vineviz wrote: ↑Sun Sep 01, 2019 12:52 pm
I think it should be very apparent that the performance of LTTs relative to t-bills has varied considerably depending on the policy regime. The 1951-1979 era not only was period in which the returns of LTTs was lower: volatility, skewness, and excess kurtosis were also much lower. We rarely observe such large swings in the basic characteristics of other securities over time, which I why I think treasury data pre-1979 should only run under a caution flag.
I think what you've laid out can be approached in a couple of ways by an investor who is operating in the forward direction.
In our lifetimes, the people who have profited the most were those who locked in high rates in the early 80s and held on and profited through this regime change. Obviously not everybody did that (else rates wouldn't have been so high). But you can only get that benefit once. We aren't going to change from a pre-Volcker to a post-Volcker world again.
Now everybody is investing based on the understanding that inflation is under control in developed economies. The bigger concern right now is mild deflation and whether policy makers can prevent that.
But what if the regime changes again? It has multiple times in the past and likely will in the future. I don't think we've reached the end of history w.r.t. monetary policy. The question is, when that happens how long will it take me to figure out that it has happened? Based on the charts vineviz and nisiprius have discussed, it seems it took the market about 20 years to figure out how fundamentally that Volcker had changed things. Assuming I'm no smarter or dumber than the market, I'll assume it would take me about the same amount of time to figure out that the next fundamental change has occurred. For a human investor, that's a long time.
The second question is, if a regime change happens, could that flip the switch in favor of short-term bonds again? Possibly. Looking at current interest rates, the deeper risk seems to be that the market is not considering the possibility of higher and unpredictable inflation in the future. For people who spend money in real dollars, that is a concern.
I agree with vineviz on the fundamental point that if one doesn't know something the market doesn't know, that balancing out reinvestment risk and interest-rate risk is prudent. That generally means using longer-term bonds than most bogleheads use.
From a risk management perspective, however, the bigger risk for an investor today is that of higher inflation in the future. Doesn't mean that is likely to happen--that's just a risk that needs to be taken into consideration more than it is currently. And that leads to moving the midpoint more in the direction of shorter-term bonds.
In any given period, either the shortest term bonds or the longest term bonds are going to "work" the best from a Sharpe Ratio perspective. Intermediate bonds (which covers a pretty broad range) will never be the best. For those who are not trying match liabilities but are simply trying to construct an efficient portfolio, using intermediate bonds will never be the best nor the worst option. For most investors, this is a good place to end up.