Bond Maturities/Durations
Bond Maturities/Durations
As some of you know, I have been worried about eventual inflation. Krugman says labor is not tight so it won't happen. But others, myself included, just wonder where all these bailout bucks are coming from.
That being said, I'd like some guidance on bond maturity/duration. For those of us with large taxable accounts (I already filled up my IRA with the Vanguard TIPS fund), exactly what is the recommendation for muni bonds? I figured out that the combination of my Vanguard PA LONG TERM (VPALX) fund (10 year av maturity/ 6.6 year duration) and my Vanguard Limited Term muni (VWLUX) (2.5 year duration and maturity) is about a 5 year duration.
What is the optimum bond portfolio duration for stay-the-course investors? I always knew that "long" bonds have too much risk for any potential reward. But is "intermediate" OK or "short"? And what exactly is intermediate and short? I guess I am remiss for not defining this before.
I've let this go but suspect that we COULD be seeing an inflection point where the bailout prevents further deflation but could bring inflation. So I am focused on this nowl.
That being said, I'd like some guidance on bond maturity/duration. For those of us with large taxable accounts (I already filled up my IRA with the Vanguard TIPS fund), exactly what is the recommendation for muni bonds? I figured out that the combination of my Vanguard PA LONG TERM (VPALX) fund (10 year av maturity/ 6.6 year duration) and my Vanguard Limited Term muni (VWLUX) (2.5 year duration and maturity) is about a 5 year duration.
What is the optimum bond portfolio duration for stay-the-course investors? I always knew that "long" bonds have too much risk for any potential reward. But is "intermediate" OK or "short"? And what exactly is intermediate and short? I guess I am remiss for not defining this before.
I've let this go but suspect that we COULD be seeing an inflection point where the bailout prevents further deflation but could bring inflation. So I am focused on this nowl.
Well, since no one has graced you with a response yet...
Here's a quote from the conclusion to John Campbell's paper Who should buy long term bonds?
If I'm reading the paper incorrectly, I'm sure Dr. Powell or someone will correct me.
hth,
Here's a quote from the conclusion to John Campbell's paper Who should buy long term bonds?
IIRC, you have to hold bonds in your taxable account you're in a high tax bracket. If I'm reading the Campbell paper correctly, if you cannot use TIPS [or they're not available] shorten the duration of your bonds to reduce your inflation exposure. Therefore, use the LT muni fund.When only nominal bonds are available, highly risk-averse investors shorten their bond portfolios in order to reduce their exposure to inflation. Less risk-averse investors hold long-term nominal bonds for speculative purposes if there is a positive inflation risk premium.
If I'm reading the paper incorrectly, I'm sure Dr. Powell or someone will correct me.
hth,
Alec
Thanks for the response. TIPS are really not an option because of the tax consequences. My IRA is fully Vanguard TIPS fund, however.
Yeah, I get it that "long" term bonds are not a good bet and generally not recommended by DIEHARDS. My question is "WHAT IS LONG TERM?"
Is a portfolio with an average duration of about 5 years (as is my case) long term?
Thanks for the response. TIPS are really not an option because of the tax consequences. My IRA is fully Vanguard TIPS fund, however.
Yeah, I get it that "long" term bonds are not a good bet and generally not recommended by DIEHARDS. My question is "WHAT IS LONG TERM?"
Is a portfolio with an average duration of about 5 years (as is my case) long term?
A few possibilities
- mirror the average duration or maturity of Vanguard's total bond market
- vary based on the reward for going longer. For example, increase a year only if you get another 20 bps (Larry writes about this)
- pick a combination of state muni fund and state money market, such as 75/25 and stick with that
Part of the calculation depends on why you hold bonds. Are you holding for safety so that you can take more equity risk or are you looking for interest payments? If the former you'd probably want to be shorter than the later. Also consider the rest of your portfolio. The more it protects from inflation, the longer you can go.
If you are very fond of modern portfolio theory statistics, which tend to be annual measures, you might want to go shorter.
- mirror the average duration or maturity of Vanguard's total bond market
- vary based on the reward for going longer. For example, increase a year only if you get another 20 bps (Larry writes about this)
- pick a combination of state muni fund and state money market, such as 75/25 and stick with that
Part of the calculation depends on why you hold bonds. Are you holding for safety so that you can take more equity risk or are you looking for interest payments? If the former you'd probably want to be shorter than the later. Also consider the rest of your portfolio. The more it protects from inflation, the longer you can go.
