Holding long-term bond to increase rebalancing bouns?

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Avi
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Holding long-term bond to increase rebalancing bouns?

Post by Avi »

I'm not start to build up my portfolio yet. But at first I think my portfolio will be 70% VWRD and 30% IUAG.

(As a NRA, I might go to LSE rather than US, due to some tax issue.
Since I don't find any good tool with Ireland-domiciled ETF yet.
For discuss convenient, I'll use US-domiciled ETF below. So VWRD~VT, IUAG~BND.)


But recently I found this article :When Doesn't It Pay to Rebalance? - William J. Bernstein

It said:
It is clear from the above that the actual rebalancing bonus of a two asset portfolio is:
1. Increased by the volatility of each asset
2. Increased by a decreased correlation between each asset,
3. Decreased as the difference in long term returns increases, and
4. Decreased further if this return difference is maintained over a long period of time
Then, I went to Portfolio Visualizer to check the correlation between VT and BND. It was -0.1, almost zero correlation.
I also check the EDV - Vanguard Extended Duration Treasury ETF. It was -0.42 with VT and 0.57 with BND. Correlations result

I also ran the Efficient Frontier: VT&BND and VT&EDV.
For 70/30 mix,
VT&BND got - Mean return: 10.79%, CAGR: 10.46%, StdDev: 12.19%.
VT&EDV got - Mean return: 12.35%, CAGR: 12.33%, StdDev: 11.67%.

It seems like VT&EDV would have better return with lower volatility. And plus better rebalancing bonus.
Since EDV aren't diversity enough. Only holding EDV as bond asset isn't so wise.
But maybe 70% VT, 15% BND, 15% EDV is a better choice rather than 70% VT, 30% BND? Am I right? :confused
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CaliJim
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Re: Holding long-term bond to increase rebalancing bouns?

Post by CaliJim »

Hi,

Me personally, I wouldn't do a Long Term Bonds barbell strategy without also having some short term FI in the middle.

For me, the problem with long term bonds is that my personal time horizon is too short. If your investing horizon is greater than 15/20 years and you can stand the huge hit LT Bonds take when interest rates go up....then sure, look into it. For me, already in retirement, I need my bond values to be somewhat stable. YMMV.

Using long term bonds has been discussed before, but I forget what was said about it. You can google "long term bonds" and see what others more knowledgeable than I have said.

Also: http://www.bogleheads.org/wiki/Barbell_strategy
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baw703916
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Re: Holding long-term bond to increase rebalancing bouns?

Post by baw703916 »

Here's a thread on EDV:

viewtopic.php?f=10&t=146879
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Kevin M
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Re: Holding long-term bond to increase rebalancing bouns?

Post by Kevin M »

I would advise caution in relying on a backtest during a period when rates were mostly falling from historically high levels, providing a nice boost in the price-change component of bond returns. That cannot happen starting from current, historically low interest rates.

On the other hand, Larry Swedroe has apparently co-authored a paper that proposes that long-term bonds can be a better diversifier for a portfolio with a high equity allocation. I'm not sure how high is high enough to justify this approach though, and have never read the paper.

Also, my understanding is that the negative correlation of stocks and long-term Treasuries is more a feature of recent decades than previous decades. The correlation of annual returns for S&P500 and 10-year Treasury is close to 0 for 1928-2014, and you can find years in previous decades when stocks went down a lot, and the 10-year Treasury also went down.

Getting back to Bernstein's criteria, with a YTM of about 2.5%, I would not say that the expected return of a 20-year Treasury is very high right now. The expected return of stocks is more debatable. We don't really know the correlations going forward, and we can debate which previous periods are more representative of a future period starting now. We can expect the volatility of both stocks and long-term Treasuries to be pretty high.

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stlutz
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Re: Holding long-term bond to increase rebalancing bouns?

Post by stlutz »

Correlations change through time. So you don't actually know that EDV will balance out a stock decline or not--the last two times they have, certainly, but that doesn't make for a rule.

If rates went up by 3% over the next year, do you think stocks would go up and balance out that massive loss you would take on EDV?
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baw703916
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Re: Holding long-term bond to increase rebalancing bouns?

Post by baw703916 »

I think Larry Swedroe's article which said that long-term bonds were a better diversifier for high equity portfolios was referring to equities of 80+%. For that portfolio volatility is going to be dominated by equities no matter what bonds you buy.
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Re: Holding long-term bond to increase rebalancing bouns?

