For Dr. Bernstein on Bond Duration

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staythecourse
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Post by staythecourse » Sat May 21, 2011 2:01 pm

Who cares what did well or not between 2 random points in time.

The only dogma in picking a bond duration is that it should be no longer then when the money is needed. If you need the money in 10 yrs. don't pick a bond duration of 15 yrs.

Other then that I think people are nicely cherry picking data points to support their cause.

If one wants to look at 1967-80 then lets look at the assets that did well in such a high inflationary period. Without looking it up I'm sure the answer involves gold and commodities. Likely farmland and real estate did well, also.

If that is true it again shows a portfolio of stocks/bonds/cash/alternative investments did fine during a time period in real returns maybe worse then the Great Depression. This again shows the dogma of asset allocation is the most important decision any investor can make. Bond duration is maybe no. 10 or 20 on that list.

Many other things will gain or lose money in your portfolio before worrying about bond duration.

Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle

matt
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Re: Both sides

Post by matt » Sat May 21, 2011 3:18 pm

wbern wrote:If I'm wrong, and I well may be, I've lost a few percent of yield.

If you're wrong, you will suffer far more serious losses.
While this is true solely in respect to the choice of bond maturity, there is no reason to believe that it is true in respect to the total portfolio return. The portfolio return is the only one that matters. By the way, I'm not actually making any predictions about future rates, just pointing out your argument in the near certainty of rising rates has no basis. Rates will go up, down, or stay sideways.

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Post by matt » Sat May 21, 2011 4:05 pm

And to follow up with actual math from historical examples. All calculations assume annual rebalancing.

1991-2008 Japan (see data here http://www.bogleheads.org/forum/viewtop ... ht=#432434):
Portfolio with 50% stocks/50% T-bills returned -0.01% per year
Portfolio with 50% stocks/50% 10-Year bonds returned 2.69% per year
Advantage with longer bond maturities: 2.70% per year

1965-1981 United States:
Portfolio with 50% S&P 500/50% T-bills returned 6.88% per year
Portfolio with 50% S&P 500/50% 5-Year bonds returned 6.26% per year
Portfolio with 50% S&P 500/50% Long-Term bonds returned 4.75% per year
Advantage with shorter bond maturities: 0.62% to 2.13% per year

Unfortunately I have limited data so there is not a direct comparison between bond maturities. However, it is clear that the advantage of a 10-year bond in Japan's deflation provided more benefit than the supposedly worrisome disadvantage of 20-Year long-term bonds during inflation. Had I been able to use a series with longer-term Japanese bonds, the advantage to the long bond in deflation scenario would have been even greater.

So here is some actual data supporting the idea that the advantages of long-term bonds in deflation may be more important than the disadvantages of long-term bonds during inflation. It is not decisive, of course, but I think it's a lot more valuable to see relevant examples from the past than rely on an unsubstantiated opinion of the future.

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TIPS

Post by Bill Bernstein » Sat May 21, 2011 5:15 pm

One last point.

I don't want to give the impression that I'm anti-TIPS.

Far from it: they're ideal for establishing a secure real stream of future income; i.e., when held to maturity, they're as riskless a real asset as you can find, and a TIPS ladder does this nicely.

But until maturity, they carry significant liquidity risk. This means two things:

1) Don't fund your retirement with a TIPS fund. (In addition, why pay anyone an expense ratio--even a skinny Vanguard one--to own the things?)

2) Don't consider them as part of the liquid, riskless part of your portfolio before they mature.

Bill

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Post by mithrandir » Sat May 21, 2011 5:52 pm

It may be helpful to review the durations of the 3 VG Treasury Funds.

Short - 2.0 years
Intermediate - 5.0 years
Long - 12.8 years

Frankly I didn't realize the intermediate fund was that "short" in duration. When I hear "intermediate" I tend to think 7-10 years. Of course the fund is actively-managed and its current duration may appear prudent.

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More

Post by Bill Bernstein » Sat May 21, 2011 6:04 pm

Matt:

My post may have strayed to another thread, not sure about that.

Your points are all well taken. I guess the point I'm making may well be a psychological one: while losses in any part of the portfolio are painful, the most painful type is that which combines significant losses in both the risky and riskless part of the portfolio. It's one thing to lose money in stocks: that's supposed to happen. But having to take after-inflation losses on the bond side to buy cheap stocks or pay living expenses is profoundly demoralizing to most folks, including this one.

Bill

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Re: More

Post by Noobvestor » Sat May 21, 2011 7:05 pm

wbern wrote:Matt:

My post may have strayed to another thread, not sure about that.

Your points are all well taken. I guess the point I'm making may well be a psychological one: while losses in any part of the portfolio are painful, the most painful type is that which combines significant losses in both the risky and riskless part of the portfolio. It's one thing to lose money in stocks: that's supposed to happen. But having to take after-inflation losses on the bond side to buy cheap stocks or pay living expenses is profoundly demoralizing to most folks, including this one.

Bill
I agree completely, but what about the increasing liquidity of TIPS, and the uniqueness of the 2008/2009 situation (banks/leverage using TIPS)? (I am borrowing these points from Larry, to be fair)
"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe

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TIPS

Post by Bill Bernstein » Sat May 21, 2011 7:17 pm

Huh? There hasn't been much improvement in TIPS spreads since 2008; before then, spreads were much tighter.

Was 2008unique, a "100-year flood"?

No. There are few guarantees in finance, but one of them is that over the course of a lifetime of investing, you're going to see several stock market crashes, and at least one or two banking panics.

Add to that the fact that nothing has changed since 2008; if anything, the remaining banks, which were too big to fail, are even bigger. The trading system has gotten even more complex and linked, which is a prescription for instability. Fear and greed have not been banished, and from time to time, we will reap the whirlwind.

Risky assets will likely (but not certainly) still do fine in the long term. But hold onto your hat, and keep some real liquidity available for a rainy day.

Bill

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BruceM
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Post by BruceM » Sat May 21, 2011 7:44 pm

Hi Bill
A bit OT..
don't know if you are aware, but local Bogelheads here (Portland) meet quarterly, and you are welcome to come and share your views.

BruceM

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Post by fishnskiguy » Sat May 21, 2011 9:02 pm

fishnskiguy wrote:New question for Dr. Bill.

