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The case for short bond duration & TIPS

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Adrian Nenu

Joined: 12 Apr 2007
Posts: 4205

Posted: Thu Feb 21, 2008 3:02 am Post subject: The case for short bond duration & TIPS

http://www.bloomberg.com/apps/....p;refer=us

Quote:

Federal Reserve officials signaled they are prepared to quickly reverse last month's interest-rate cuts after concluding that borrowing costs need to be kept low for now.

Policy makers cut their 2008 growth forecasts and said that rates should be held down ``for a time,'' minutes of their Jan. 29-30 meeting showed yesterday. They also called inflation ``disappointing,'' and some foresaw raising rates, possibly at a ``rapid'' pace once the economy recovers.

At any rate, as Jack Bogle advised, the bond allocation is not the place to get greedy and take on more risk for additional yield.

Adrian
anenu@tampabay.rr.com

craigr

Joined: 13 Mar 2007
Posts: 2126

Posted: Thu Feb 21, 2008 3:29 am Post subject:

Quote:

At any rate, as Jack Bogle advised, the bond allocation is not the place to get greedy and take on more risk for additional yield.

I don't recall where he stated that explicitly in terms of only using short-term bonds. Perhaps he was referring to using junk bonds or other shaky debt? Everything I've seen him say revolved around using TBM or (more recently [past few years]) Intermediate-Term Treasury bonds. Both of which have durations around 5-7 years.

Short term bonds do have risks, too. For instance, a period of sustained deflation would be bad for short-term bonds and be a boon for longer term issues. During the Great Depression short-term bonds had negative interest rates for a period of time whereas holders of long-term bonds saw their prices go up substantially as interest rates collapsed. This has even happened more recently (1998 at least) in countries like Japan in their sustained deflationary environment they've been fighting with since about 1990(!):

http://query.nytimes.com/gst/f....gewanted=1

Quote:

This week, investors have bought short-term Japanese Government bills that have negative yields. In other words, they are paying more money than they can expect to earn when the bills mature in six months, in effect paying simply for the privilege of holding bonds.

Not to say this would happen here (again!), but you never know. A mix of short-term and long-term bonds is an effective diversifier, but an Intermediate term bond fund is simpler and could provide nearly the same benefits.

Doubling up on short-term bonds and TIPS gives you OK inflation protection, but leaves you open to deflation risk.

nisiprius

Joined: 26 Jul 2007
Posts: 9258
Location: North America; Western Hemisphere; the Earth; the Solar System; the Universe; the Mind of God

Posted: Thu Feb 21, 2008 6:42 am Post subject:

craigr wrote:

Doubling up on short-term bonds and TIPS gives you OK inflation protection, but leaves you open to deflation risk.

???? How do you figure that for TIPS? In deflation, at maturity the nominal value of a TIPS has declined but its real value, as always, remains constant, and meanwhile it has been trickling out interest at its coupon rate... so what's the problem?
_________________
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

CaptMidnight

Joined: 15 May 2007
Posts: 677

Posted: Thu Feb 21, 2008 9:04 am Post subject:

nisiprius wrote:

That's not true. If deflation occurred over the life of a TIPS, the maturity value would be $1000. The nominal value would then be constant, but the real value would have grown. US TIPS, unlike Canadian RR bonds, for example, never pay less than face, even during deflation. TIPS are therefore one of the few investments that do well in both inflationary and deflationary environments, although normal bonds would do better in deflation.

nisiprius

Joined: 26 Jul 2007
Posts: 9258
Location: North America; Western Hemisphere; the Earth; the Solar System; the Universe; the Mind of God

Posted: Thu Feb 21, 2008 9:58 am Post subject:

CaptMidnight wrote:

nisiprius wrote:

In other words, deflation is even less of a problem than I thought.
_________________
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

bos

Joined: 24 Jan 2008
Posts: 17

Posted: Thu Feb 21, 2008 11:07 am Post subject:

Right. However, secondary-market TIPS and current holdings in a TIPS fund already have an inflation value factored in. Therefore, they can lose value due to deflation, until deflation brings them back to their face value. Only if you buy a new TIPS at auction is this not possible.

