For Dr. Bernstein on Bond Duration

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For Dr. Bernstein on Bond Duration

Post by Leesbro63 » Fri May 20, 2011 10:06 am

This is for Dr. Wm Bernstein: Doc, there are a number of threads here about the current state of the bond market and how to invest (or avoid) it. Previously I remember you stating that you feel that the risks vs the rewards of anything longer than cash and short term bonds is a fool's errand. The other professionals here basically are championing "stay the course" with intermediate bonds. Please clarify, if you would, your current thinking on this. Thank you in advance for your consideration here.

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Post by livesoft » Fri May 20, 2011 10:18 am

I am not Bernstein, but I think his current thinking is all over the internet, so there is nothing to clarify. Example: http://www.morningstar.com/cover/videoc ... ?id=355635
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Post by Scott S » Fri May 20, 2011 10:26 am

livesoft wrote:I am not Bernstein, but I think his current thinking is all over the internet, so there is nothing to clarify.

Methinks this thread is directed at everyone else, since a PM could have sufficed.

- Scott
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Post by White Coat Investor » Fri May 20, 2011 10:43 am

I think the best argument for staying the course is considering what could really happen with bonds if rates go up. Take the VG intermediate index fund for example. It has a duration of 6.3 years. That means if intermediate interest rates go up 1%, you'll lose about 6.3% on the value of the fund. Of course, then the fund will be yielding 4.3% instead of 3.3%, so within just a few years you're better off with taking that 6.3% hit up front anyway.

So think about a really awful scenario, where intermediate rates (remember this isn't the rate the fed controls) go up 3% over a short time period of say, a year. Your fund drops 19% (well, 15% since you did get the yield during that time). That's like two days worth of volatility in the REIT fund in Fall 2008. Sure, a pretty big loss for a bond fund, but then you've got a fund yielding 6.3%. Won't take long to get back to where you were

If that isn't a risk you're willing to run to get the higher rates, then consider the VG ST Index Fund, it's duration is only 2.6 years.
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Post by livesoft » Fri May 20, 2011 10:44 am

I will also suggest that great gurus do not change their "current thinking" much at all.

What they are thinking now is the same thing they were thinking 5 years ago, 3 years ago, last year, last month, last week, and yesterday.

It will also be what they will be thinking tomorrow, next week, next month, next year, 3 years from now, ....
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Post by Scott S » Fri May 20, 2011 11:01 am

EmergDoc wrote:So think about a really awful scenario, where intermediate rates (remember this isn't the rate the fed controls) go up 3% over a short time period of say, a year. Your fund drops 19% (well, 15% since you did get the yield during that time). That's like two days worth of volatility in the REIT fund in Fall 2008. Sure, a pretty big loss for a bond fund, but then you've got a fund yielding 6.3%. Won't take long to get back to where you were

And if something so catastrophic happens to our bond holdings, most of us will be rebalancing (or at least directing all new contributions) into them, so we should be recouped even faster in theory. Right?

- Scott
Last edited by Scott S on Fri May 20, 2011 11:05 am, edited 1 time in total.
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Post by livesoft » Fri May 20, 2011 11:03 am

For some fun and riffing on nisiprius's posts, let's look at what happened to bond funds since the October 2010 M* video interview of Bernstein by Benz.

In the 3 months from the first week of November to the first week of February, the total returns of some bond funds are show in this graph (data mining at its best!!):

Image

-2.4% GNMA
-0.7% Short-term investment grade
-3.4% TotalBondIndex
-5.2% Inflation-protected securities
-5.7% Intermediate-term Treasuries

So it kinda looks like Bernstein has a point and bond funds did worse over that 3 months than at other periods in their history. OTOH, I didn't show you what bond funds have done since that first week of February. :twisted:
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Post by Munir » Fri May 20, 2011 11:42 am

" OTOH, I didn't show you what bond funds have done since that first week of February." quote by livesoft.

So, what did bond funds do since that first week in February? I'm holding my breath. :)

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Post by Leesbro63 » Fri May 20, 2011 11:47 am

EmergDoc wrote: So think about a really awful scenario, where intermediate rates (remember this isn't the rate the fed controls) go up 3% over a short time period of say, a year. Your fund drops 19% (well, 15% since you did get the yield during that time).


A 3% rise isn't an awful scenario. It's just a moderately bad scenario. What if rates rise 6 or 7 percent? Not at all merely a miniscule chance.