Have you actually shortened the duration of your client's FI portfolios since, say, 1999, or have you always been short?

Thanks in advance.

Chris
Bump.
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Post by fredflinstone » Sun May 22, 2011 5:39 am

Lbill wrote: Dr. B. - Appreciate your comments, all of which are critical. I've thought of them also, and like to play Devil's Advocate if you'll indulge me. First, you are certainly correct that we've enjoyed a long period of falling interest rates and that's boosted bond returns historically. So you'd expect the 50% bonds portfolio to do better than 50% T-Bills. The only period of rising rates I'm able to backtest is during the inflationary 1970s. As expected, holding 50% in intermediate treasuries didn't fare as well as having 50% in T-Bills, but the difference wasn't catastrophic. The average annual real difference from 1972-1981 was (-0.88%) and the worst real single year difference was (-3.29%) in 1980.

If you look at rolling 3- and 5-year returns during this period the difference is ameliorated - the average real difference was (-0.46%) and (-0.14%) respectively.
This is an outstanding analysis. Thank you! I am curious: How did you backtest this?

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Post by Lbill » Sun May 22, 2011 8:16 am

Dr. B. Thanks so much for your input to this thread. It is terrific to have so much of your time, generously given. I strongly agree with your point that investors should weigh the "worst case" scenario for their portfolio and I try to do that. I'm still a bit intellectually troubled by the Pascal's Wager argument, however, and perhaps you can help me with this. On it's face, PW would seem to support always taking a very conservative investment approach. With particular regard to bonds, PW would seem to suggest having very short duration at all times, and not just now when there is a justifiable expectation that rates may escalate. Otherwise, aren't we engaging in a bit of "market timing," in the sense that we're saying that there are some times when PW should be factored in, and other times when it is less relevant? I suppose one could argue that when interest rates were in the double digits back in 1980 the "worst case" scenario for rates wasn't as likely as is the worst case scenario today (e.g. that rates could double or triple). But we didn't know this for sure back then did we - only in retrospect? I was there, and even when rates were 15%, everyone was quite worried about hyperinflation and justifiably avoided long bonds like the plague (which would have been the investment of the century). I'd be interested in your take on the fine points of consistently applying the Pascal's Wager standard across time and markets and avoiding what could be a sort of "closet" market-timing approach. Thanks.
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Post by Leesbro63 » Sun May 22, 2011 8:26 am

<moved>
Last edited by Leesbro63 on Sun May 22, 2011 9:56 am, edited 1 time in total.

Bill Bernstein
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PW

Post by Bill Bernstein » Sun May 22, 2011 9:16 am

One has to use one's judgment, of course.

Back in 1981, PW would have told you to avoid long T's, but with the coupon on the 5-year at 15%, there was a huge margin of safety for any inflation rate lower than that. With the 5-year at 1.8%, that margin is gone.

Similarly, what I wrote in TIM in 2009 was that expected returns were high, but so were significant risks. If you went all in and were wrong, the results would be very bad. So PW dictated keeping something in reserve.

The key thing is not to chicken out at every 1% or even 5% possibility.

I would rate the possibility of severe inflation at maybe less than 50%, maybe not. But certainly a lot more than 5%.

That, I think, is the key. Some posters on this thread have laughed at the risk of hyperinflation, and, I'm assuming, rate its probability at less than, say, 5%. How can they be so sure? I think there's a risk of it, but there may be a 50% chance I'm wrong. We are in terra nova here; never before has a central bank printed vast amounts of money and then bought government securities with it. The outcome is highly uncertain, and anyone who tells you they know for sure whether or not it's going to produce severe inflation is fooling at least themselves, and probably others as well.

What PW certainly tells you, which I think such folks are ignoring, is to be beware of such inappropriate certitude.

Bill

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Post by Leesbro63 » Sun May 22, 2011 9:56 am

Dr. Bill: I know this is off the bond topic (but still within the PW topic that the original topic evolved to), but while we have you chatting: What about the PW problem of selling a lot of safe fixed income after a stock crash to rebalance? Risking yet a further crash? Like rebalancing at DOW 6600 after DOW 14000 but the DOW goes to 3300 instead of 12000?
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Re: PW

Post by Noobvestor » Sun May 22, 2011 9:56 am

wbern wrote:One has to use one's judgment, of course.

Back in 1981, PW would have told you to avoid long T's, but with the coupon on the 5-year at 15%, there was a huge margin of safety for any inflation rate lower than that. With the 5-year at 1.8%, that margin is gone.

Similarly, what I wrote in TIM in 2009 was that expected returns were high, but so were significant risks. If you went all in and were wrong, the results would be very bad. So PW dictated keeping something in reserve.

The key thing is not to chicken out at every 1% or even 5% possibility.

I would rate the possibility of severe inflation at maybe less than 50%, maybe not. But certainly a lot more than 5%.

That, I think, is the key. Some posters on this thread have laughed at the risk of hyperinflation, and, I'm assuming, rate its probability at less than, say, 5%. How can they be so sure? I think there's a risk of it, but there may be a 50% chance I'm wrong. We are in terra nova here; never before has a central bank printed vast amounts of money and then bought government securities with it. The outcome is highly uncertain, and anyone who tells you they know for sure whether or not it's going to produce severe inflation is fooling at least themselves, and probably others as well.

What PW certainly tells you, which I think such folks are ignoring, is to be beware of such inappropriate certitude.

Bill
Well put and, like the others: much appreciate you weighing in here in general.

Having come back to the question of serious inflation, is it time to time the market beyond bond duration? As in: are there new places in a portfolio for cash, commodities, REITs (perhaps even TIPS, despite the liquidity issue) for those who hold none of the above - or is that excessively panicky?

