skierincolorado wrote: ↑Sun Sep 12, 2021 2:25 am
comeinvest wrote: ↑Sun Sep 12, 2021 12:55 am
skierincolorado wrote: ↑Thu Sep 09, 2021 2:35 pm
The only scenario where LTT wins are if we assume 1) ITT rates will rise 2) LTT rates don't rise at all and 3) the rate increase of ITT is so large it overcomes the 0.7% return from roll on ITT leaving us with only 0.8% of carry 4) we ignore points #1 and #4 and assume the future will be different than the past and that we can predict when and how it will be different.
This scenario describes a yield curve flattening. I'm wondering if it's really so far-fetched, if we assume that the U.S. follows Europe and Japan i.e. most of the rest of the developed world with a certain lag, and that real returns, and along with them term premia, will permanently converge to zero or negative. I know this scenario is heavily debated, but it's a scenario that many economists predict for a variety of reasons.
Also, in this scenario, your 0.7% roll return may not last long, if it materializes at all. The "roll return", by definition, is based on an assumption of a static yield curve, which is purely hypothetical and does not even take into account current forward rates.
In summary, even after reading this thread and your arguments for STT/ITT vs. LTT, I'm wondering if a "diversification of treasury maturities" that for example NTSX implements is not beneficial, as different maturities thrive in different future interest rate scenarios.
To be clear, I'm not arguing against your rationale to shift to STT and ITT. In fact, you made me re-consider and change my own allocation. I'm just saying, maybe some of the math proposed in this thread is the result of a bit of over-engineering based on history, assumptions, and models that may or may not reflect the future, while the aspect of diversification might have got a bit lost.
I agree it's not terribly far-fetched, but it shouldn't be our starting point of assumptions which would be market timing. I don't think the math is over-engineered - I'm not sure how far along you've read but eventually we do calculate expected returns factoring in forward rates. The results weren't *quite* as rosy for ITT as I expected, because rate increases for ITT were a little higher than I expected, but the expected return of LTT was very poor as well. We calculated 0.1% expected return for both ITT and LTT. But given the risk on LTT is higher, .1% for ITT is better than .1% for LTT.
This .1% is not the term premium, it's the expected return. Despite the slightly negative term premium, expected returns are probably slightly positive because future short term rates are expected to be higher than current short term rates. The expected return captures both aspects of return - the path of future short term rates (positive), and the term premium (slightly negative).
This fits an expectation of term-premia declining to zero. If the term-premia is zero for all durations, that's a very strong argument for owning shorter durations. Owning shorter durations captures the return of the other component of bond returns - the expected evolution of short-term interest rates. Since the term-premia is zero, why would we bother to try capture it by owning longer durations? That would be taking duration risk without compensation, by definition.
My understanding is even as rates have declined across the rest of the developed world, risk adjusted returns on shorter durations have still generally been higher than for longer durations.
So while term premia declining to zero seems like an argument for shorter durations to me, it also seems like an argument for a lower bond allocation in general - which is something else I've been suggesting in this thread. While the historical efficient frontier since 1978 is like 67% ITT (or like 70% STT + 10% LTT) I think a somewhat lower allocation is prudent going forward given lower expected returns (due to the apparent falling of the term premia). This would be especially true when current financing costs exceed future expected short-term interest rates. Overall, I agree some diversification is prudent and the historical efficient frontier backs this up as the sharpe ratio for 70% STT + 10% LTT is a hair higher than for ITT alone. Presumably this is the diversification benefit showing up in the efficient frontier.
For example, this paper suggests that a low term-premium is an argument for owning shorter duration bonds: https://www.nb.com/documents/public/glo ... undrum.pdf
It does appear the term-premium has fallen, but I haven't read anything yet that explains why this is the case. You've mentioned a number of economists forecast this to be a permanent phenomenon, can you point me to some of those papers?
"I'm not sure how far along you've read" - I'm admittedly in the process of catching up with this and related threads. Therefore my apologies if I'm asking something that would be evident in the math done already.
"We calculated 0.1% expected return for both ITT and LTT" - In your calculation of the expected future ITT and LTT interest rates for purpose of calculating the expected returns of ITT and LTT, did you take into account the fact that realized rates are usually lower than forward rates (forward rates for example based on STIR futures), because forward rates basically reflect the term (risk) premium, while realized rates don't? In other words, the forward rates (and by implication future ITT and LTT rates implied by forward rates) are NOT the expected rates that people actually expect to prevail on a given future date. That's my understanding. Correct me if I'm wrong. If we accept that forward rates are not expected rates (i.e. the expectations hypothesis is not true, and I think it is not considered true), then by implication, I'm questioning the approach of calculating expected returns from forward rates.
"My understanding is even as rates have declined across the rest of the developed world, risk adjusted returns on shorter durations have still generally been higher than for longer durations" - I think not true for Europe for a while. I've been shorting the 2-year Bund futures for some time as an insurance against rising interest rates worldwide, and at the same time I have made some money from this "insurance" short position. Whatever the risk of the 2-year Bund is (probably more an opinion as to how far negative real rates can go, than a quantifiable risk), the carry is negative, while the longer maturities have positive carry.
Another question: If indeed the expected return of ITT and LTT is 0.1%, then it is currently about equal to the funding rate, and will be lower than the funding rate soon, i.e. the expected return of the futures will be negative soon. I think someone showed a long time ago in the HFEA thread that rebalancing with an asset with zero or negative expected returns does not make sense, even when correlations are negative, i.e. you are better off just investing in the asset with positive expected returns and "rebalancing with cash". Can you elaborate if that argument might be applicable to the situation of zero or negative expected returns from the treasury futures, i.e. shouldn't the treasury futures allocation be zero under your assumption of zero expected return for treasury futures?
Whether the term premium might possibly be permanently gone: I don't have a citation handy right now, but I think the argument is similar to that of lower expected equity returns, higher valuations across almost all asset classes, etc.: A glut of savings worldwide on one hand, and reduced need from businesses for capital on the other hand, compared to the era of industrialization. I've also seen the argument that the world is perceived "safer" now than in the past, which would lower the discount rates that investors demand to "store" capital.
Not from an explanatory, but purely from an observational point of view, let's also not forget that the rest of the developed world has been in that mode for like 10+ years, with no end in sight. I have a hard time ignoring what might seem like, and could be, a race to zero or negative real and nominal returns. The last 10+ years have seen economically good and bad times, but nothing reversed that trend. I'm wondering what could in fact reverse this trend. I know that "other experts" argue for "mean reversion", and in business schools they teach theories that I don't know well enough about what an "equilibrium" interest rate should be (theories which didn't play out in the developed world for 10+ years), but whatever the future brings, I think we can agree that there is no guarantee or "entitlement", or law of physics, that says investors can increase their NAV on average over time just by "sitting it out", rather than consuming their assets now.