If you are very fond of modern portfolio theory statistics, which tend to be annual measures, you might want to go shorter.
- drjdpowell
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That's correct. Short-term bonds are relatively immune to increased inflation since interest rates should increase with inflation.alec wrote:IIRC, you have to hold bonds in your taxable account you're in a high tax bracket. If I'm reading the Campbell paper correctly, if you cannot use TIPS [or they're not available] shorten the duration of your bonds to reduce your inflation exposure. Therefore, use the LT muni fund.
daryll40,
Your 5-year duration mix of long and short Muni funds is about the duration of the Total Bond Market. Picking that would be following Richard's first suggestion, and that would probably be my suggestion. Picking only the short-term fund would be better protection against inflation, but be wary of the trap of focusing so much one one risk that you are open to being blind-sided by others (like unexpected Japan-style deflation).
-- James
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Darryl,
One of my coworkers and I just finished a research project on this very issue. We are submitting the paper to one of the Journals (I had Martin Fridson review and he thought we should submit it).
The findings were very interesting. Basically, the answer is it depends on the equity allocation. The higher the equity allocation the longer the maturity you can go--out to about intermediate is best, like 5 years or so. The lower the equity allocation the shorter the maturity should be, like very short.
But even that misses other issues--like you can take more duration risk if you own some CCF, like I do. And with the muni curve steep I think that is a good idea to combine bit of CCF with bit longer muni bond holdings
I hope that helps
One of my coworkers and I just finished a research project on this very issue. We are submitting the paper to one of the Journals (I had Martin Fridson review and he thought we should submit it).
The findings were very interesting. Basically, the answer is it depends on the equity allocation. The higher the equity allocation the longer the maturity you can go--out to about intermediate is best, like 5 years or so. The lower the equity allocation the shorter the maturity should be, like very short.
But even that misses other issues--like you can take more duration risk if you own some CCF, like I do. And with the muni curve steep I think that is a good idea to combine bit of CCF with bit longer muni bond holdings
I hope that helps
I own NJ long-term, limited term, and the NJ MM fund.
The main reason I own NJ long-term isn't so much because of the income, it's because it's the only thing I can keep in taxable paying more than MM where I won't have to pay 6.37% NJ state tax.
I have been strongly considering selling all of NJ long-term and moving into a combination of national short-term and limited term. While a 5 year duration is hardly 'long-term' and avoiding state tax is nice, I don't want the NAV to get crushed.
Not sure how premature all of this is. I'd hate to do this and then rates fall and stay that way for a while. I've already lost a little NAV on the NJ long-term fund because of the shakiness in the muni market a little while ago.
The main reason I own NJ long-term isn't so much because of the income, it's because it's the only thing I can keep in taxable paying more than MM where I won't have to pay 6.37% NJ state tax.
I have been strongly considering selling all of NJ long-term and moving into a combination of national short-term and limited term. While a 5 year duration is hardly 'long-term' and avoiding state tax is nice, I don't want the NAV to get crushed.
Not sure how premature all of this is. I'd hate to do this and then rates fall and stay that way for a while. I've already lost a little NAV on the NJ long-term fund because of the shakiness in the muni market a little while ago.
Larry, that's a bit odd. I would imagine many people either (1) are looking to equity for growth and therefore would want short bonds for stability, which usually is associated with low correlation, or (2) are looking to bonds for income, with a small equity kicker, and therefore would want the higher income of longer munis.
Is your study of the results of historical performance? Could you please provide a bit more information on the study?
Is your study of the results of historical performance? Could you please provide a bit more information on the study?
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Richard, it results from fact that when have high equity allocations it is the violatility of the equity side that dominates the portfolio risk and adding small amount of longer term debt gives you the higher return without overall portfolio risk rising.
With low equity allocation the higher volatility of the longer fixed income now dominates.
With low equity allocation the higher volatility of the longer fixed income now dominates.
larryswedroe wrote:Darryl,
One of my coworkers and I just finished a research project on this very issue. We are submitting the paper to one of the Journals (I had Martin Fridson review and he thought we should submit it).
