Is there any downside to investing in bond futures?

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acegolfer
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Re: Is there any downside to investing in bond futures?

Post by acegolfer » Wed Jul 23, 2014 11:34 am

lee1026 wrote:
To see how big that difference is, consider buying the 4 year STRIPS, holding for a year, and then selling it as a 3 year STRIPS. The difference in price is 2.52%. You will have to buy very long yielding munis to have a comparable yield and open yourself up for far more interest rate risk.
How do you know what the 3yr strip price will be 1 yr from now? Its not going to be 2.52% higher.

lee1026
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Re: Is there any downside to investing in bond futures?

Post by lee1026 » Wed Jul 23, 2014 11:53 am

A long-term municipal bond fund, like a long-term Treasury bond fund, will sell bonds with durations much lower than its target and replace them with longer duration bonds.
Vanguard does not.
https://personal.vanguard.com/us/funds/ ... =INT#tab=2
How do you know what the 3yr strip price will be 1 yr from now? Its not going to be 2.52% higher.
I don't know what it is going to be, but I am counting on the fact that the yield curve is usually upwards sloping, and that inverted yield curves are fairly rare.

Tanelorn
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Re: Is there any downside to investing in bond futures?

Post by Tanelorn » Wed Jul 23, 2014 12:06 pm

Thank you magician for correcting my math on the futures pricing.

More generally, would it be right to say that a fully collateralized position of rolling front month treasury futures, say 10 year ones, would approximate have the same interest rate risks and returns as a treasury bond fund with the same duration as whatever is typical of the 10 year cheapest to deliver treasury bond?

acegolfer
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Re: Is there any downside to investing in bond futures?

Post by acegolfer » Wed Jul 23, 2014 12:32 pm

lee1026 wrote: I don't know what it is going to be, but I am counting on the fact that the yield curve is usually upwards sloping, and that inverted yield curves are fairly rare.
Upward slope is irrelevant in your example. To make 2.52% gain as you predicted, you need assume the 3-yr zero rate will stay the same next year.

lee1026
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Re: Is there any downside to investing in bond futures?

Post by lee1026 » Wed Jul 23, 2014 12:40 pm

Sure, but "assume interest rates are unchanged" is part of any bond investment for anything but money market investments.

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magician
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Re: Is there any downside to investing in bond futures?

Post by magician » Wed Jul 23, 2014 1:14 pm

Tanelorn wrote:Thank you magician for correcting my math on the futures pricing.

More generally, would it be right to say that a fully collateralized position of rolling front month treasury futures, say 10 year ones, would approximate have the same interest rate risks and returns as a treasury bond fund with the same duration as whatever is typical of the 10 year cheapest to deliver treasury bond?
Yup.

The downside would be all of the transaction costs every time you roll over the futures.
Simplify the complicated side; don't complify the simplicated side.

acegolfer
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Re: Is there any downside to investing in bond futures?

Post by acegolfer » Wed Jul 23, 2014 1:19 pm

lee1026 wrote:Sure, but "assume interest rates are unchanged" is part of any bond investment for anything but money market investments.
Any source to verify your statement?

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Re: Is there any downside to investing in bond futures?

Post by lee1026 » Wed Jul 23, 2014 1:31 pm

Perhaps I was being a bit hasty there, but the risk of the interest rates shifting is always there for any bond investment, and that part is extremely well documented. But if we make the assumptions that none of us have a crystal ball with respect to interest rates, it makes sense to talk about two numbers - the return if interest rates do not change, and the amount that one would lose or gain if the interest rates shifted.

acegolfer
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Re: Is there any downside to investing in bond futures?

Post by acegolfer » Wed Jul 23, 2014 1:42 pm

lee1026 wrote:Perhaps I was being a bit hasty there, but the risk of the interest rates shifting is always there for any bond investment, and that part is extremely well documented. But if we make the assumptions that none of us have a crystal ball with respect to interest rates, it makes sense to talk about two numbers - the return if interest rates do not change, and the amount that one would lose or gain if the interest rates shifted.
And you ignored the 2nd part in your strategy. That is the interest rate risk, which is the fundamental risk of fixes income securities.

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Chan_va
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Re: Is there any downside to investing in bond futures?