That's like two days worth of volatility in the REIT fund in Fall 2008.


But this is our SAFE money. And while REITS did go down, we invested because THEY COULD GO UP. Bonds really can't go up.

Sure, a pretty big loss for a bond fund, but then you've got a fund yielding 6.3%. Won't take long to get back to where you were


6.3% on a MUCH SMALL pile than you started with.

If that isn't a risk you're willing to run to get the higher rates, then consider the VG ST Index Fund, it's duration is only 2.6 years.


Exactly.
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Post by Leesbro63 » Fri May 20, 2011 11:48 am

Scott S wrote:And if something so catastrophic happens to our bond holdings, most of us will be rebalancing (or at least directing all new contributions) into them, so we should be recouped even faster in theory. Right? - Scott


Not if rising interest rates sinks BOTH your RISK money (equities) AND your "safe" money at the same time.

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Post by Leesbro63 » Fri May 20, 2011 11:50 am

livesoft wrote:For some fun and riffing on nisiprius's posts, let's look at what happened to bond funds since the October 2010 M* video interview of Bernstein by Benz.


How about looking at what bond funds did the last time we ran huge deficits, oil spiked and government was unable to tame the beasts? I'm talkin' '70s.

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Post by nisiprius » Fri May 20, 2011 11:52 am

Leesbros63, perhaps you meant to post in QUESTIONS FOR THE Q&A w/ THE EXPERTS @ BOGLEHEADS 10?? Please post it there, I think that thread could use a "bump for visibility."
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Post by Leesbro63 » Fri May 20, 2011 11:54 am

Scott S wrote:Methinks this thread is directed at everyone else, since a PM could have sufficed. -Scott


No. I am hoping that Dr. B. will chime in here for an interactive discussion with the various other gurus to hash this out. It's rare that the gurus are this far in disagreement.

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Post by Leesbro63 » Fri May 20, 2011 11:55 am

nisiprius wrote:Leesbros63, perhaps you meant to post in QUESTIONS FOR THE Q&A w/ THE EXPERTS @ BOGLEHEADS 10?? Please post it there, I think that thread could use a "bump for visibility."


DONE! Thanks!

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Post by Scott S » Fri May 20, 2011 12:09 pm

Leesbro63 wrote:How about looking at what bond funds did the last time we ran huge deficits, oil spiked and government was unable to tame the beasts? I'm talkin' '70s.


Now we have TIPS and the lessons learned from that era, so maybe this time will be different? :wink:

- Scott
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Post by Valuethinker » Fri May 20, 2011 12:14 pm

Leesbro63 wrote:
livesoft wrote:For some fun and riffing on nisiprius's posts, let's look at what happened to bond funds since the October 2010 M* video interview of Bernstein by Benz.


How about looking at what bond funds did the last time we ran huge deficits, oil spiked and government was unable to tame the beasts? I'm talkin' '70s.


1. the US did not run huge deficits in the 1970s. Look it up, I remember the debate during the Carter Presidency was the $40bn deficit.

If you look at % of GDP ie to correct for inflation, the US did not run huge deficits until the 1980s.


2. oil spiked-- last time was summer 2008. Inflation did not.

Oil is lower than it is that time.

Will this lead to sustained inflation across the western world, as it did in the 1970s? If you'd told me in 2000 that oil would go to $150 and our biggest worry would be deflation, I'd have told you you were nuts.

But we have reached that point, and what we see around us is no signs of the wage-price spiral that characterized the 70s. Even in the UK, where inflation is running high (5%) there are a series of one-off factors at play (like raising all retail prices 2.5% with a tax increase) and wages are significantly lagging inflation. No sign of an inflationary spiral here, yet.

Truly, the labour market is a different beast than it was in 1978-- here and in the US (and Canada for that matter).

3. 'government unable to tame the beast'.

Let's not confuse monetary and fiscal policy.

Since I presume you mean inflation, that is the Fed's job. The Fed watches inflation like a hawk. The last time the Fed lost control of inflation was in the 70s, and we know what happened next: the era of radical monetary policy under Paul Volker.

Just about everybody in macroeconomics and certainly everyone who makes decisions in the Fed was around at that time, or taught by people who were around.

Inflation is, by and large, not the domain of the US Treasury Department. It's the domain of the Fed.