The findings were very interesting. Basically, the answer is it depends on the equity allocation. The higher the equity allocation the longer the maturity you can go--out to about intermediate is best, like 5 years or so. The lower the equity allocation the shorter the maturity should be, like very short.
But even that misses other issues--like you can take more duration risk if you own some CCF, like I do. And with the muni curve steep I think that is a good idea to combine bit of CCF with bit longer muni bond holdings
I hope that helps
Larry and all, thank you SO MUCH for some helpful info regarding bond maturities/duration. I need to think about this but it seems that I'm probably about where I need to be, perhaps maybe shorten it up a bit. That being said, Larry you mentioned "maturities" of 5 years or so above. Did you mean "duration"? Not to nitpick, but my understanding is that duration is the key because it combines cash flow WITH maturity to get the real risk parameter. Put another way, the PA LONG TERM muni bond fund has a duration of 6.6 years but an average maturity of 10 years. Do I need to be concerned about that 10 year maturity or can I just worry about the 6.6 year maturity? :lol:
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Larry,
I thought as Richard did. I would have expected that lower correlations between fixed and equities would be the desired goal, and thus shorter bonds. I thought that would have applied at any equity %, never having read contrary evidence.
Is there some % between fixed and quities where the switch occurs from short to longer?
In past, your recommendations have usually been to short bonds, and you cited evidence for why in your books. Going forward, do you now see a modification of that opinion based on this new work?
Thanks.
Roy
I thought as Richard did. I would have expected that lower correlations between fixed and equities would be the desired goal, and thus shorter bonds. I thought that would have applied at any equity %, never having read contrary evidence.
Is there some % between fixed and quities where the switch occurs from short to longer?
In past, your recommendations have usually been to short bonds, and you cited evidence for why in your books. Going forward, do you now see a modification of that opinion based on this new work?
Thanks.
Roy
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First, we learn all the time --and only fools stick with ideas when they learn the original thought was incorrect. Theory advances all the time and we make decisions based on what we know at the time.
Second, staying short is still okay, though not optimal at very high equity allocations.
Third, I went back to look at the paper and I was mistaken, the long term bond (20 year) is highest return and highest sharpe ratio at 80% equity. The cross over is probably about 70 or higher. We did not look at all allocations. At 60% or less the 5 year had the best Sharpe Ratio.
Now you have to be bit careful with any data as the end and starting points matter. We did end with relatively low long term bond yields. So want to be careful
Second, staying short is still okay, though not optimal at very high equity allocations.
Third, I went back to look at the paper and I was mistaken, the long term bond (20 year) is highest return and highest sharpe ratio at 80% equity. The cross over is probably about 70 or higher. We did not look at all allocations. At 60% or less the 5 year had the best Sharpe Ratio.
Now you have to be bit careful with any data as the end and starting points matter. We did end with relatively low long term bond yields. So want to be careful
I look forward to reading it as well...I hope I'm smart enough to understand it. I'm good at general concepts but lacking with details sometimes.
Like DURATION versus MATURITY. I always thought that DURATION was really all that mattered if you were a long term investor who never needed to withdraw principal.
Is this NOT true? And if not, why not?
Sorry if I am being annoying with these type of questioning but my experience has been that others wonder the same things so asking "stupid" questions actually might not be so stupid.
Anyway, what's the point of DURATION if MATURITY is the main determinant of risk/reward? Or is it? Or is there some measure that COMBINES both?
Like DURATION versus MATURITY. I always thought that DURATION was really all that mattered if you were a long term investor who never needed to withdraw principal.
Is this NOT true? And if not, why not?
Sorry if I am being annoying with these type of questioning but my experience has been that others wonder the same things so asking "stupid" questions actually might not be so stupid.
Anyway, what's the point of DURATION if MATURITY is the main determinant of risk/reward? Or is it? Or is there some measure that COMBINES both?