I posted these on another thread (here: http://www.bogleheads.org/forum/viewtopic.php?p=1014318 ) but they seemed appropriate to repost:

Image

Image

Image

via: https://guidance.fidelity.com/viewpoint ... -deflation

And as long as I'm going a bit off-topic, but have your ear yet, I would really like to know your thoughts on a specific commodities fund, namely: the equally-weighted GCC (Greenhaven Continuous Commodities) which strikes me as a potentially 'better' play than market-weighted ones.
"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe

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Post by matt » Sun May 22, 2011 11:34 am

Lbill wrote:I'm still a bit intellectually troubled by the Pascal's Wager argument, however, and perhaps you can help me with this. On it's face, PW would seem to support always taking a very conservative investment approach.
Leesbro63 wrote:Dr. Bill: I know this is off the bond topic (but still within the PW topic that the original topic evolved to), but while we have you chatting: What about the PW problem of selling a lot of safe fixed income after a stock crash to rebalance? Risking yet a further crash? Like rebalancing at DOW 6600 after DOW 14000 but the DOW goes to 3300 instead of 12000?
It is wise to challenge the Pascal's Wager argument, as it's original use in relation to belief in God is fallacious. As we are seeing, it is just as fallacious in investing.

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Post by Leesbro63 » Sun May 22, 2011 12:29 pm

matt wrote: It is wise to challenge the Pascal's Wager argument, as it's original use in relation to belief in God is fallacious. As we are seeing, it is just as fallacious in investing.
Matt, I fess up that I don't understand your point. But I THINK you are reinforcing these two issues I have with even the BOGLEHEAD system. Inability or unwillingness to confront these two Pascal's Wager issues. Or, more probably, to loudly declare and acknowledge that these are the anomalies of even the best investing system that cannot be avoided. Personally, I think the answer is to stay short when bond yields leave no room for error, as Dr. Bernstein so succinctly stated. And as to the rebalance conundrum, there has to be some sort of rule or system that addressed the "rebalance and die" problem. I'm hoping that Dr. Bill addresses this here.

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Post by matt » Sun May 22, 2011 1:10 pm

Leesbro63 wrote:
matt wrote: It is wise to challenge the Pascal's Wager argument, as it's original use in relation to belief in God is fallacious. As we are seeing, it is just as fallacious in investing.
Matt, I fess up that I don't understand your point. But I THINK you are reinforcing these two issues I have with even the BOGLEHEAD system. Inability or unwillingness to confront these two Pascal's Wager issues. Or, more probably, to loudly declare and acknowledge that these are the anomalies of even the best investing system that cannot be avoided. Personally, I think the answer is to stay short when bond yields leave no room for error, as Dr. Bernstein so succinctly stated. And as to the rebalance conundrum, there has to be some sort of rule or system that addressed the "rebalance and die" problem. I'm hoping that Dr. Bill addresses this here.
The point is that since Pascal's Wager is a logical fallacy, you should not accept it as an argument to do or not do anything in particular. This idea that it's a one-sided bet is completely false.

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Post by BC_Doc » Sun May 22, 2011 2:47 pm

I'm not sure if anyone has posted this link up on another thread. Here's a chart from Morning Star comparing the performance of short-term municipal securities (VWSTX) versus intermediate term municipal bonds (VWITX) beginning in late 1977. It looks like it takes about ten years for the $10k invested in the intermediate term fund to catch up with the same $10k invested in the short-term fund. VWITX takes about a 20%+ haircut in the first four years post investment. VWSTX does a slow and steady chug upwards. Short looks good in this rising interest rate scenario.


http://quote.morningstar.com/fund/chart ... %2C0%22%7D

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Post by Leesbro63 » Sun May 22, 2011 3:16 pm

matt wrote: The point is that since Pascal's Wager is a logical fallacy, you should not accept it as an argument to do or not do anything in particular. This idea that it's a one-sided bet is completely false.
I don't understand what you are claiming here. I don't think "one side" bet is what is claimed...just a "bet with not great odds and terrible consequences".

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Post by Leesbro63 » Sun May 22, 2011 3:17 pm

By the way, Rick Ferri seems to be the guru who sticks to "the system" the most, like religion. He stays with intermediate "peak of the yield curve" bonds, rebalances come hell or high water and doesn't time anything.

Larry market-times TIPS and Dr. Bernstein is timing bonds. Don't get me wrong, I am actually in agreement with Dr Bernstein (and am not sure either way about timing TIPS). But for the record, this exercise in "comparison of the gurus" seems to show Rick as the "most religious".

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Orthodoxy

Post by Bill Bernstein » Sun May 22, 2011 3:32 pm

Uh, no. Even Rick will admit to the odd heresy, as when he talked up bank stocks in Sept. '08. In the end, he was right.

The more righteous, the more delicious the sin ;-)

Bill

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Post by Leesbro63 » Sun May 22, 2011 3:48 pm

:)

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Post by BC_Doc » Mon May 23, 2011 3:40 am

Dr. Bernstein,
Do you have any thoughts on the merits of underweighting or even avoiding US Treasuries? With QE, the Federal Reserve has been involved in some pretty heavy product tampering (to the holder's detriment). For US fixed income exposure, should a rational consumer steer toward municipal and corporate bonds?
Thanks for any insight you may have.
BC Doc

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Re: PW

Post by Valuethinker » Mon May 23, 2011 4:59 am

wbern wrote: That, I think, is the key. Some posters on this thread have laughed at the risk of hyperinflation, and, I'm assuming, rate its probability at less than, say, 5%. How can they be so sure? I think there's a risk of it, but there may be a 50% chance I'm wrong. We are in terra nova here; never before has a central bank printed vast amounts of money and then bought government securities with it. The outcome is highly uncertain, and anyone who tells you they know for sure whether or not it's going to produce severe inflation is fooling at least themselves, and probably others as well.

What PW certainly tells you, which I think such folks are ignoring, is to be beware of such inappropriate certitude.

Bill
Let me summarize the below:

If we have never had hyperinflation before, not even in the 1970s, and Central Banks are merely using tools they already use, but to a greater extreme, and we've had the 1970s triggers to higher inflation, without much apparent effect to wages and expectations, then why should we worry about hyperinflation now?

Conversely we could worry about Central Banks trying to get 'ahead of the curve' and raise interest rates faster than current market expectations.

And we should always worry about the long term effects of even 3-4% inflation on the position of retirees and future retirees.


Hmmm..

Well Zimbabwe did and it did produce hyperinflation.

Japan did, and the deflationary forces continued.