Tramper Al

Joined: 18 Oct 2007
Posts: 3109

Posted: Thu Feb 21, 2008 11:25 am Post subject:

bos wrote:

Right. However, secondary-market TIPS and current holdings in a TIPS fund already have an inflation value factored in. Therefore, they can lose value due to deflation, until deflation brings them back to their face value.

Only if you buy a new TIPS at auction is this not possible.

That's an interesting point, if I understand it correctly. Note that the Jan 2028 is trading below par, and a few other issues are very close to it.

alec

Joined: 02 Mar 2007
Posts: 1493

Posted: Thu Feb 21, 2008 12:35 pm Post subject:

Why exactly do I need "deflation protection?" In deflationary times, my expenses stagnate or go down, just like TIPS. And in inflationary times, my expenses go up, just like TIPS. So, with TIPS, I'm covered each way. LT nominal bonds seem to do the opposite of what I need. - Alec

craigr

Joined: 13 Mar 2007
Posts: 2126

Posted: Thu Feb 21, 2008 1:51 pm Post subject:

alec wrote:

Why exactly do I need "deflation protection?" In deflationary times, my expenses stagnate or go down, just like TIPS. And in inflationary times, my expenses go up, just like TIPS. So, with TIPS, I'm covered each way. LT nominal bonds seem to do the opposite of what I need.

During deflation your expenses go down (then again, so could your salary), but depending on how bad it is the stock market will also be doing terribly as companies need to adjust to the new situation. If you tilt your entire bond allocation towards inflation scenarios you can leave yourself exposed to possible deflation impacts that will engulf your stock and bond holdings simultaneously.

TIPS yield will be falling due to the reduced inflation adjustment. You'll still get a real yield from the TIPS and whatever value the mature bond is worth, but it will be far below the yield of a longer/intermediate term bond which will be paying you higher interest in much more valuable dollars.

Deflationary scenarios can be quite bad and protracted (over a decade here in the US in the 1930's and almost 20 years now in Japan). I'm not predicting it will happen here again, but I like to consider all possibilities that can impact investments.

alec

Joined: 02 Mar 2007
Posts: 1493

Posted: Thu Feb 21, 2008 2:24 pm Post subject:

craigr wrote:

alec wrote:

Well, let's say that my stock/TIPS portfolio goes nowhere exactly when no inflation, or deflation, is occuring. But I don't need my portfolio to be returning a lot, if anything at all, if my expenses are declining. Why should I want my portfolio to be doing well if I don't need it to, and why should I want my portfolio to be doing poorly when I need to do well?

- Alec

Adrian Nenu

Joined: 12 Apr 2007
Posts: 4205

Posted: Thu Feb 21, 2008 3:09 pm Post subject:

Quote:

Short term bonds do have risks, too. For instance, a period of sustained deflation would be bad for short-term bonds and be a boon for longer term issues. During the Great Depression short-term bonds had negative interest rates for a period of time whereas holders of long-term bonds saw their prices go up substantially as interest rates collapsed. This has even happened more recently (1998 at least) in countries like Japan in their sustained deflationary environment they've been fighting with since about 1990(!):

Agreed, but odds of inflation/recession scenario are much higher than a 1929 style depression/deflation. Here's a Bernanke speech concerning mistakes the Fed made prior to and during the great depression of 1929:

http://www.federalreserve.gov/....efault.htm

Adrian
anenu@tampabay.rr.com

craigr

Joined: 13 Mar 2007
Posts: 2126

Posted: Thu Feb 21, 2008 4:22 pm Post subject:

alec wrote:

I don't understand your question. If there is deflation your longer term bonds would be providing you with a strong revenue stream and capital appreciation. This money could be used to offset the losses in the stocks and short-term bond allocations by re-balancing to prepare for a (hopeful) recovery.