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Post by Valuethinker » Fri May 20, 2011 12:16 pm

Scott S wrote:
Leesbro63 wrote:How about looking at what bond funds did the last time we ran huge deficits, oil spiked and government was unable to tame the beasts? I'm talkin' '70s.


Now we have TIPS and the lessons learned from that era, so maybe this time will be different? :wink:

- Scott


And indeed so.

From the point of view of investors, TIPS and Real Return Bonds exist, and they did not then. That's a sea change.

From the point of view of Central Bankers, how to control inflation is known-- Paul Volker laid out the map.

What is not known, because we did not really solve the problem in the 30s, nor has Japan solved its problems, is what to do about deflation or the threat thereof.

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Post by Leesbro63 » Fri May 20, 2011 12:17 pm

Valuethinker, you make very good points. If you're right, you'll continue to get your bond scraps every coupon. But if you are wrong, the consequences are huge. Asymmetry.

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Re: For Dr. Bernstein on Bond Duration

Post by Valuethinker » Fri May 20, 2011 12:17 pm

Leesbro63 wrote:This is for Dr. Wm Bernstein: Doc, there are a number of threads here about the current state of the bond market and how to invest (or avoid) it. Previously I remember you stating that you feel that the risks vs the rewards of anything longer than cash and short term bonds is a fool's errand. The other professionals here basically are championing "stay the course" with intermediate bonds. Please clarify, if you would, your current thinking on this. Thank you in advance for your consideration here.


The one difference from when Bernstein wrote is the unprecedented steepness of the yield curve.

That makes ST bonds a little trickier than they were.

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Post by White Coat Investor » Fri May 20, 2011 12:21 pm

Leesbro63 wrote:
EmergDoc wrote: So think about a really awful scenario, where intermediate rates (remember this isn't the rate the fed controls) go up 3% over a short time period of say, a year. Your fund drops 19% (well, 15% since you did get the yield during that time).


A 3% rise isn't an awful scenario. It's just a moderately bad scenario. What if rates rise 6 or 7 percent? Not at all merely a miniscule chance.

That's like two days worth of volatility in the REIT fund in Fall 2008.


But this is our SAFE money. And while REITS did go down, we invested because THEY COULD GO UP. Bonds really can't go up.

Sure, a pretty big loss for a bond fund, but then you've got a fund yielding 6.3%. Won't take long to get back to where you were


6.3% on a MUCH SMALL pile than you started with.

If that isn't a risk you're willing to run to get the higher rates, then consider the VG ST Index Fund, it's duration is only 2.6 years.


Exactly.


When is the last time intermediate term interest rates went up 6 or 7% quickly (say, over a year or two?) 10 year treasury yields went from 4% to 8% over a decade in the 60s, and from about 8% to about 15% from 1977 to 1981. Can it happen? Sure. Will it happen? Seems unlikely. But if it does, I'll get down on my knees and give thanks (since I'm still accumulating), then get up and buy some 30 year treasuries.

On the intermediate term fund, a 3% rise in intermediate rates (not the ones the fed controls) would mean a loss of about 19%. That's hardly a "MUCH SMALLER" pile. How can you stand to invest in equities when you have that much fear of bonds? TSM went down 48% in the last bear market and REITs went down 75%, neither with any promise of recovery.
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Post by Valuethinker » Fri May 20, 2011 12:22 pm

Leesbro63 wrote:Valuethinker, you make very good points. If you're right, you'll continue to get your bond scraps every coupon. But if you are wrong, the consequences are huge. Asymmetry.


But that is always the truth with bonds.

ie you've got full inflation risk/ interest rate risk.

It's why I suggest investors hold large amounts of TIPS, because you don't have inflation risk then. You can get hurt by fluctuations in real interest rates, but fluctuations in inflation don't hit you.

There are parallels to 1994 and I think I have mentioned them in other posts ie a Fed slamming on the brakes, rout in the bond market, *without* inflation or anything else shooting up.

Generally in you are going to hold nominal bonds, I think you want to hold them on the ST side of Intermediate. Punting in long bonds is an adult only game (except for real return securities like TIPS).

I don't worry about replaying the 70s because the conditions are so different and because the 70s are recent enough in the policymakers' minds (especially in Central Banks) to cause quite a strong reaction.

I do worry about replaying Japan: go nowhere for 20 years. And I also think a 1994 rerun is quite credible: rout in the bond market. But despite the latter's twitchiness and some bad quarters, it doesn't feel at all euphoric in its behaviour.