The problem is that to cause hyperinflation, the market has to believe that the money supply is not only increased now, but is permanently increased for all future states of the world. Ie that the last 100 years of Central Banking discipline is abandoned (which it was, in Zimbabwe). If the market thinks at any time in the future you might get low inflation orthodoxy again, then the expected money supply has not increased, and so you don't get inflation.

I am not sure 'never' re printing money. In fact buying securities with printed money is precisely what central banks do every day (they also do the reverse: sterlization).

I am not sure how one puts a probability on hyperinflation.

The reason being Central Banks (and not just the ECB) are itching to 'pull the trigger' and raise interest rates. One has to figure the institutional response.

The risk then would be that they were 'behind the curve' on rising inflationary expectations.

In which case, they would try to get ahead of the curve, an unpleasant place for bond markets which have grown quiescent on low, and unchanging, official interest rates.

Remember the Fed and the B of E simply have to *stop* QE and, roughly speaking, c. 10-15% of that monetary stimulus is withdrawn in the subsequent 12 months (depending on the duration of the bond portfolio).

So in some sense 'probability of hyperinflation' strikes me as a bit like 'probability of the Big One flattening California' or 'probability of a significant meteorite striking in the North Atlantic' or 'probability of the Canary Islands undersea slide taking place'. They'd all be completely devastating to financial markets, might drown New York and/or London, but it's hard to position your portfolio against them.

However 'probability of significant inflation, more than markets are forecasting' is a more realistic concern. Somehow what is going on in China (higher wages, domestic inflation) spreads out into the global macroeconomy.

(there's a symmetry issue here. The reason the US economy could grow much faster than historic, with very loose monetary policy, in the 1990s was really down to WalMart, the logistics revolution, and Chinese manufacturing lowering the price of goods (Schwab going online was another factor). The McKinsey studies seemed to show that clearly. However whether the converse is also true (that without China, you cannot have that deflationary force) is not abundantly clear. What I think will happen is simply Chinese production will move: some will resource back to the US (where labour productivity is high and high unemployment prevents wage rises), some to inland China, some to other E Asian countries).)

Because it would solve the macroeconomic problem of excessive private sector debt. The very thing which is crippling the economies of many western nations right now. 5 or 6% inflation would do a world of good for Ireland, Greece, Portugal, Spain and, in fact, the UK and US. 5 or 6% inflation if unanticipated, that is.*

*that* we can worry about. And the response of the Fed and the B of E (which would likely be dramatic).

What is interesting is that if you had given you or I a card with commodity, especially oil, prices now in 2000 we would have predicted far, far higher inflation. The 70s would have told us that higher raw materials prices kicks off higher inflation via the wage-price spiral.

And yet it hasn't happened. It just has not happened. Oil is the critical commodity of industrial civilisation, the price has trebled, and the inflation dial has hardly flexed.

There is something quite unique about the 1970s in macroeconomic history. Rooted in the power of trade unions at that time, low unemployment, the aftereffects of the Vietnam War demand shock, rising oil prices.

As to hyperinflation, it has not happened in a western economy in a long time: you usually have to have military defeat/ political collapse (Weimar, Confederate States of America, KMT China 1945-1949, South Vietnam etc.). It has happened in some emerging markets (Turkey, Israel, Brasil) and you could argue it came close in Britain and Italy in the 70s (20% inflation) but nowhere else, and both of those centred around very strong trade unions and political compromises with same (the Coal Miner's Strike of 1974 looms large).

* the UK and the US have almost pulled this off. The precipitate falls in currency, post crisis, have been much bigger factors in monetary easing than any 'QE' (directly). You make imports more expensive, exports and tourism cheaper, and you deflate real wages by holding nominal wages and prices sticky (easy to do when unemployment is soaring) and letting the rising prices of imports do the work for you.

The effect is obviously far more pronounced here.

If the Chinese had allowed their currency to appreciate more we'd have lower inflation in China, fewer concerns with Chinese prices, and probably the Fed and the B of E would be that much closer to raising rates. And the Euro would be in (a little bit) less of a mess.

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Post by Valuethinker » Mon May 23, 2011 5:06 am

BC_Doc wrote:I'm not sure if anyone has posted this link up on another thread. Here's a chart from Morning Star comparing the performance of short-term municipal securities (VWSTX) versus intermediate term municipal bonds (VWITX) beginning in late 1977. It looks like it takes about ten years for the $10k invested in the intermediate term fund to catch up with the same $10k invested in the short-term fund. VWITX takes about a 20%+ haircut in the first four years post investment. VWSTX does a slow and steady chug upwards. Short looks good in this rising interest rate scenario.


http://quote.morningstar.com/fund/chart ... %2C0%22%7D
In a 'scram the reactor' scenario by the Central Banks the yield curve swiftly reverses. That hits ST rates hard, but LT rates much less so (the market figures eventually the Central Bank gets inflation under control).

In a falling interest rate scenario then IT and LT bonds beat ST bonds. Given where interest rates are now, it's a lot harder to bet on Japan (1.5% interest rates long) than it is on a reversal to normal (US Treasury 30 year at 5-5.5%?).

The one problem with ST bonds right now is that yields are exceptionally low due to a highly stimulative monetary policy (the Fed and the B of E are maxed out, trying to create some inflation in the system).

Generally you are better in ST bonds, though. Why live in a more risky world than you need to?

Remembering that interest rates can fall from 21% to 3%, but it's a lot shallower dive down to 1.5%-- your upside is limited. But they could go back up a lot higher (and a doubling of interest rates from 3% to 6% would really hurt bond prices).

The old nostrum is there:

- for fixed income, stay on the short side

- if you must go long, favour Real Return Bonds/ TIPS (although the Canadian RRBs aren't terribly attractive right now)

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Post by Valuethinker » Mon May 23, 2011 5:12 am

BC_Doc wrote:Dr. Bernstein,
Do you have any thoughts on the merits of underweighting or even avoiding US Treasuries? With QE, the Federal Reserve has been involved in some pretty heavy product tampering (to the holder's detriment). For US fixed income exposure, should a rational consumer steer toward municipal and corporate bonds?
Thanks for any insight you may have.
BC Doc
Corporate bonds give you a bit of a higher yield but they give you equity risk.
(disclosure I hold investment grade corporate bond funds)

You have to bet we don't rerun 2008, or do a Japan, or it might not be pretty.

