HEDGEFUNDIE wrote: ↑
Wed Aug 07, 2019 3:58 pm
Lee_WSP wrote: ↑
Wed Aug 07, 2019 3:53 pm
MotoTrojan wrote: ↑
Wed Aug 07, 2019 3:16 pm
Lee_WSP wrote: ↑
Wed Aug 07, 2019 3:07 pm
Meaty wrote: ↑
Wed Aug 07, 2019 2:58 pm
What’s the impact to this strategy if T rates go negative?
We make out like bandits.
It is good to keep perspective. Stealing this from Kevin M
A drop from about 3% to about 2% on 20-30 year Treasuries gives you your 20% YTD return on long-term Treasuries. A drop from 2% to 1% gives you another 20%, and a drop from 1% to 0% gives you another 20%. That pretty much limits you to about 73% capital return (=1.2^3-1), to which you add the income return.
The Simba backtest spreadsheet shows long-term Treasury cumulative total return from 1982-2018 at about 2,400%. So yeah, it seems more than just borderline fundamentally impossible, but just impossible to earn 2,400% on long-term Treasuries over the next 37 years. This is especially true if you expect yields to remain low, since 2% compounded over 37 years only gives you a 108% income return.
I'm confused as to the response. If rates go negative, the bond fund will continue to increase in value as investors are now paying the government to hold onto the bond. Unless you are implying that the leveraged fund would not mirror the underlying asset, I am confused as to why TMF would not increase in value by a lot.
Also, are you sure Kevin is correct that a drop from 1% to 0% will only increase the fund value by 20%?
Kevin is not correct, he is not accounting for convexity.
Once again (for the third time I think), this is not a matter of convexity, but a matter of duration being related to both yield and coupon rate, but that's just a technical point. The more fundamental point is that I was just using a rough duration rule of thumb, but that doesn't change the main point. To amplify on this ...
Assuming a 25-year par bond (coupon rate = yield) is rolled annually starting at 3%, with rates dropping one percentage point per year, here are the annual capital returns:
3% -> 2%: 19.5%
2% -> 1%: 22.0%
1% -> 0%: 25.0%
(Although the increasing capital returns as both
coupon rate and yield drop looks similar to convexity, that's not how convexity typically is defined).
Adding in the coupon returns of 3%, 2% and 1% for each year, we get total annual returns of 22.5%, 24.0% and 26.0%. This generates a 3-year compound return of 91%, so yeah, higher than the off-the-cuff estimate of 73%, but still far shy of the 2,400% return generated from 1982-2018.
Missing the forest (73% compared to 2,400%) for the trees (91% compared to 73%)?
To answer the question about returns if you really believe that the 25-year yield could drop significantly
below 0%, a drop from 0% to -1% with a 0% coupon 25-year bond results in a capital return (and total return) of 28.6% = -PV(-1%,25,0%,1)-1. Adding that annual return to the previous three to get to 0% gives a compound return of 146%, so you'll have to go way negative to get to 2,400%, and I don't think anyone wants to live in that world.