Post by Chan_va » Wed Jul 23, 2014 2:19 pm

lee1026 wrote:Perhaps I was being a bit hasty there, but the risk of the interest rates shifting is always there for any bond investment, and that part is extremely well documented. But if we make the assumptions that none of us have a crystal ball with respect to interest rates, it makes sense to talk about two numbers - the return if interest rates do not change, and the amount that one would lose or gain if the interest rates shifted.
The phrase "Apart from that Mrs. Lincon, how was the play?" springs to mind.

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Re: Is there any downside to investing in bond futures?

Post by Kevin M » Wed Jul 23, 2014 2:25 pm

Fascinating topic. Seems a little too complicated for me these days, but I have been taking advantage of 5-year direct CDs as a superior alternative to 5-year treasuries (which as pointed out gives one the similar retail-investor-arbitrage benefit).

Kevin
Wiki ||.......|| Suggested format for Asking Portfolio Questions (edit original post)

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Taylor Larimore
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A complex Wall Street creation. What to do?

Post by Taylor Larimore » Wed Jul 23, 2014 2:57 pm

"As a general rule of thumb, the more complexity that exists in a Wall Street creation, the faster and farther investors should run." -- David Swensen, Yale Chief Investment Officer
"You shouldn't buy anything too complex to explain to the average 12-year old." -- Jane Bryant Quinn, Financial author and syndicated columnist.
Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

Johno
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Re: Is there any downside to investing in bond futures?

Post by Johno » Wed Jul 23, 2014 3:07 pm

magician wrote:
Tanelorn wrote:Thank you magician for correcting my math on the futures pricing.

More generally, would it be right to say that a fully collateralized position of rolling front month treasury futures, say 10 year ones, would approximate have the same interest rate risks and returns as a treasury bond fund with the same duration as whatever is typical of the 10 year cheapest to deliver treasury bond?
Yup.

The downside would be all of the transaction costs every time you roll over the futures.
Which as described above comes to around 8bps pa. OTOH putting the 90% of the cash you'd need to buy the treasury, but don't need to support the futures position, into a bank account results in a pick up of around 60bps by doing it with futures/bank account rather than cash bonds. So the return is not the same, it's much better doing it with futures and bank account. But again to note, it's also much better doing it with a CD (and for the same underlying reason) though liquidity is more limited than futures/bank account option, and duration also more limited if you want long duration.
Last edited by Johno on Wed Jul 23, 2014 3:09 pm, edited 1 time in total.

Beliavsky
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Re: Bond futures -- A Wall Street creation. What to do?

Post by Beliavsky » Wed Jul 23, 2014 3:09 pm

Taylor Larimore wrote:
As a general rule of thumb, the more complexity that exists in a Wall Street creation, the faster and farther investors should run. -- David Swensen, Yale Chief Investment Officer
Best wishes.
Taylor
Yale's endowment is not invested primarily in simple, passive, stock and bond investments:

http://investments.yale.edu/index.php/2 ... allocation
Over the past two decades, Yale dramatically reduced the Endowment's dependence on domestic marketable securities by reallocating assets to nontraditional asset classes. In 1993, just under half of the Endowment was committed to U.S. stocks, bonds, and cash. Today, domestic marketable securities account for approximately one-tenth of the portfolio, while foreign equity, private equity, absolute return strategies, and real assets represent nearly nine-tenths of the Endowment.

The heavy allocation to non-traditional asset classes stems from their return potential and diversifying power. Today's actual and target portfolios have significantly higher expected returns and lower volatility than the 1993 portfolio. Alternative assets, by their very nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management. The Endowment's long time horizon is well suited to exploiting illiquid, less efficient markets such as venture capital, leveraged buyouts, oil and gas, timber, and real estate.

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Taylor Larimore
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Yale's endowment and Vanguard's Balanced Index Fund

Post by Taylor Larimore » Wed Jul 23, 2014 3:35 pm

Taylor Larimore wrote:
As a general rule of thumb, the more complexity that exists in a Wall Street creation, the faster and farther investors should run. -- David Swensen, Yale Chief Investment Officer
Beliavsky wrote:
Yale's endowment is not invested primarily in simple, passive, stock and bond investments.
Perhaps it should be. In 2013 Yale's Endowment generated a 12.5% return. Vanguard's Balanced Index Fund generated a 18.2% return.

Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

Johno
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Re: A complex Wall Street creation. What to do?

Post by Johno » Wed Jul 23, 2014 3:36 pm

Taylor Larimore wrote:
"As a general rule of thumb, the more complexity that exists in a Wall Street creation, the faster and farther investors should run." -- David Swensen, Yale Chief Investment Officer
"You shouldn't buy anything too complex to explain to the average 12-year old." -- Jane Bryant Quinn, Financial author and syndicated columnist.
Best wishes.
Taylor
An investor shouldn't do anything he or she doesn't fully understand. That goes without saying IMO, but whether or not a 12 yr old understands it is irrelevant either way, with all due respect to Jane Bryant Quinn. And as the come back on Yale endowment illustrates, there's a valid distinction between doing more complicated things one understand, and buying 'Wall Street creations'. One year's returns certainly don't invalidate that general idea, but actually I don't know or care what the Yale endowment does relative to slightly complicated trades I might do that definitely work.

As far as how bond futures prices work relative to bonds that is a bit complicated but I haven't chimed in because it's not relevant to the individual investor. In that case you can be sure that professionals will arbitrage any but very small deviation in the price of the futures contract from the economics of buying the cheapest to deliver bond and financing it in the repo market (you should be aware which issue is CTD, even though you'd never take delivery, because tells you where you are on the yield curve by being long the contract, eg. the CTD for the 10 yr note contract in today's environment is generally a 7-8yr).

The thing the professional market *cannot* arb out is the difference between the repo rate and the similarly govt risk, ~0 duration maximum available FDIC insured retail bank account rate. Once more, a similar form of this arb, the essence of it, exists between CD's and treasuries, but futures might work better in certain cases based on liquidity, very long duration available (in the 'ultra' contract), and/or if one has limited room in tax deferred accounts. In such a case the IRA can be used to house the return from duration via futures, compactly, with only the zero duration (bank account) return subject to immediate tax outside the IRA.

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Re: Is there any downside to investing in bond futures?

Post by Tanelorn » Wed Jul 23, 2014 4:09 pm

Ok, here's a first crack at the math behind the advantages of bond futures over a bond fund. I'm using Johno's information on spreads and costs from earlier in this thread, and applying both the tax and collateral arbitrage effects to compute the net benefit. First, some assumptions:

33% Federal marginal income tax rate (interest and short term capital gains)
15% Long term capital gain tax rate
0% State tax rate
10% Futures collateral held (5-10x as much as minimum)
1% FDIC bank account interest (i.e. SFGI Direct or GE Bank)
0.09% annual costs for rolling futures quarterly ($62.5 in spreads, 4 round trips @ 1/2 tick each, $3.50/contract * 8 = $90.50)
0.25% risk free rate for futures

Now two benchmarks for the lazy, treasury bond investor:

1. Vanguards Intermediate Treasury Fund, Admiral Class
https://personal.vanguard.com/us/funds/ ... =INT#tab=0
ER: 0.12%
SEC yield: 1.63% (after expenses)
Duration: 5.2 years

2. Vanguards Long Term Treasury Fund, Admiral Class
https://personal.vanguard.com/us/funds/ ... IntExt=INT
ER: 0.12%
SEC yield: 3.09% (after expenses)
Duration: 16.2 years

Our lazy investor will get roughly the SEC yield (+- luck from market movements) on a pretax basis. After taxes at 33%, he would be left with 1.09% or 2.07% respectively for the intermediate and long term funds. How much better can he do with bond futures? For now, I will assume there exists a hypothetical bond future corresponding to the right duration of these funds so we can see the benefit without getting too deep into the logistics. First, let's get the pretax return of the futures investor:

Futures yield = SEC yield + fund ER (what the bond would earn) - risk free = 1.50% (Int) or 2.96% (Long)
Cash yield = FDIC rate * 90% (leaving 10% for futures collateral) = 0.90%
Pretax total yield = 2.31% (Int) or 3.77% (Long)
Post-tax total yield = 1.70% (Int) or 2.84% (Long), by applying the 60/40 rates to the futures and regular to the cash

This is 0.68% better than the bond versions in both cases on a pretax basis (due to the cash collateral arbitrage), and 0.61% (Int) or 0.77% (Long) better on an after-tax basis (due to the lower average tax rate on the futures yield). State taxes may complicate this, since treasuries are state tax exempt but capital gains from futures and bank interest are not. However, even with a 10% state tax, there was still about a 0.4% after-tax advantage to the bond futures.