Municipals normally for USians choice is extremely limited re term etc. Beware of credit risk-- we don't have to be Meredith Whitney to think there is some trouble ahead (again not much you can do about it, usually, but a national muni fund perhaps a side bet alongside your state one?).

If one is bearish about US Treasury Bonds, probably the best strategy is to be in ST bonds. The same factors that would hit those T Bonds will hit all bonds (higher interest rates).

The one thing to watch over this summer is Washington, because that really would disrupt the bond markets if a lot of brinksmanship goes on. But that's just a timing view.

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Post by Lbill » Mon May 23, 2011 9:10 am

That, I think, is the key. Some posters on this thread have laughed at the risk of hyperinflation, and, I'm assuming, rate its probability at less than, say, 5%. How can they be so sure? I think there's a risk of it, but there may be a 50% chance I'm wrong. We are in terra nova here; never before has a central bank printed vast amounts of money and then bought government securities with it. The outcome is highly uncertain, and anyone who tells you they know for sure whether or not it's going to produce severe inflation is fooling at least themselves, and probably others as well.
Thank you, Dr. B for your explanation. Pascal's Wager is a special example of decision utility, which is modelled as the multiplicative product of the magnitude of gains or losses and their associated probabilities. Pascal's Wager exemplifies decision utility where the magnitude of consequences is infinitely large; hence, outcome probability - as long as it is nonzero - has almost no significance in determining outcome utility. That is, if I believe there is any possibility, however small, of ending up in eternally in Hades for enjoying the benefits of living corruptly, utility theory says that I should choose to incur the opportunity costs of living virtuously over my mortal lifespan if that will enable me avoid incurring the infinitely negative utility of ending up in Hades.

With respect to the more secular issue of fixed-income duration, we have a less dramatic application of utility theory. Here, as your comments illustrate, the assumed probabilities of outcomes are a more significant consideration than in the arch-typical Pascal's Wager. The consequences of being "wrong," however unpleasant as they may be, are not quite as severe as eternal damnation. The decision utility matrix is much more dependent on the outcome probabilities that are assumed. Dr. B makes a compelling argument that the probability of incurring the negative consequences of holding long-term fixed income - whatever it is - is probably higher now than it has been in the past, or that it is at least much more uncertain. Utility theory would suggest that a prudent strategy would be to reduce one's usual or typical exposure to that risk in proportion to assumed probability. If the odds are 50%, which Dr. B suggest is not unreasonable, then exposure should be reduced accordingly. I'm hoping this is an accurate and reasonable - if overly pedantic - analysis of the application of PW to this issue.
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Post by matt » Mon May 23, 2011 10:10 am

Lbill wrote:
That, I think, is the key. Some posters on this thread have laughed at the risk of hyperinflation, and, I'm assuming, rate its probability at less than, say, 5%. How can they be so sure? I think there's a risk of it, but there may be a 50% chance I'm wrong. We are in terra nova here; never before has a central bank printed vast amounts of money and then bought government securities with it. The outcome is highly uncertain, and anyone who tells you they know for sure whether or not it's going to produce severe inflation is fooling at least themselves, and probably others as well.
Thank you, Dr. B for your explanation. Pascal's Wager is a special example of decision utility, which is modelled as the multiplicative product of the magnitude of gains or losses and their associated probabilities. Pascal's Wager exemplifies decision utility where the magnitude of consequences is infinitely large; hence, outcome probability - as long as it is nonzero - has almost no significance in determining outcome utility. That is, if I believe there is any possibility, however small, of ending up in eternally in Hades for enjoying the benefits of living corruptly, utility theory says that I should choose to incur the opportunity costs of living virtuously over my mortal lifespan if that will enable me avoid incurring the infinitely negative utility of ending up in Hades.

With respect to the more secular issue of fixed-income duration, we have a less dramatic application of utility theory. Here, as your comments illustrate, the assumed probabilities of outcomes are a more significant consideration than in the arch-typical Pascal's Wager. The consequences of being "wrong," however unpleasant as they may be, are not quite as severe as eternal damnation. The decision utility matrix is much more dependent on the outcome probabilities that are assumed. Dr. B makes a compelling argument that the probability of incurring the negative consequences of holding long-term fixed income - whatever it is - is probably higher now than it has been in the past, or that it is at least much more uncertain. Utility theory would suggest that a prudent strategy would be to reduce one's usual or typical exposure to that risk in proportion to assumed probability. If the odds are 50%, which Dr. B suggest is not unreasonable, then exposure should be reduced accordingly. I'm hoping this is an accurate and reasonable - if overly pedantic - analysis of the application of PW to this issue.
Supposedly people are laughing at the idea of hyperinflation. I haven't noticed that, but if Bernstein is indeed talking about hyperinflation (25+% per year) as opposed to just high inflation (5+% per year), then I will laugh. Odds are he's not talking about actual hyperinflation and this is just more of his hyperbole.

But your point of the probabilities and magnitudes is what I've been trying to get to. Bernstein laughs at the idea of low inflation and especially deflation, but I have no reason to believe that is less likely than high inflation. But since he appears to give it no weight and inflation is a sure thing and hyperinflation also a high probability, then of course the conclusion is that long-term bonds are a bad deal. In fact, he should be going one step farther and saying that all bonds are a bad deal.

But this is all just his ideological view leading to a Garbage In, Garbage Out result. Note that he hasn't provided any evidence as to why there will be so much inflation; he just thinks it is so.

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Post by Angst » Mon May 23, 2011 10:21 am

matt wrote:Supposedly people are laughing at the idea of hyperinflation. I haven't noticed that, but if Bernstein is indeed talking about hyperinflation (25+% per year) as opposed to just high inflation (5+% per year), then I will laugh. Odds are he's not talking about actual hyperinflation and this is just more of his hyperbole.

But your point of the probabilities and magnitudes is what I've been trying to get to. Bernstein laughs at the idea of low inflation and especially deflation, but I have no reason to believe that is less likely than high inflation. But since he appears to give it no weight and inflation is a sure thing and hyperinflation also a high probability, then of course the conclusion is that long-term bonds are a bad deal. In fact, he should be going one step farther and saying that all bonds are a bad deal.