Bond Durations & Stocks
FYI, here is what I have over the longest period we have available on cash (1mo t-bills), ultra short bonds (1YR), short term bonds (1-5YR), intermediate term bonds (5YR), and long term bonds (20YR) mixed with a small/value tilted US equity portfolio (40% size, 40% price exposure):
1963-2008
Sharpe Ratios:
80/20 Equity/ST Bond = .418
80/20 Equity/Int'd Bond = .421
60/40 Equity/ST Bond = .459
60/40 Equity/Int'd Bond = .462
40/60 Equity/ST Bond = .509
40/60 Equity/Int'd Bond = .504
...for those who think in terms of risk/return:
Return/Standard Deviation:
80/20 Equity/ST Bond = +11.90% / 14.85
80/20 Equity/Int'd Bond = +11.97% / 14.92
81/19 Equity/ST Bond = +11.95% / 15.03
60/40 Equity/ST Bond = +10.89% / 11.34
60/40 Equity/Int'd Bond = +11.02% / 11.54
62/38 Equity/ST Bond = +10.99% / 11.68
40/60 Equity/ST Bond = +9.73% / 7.93
40/60 Equity/Int'd Bond = +9.93% / 8.42
43/57 Equity/ST Bond = +9.92% / 8.43
If you can see a lot of difference between ST and Int'd bonds in a balanced portfolio, you have a better eye than I do. Adding a lower risk asset in an attempt to reduce uncertainty makes intuitive sense to me, but I don't think you will get burned too badly. If next year is a better year for short relative to longer term (for example), that long term advantage would shift back to ST. But there isn't a lot of light between the two regardless.
I also think ST allows you to take on some AAA/AA rated credit risk (only works on the short end), which can possibly improve portfolio efficiency <1-3YR Corp = +7.88% from 76-08; 1-3YR Gov't = +7.48%>
sh
(period studied in chart above spans 8/63 through 10/08, and entails annual rebalancing)
1963-2008
Sharpe Ratios:
80/20 Equity/ST Bond = .418
80/20 Equity/Int'd Bond = .421
60/40 Equity/ST Bond = .459
60/40 Equity/Int'd Bond = .462
40/60 Equity/ST Bond = .509
40/60 Equity/Int'd Bond = .504
...for those who think in terms of risk/return:
Return/Standard Deviation:
80/20 Equity/ST Bond = +11.90% / 14.85
80/20 Equity/Int'd Bond = +11.97% / 14.92
81/19 Equity/ST Bond = +11.95% / 15.03
60/40 Equity/ST Bond = +10.89% / 11.34
60/40 Equity/Int'd Bond = +11.02% / 11.54
62/38 Equity/ST Bond = +10.99% / 11.68
40/60 Equity/ST Bond = +9.73% / 7.93
40/60 Equity/Int'd Bond = +9.93% / 8.42
43/57 Equity/ST Bond = +9.92% / 8.43
If you can see a lot of difference between ST and Int'd bonds in a balanced portfolio, you have a better eye than I do. Adding a lower risk asset in an attempt to reduce uncertainty makes intuitive sense to me, but I don't think you will get burned too badly. If next year is a better year for short relative to longer term (for example), that long term advantage would shift back to ST. But there isn't a lot of light between the two regardless.
I also think ST allows you to take on some AAA/AA rated credit risk (only works on the short end), which can possibly improve portfolio efficiency <1-3YR Corp = +7.88% from 76-08; 1-3YR Gov't = +7.48%>
sh
(period studied in chart above spans 8/63 through 10/08, and entails annual rebalancing)
Re: Bond Durations & Stocks
SH,60/40 Equity/ST Bond = +10.89% / 11.34
40/60 Equity/ST Bond = +9.73% / 7.93
Thanks. What I find interesting is how much less risky the 40/60 is yet without giving up a great deal of return compared with 60/40. Makes me think somewhat of Larry's portfolio that cuts fat tails.
Are these balanced portfolios 1/2 SV and 1/2 TSM--and al US? How are the equities allocated?
And yes, there does not seem much difference between Short and longer bonds, based on above.
Roy.
Roy,
I would be careful reading too much into my illustrations above. I think there are some things you can take away, and some things you can't.
CAN
ST Bonds will likely continue to capture most of the return of longer term bonds with far less risk. The low volatility nature of the asset class should mean it will continue to be a worthwhile and dependable diversifier.
Given the seriously depressed levels on equity prices, past stock returns could be similar over the next 20-30 years as the last 30 or 40.