Could I be wrong and be underestimating the dangers of inflation? Of course.


But the conditions for the 70s inflation in the western world have just not been repeated (ask Greece or Ireland, which are melting down). The labour market is quiescent, unemployment is high, there are plenty of slack production resources out there.

Where you do see inflation is in emerging markets and, indeed, we could import it via higher prices for goods. But there too you see other factors. China is not allowing its currency to rise, and so other currencies (Brasil, SE Asian) are rising more (deflationary). And production is being switched from high cost China to lower cost Vietnam, for example. In things like textiles there is Vietnam, Philipines, Sri Lanka, Bangladesh, Pakistan, Indonesia etc. And beyond that there is Africa, Haiti etc.

The thing about the 70s inflation was that it was unique in world history-- have to go back to the 1500s and 1600s and the flood of New World silver into Europe via Spain to see it.

There's another factor. Most western countries are aging rapidly. Whilst that's bad for things like health care costs, it tends to be deflationary (again see Japan)-- at least to the limited extent we have data on this (it's a new thing in world history for countries to voluntarily shrink themselves). When you get new waves of consumers, they drive prices up. When you get existing people retiring, cutting back on spending, cutting working, then it tends to be deflationary.

That parallels what has happened in previous financial crises all over the world. You get a long period of forced deleveraging as private sector consumers and companies try to reduce their debts. The economy has a protracted slump.

Loop back to investing:

- ST bond funds (nominal) are generally preferred

- amongst LT bnds, TIPS are preferred because the risk of renewed inflation has been zeroed out for the holder
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Chiming in

Post by Bill Bernstein » Fri May 20, 2011 12:49 pm

All excellent points.

I'm actually amazed to see that since that interview in mid-October '10, VBMFX is up only about .6% on a total return basis; that's a lousy return/risk.

But even if I was dead wrong, I'd still return with one of my favorite Larryisms: "Don't confuse outcome with strategy."

You take risk on the stock side, not the bond side. Bonds are what help you to sleep at night, pick up bargains at the fire sale, and pay your bills when you get fired; a long bond has very real risk in those scenarios.

Consider, for example, 1977: S&P -7.18%, Lehman Agg +3.05% (with a yield of about 9%, that's real capital loss), and CPI +6.77%. A negative real return of almost 4% is not what I want from a riskless asset in a bad stock year.

Bill

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Post by Leesbro63 » Fri May 20, 2011 12:57 pm

Value thinker: Very good analysis. Thanks for those points.

Dr. B: Thank you for responding. I keep hearing the argument for longer term fixed income as we've become complacent with the current near zero interest rate environment. I wanted to be sure I didn't miss something in my concern to keep my safe money safe.

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wbern: How short is short enough?

Post by RooseveltG » Fri May 20, 2011 1:00 pm

Dr. Bernstein:

How "short" would you recommend? Is a 5 year duration too risk from a Pascal's Wager point of view? Are TIPS overpriced?

Very few people are long on bonds, but the real question is how short is short enough?

Thanks.

Roosevelt.

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Post by Opponent Process » Fri May 20, 2011 1:04 pm

Leesbro63 wrote:Value thinker: Very good analysis. Thanks for those points.

Dr. B: Thank you for responding. I keep hearing the argument for longer term fixed income as we've become complacent with the current near zero interest rate environment. I wanted to be sure I didn't miss something in my concern to keep my safe money safe.


I don't think there's that much sentiment for long bonds. the sentiment is for/against a buy-and-hold strategy and trying to time the bond market. Boglehead experts would seem to be divided on this, whereas historically market timing was typically discouraged.
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Post by Valuethinker » Fri May 20, 2011 1:04 pm

Leesbro63 wrote:Value thinker: Very good analysis. Thanks for those points.

Dr. B: Thank you for responding. I keep hearing the argument for longer term fixed income as we've become complacent with the current near zero interest rate environment. I wanted to be sure I didn't miss something in my concern to keep my safe money safe.


If you want to see where I am wrong, keep an eye on inflation in China and other Emerging Markets and signs that is creeping into the western economies (other than through higher raw materials prices) via the price of imports (ie directly, rather than indirectly through raw materials prices).

China spent the last 20 years driving down the price of manufactured goods. India has started to do that in business services. If either of those trends abate, then we could see higher inflation generally. That's Greenspan's worry, and it's a legitimate one.