But this is all just his ideological view leading to a Garbage In, Garbage Out result. Note that he hasn't provided any evidence as to why there will be so much inflation; he just thinks it is so.
Honestly, I really don't sense "hyperbole" in Dr. Bernstein's posts here; I do though in yours.

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Post by matt » Mon May 23, 2011 10:39 am

Angst wrote:Honestly, I really don't sense "hyperbole" in Dr. Bernstein's posts here; I do though in yours.
Look up the definition of hyperinflation, which Bernstein claims a fairly high probability; hyperinflation is not just "high" inflation. Then look up the definition of hyperbole. If you don't see the connection, then I guess I can't help you.

The problem is that way too many Bogleheads, you included apparently, accept as received wisdom anything one of the "experts" say. But ask yourself what it is that Bernstein is an expert in. Why is it that his opinion on the future rate of inflation should be given more weight than what the market has already forecast? I don't even believe in efficient markets, so I'm more inclined to believe that an individual can be right and the market wrong than most Bogleheads, yet I have no reason to believe Bernstein because he has provided no evidence to back up his opinion. I'm the one presenting the ideology-free viewpoint that has a rational basis. I suppose if you share his ideology, then you will accept his view uncritically. In that case, again, I can't help you.

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Re: Long Versus Short

Post by KarlJ » Mon May 23, 2011 1:01 pm

wbern wrote: Now, even with 5-year bonds, we're not talking big money. VBMFX (or, what I'd really prefer in its place, a 10-year T ladder with an intermediate corporate fund) will not be, as you point out, that much of a catastrophe in an inflationary scenario. But anything longer than that, and I think you're taking real chances.
I am impressed with the idea of a 10-year T ladder coupled with an intermediate corporate fund in preference to VBMFX, which I cannot recall being made reference to before. My understanding, perhaps limited, is that Dr Bernstein is proposing short rather than intermediate bond investments, so would a 5-year T ladder coupled with a short-term corporate bond fund be advisable for the bond portion of a portfolio, especially for those in low marginal tax brackets?

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Post by BC_Doc » Mon May 23, 2011 1:21 pm

Valuethinker wrote:
BC_Doc wrote:Dr. Bernstein,
Do you have any thoughts on the merits of underweighting or even avoiding US Treasuries? With QE, the Federal Reserve has been involved in some pretty heavy product tampering (to the holder's detriment). For US fixed income exposure, should a rational consumer steer toward municipal and corporate bonds?
Thanks for any insight you may have.
BC Doc
Corporate bonds give you a bit of a higher yield but they give you equity risk.
(disclosure I hold investment grade corporate bond funds)

You have to bet we don't rerun 2008, or do a Japan, or it might not be pretty.

Municipals normally for USians choice is extremely limited re term etc. Beware of credit risk-- we don't have to be Meredith Whitney to think there is some trouble ahead (again not much you can do about it, usually, but a national muni fund perhaps a side bet alongside your state one?).

If one is bearish about US Treasury Bonds, probably the best strategy is to be in ST bonds. The same factors that would hit those T Bonds will hit all bonds (higher interest rates).

The one thing to watch over this summer is Washington, because that really would disrupt the bond markets if a lot of brinksmanship goes on. But that's just a timing view.

Thank you for your helpful reply VT.

To me, Quantitative Easing is like the house stacking the deck-- I'm not convinced I should be buying a financial instrument whose yield has been so obviously and artificially depressed by the seller. The advantage here seems to be all to the seller. I know this line of thinking was behind PIMCO's recent decision to dump US Treasuries from its Total Return Fund. I'm wondering if short-duration corporates are the place to be (e.g. VCSH) until the US government steps out of the Treasury market as both seller and buyer.

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Post by Lbill » Mon May 23, 2011 1:26 pm

Thanks to Dr. B's participation, this thread has helped me to try to think through the fixed-income side of my portfolio. I've thought of it every which way, but still feel caught in the web of contradictory arguments for and against holding only short-term fixed investments. I'm wondering about a couple of points:

First, is one of the points favoring Dr. B's position that - since rates are currently so low - the "reward" for holding intermediate or longer duration is not very compelling in light of the prospectively skewed "risk" of rising rates? You can currently make about 2.2% on the 5-Yr T. and if you look around you can make about 1.2% on a 1-year FDIC insured CD. Is it worth 1% annually to assume the risk of rising rates on the 5-year?

Second, is there a latent concern about having reached a point of secular change in the trend of interest rates that has long term implications for fixed-income returns? Just as we experienced a secular change in 1981 which marked a high of 15% in the 5-year and a steady decline to the current level that has lasted for 30 years, are we looking at the real possibility that we've reached a secular low to be followed by increasing rates for a decade or two? Lots of money has been made and lost on the basis of these long secular trends. Is Dr. B perhaps factoring in this possibility?
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I'm Not Laughing at Anything: That's the Point

Post by Bill Bernstein » Mon May 23, 2011 2:54 pm

I take all the possibilities seriously: hyperinflation, deflation, or anything in between.

What I am saying is that uncertainty has certainly increased, and for one simple reason: the Fed's balance sheet has tripled, because of QE1 and QE2, to around $2.6T Such an expansion is far, far, far, outside any historical bounds. As matt politely points out, I'm not an expert on central banking operations, but the people I listen to and read, like Alan Meltzer (as in the multi-volume "History of the Federal Reserve") and John Taylor (as in, the Taylor Rule), are both predicting hyperinflation. That's not my word, by the way, it's theirs.

Others that I respect, such as Paul Krugman, disagree.

That, ladies and gentlemen, is uncertainty, red in tooth and claw, and in such circumstances, what matt, I, Larry, or even Bill Gross think is irrelevant.

That uncertainty leads me to ask, for a given course of action, what is the least bad worst case scenario for a given course of action in the bond market? Hair-splitting metaphysical analysis of Pascal's Wager is well beside the point; for my purposes, it's merely an easily understood distillation of the problem at hand.

And yes, if you want to stay short, then a 5- or even 2-year T ladder and a corporate bond fund, I think, is preferable to a total bond index fund of the same average duration.

Bill

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Post by matt » Mon May 23, 2011 3:30 pm

Alright, we've got Alan Meltzer and John Taylor predicting hyperinflation. My Google searches didn't turn up many hits on this, but here's what I found.