CAN'T
Low equity allocations will have similar returns as higher equity allocations (yields and expected returns on low risk bonds are very low relative to historical returns). A 1-5YR Treasury portfolio today yields, what, 2%? The same portfolio returned 7% from 64-08. We would have to see another record setting round of interest rate hikes to duplicate bond returns of 6% or 7% (if we did, you can bet this would impair Int'd/Longer term bonds very badly -- as well as portfolios with those as their bond allocation)
Similar % returns don't mean similar impacts on wealth. Over 20 years, the difference in net wealth between the 60/40 portfolio and the 40/60 portfolio on a $1,000,000 starting value was $1,500,000! Small performance differences lead to big changes in net wealth.
sh
PS -- equity was approximately 50/50 TSM/SV, and was 100% US for simplicity.
I would be careful reading too much into my illustrations above. I think there are some things you can take away, and some things you can't.
CAN
ST Bonds will likely continue to capture most of the return of longer term bonds with far less risk. The low volatility nature of the asset class should mean it will continue to be a worthwhile and dependable diversifier.
Given the seriously depressed levels on equity prices, past stock returns could be similar over the next 20-30 years as the last 30 or 40.
CAN'T
Low equity allocations will have similar returns as higher equity allocations (yields and expected returns on low risk bonds are very low relative to historical returns). A 1-5YR Treasury portfolio today yields, what, 2%? The same portfolio returned 7% from 64-08. We would have to see another record setting round of interest rate hikes to duplicate bond returns of 6% or 7% (if we did, you can bet this would impair Int'd/Longer term bonds very badly -- as well as portfolios with those as their bond allocation)
Similar % returns don't mean similar impacts on wealth. Over 20 years, the difference in net wealth between the 60/40 portfolio and the 40/60 portfolio on a $1,000,000 starting value was $1,500,000! Small performance differences lead to big changes in net wealth.
sh
PS -- equity was approximately 50/50 TSM/SV, and was 100% US for simplicity.
A bond guru would be appreciated. I always thought that duration took into account cash flow from the coupon, which then computed the real number to use to determine risk/reward. A zero coupon bond will have a hugely different duration than a 4% coupon bond than an 8% coupon bond. Even if all have the same maturities.
So I guess I am wondering from Larry if his study would not have more value if they looked at durations instead of maturities (although I suspect that's very hard to do with historical data requiring the knowledge of coupon rates at different times for different maturities). Nevertheless, just looking at maturities without considering various coupon rates...thus duration...isn't THAT really required to make the study useful?
Asked differently: If the Vanguard PA Long Term Muni Bond Fund has a 10 year av maturity but only a 6.6 year average duration, isn't the duration number the only thing that really matters for the long term investor?
So I guess I am wondering from Larry if his study would not have more value if they looked at durations instead of maturities (although I suspect that's very hard to do with historical data requiring the knowledge of coupon rates at different times for different maturities). Nevertheless, just looking at maturities without considering various coupon rates...thus duration...isn't THAT really required to make the study useful?
Asked differently: If the Vanguard PA Long Term Muni Bond Fund has a 10 year av maturity but only a 6.6 year average duration, isn't the duration number the only thing that really matters for the long term investor?
.
Method of analysis: Over two time periods, I determined the respective bond term exposure that maximized the portfolios Sharpe Ratio, and minimized its cumulative loss (for the worst bear market in the respective time periods) for a range of stock:bond combinations (using the Solver function in excel). The stock allocation had a 1, 0.2 and 0.4 market, size and value load respectively, and the bond allocation had no credit risk (i.e. a default load of zero).
Results/interpretation: (results in table below).
Possible explanation: Unexpected inflation impacts on portfolio performance.
Term exposure of Vanguard funds: FWIW here are the past TERM and DEFAULT loads on some of the Vanguard Treasury Funds
Method of analysis: Over two time periods, I determined the respective bond term exposure that maximized the portfolios Sharpe Ratio, and minimized its cumulative loss (for the worst bear market in the respective time periods) for a range of stock:bond combinations (using the Solver function in excel). The stock allocation had a 1, 0.2 and 0.4 market, size and value load respectively, and the bond allocation had no credit risk (i.e. a default load of zero).
Results/interpretation: (results in table below).