I am not an expert on bond futures, so I would appreciate corrections of any errors or bad assumptions I may have made here. It does look like it should be possible to take the same risk as a treasury mutual fund while earning around 0.5% more. That's a big % given present interest rates!

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Chan_va
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Re: Is there any downside to investing in bond futures?

Post by Chan_va » Wed Jul 23, 2014 4:27 pm

Isn't this another variation on the "borrow short, lend long" strategy? You are comparing a 0 duration bond (FDIC savings acct) with a 5 year duration bond. All is well if the interest rates don't move, but what if they do?
Tanelorn wrote:Ok, here's a first crack at the math behind the advantages of bond futures over a bond fund. I'm using Johno's information on spreads and costs from earlier in this thread, and applying both the tax and collateral arbitrage effects to compute the net benefit. First, some assumptions:

33% Federal marginal income tax rate (interest and short term capital gains)
15% Long term capital gain tax rate
0% State tax rate
10% Futures collateral held (5-10x as much as minimum)
1% FDIC bank account interest (i.e. SFGI Direct or GE Bank)
0.09% annual costs for rolling futures quarterly ($62.5 in spreads, 4 round trips @ 1/2 tick each, $3.50/contract * 8 = $90.50)
0.25% risk free rate for futures

Now two benchmarks for the lazy, treasury bond investor:

1. Vanguards Intermediate Treasury Fund, Admiral Class
https://personal.vanguard.com/us/funds/ ... =INT#tab=0
ER: 0.12%
SEC yield: 1.63% (after expenses)
Duration: 5.2 years

2. Vanguards Long Term Treasury Fund, Admiral Class
https://personal.vanguard.com/us/funds/ ... IntExt=INT
ER: 0.12%
SEC yield: 3.09% (after expenses)
Duration: 16.2 years

Our lazy investor will get roughly the SEC yield (+- luck from market movements) on a pretax basis. After taxes at 33%, he would be left with 1.09% or 2.07% respectively for the intermediate and long term funds. How much better can he do with bond futures? For now, I will assume there exists a hypothetical bond future corresponding to the right duration of these funds so we can see the benefit without getting too deep into the logistics. First, let's get the pretax return of the futures investor:

Futures yield = SEC yield + fund ER (what the bond would earn) - risk free = 1.50% (Int) or 2.96% (Long)
Cash yield = FDIC rate * 90% (leaving 10% for futures collateral) = 0.90%
Pretax total yield = 2.31% (Int) or 3.77% (Long)
Post-tax total yield = 1.70% (Int) or 2.84% (Long), by applying the 60/40 rates to the futures and regular to the cash

This is 0.68% better than the bond versions in both cases on a pretax basis (due to the cash collateral arbitrage), and 0.61% (Int) or 0.77% (Long) better on an after-tax basis (due to the lower average tax rate on the futures yield). State taxes may complicate this, since treasuries are state tax exempt but capital gains from futures and bank interest are not. However, even with a 10% state tax, there was still about a 0.4% after-tax advantage to the bond futures.

I am not an expert on bond futures, so I would appreciate corrections of any errors or bad assumptions I may have made here. It does look like it should be possible to take the same risk as a treasury mutual fund while earning around 0.5% more. That's a big % given present interest rates!

Beliavsky
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Re: Is there any downside to investing in bond futures?

Post by Beliavsky » Wed Jul 23, 2014 4:42 pm

S&P has created bond futures indices that roll to the front-month contracts, as described in their publication "S&P Global Bond Futures Index Series Methodology", available online. With the ticker symbols in that report you can download historical data from Quandl from late 2008 on. So if someone wants to test long-only bond futures strategies, this is a way to start.

Tanelorn
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Re: Is there any downside to investing in bond futures?