John Taylor, in May 2009, predicted "hyperinflation" of 100% over 10 years. http://blogs.reuters.com/felix-salmon/2 ... nuousness/ Taylor thought this was a rate of 10% per year, while Felix Salmon points that it is actually just 7% per year, as well as some other errors on Taylor's part. So A) 7% per year is definitely high inflation for the U.S., but it is far removed from hyperinflation; and B) I don't know if I want to trust the predictions of future inflation rates from a guy who doesn't know how compounding works. Why would we assume that he is doing his calculations correctly?

Allan Meltzer, in April 2009, predicted that inflation would be worse than the 1970's, so that may or may not be hyperinflation. http://www.economicpolicyjournal.com/20 ... er-on.html However, what was Mr. Meltzer's reasoning?

"M2, a broad measure of the money supply that includes checking accounts and money-market mutual funds, rose in the last six months at an annual rate of 14 percent. That compares with an average 6.3 percent during the last decade."

So, has anything changed since then? Yes, actually, quite a bit. You see, M2 money growth was peaking at the time of that observation and collapsed within a few months to as low as one percent. Just eyeballing this chart http://research.stlouisfed.org/fred2/gr ... ation]=pc1, it has probably averaged around 5% in the past two years. So Meltzer's rapid money supply growth argument has fallen flat on its face. (And I'm not a big Fed fan and criticized them quite a bit for being so far behind the curve in 2007-8, but it seems clear to me in this instance of crisis response that the Fed did something right in ramping up money supply in late 08/early 09 with the expectation that it was going to collapse*. They were right and Meltzer's worries have so far proven wrong. Perhaps he is not permanently wrong, but high money supply growth rates were obviously not pre-ordained and the Fed has flexibility to restrain money supply if it begins to advance too quickly from here.)

So we've got one guy who's not so great at math and other basic economic concepts and another guy whose original thesis has been proven incorrect (I would not be surprised if he's changed it, though!) trying to convince me that hyperinflation is on the way. I remain, shockingly, unconvinced.

FACTS > OPINIONS

* This also is consistent with my view that monetary authorities have questionable ability to forecast (just like everyone else), but may be good at reacting to events.

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Post by biasion » Mon May 23, 2011 3:39 pm

Any bond duration longer than a year will increase your portfolio's equity correlation; up to a year there is no correlation.

I have posted elsewhere, but basically long bonds are good for equity heavy portfolio where the volatility is ruled by equity. By going from 5y to 20y duration of treasuries, you increase risk somewhat, but the expected reward increases by much more, producing a more "efficient portfolio".

Long bonds are also good to lock in a certain amount of money that you know you will need in that period of time. If you have fixed obligations in the future that you know will be a certain amount of money, a long bond is good to match that liability. This is more pension fund and insurance companies because no one can truly predict with any accuracy what prices will be in the future.

Intermediate bonds can work if you allocate to commodities. That is the purpose of commodities. Take 5% of your AA and use it as part of your equity. Instead of keeping your bonds say at 1-3 years or less, you can maybe go 3-5 years with treasuries, or 6-7 with municipals because the curve is steeper owing to greater supply of longer term issues. If rates drop you win because of your somewhat longer duration. If rates rise, the commodities will cushion the blow due to their volatility. This is the optimal position for efficiency.

If commodities are not available, then the best thing is to use very short bonds and not go out on the yield curve because other than the examples mentioned, portfolio efficiency will drop when extending durations past one year.
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What Dummies!

Post by Bill Bernstein » Mon May 23, 2011 3:49 pm

OK, so as I understand it, Meltzer's a math illiterate and Taylor doesn't know how to relate monetary policy, economic growth, and inflation.

Or do I have that reversed?



Bill

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Post by Lbill » Mon May 23, 2011 3:58 pm

And yes, if you want to stay short, then a 5- or even 2-year T ladder
Isn't a T-bond fund or ETF with an average 5-year maturity about the same thing as a perpetual bond ladder with an average 5-year maturity? The fund is constantly rolling over its holdings to maintain its average maturity, so how is this really any different from rolling over bonds as they mature in a ladder? I understand that the ladder gives you a known return for each rung, but if you don't need to target specific annual returns do you need to hold a ladder? If you wish to buy Ts at auction, VBR requires a minimum $10K purchase, so you'd need about $100K for a 10-year ladder (average maturity of 5 years). Otherwise, you have to shell out the secondary market commission and the bid-ask spread for each smaller rung that you can afford. For small potatoes investors, an ETF with a 0.15% ER is much easier to deal with, and rebalancing is easier too.
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Post by matt » Mon May 23, 2011 4:26 pm

biasion wrote:Any bond duration longer than a year will increase your portfolio's equity correlation; up to a year there is no correlation.
In a high inflation period, this will probably be true. But it has been false for at least the last decade as Treasury bond returns have been negatively correlated to equities.

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Re: What Dummies!

Post by matt » Mon May 23, 2011 4:44 pm

wbern wrote:OK, so as I understand it, Meltzer's a math illiterate and Taylor doesn't know how to relate monetary policy, economic growth, and inflation.

Or do I have that reversed?



Bill
Taylor appears to suffer some innumeracy. Meltzer was just wrong in assuming the present trend would continue. It happens.

I have no doubt that they have above average intelligence. But so what? You know that just being smart doesn't mean you can predict the future. Do these guys have any track record of accurate past predictions? And why are these guy any smarter than Bernanke, who doesn't believe inflation will be a problem?

It is really bizarre to see you, who has relied heavily on statistics and history in your work on investing, to completely abandon both on this topic in favor of your predisposition toward inflation. It is really sad considering the hero worship you get from some readers, who may be led astray in assuming that you have done some rigorous analysis like you would generally do. But since you have yet to make any attempt to move outside of opinions and into facts, I will not follow up further.

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Ladder vs. Fund

Post by Bill Bernstein » Mon May 23, 2011 5:02 pm

You're absolutely right: there's not much difference between a 10-year ladder and a 5-year T-fund, and if you have <<$100k in the position, sure, go buy the fund.