- - For the period 1927-2005 longer-term bonds both maximized mean-variance efficiency (Sharpe Ratio), and minimized cumulative losses for portfolios with a 60% or more equity exposure. As equity exposure declined, so did the most efficient term exposure (from 1 to 0.34 with 80% and 20% equity exposure respectively). Results for this period are significantly influenced by the 1929-32 period.
- For the period 1963-2005 short(er) term bonds both maximized mean-variance efficiency, and minimized cumulative losses. On a mean-variance efficiency basis, intermediate-term bonds were ‘optimal’ for a portfolio with an 80% equity allocation. As equity exposure declined, so did the most efficient term exposure (from 0.57 to 0.12 with 80% and 20% equity exposure respectively). Having no term exposure minimized cumulative loss – a result driven by the 1973-74 period (Just a note. The cumulative losses in 1929-32 were double those in 1973-74 in nominal terms, obviously differences were smaller in real terms).
Code: Select all
TERM EXPOSURE (factor load) that maximized portfolio Sharpe Ratio
Equity % 1927-2005 1963-2005
80 1.00 0.57
70 1.00 0.35
60 1.00 0.24
50 0.95 0.18
40 0.66 0.14
30 0.46 0.12
20 0.34 0.12
TERM EXPOSURE (factor load) that minimized cumulative loss during the worst bear market period
Equity % 1927-2005 1963-2005
80 1.00 0.00
70 1.00 0.00
60 1.00 0.00
50 1.00 0.00
40 1.00 0.00
30 1.00 0.11
20 1.00 0.12
Data used from Ken French website and Ibbotson Yearbook.
- - While unanticipated inflation erodes the purchasing power of the promised stream of fixed payments from nominal bonds, it also increases the replacement cost of corporate assets, which should (eventually) be reflected in higher stock prices (re: Seigel’s observation than stock prices “provide excellent long-term hedges against inflation”, but weak/poor short-term protection).
- As an equity allocation declines, its (long-term) inflation hedging impacts on an overall portfolio declines, and overall portfolio performance is more and more influenced by the rising bond allocation.
- As the bond allocation increases, a shift from longer term to shorter term nominal bonds, replaces some of the (long-term) unexpected inflation protection lost with a declining equity allocation.
- This may explain why the 'optimal' term exposure varies with equity allocation. And IMO seems to demonstrate that its important to look at a portfolio as a whole not just the individual components.
Term exposure of Vanguard funds: FWIW here are the past TERM and DEFAULT loads on some of the Vanguard Treasury Funds
Code: Select all
Using monthly data from Nov. 1991 to Dec. 2005
Vanguard
Treasury Funds Alpha (t-stat) TERM (t-stat) DEFAULT (t-stat) R^2
Short-term 0.04 (1.50) 0.20 (14.50) 0.02 (0.51) 0.67
Intermediate-term 0.02 (0.49) 0.54 (26.96) 0.05 (0.81) 0.88
Long-term -0.03 (-1.23) 0.93 (91.13) 0.03 (1.18) 0.99
A 0.54 term coefficient on the Vanguard Intermediate Treasury funds simply means than over this time period the fund captured 54% of the term premium.
- Caveat: The positive (but ‘not statistically significant’) alpha on ST treasury, and the negative (but ‘not statistically significant’) alpha on LT treasury, coupled with the relatively low R^2 on the ST treasury regression may reflect non-linearities in bond returns (i.e. possible two-factor model misspecification).
Last edited by Robert T on Thu Nov 27, 2008 8:32 am, edited 1 time in total.
Anti-Fat Tail Portfolio?
Cant
Low equity allocations will have similar returns as higher equity allocations (yields and expected returns on low risk bonds are very low relative to historical returns). A 1-5YR Treasury portfolio today yields, what, 2%? The same portfolio returned 7% from 64-08. We would have to see another record setting round of interest rate hikes to duplicate bond returns of 6% or 7% (if we did, you can bet this would impair Int'd/Longer term bonds very badly -- as well as portfolios with those as their bond allocation)
Thanks, Small Hi, for clarifying. I see your points. I'm also amazed at your ability to crunch data so rapidly.