Post by Tanelorn » Wed Jul 23, 2014 6:10 pm

Chan_va wrote:Isn't this another variation on the "borrow short, lend long" strategy? You are comparing a 0 duration bond (FDIC savings acct) with a 5 year duration bond. All is well if the interest rates don't move, but what if they do?
No, it is not a borrowing trade - the advantages, as I laid out, come from both superior tax treatment and superior cash collateral returns available to individual investors via FDIC. The idea is that, up to a few adjustments (like costs), holding an appropriate bond future is the same as holding that bond. This is what I confirmed with magician a few post up (http://www.bogleheads.org/forum/viewtop ... 5#p2131026).

This means that you will get all the gains or losses of the bond fund, only via the future instead. That will be good if rate expectations fall, and bad if they rise. And you'll get an extra 0.50% after tax on top of whatever the bonds end up doing if you go the futures route (assuming I got my calculations right).

It's a little like owning a house. Even with a mortgage, you get all the gains or losses of the real estate market (barring default), from the time you buy until the time you sell. Futures let you get a lot of exposure with only a little capital, although you have to keep adding capital if the position moves against you or your broker will sell it.

lee1026
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Re: Is there any downside to investing in bond futures?

Post by lee1026 » Wed Jul 23, 2014 7:32 pm

And you ignored the 2nd part in your strategy. That is the interest rate risk, which is the fundamental risk of fixes income securities.
I did. I was comparing between rolling treasuries to buy a much longer dated muni fund. Rolling the 5 year treasury seems to offer around the same yield as the 20+ year CA tax exempt bond funds. As the 5 year treasury is a 5 year bond, it would be far less exposed to interest rate shifts relative to muni bonds. Same gains with lower risk seems like a win in my book.
"You shouldn't buy anything too complex to explain to the average 12-year old." -- Jane Bryant Quinn, Financial author and syndicated columnist.
Even stocks seem too complicated to explain to an average 12-year old, when you really get down into it. It is quite complex to explain the precise set of conditions under which a stock would lose or gain value. Bonds have the problem with interest rates and default risk. Simpler, but still somewhat complex, especially for anything other then a treasury. The only thing that I think I can explain to an 12 year old is a checking account, really.

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Re: Is there any downside to investing in bond futures?

Post by market timer » Wed Jul 23, 2014 9:44 pm

lee1026 wrote:Perhaps I was being a bit hasty there, but the risk of the interest rates shifting is always there for any bond investment, and that part is extremely well documented. But if we make the assumptions that none of us have a crystal ball with respect to interest rates, it makes sense to talk about two numbers - the return if interest rates do not change, and the amount that one would lose or gain if the interest rates shifted.
You're describing roll down return, e.g., http://www.raymondjames.com/fixed_income_rolling.htm

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Re: Is there any downside to investing in bond futures?

Post by market timer » Wed Jul 23, 2014 9:53 pm

Tanelorn wrote:I am not an expert on bond futures, so I would appreciate corrections of any errors or bad assumptions I may have made here. It does look like it should be possible to take the same risk as a treasury mutual fund while earning around 0.5% more. That's a big % given present interest rates!
Your numbers looks correct. It's important to note that your analysis does not depend on earning that SEC yield you have assumed as a return. Regardless of where interest rates go, the futures strategy outperforms the mutual fund strategy. If you have carryforward losses, the comparison is even more favorable.

Tanelorn
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Re: Is there any downside to investing in bond futures?

Post by Tanelorn » Wed Jul 23, 2014 9:59 pm

market timer wrote:
Tanelorn wrote:I am not an expert on bond futures, so I would appreciate corrections of any errors or bad assumptions I may have made here. It does look like it should be possible to take the same risk as a treasury mutual fund while earning around 0.5% more. That's a big % given present interest rates!
Your numbers looks correct. It's important to note that your analysis does not depend on earning that SEC yield you have assumed as a return. Regardless of where interest rates go, the futures strategy outperforms the mutual fund strategy.
Yes, I was just using the SEC yield as the expected return for the base case. Certainly if bonds rise or fall, that will impact the tax calculations as well, but as you say the outperformance will be there from the collateral effect even if it just means you lost less than you would have otherwise.
If you have carryforward losses, the comparison is even more favorable.
Absolutely! Hopefully that will cease to be an issue for you soon :).

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