The US has a particular medical cost inflation issue (all western countries have that, but the US starts further ahead on this). The political and social pain of that one will be awful-- making choices. That's irrespective of which national system of healthcare you have: UK, US, Sweden, Germany, France etc. etc. But it isn't necessarily generally inflationary.

Offsetting that to an extent, you will see far more international medical tourism in the times to come.

But general inflation, no big signs of it yet: the UK might be the standout in that regard.

The risk to bonds is more proximate. It's the Fed's move which will hit the bond market, and the Fed will try to 'get ahead of the curve' if it thinks inflationary expectations are ramping up. That reminds me of 1994 and it was a painful year.

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Re: Chiming in

Post by matt » Fri May 20, 2011 1:05 pm

wbern wrote:I'm actually amazed to see that since that interview in mid-October '10, VBMFX is up only about .6% on a total return basis; that's a lousy return/risk.


That's 0.6% more than a money market fund, isn't it?

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Tips in a bond fund

Post by shawcroft » Fri May 20, 2011 1:06 pm

From what I have read, I believe individual TIPS are the preferred means to hold TIPs. How "less preferred" is the TIPS bond fund if that and the Total Bond Fund are the only fixed income funds offered within your 401(k).
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How short is short?

Post by Bill Bernstein » Fri May 20, 2011 1:09 pm

As always in finance, there's no right answer. If we do get a bond debacle, no matter how short you were you'd have wished you'd been in 30-day bills.

But certainly a Vanguard Fund containing the words "short-term" will fill the bill better than one containing the words "intermediate-term," or better than VBMFX.

Are TIPS overvalued? Don't know about at the long end, but at the short end, I cannot imagine that negative rates are the, ahem, new normal.

Bill

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Post by RooseveltG » Fri May 20, 2011 1:24 pm

Dr. Bernstein:

I appreciate your thoughts.

Roosevelt.

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Re: Chiming in

Post by Scott S » Fri May 20, 2011 1:25 pm

wbern wrote:Consider, for example, 1977: S&P -7.18%, Lehman Agg +3.05% (with a yield of about 9%, that's real capital loss), and CPI +6.77%. A negative real return of almost 4% is not what I want from a riskless asset in a bad stock year.

Bill


Doesn't this mean that bonds still beat cash by 3%? Looks like 1977 was a crappy year for pretty much everything.

Thanks,
- Scott
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Post by fishnskiguy » Fri May 20, 2011 1:39 pm

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.

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Bills

Post by Bill Bernstein » Fri May 20, 2011 1:40 pm

Excellent question; I should have included the 30-day bill return, which was 5.13% money market returns would have been a tad higher). Still a negative real return, but better than longer bonds/notes, with no worries about capital loss.

Bill

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Post by White Coat Investor » Fri May 20, 2011 2:56 pm

Is there a rule of thumb anyone knows of that would indicate how much yield you should get for an additional year of duration? Is 0.5% a year good? 0.25% a year? Surely at 1% you've got to wonder if taking more interest rate risk is worth it. (The current difference between short-term and intermediate is about 0.5%, the difference between intermediate and long is about 0.25%.)
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Post by woof755 » Fri May 20, 2011 3:23 pm

IIRC, Larry's bond book suggested 0.20% for each extra year.
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Post by Lbill » Fri May 20, 2011 5:03 pm

You take risk on the stock side, not the bond side. Bonds are what help you to sleep at night, pick up bargains at the fire sale, and pay your bills when you get fired; a long bond has very real risk in those scenarios.

Dr. B. I've pondered this statement but I'm afraid that I still don't get it. What is the "risk" we're concerned about - isn't it total portfolio risk? I did a quick comparison of how you would have fared over the 1972-2010 time period if you were 50% TSM + 50% 5-Yr Treasuries vs. 50% T-Bills. Guess what? The portfolio with 50% in 5-yr. beat 50% in T-bills in CAGR (9.38% vs 8.18%) and risk-adjusted return (.42 vs. .32). What really surprised me was that in 2008, the 50% treasuries portfolio lost 11.9% vs. 17.5% for the 50% T-Bills portfolio. Of course, the reason for this is that treasury bonds tend to be negatively correlated to stocks and produce a higher return than T-bills. So - which is really riskier from a total portfolio perspective, IT or T-Bills? If my crystal ball was telling me that there is going to be a huge interest rate spike that will kill stocks and bonds, I'd have the answer. But it hasn't been working lately.
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Post by kenyan » Fri May 20, 2011 5:11 pm

It seems to me that a steep rise in bond yields would be bad for older folks with larger portfolios, but beneficial to those of us with long-term goals. The best estimate for your bond earnings is their yield. I'm not sweating the possibility too much. The last steep rise in yield would've been painful at the time, yes, but it did give rise to the great bond bull market.