Post by alex_686 »

stlutz wrote:Correlations change through time. So you don't actually know that EDV will balance out a stock decline or not--the last two times they have, certainly, but that doesn't make for a rule.
I too would extend caution. Overconfidence kills as often as ignorance.

On a slightly different note, most of the statically tools assume normal distributions which the market does not have. In particular, I will point out that the expected returns on long bonds are not normally distributed. The up side is limited and the down side is huge.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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Avi
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Re: Holding long-term bond to increase rebalancing bouns?

Post by Avi »

Kevin M wrote:Also, my understanding is that the negative correlation of stocks and long-term Treasuries is more a feature of recent decades than previous decades. The correlation of annual returns for S&P500 and 10-year Treasury is close to 0 for 1928-2014, and you can find years in previous decades when stocks went down a lot, and the 10-year Treasury also went down.
So the long-term bond isn't always a good hedge against stocks. It just a special case in recent years.
I got it. Thanks a lot! :D
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Rx 4 investing
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Re: Holding long-term bond to increase rebalancing bouns?

Post by Rx 4 investing »

Earlier this year, Wes Gray, Ph.D. (Alpha Architect) looked at the top 30 drawdowns in the S&P 500 Total Return Index from 1927 to 2013, and the returns of the 10 year T-Bond during the same periods.

The finding: " ...with US Treasury Bonds, we actually earn a positive expected return AND get the insurance benefit. " Gray offers no guarantees that the past performance equals future performance, but the 10 year T-Bonds "zigged" when stocks "zagged".

http://blog.alphaarchitect.com/2015/01/ ... LrRnyyXTlw

What is the optimal bond maturity / duration range to carry in a portfolio? Rick Ferri believes it is intermediate term. Ferri wrote: "The moral of the story is not to let the fear of rising rates stop you from investing properly. By all means buy a short-term bond fund if you have short-term liabilities. If your liabilities are long-term, stay in an intermediate-term bond fund for the duration. It pays to do so."

http://www.rickferri.com/blog/investmen ... ond-funds/

Disclosure: My bonds portfolio has a 25% allocated to long-dated bonds ; 1/2 of that allocation is in Vanguard's Long-Term Treasury Fund Admiral Shares (VUSUX). I try to keep my long allocation in a range between 15-25%.

Best wishes for finding your SWAN (sleep well at night) to US treasuries.
“Everyone is a disciplined, long-term investor until the market goes down.” – Steve Forbes
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baw703916
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Re: Holding long-term bond to increase rebalancing bouns?

Post by baw703916 »

Avi wrote:
Kevin M wrote:Also, my understanding is that the negative correlation of stocks and long-term Treasuries is more a feature of recent decades than previous decades. The correlation of annual returns for S&P500 and 10-year Treasury is close to 0 for 1928-2014, and you can find years in previous decades when stocks went down a lot, and the 10-year Treasury also went down.
So the long-term bond isn't always a good hedge against stocks. It just a special case in recent years.
I got it. Thanks a lot! :D
Well, it is always a good hedge in the particular situation of a deflationary financial crisis (1929, 2008). Has to be nominal Treasuries only. It's a very bad hedge in an inflationary bear market like 1973 or 1980.
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Kevin M
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Re: Holding long-term bond to increase rebalancing bouns?

Post by Kevin M »

Just looking at worst calendar years, not maximum drawdowns, here is what we see for S&P 500, 3-month T.bills, and 10-year Treasuries:

Code: Select all

Year  S&P500   3moTB  10yrTB
----  -------  -----  ------
1931  -43.84%  2.31%  -2.56%
2008  -36.55%  1.59%  20.10%
1937  -35.34%  0.30%   1.38%
1974  -25.90%  7.78%   1.99%
1930  -25.12%  4.55%   4.54%
2002  -21.97%  1.66%  15.12%
1973  -14.31%  6.73%   3.66%
1941  -12.77%  0.08%  -2.02%
2001  -11.85%  3.67%   5.57%
1940  -10.67%  0.03%   5.40%
1957  -10.46%  3.23%   6.80%
avg   -22.62%  2.90%   5.45%
ex2/8 -21.14%  3.19%   2.75%
The last row shows the averages excluding 2002 and 2008.