Last edited by craigr on Thu Feb 21, 2008 4:39 pm; edited 1 time in total

craigr

Joined: 13 Mar 2007
Posts: 2126

Posted: Thu Feb 21, 2008 4:38 pm Post subject:

Adrian Nenu wrote:

I agree that inflation is more likely right now, but I'm never really sure enough to wager anything in a particular direction as I always end up surprised. For the past five years people have been saying to keep bond durations short because interest rates were going to go up dramatically any time now. Now it's 2008 and they keep cutting the rates. So the predictions will come true eventually, but maybe it will be in another five years, or maybe five days. I just don't know.

The Fed can influence the market but it can't control it. The market is bigger than any one or any thing and just can't be predicted. As the late Milton Friedman pointed out, if the Fed really could control the markets do we really think they would have allowed the prime interest rate to hit 21% in 1980?

Also keep in mind that inflation and deflation are connected at the hip. The response to high inflation is to restrict monetary supply, sometimes dramatically, which is deflationary. If they do it too much (say to control a recession), then you can end up going into a deflationary cycle. The Japanese for instance are very bright folks and they've been stuck in their deflationary cycle for almost 20 years now. Certainly they have access to the same tools and knowledge that our central bankers have yet the problem persists despite their efforts.

I just don't think the markets can be predicted so I don't think it's a good idea to bet on any one particular outcome. It seems of late that folks are moving their bonds to a more inflationary defensive mode (short-term and TIPS). This is fine I suppose, but they probably should have done that when inflation wasn't threatening and these assets were better buys. Doing it now seems to be bordering on market timing to me. I've noticed that there exists this idea that moving stocks around due to market conditions is bad, but somehow it's OK to do this with the bond allocations people have. This seems inconsistent to me and probably just as bad an idea as stock timing is.

I don't mean to be critical, I'm just presenting the other side of the argument. I find I do that a lot when it comes to investing. Nothing in investing ever turns out as expected and I think it's just a good idea to consider all possibilities, even those we may consider unlikely.

Last edited by craigr on Thu Feb 21, 2008 4:47 pm; edited 1 time in total

nisiprius

Joined: 26 Jul 2007
Posts: 9258
Location: North America; Western Hemisphere; the Earth; the Solar System; the Universe; the Mind of God

Posted: Thu Feb 21, 2008 4:47 pm Post subject:

alec wrote:

Greed, man, where's your greed?

It's people like you, people who drink water when they coulda had a V8, that cause the invisible hand of the marketplace to tremble.
_________________
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

Valuethinker

Joined: 11 May 2007
Posts: 12881

Posted: Thu Feb 21, 2008 5:47 pm Post subject:

bos wrote:

This is absolutely correct. A TIPS can only return to 100, so if you buy above 100, you could in theory lose value in a deflation.

However AFAIK the TIPS coupon can drop to any level, so in that sense deflation does hurt TIPS.

The best rule of thumb is the breakeven inflation rate (approximately equal to the difference between the nominal bond interest rate of the same maturity, and the TIPS real rate): if the inflationary outcome is below that number, you were better off in the nominal bond. If above, you were better off in the TIPS.

alec

Joined: 02 Mar 2007
Posts: 1493

Posted: Thu Feb 28, 2008 9:24 pm Post subject:

craigr wrote:

alec wrote:

Sorry to resurrect this thread, but IMO the question/situation is pretty simple. My liabilities/expenses are real, not nominal, meaning that they go up [down] with inflation [deflation]. Long term nominal bonds go up [down] with deflation [inflation]. This is the exact opposite of what I want from my assets, isn't it?