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Theoretically Yes

Post by Bill Bernstein » Fri May 20, 2011 6:17 pm

You're concerned only about overall portfolio risk.

But careful how you choose your time periods. 1972 to present was a period of falling interest rates, in general, so of course the return/risk profile of a portfolio looks better with longer bonds.

The dominant events risk wise of that period were the '73-74, '00-'02, and '08-09 crashes; in the last two, the longer the bonds, the better, and in the first, nominal bond returns were not that horrible because of the high coupon, when in reality the real returns of bonds were terrible--ie, the badness of long bonds didn't show up because you're calculating in nominal terms.

Test long versus short bonds in a portfolio in a period of rising rates, and things look different.

Bottom line: it's almost mathematically impossible we'll be living in a period of significantly falling rates the next few decades, so it makes more sense to stay short.

Bill

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Re: Theoretically Yes

Post by Jagman » Fri May 20, 2011 7:19 pm

wbern wrote:You're concerned only about overall portfolio risk.

But careful how you choose your time periods. 1972 to present was a period of falling interest rates, in general, so of course the return/risk profile of a portfolio looks better with longer bonds.

The dominant events risk wise of that period were the '73-74, '00-'02, and '08-09 crashes; in the last two, the longer the bonds, the better, and in the first, nominal bond returns were not that horrible because of the high coupon, when in reality the real returns of bonds were terrible--ie, the badness of long bonds didn't show up because you're calculating in nominal terms.

Test long versus short bonds in a portfolio in a period of rising rates, and things look different.

Bottom line: it's almost mathematically impossible we'll be living in a period of significantly falling rates the next few decades, so it makes more sense to stay short.

Bill


In a 60% stocks/40% bonds portfolio, do you still think Vanguard's short-term investment grade (VFSTX) is a good choice for the entire 40% bond portion? Thanks.

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Post by Lbill » Sat May 21, 2011 7:59 am

Dr. B wrote:
You're concerned only about overall portfolio risk.

But careful how you choose your time periods. 1972 to present was a period of falling interest rates, in general, so of course the return/risk profile of a portfolio looks better with longer bonds.

The dominant events risk wise of that period were the '73-74, '00-'02, and '08-09 crashes; in the last two, the longer the bonds, the better, and in the first, nominal bond returns were not that horrible because of the high coupon, when in reality the real returns of bonds were terrible--ie, the badness of long bonds didn't show up because you're calculating in nominal terms.

Test long versus short bonds in a portfolio in a period of rising rates, and things look different.

Bottom line: it's almost mathematically impossible we'll be living in a period of significantly falling rates the next few decades, so it makes more sense to stay short

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 isn't unexpected, because in a rising interest rate period bond fund duration is inversely related to the lag of capital losses. Funds with greater mean duration will experience larger losses at the front-end of rising rates but will catch-up with a lag as bond holdings are rolled over into higher rate bonds. So, the main risk of bond duration is to investors who must take frequent withdrawals (i.e., retirees). For investors who are in the accumulation phase, it seems to me they will be leaving a lot of money on the table by holding a large chunk of T-Bills or ST Bonds that are earning nothing in interest, all for the benefit of reducing short-term losses that aren't particularly significant in the context of longer-term objectives.

As for the odds of experiencing an inflationary rising rate vs. a falling rate environment over the coming years, you may be right that a rising rate environment is more likely. Again, no-one knows this. We could be in for a Japan-style deflation in which rates go even lower. A change in the 10-year rate from 3% to 1% (paralleling the Japan experience) would produce large capital gains in bonds. I wouldn't bet the farm on rising rates, especially if I'm a long-term investor who is in the portfolio accumulation phase. I might consider some TIPS or a dollop of commodities to provide some insurance against rising rates, and continue to hold intermediate bonds to earn their higher interest. Once again, I believe one should think in terms of the total portfolio within the context of one's particular investment needs, rather than worrying about what single assets in isolation might or might not do.
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Long Versus Short

Post by Bill Bernstein » Sat May 21, 2011 10:16 am

Lbill:

You're right on all counts.