Note that in several of the large-decline years for stocks, 10-year Treasury also had negative returns, and in even more years, 3-month T Bills provided better diversification. If we exclude 2002 and 2008, the average return for 3-month T Bills was higher than the average return for 10-year Treasuries in the worst calendar years for stocks; i.e., short-term bonds provided better diversification than long-term bonds.

You don't need a PhD to do this analysis.

Kevin
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jimkinny
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Re: Holding long-term bond to increase rebalancing bouns?

Post by jimkinny »

my guess is the greatest risk is staying the course. Is this a plan you can stick with for 30-40 years?
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Re: Holding long-term bond to increase rebalancing bouns?

Post by rca1824 »

It is clear from the above that the actual rebalancing bonus of a two asset portfolio is:
1. Increased by the volatility of each asset
2. Increased by a decreased correlation between each asset,
3. Decreased as the difference in long term returns increases, and
4. Decreased further if this return difference is maintained over a long period of time
Ignoring points 2, 3, and 4 for a moment, focusing on 1..

Can someone explain to me why volatility in both assets in desired? It seems that you want at least one stable asset so you can count on it when rebalancing. If both assets are volatile then both can fall at the same time. Maybe volatility boosts expected returns somehow, but it also seems to come with more risk. I cannot imagine a portfolio stocks + long bonds having less risk than a portfolio of stocks + cash.
Last edited by rca1824 on Sun Aug 09, 2015 9:59 am, edited 1 time in total.
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Hodor
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Re: Holding long-term bond to increase rebalancing bouns?

Post by Hodor »

The main problem with this approach is if we get 1970's style stagflation. Stocks will get hit and long term bonds will get whacked at the same time. In recent decades, we have very low inflation during recessionary periods so long term bonds generally rose when stocks were falling.
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Kevin M
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Re: Holding long-term bond to increase rebalancing bouns?

Post by Kevin M »

rca1824 wrote:
It is clear from the above that the actual rebalancing bonus of a two asset portfolio is:
1. Increased by the volatility of each asset
2. Increased by a decreased correlation between each asset,
3. Decreased as the difference in long term returns increases, and
4. Decreased further if this return difference is maintained over a long period of time
Ignoring points 2, 3, and 4 for a moment, focusing on 1..

Can someone explain to me why volatility in both assets in desired? It seems that you want at least one stable asset so you can count on it when rebalancing. If both assets are volatile then both can fall at the same time. Maybe volatility boosts expected returns somehow, but it also seems to come with more risk. I cannot imagine a portfolio stocks + long bonds having less risk than a portfolio of stocks + cash.
Rather than just look at the bullet points, and especially just singling out one of them, it's probably better to read the article the points came from, linked in the OP: When Doesn't It Pay to Rebalance?.

As noted in the article:
However, the RB calculated from the above formula is valid only when returns for the assets involved are similar.
(The bullet points are based on the formula referenced in the quote as "the above formula")

Kevin
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randomguy
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Re: Holding long-term bond to increase rebalancing bouns?

Post by randomguy »

rca1824 wrote:
It is clear from the above that the actual rebalancing bonus of a two asset portfolio is:
1. Increased by the volatility of each asset
2. Increased by a decreased correlation between each asset,
3. Decreased as the difference in long term returns increases, and
4. Decreased further if this return difference is maintained over a long period of time
Ignoring points 2, 3, and 4 for a moment, focusing on 1..

Can someone explain to me why volatility in both assets in desired? It seems that you want at least one stable asset so you can count on it when rebalancing. If both assets are volatile then both can fall at the same time. Maybe volatility boosts expected returns somehow, but it also seems to come with more risk. I cannot imagine a portfolio stocks + long bonds having less risk than a portfolio of stocks + cash.
What would be better over 30 years: an asset that returned a steady 1% with no flucations or one that returned 6% with flucations. Yes the bond might not be available to rebalance sometimes but hopefully you are getting paid enough along the way to take that risk.

It is easy to focus on crashes and say treasuries are a no brainer. If you are seeking to minimize lows that is a pretty good view point. If you are looking for a combo of returns and stability, you start looking at corporates and long term bonds and you can debate if the gains are worth the various risks.

To some extent the low rates of total amplify the risks of holding long bonds. If your holding a 20 year bond fund with 7% yields, you recover from a 1% rate hike pretty quickly. If your holding a 3% yield fund, your recovery time is a heck of a lot longer.
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