But what about a low equity portfolio that is high risk in its equities--the "anti-fat tail portfolio"--that has been discussed here too (Larry in particular has made points about this). Say, something like: SV (15%), ISV (10%), EM (5%) and then 70% in ST? I've never seen the Return/SD workup on that, though its theoretical benefits have been tauted.
Or for simplicity, SV (30%) and ST Treasuries (70%), say, and all in US?
How do portolios like these compare with portfolios of much higher equity allocations and not as tilted (Return/SD)?
Thanks and Happy Thanksgiving!
Roy
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larryswedroe and all
The bond market is currently dysfunctional (and may be for some time) with big risk premiums for Treasurys and unprecedented penalties for almost everything else
Are the studies discussed here even relevant at present?
What's recommended today for an investor's bond allocation (sector, maturity)?
S L
The bond market is currently dysfunctional (and may be for some time) with big risk premiums for Treasurys and unprecedented penalties for almost everything else
Are the studies discussed here even relevant at present?
What's recommended today for an investor's bond allocation (sector, maturity)?
S L
For what its worth.
The December issue of Smart Money magazine has an interview with Dan Fuss in which he states"This is the best opportunity in investment grade corporate bonds in just over 50 years". He further recommends buying a corporate bond fund or corporate bond index fund. I didn't see anything in the article about term exposure.
The December issue of Smart Money magazine has an interview with Dan Fuss in which he states"This is the best opportunity in investment grade corporate bonds in just over 50 years". He further recommends buying a corporate bond fund or corporate bond index fund. I didn't see anything in the article about term exposure.
.
Robert
PS: Apologies, couldn't embed the weblinks. Those interested in reading the articles will just need to copy and past the websites into their web address bar to get to them.
.
Fairly interesting to hear what Dan Fuss has to say. Here's a bit more...The December issue of Smart Money magazine has an interview with Dan Fuss in which he states "This is the best opportunity in investment grade corporate bonds in just over 50 years". He further recommends buying a corporate bond fund or corporate bond index fund. I didn't see anything in the article about term exposure.
- 1. On corporate bonds: Here’s Loomis Sayles’s more detailed view: How Cheap are Corporate Bonds?. (FWIW they started a new corporate bond fund this month…).
2. On term: They are still one to two years longer than their benchmark index, at least on the Loomis Sayles Bond Fund. (Here’s a recent update on that fund)
3. On timing bond markets: Its difficult to time the market, even for seasons managers such as Loomis Sayles. They admit to being too early in their recent letter to Shareholders. “After avoiding the problems in the securitized markets in 2007, we were early entrants into the corporate credit markets in late 2007 and the beginning of 2008. In hindsight, our timing was too early.” And that seems to have had a significant effect. The Loomis Sayles Bond fund is down 28% for the year to date.
4. On credit risk and equity returns: Using the same periods of credit market stress and recovery as in the Loomis Sayles article (see tables in the article), I calculated a simple default premium from their tables and added the equity premium for the same time periods. In all cases when the default premium was negative (periods of credit market stress), so was the equity premium, and when the default premium was positive (periods of recovery), so was the equity premium. So looking forward I would expect the default premium to be significantly positive during the eventual recovery, but would also expect the same of equities. Personally I would prefer to increase my equity allocation slightly, than add corporate bonds to fixed income (but I don't need to make that choice).
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Default and Equity Premiums During Credit Market Stress and Recovery
S&L Crisis LTCM Subprime
Credit Market Stress 2/89–12/90 9/97-10/02 5/07–10/17/08
...Corporate Default premium -2.6 -9.1 -16.1
...HY Default premium -34.3 -51.3 -39.1
...Equity premium -10.5 -45.7 -45.7
Credit Market Recovery 12/90–4/92 10/02–2/05 ?
...Corporate Default premium +4.3 +12.2 ?
...HY Default premium +43.7 +49.0 ?
...Equity premium +23.9 +54.3 ?
Corporate Default Premium = Lehman US Corporate Inv. Grade Index – Lehman US Treasury Index
HY Default Premium = Lehman US Corporate HY Index – Lehman US Treasury Index
Equity Premium = US Equity Market Return* – Lehman US Treasury Index
* From the FF Research Data File on Ken French’s website
PS: Apologies, couldn't embed the weblinks. Those interested in reading the articles will just need to copy and past the websites into their web address bar to get to them.
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