’s volatile standards. The reason is because the starting yield in 1954 was an equally tiny 2.85%.
In other words, the drawdown severity and duration isn’t determined exclusively by the magnitude of the interest rate rise. It’s determined by the relationship of the interest rate increase compared to the starting yield. Today’s record low yields imply historically high risk of capital loss.
For example, Welton also analyzed what could happen to Aaa corporate bonds under different interest rate increase scenarios:
A 6% increase spread over 5 years would result in a 36.2% drawdown and a 6.4% annual loss.
A 4% increase in just 1 year would result in a whopping 34.8% drawdown and a 34.8% annual loss.
Even a modest increase spread over many years could cause zero return (or worse) for more than a decade."
Putting 25% of the portfolio in LTT's that have a strong possibility of experiencing sustained major losses and then offsetting that gamble with 25% cash returning 2.5%, 25% overvalued market-cap weighted U.S. equities and the remaining 25% in a volatile asset with no inherent rate of return certainly doesn't look like the all-weather bunker the PP is supposed to be.