But on a $100k T position, that's a very nice dinner out once per year; for that, I'll happily log on to the auctions every once in a while.

Bill

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Post by Lbill » Mon May 23, 2011 5:17 pm

Something to think about for those of us who have become accustomed to thinking of bonds as "safe" investments:
The scope for deep and protracted losses from stocks makes fixed-income investing look, to some, like a superior alternative. But how well do bonds protect an investor’s wealth? Historically, bond market drawdowns have been larger and/or longer than for equities. In the US bond market, there were two major bear periods. Following a peak in August 1915, there was an initially slow, and then accelerating, decline in real bond values until June 1920 by which date the real bond value had declined by 51%; bonds remained underwater in real terms until August 1927. That episode was dwarfed by the next bear market, which started from a peak on December 1940, followed by a decline in real value of 67%; the recovery took from September 1981 to September 1991. The US bond market’s drawdown, in real terms, lasted for over 50 years.
Source: Credit-Suisse Global Investment Returns Yearbook 2011

This report contains a wealth of data and analysis about equities and stocks and is quite worth reading. Summary:
After a decade with two savage bear markets, investors are wary of equities. Government bonds have been a bright spot, but capital values could fall. This article examines how far government bonds can decline, investigates the role of bonds as a diversifier, shows how the crucial stock-bond correlation has changed over time, and compares the performance of corporate, long- and midmaturity government bonds, and Treasury bills. A global study of government bonds reveals the pain and potential reward from exposure to inflation risk
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Post by hudson » Mon May 23, 2011 8:26 pm

Great discussion...maybe a top 5 all time?

I started to go looking for wbern's Four Pillars of Investing Lessons for Building a Winning Portfoliio..copyright 2002 and found it on the corner of my desk. I had to read what he said about bonds. On page 257, I found "keep it short" in italics. On page 259, he recommended bonds with 1-5 year maturities.

I think this discussion updates his 2002 thinking....now it's go shorter.

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Post by staythecourse » Tue May 24, 2011 6:05 am

hudson wrote:Great discussion...maybe a top 5 all time?

I started to go looking for wbern's Four Pillars of Investing Lessons for Building a Winning Portfoliio..copyright 2002 and found it on the corner of my desk. I had to read what he said about bonds. On page 257, I found "keep it short" in italics. On page 259, he recommended bonds with 1-5 year maturities.

I think this discussion updates his 2002 thinking....now it's go shorter.
Also with Dr. Berstein I believe Ben Grahams last edition of Intelligent Investor boldly states anything less then 7 yrs. if guarded against interest rate risk.

Good luck.
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Post by Slick8503 » Tue May 24, 2011 10:36 am

As a(somewhat) recent adopter of the Boglehead way, certain aspects of this thread trouble me. We have Dr. Bernstein(whose book is highly touted here) basically market timing bonds.(I'm guessing due to Fed policy of buying treasuries). This seems to go against everything that I've come to love about passive investing.

Its been mentioned many times on the board, and in this thread, that Bill Gross is out of treasuries, so on and so forth... how many others are making the same call? Quite a few, I would imagine. What does this do to the bond market? It would appear to me that it would offset some of what the Fed is buying, no? Looks like yet another example of the market being fairly efficient.

My opinion, is you should let your personal situation dictate what type of bonds you own, and not what's in the news, or how you interpret economic policy.

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Post by Scott S » Tue May 24, 2011 11:15 am

Slick8503 wrote:As a(somewhat) recent adopter of the Boglehead way, certain aspects of this thread trouble me. We have Dr. Bernstein(whose book is highly touted here) basically market timing bonds.(I'm guessing due to Fed policy of buying treasuries). This seems to go against everything that I've come to love about passive investing.

Its been mentioned many times on the board, and in this thread, that Bill Gross is out of treasuries, so on and so forth... how many others are making the same call? Quite a few, I would imagine. What does this do to the bond market? It would appear to me that it would offset some of what the Fed is buying, no? Looks like yet another example of the market being fairly efficient.

My opinion, is you should let your personal situation dictate what type of bonds you own, and not what's in the news, or how you interpret economic policy.
Just speaking for myself: With my genes and assuming I don't get hit by a bus in the meantime, I have an investing horizon of 60 years. That's plenty of time to recover from a dip in bond NAVs. I've got a half-decent plan, but neither the ability nor the interest to try to outsmart the bond market. Good luck to everyone else on that. :wink:

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My Plan: (Age-10)% in bonds until I reach age 60, 50/50 thereafter. Equity split: 50/50 US/Int'l, Bond split: 50/50 TBM/TIPS.

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Post by lazyday » Tue May 24, 2011 11:42 am

Slick8503 wrote:As a(somewhat) recent adopter of the Boglehead way, certain aspects of this thread trouble me. We have Dr. Bernstein(whose book is highly touted here) basically market timing bonds.(I'm guessing due to Fed policy of buying treasuries). This seems to go against everything that I've come to love about passive investing.
Just my opinion:

If one's AA for fixed income is strictly intermediate term Treasuries and/or TIPS, or if it's strictly short term Treasuries and/or TIPS, then you're perfectly fine just sitting there for the long term.

There might be some benefit if you did a conservative version of Larry's switching between Tips and Treasuries depending on yields, but probably not much. It isn't necessary at all.

There might be some benefit if you listened to the best of the gurus when yields are historically low or high, and/or risk is unusally low or high, and you made small changes in duration. But probably not much benefit, assuming your AA is reasonable to start with. Again, this isn't needed, with a good AA.

Those who do choose to make conservative changes to FI based on methods or posts by Bill Bernstein or Larry Swedroe, aren't taking large risks, compared to market timing with equities. Remember that even with equities, Bogle allows a bit of shifting of %, or TAA, when valuation differences are wide.

(My opinion on equity TAA is different than above.)

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Post by cb474 » Tue May 24, 2011 12:20 pm

lazyday wrote:If one's AA for fixed income is strictly intermediate term Treasuries and/or TIPS, or if it's strictly short term Treasuries and/or TIPS, then you're perfectly fine just sitting there for the long term.
How does all of this effect someone in retirement/withdrawal phase? Are you stuck with almost zero interest short term T-bills? Is even Vanguard's short term treasury fund risky (current average maturity 2.6 years)?

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