But remember, this isn't about expected return, it's about risk.

And in that case, all the engineering and backtesting goes out the window, and gets replaced with this simple heuristic: all other things being equal (which, as you've just shown, is pretty much true, give or take a dozen or two basis points, on the return side) if you hold longer bonds, you risk a "super 1977 scenario" where stocks do poorly for whatever reason, and your bonds get nailed by unexpected inflation.

That's a risk I'd rather not take.

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.

Bill

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Post by Lbill » Sat May 21, 2011 11:16 am

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.

Thank you for your observations, Dr. B. I certainly agree that going longer with bond maturity adds unnecessary risk and I wouldn't want to do it either. My current thoughts are that it would be OK to hold a 5-year duration bond fund or ladder assuming: (1) you don't need to take regular frequent portfolio withdrawals and have long term investing horizon, and (2) you're willing to ride out somewhat larger short-intermediate portfolio losses that could occur if we experience significant interest rate escalation. I'd add that, as Larry suggests, one might consider holding a small allocation to commodities as "insurance" against unexpected inflationary spikes - though I'm on the fence a bit on this one. Or, one might consider holding intermediate TIPS instead of nominals to provide insurance against rising rates - although nobody is currently writing home about the real yields on these either (I just got about 0.88% on the 10-year at auction). Wondering if you generally agree with these conditionals, or feel just about everyone would be better off just staying short and earning nada on bonds?
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No

Post by Bill Bernstein » Sat May 21, 2011 11:30 am

No, I don't.

Think about what happened in late '08.

That was a classic financial crisis. In that state of the world, there are only two asset classes: nominal Treasuries, and everything else.

TIPs got hammered. Corporates got hammered. Commodities got hammered.

If you needed liquidity, plain vanillas are the only thing that didn't give you a haircut. (Even VBMFX took a dip of about 4%, top to bottom, total return wise, because of the corporates in it, which is why I like the combination of separate Treasury and corporate positions instead.)

Add in inflation at some point before or after, and it simplifies even further: short T's, CDs, and maybe, maybe, money markets.

Bill

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Post by matt » Sat May 21, 2011 12:29 pm

It seems fairly clear to me that Mr. Bernstein, like most investors, became a victim of recency bias in his early investing years. The rising interest rates in the 1960's-70's created a persistent fear that rate increases are always just around the corner. This is no different than the stock perma-bulls in the late 90's whose only experience in the market was gains; all pull-backs were buying opportunities. Once they became convinced of this, stocks have been a massive disappointment.

So as it turned out, the message learned in that high inflation period - to reduce bond duration - has been wrong for the past 30 years. Yet the phantom continues to chase after all these years, biasing the viewpoint of those scarred by inflation decades ago.

For example,
wbern wrote:Test long versus short bonds in a portfolio in a period of rising rates, and things look different.


This is self-evident for a parallel shift in the yield curve. It is not necessarily the case if maturity spreads tighten, which is a very likely case going forward. And it is also obviously dependent on a correct forecast of interest rates, which most here claim cannot be done.

wbern wrote:Bottom line: it's almost mathematically impossible we'll be living in a period of significantly falling rates the next few decades, so it makes more sense to stay short.


Oh, I see you are in fact claiming you can predict future interest rates. But this near mathematical certainty you claim is just an opinion as far as I can tell. What is the mathematics that supports the claim? I have yet to see evidence that high government deficits alone cause inflation and there are in fact contra examples that inflation can occur when deficits are low. What I have seen is evidence that a country's interest rates tend to stay low for about a decade after a major financial crisis. I've also seen the experience of Japan, which has had substantial deficits and extremely low interest rates for many years.

So let's be very clear. There is no math and there is no history supporting your opinion, a viewpoint that has been wrong for 30 years now. At some point, without question, there will be a secular period where short duration bonds will be favorable, but no one knows when that begins or how long it will last.

wbern wrote:But remember, this isn't about expected return, it's about risk.


Of course, but that doesn't lead to a direct investment conclusion. To you, the conclusion appears straightforward, but that's because you have put so much weight behind the inflation view and almost none behind the stagnation view in which both real and nominal economic growth remains low for many years and stocks perform poorly. In the latter case, long-term bonds are very likely to be the winner and, indeed, without them you are substantially increasing the risk that matters - not generating real returns over a long period of time.