- Alec

mithrandir

Joined: 08 Nov 2007
Posts: 527
Location: Southeastern PA

Posted: Fri Feb 29, 2008 12:05 am Post subject:

alec wrote:

That only applies if 100% of your portfolio is LT nominal bonds. Rather, you would own them with other asset classes. Like Swedroe says you can't look at investments in isolation.

craigr

Joined: 13 Mar 2007
Posts: 2126

Posted: Fri Feb 29, 2008 12:08 am Post subject:

alec wrote:

In a vacuum I suppose so, but in a balanced portfolio the assets you hold can offset the losses of other parts. During inflation your longer term bonds will get hammered, but a solid inflation hedge can make up the difference and then some. During deflation traditional assets like stocks, short-term bonds and inflation hedges get hurt but longer term bonds can provide a capital appreciation to help offset the damage plus a much more valuable income stream in appreciated dollars.

Also your liabilities may not fluctuate. Mortgages are often fixed rate. Under high inflation you can pay back in cheaper dollars which is great news for you. But under deflation you are paying back in more valuable dollars which may have been harder for you to earn as bad deflations usually mean bad economies.

EDIT: Mithrandir beat me to it while I was composing...

retired at 48

Joined: 15 Jan 2008
Posts: 1726
Location: Saratoga NY; Port Saint Lucie, FL

Posted: Fri Feb 29, 2008 1:03 am Post subject:

craigr earlier stated:

Quote:

Reply: I believe the way to bet is inflation (vs. deflation). Look at the following telltales: oil prices; wheat prices; all other commodities; silver and gold prices; US Inflation rate (probably understated) moving upward; currency devaluation; chinas new inflation; Prime rate now artificially low to bailout subprime situation; national debts to be resolved, and gut feel.

craigr, you yourself provided the prime rate table in post above. Diehards should study this, and reflect on a 20% prime rate. As money market rates moved to high teens, I wonder where TIPs would actually have gone to? The money market was one of the safer places to be.

Retired at 48

craigr

Joined: 13 Mar 2007
Posts: 2126

Posted: Fri Feb 29, 2008 2:02 am Post subject:

Quote:

craigr, you yourself provided the prime rate table in post above. Diehards should study this, and reflect on a 20% prime rate. As money market rates moved to high teens, I wonder where TIPs would actually have gone to? The money market was one of the safer places to be.

Inflation is nasty business for sure. The 1970's saw a 50% decline in the value of the dollar. An interest rate of 20+% is really dangerous for a currency. It really reflects the confidence people have in its (lack of) value and a central bank scrambling to get control of the situation.

It's interesting hearing people complaining about their adjustable rate mortgages going up to a measly 6% or so and needing to foreclose. Can you imagine getting a 5/1 ARM (if they existed??) in 1976 at 7% only to see your new rate adjust to +20% in 1981!

I was too young to remember it, but Gerald Ford had a "Whip Inflation Now" program. I guess people were supposed to wear buttons and try to stop inflation. As if somehow it was the citizens printing all the money and debt causing inflation and not the govt. and their out of control spending.

One other thing that people may find of interest is how the Fed has changed over the years in how they deal with recessions. In the bear market of 1973-1974 they raised rates dramatically, but during 2000-2002 they slashed rates dramatically: http://www.federalreserve.gov/....5_FF_O.txt

It's an interesting example that illustrates that even the heads of central banks disagree about how to deal with problems in an economy over time.

Valuethinker

Joined: 11 May 2007
Posts: 12881

Posted: Fri Feb 29, 2008 3:34 am Post subject:

retired at 48 wrote:

Real rates were about 8% in 1980-81. But that's on a very steeply inverted yield curve (long term interest rates were much lower).

We didn't have a TIPS market, but it's a fair bet TIPS real yields would have gone to 8%. Yes that would have been a loss of capital value to those who bought them at less than 8%

*but*

if held to maturity their real returns would have been unchanged.

Note long US Treasuries were about 13% but they were callable (and they were almost all called when rates were lower in the mid 80s). On that basis, long term real yields were much closer to 5%.

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