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Both sides

Post by Bill Bernstein » Sat May 21, 2011 12:44 pm

Matt:

You could well be right about deflation, but as I've written multiple times, one has always to ask what are the consequences of one's being wrong, and to favor the "least worst" worst-case scenario--ie., Pascal's Wager.

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.

What are the probabilities of these two events? I don't know, and I think it's unwise to be too certain of one's ability to predict the future.

Bill

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Post by wbond » Sat May 21, 2011 12:57 pm

Dr. Bernstein,

A related, but slightly different question:

What do you think of Swenson’s argument, in general, - not necessarily in this current interest rate environment - that with equity-heavy portfolios not in need of significant near-term withdrawals (institutions, investors accumulating, etc.) one can buy the diversifying power of nominal Treasuries “cheaper” by going longer, i.e. one can devote a smaller portion of the portfolio to bonds if you extend duration?

Thanks, wbond

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Swensen

Post by Bill Bernstein » Sat May 21, 2011 1:13 pm

He's right in *most* scenarios, but not in all.

Consider the long bear market from 1967 to 1980. Here are the real ann'd returns for:

S&P +0.85%
Bills -0.63%
20 Y T's -4.31%

Again, this is but one parallel universe; many others are possible.

In the deflationary parallel universe, you're somewhat better off with long bonds. In the inflationary parallel universe, illustrated above, you're a *lot* worse off with long bonds--the difference between bills and bonds of 3.7% compounded over 14 years is a very big deal.

Once again, my goal is not to do well in the best draws, it's to avoid catastrophe in the worst ones.

Bill

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Re: Swensen

Post by wbond » Sat May 21, 2011 1:38 pm

wbern wrote:He's right in *most* scenarios, but not in all.

Consider the long bear market from 1967 to 1980. Here are the real ann'd returns for:

S&P +0.85%
Bills -0.63%
20 Y T's -4.31%

Again, this is but one parallel universe; many others are possible.

In the deflationary parallel universe, you're somewhat better off with long bonds. In the inflationary parallel universe, illustrated above, you're a *lot* worse off with long bonds--the difference between bills and bonds of 3.7% compounded over 14 years is a very big deal.

Once again, my goal is not to do well in the best draws, it's to avoid catastrophe in the worst ones.

Bill


Thanks.

In that setting - unexpected inflation - I have a question about TIPS.

They obviously will do better than nominal Treasurys of the same maturity. But what of the question of short-term vs. longer with TIPS in that scenario? It strkes me as an open question, since it depends on what happens to real rates at the same time. If short TIPS are better than long in that scenario (due to real rates rising, as they did during the time period in question) - i.e. if the best "bonds" to have for unexpected inflation turn out to be either short-term nominals or short-term TIPS then don't these two approximate each other in a way that the difference is close to meaningless? And, if so, wouldn't this undermine any significant advantage TIPS might be thought to have in a rebalanced portfolio?

Thanks again.

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TIPS in a Crisis

Post by Bill Bernstein » Sat May 21, 2011 1:44 pm

Yes, you have the mechanics right, but there's a more important overriding concern with TIPS, which is that in a crisis they have lousy liquidity.

Again, I cannot stress strongly enough the need to think in terms of the worst-case scenario of a crisis. These are the defining events of any investor's career, and he/she will experience more than a few over an investing lifetime.

In those times, you want your "riskless assets" to be liquid. And TIPS fail that test. (I suppose if they're short enough, you can wait for them to mature. In which case the daylight between short TIPS and short nominals is pretty slim.)

Bill

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Re: Both sides

Post by magneto » Sat May 21, 2011 1:52 pm

wbern wrote:Matt:

You could well be right about deflation, but as I've written multiple times, one has always to ask what are the consequences of one's being wrong, and to favor the "least worst" worst-case scenario--ie., Pascal's Wager.

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.

What are the probabilities of these two events? I don't know, and I think it's unwise to be too certain of one's ability to predict the future.

Bill



Many thanks for taking the time to make the point again about the least worst option. It is a point well worth repeating for contrarians such as myself wondering about long bonds.

Another point I must keep reminding myself about is that as a retiree which is the bigger danger, inflation or deflation? I conclude that I could live with deflation on a fixed income, but inflation would reduce the purchasing power of both capital and income, in turn reducing my standard of living. So TIPS type investments should be favoured.

In the UK at present we seem to be in stagflation with very little sign of economic growth and RPI running in excess of 5%. Hopefully the US will avoid this scenario and manage to grow.

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