Help me understand long-term bond funds (TLT)

[MediumTex]

I believe that going 50% 10 year bonds instead of 25/25 ST/LT provides similar returns to the traditional HB PP.  However, in a severe and prolonged deflationary situation you would "grow out" of your protection with a 50% 10 year setup much more quickly than in a traditional 25/25 ST/LT configuration.

There is also the issue of not having anything to rebalance your treasury gains into if you are using a 50% 10 year approach.

[Storm]

Just out of curiosity, then, is there any reason that Harry recommended the ST/LT barbell?  If a 50% intermediate term treasury performs nearly identically to a 25/25 ST/LT portfolio, it seems like the added simplicity (for those of us using funds, as opposed to holding actual bonds) would weigh in favor of the intermediate-term approach.  With that approach, I could have one less fund to deal with.

I believe that the reason HB recommended the ST bonds as cash is because there is little to no inflationary risk.  With a 6 month time horizon, you simply buy new ones at a higher interest rate in 6 months.

In an inflationary period, the value of your LT bonds can go down significantly.  You don't have this risk with ST bonds.  In essence, buying LT bonds is sort of like a leveraged bet on future deflation.  Of course you can't lose more than your principal, so it's not the same as leverage.

HB would have wanted the cash portion to have no leverage, or no bets at all, since it is supposed to remain stable (in absolute value, not relative) in both deflationary and inflationary times.

[Lone Wolf]

I believe that going 50% 10 year bonds instead of 25/25 ST/LT provides similar returns to the traditional HB PP.  However, in a severe and prolonged deflationary situation you would "grow out" of your protection with a 50% 10 year setup much more quickly than in a traditional 25/25 ST/LT configuration.

I remember reading this at one point, too, but I don't remember how that was established.  Was this based on looking at Japan's deflation or some other data set?

[chrikenn]

Ok.  It makes sense to me that long-term would be better in prolonged deflationary periods.  Has the U.S. had any periods of prolonged deflation against which we can backtest?  None immediately come to mind.

Because, as has been pointed out, just as LT would be better in prolonged deflation, one would expect that intermediate-term would do slightly better (or should we say, slightly "less worse") in periods of prolonged inflation.  Using Simba's backtesting spreadsheet from Bogleheads for the years 1973-1981 (high inflation), the ST/LT barbell has the following statistics:

CAGR: 12.27%
Std. Dev.: 11.70

Using 50% intermediate-term instead of the ST/LT barbell yields the following:

CAGR: 12.21%
Std. Dev.: 11.75

That's not what I was expecting.  Given the prolonged inflation I figured int-term might have slightly outperformed.

In 2008 (closest thing to deflation I can get in Simba's spreadsheet), ST/LT barbell returned -0.71%.  50% Intermediate returned -1.35%.

At any rate, I guess I'm just thinking out loud and wondering if switching to 50% intermediates would be a way to simplify an already-simple portfolio.  It's probably not necessary.  Nobody can predict the future, but based on the backtesting I've done, it seems like over a 30-40 year investing lifetime, as Clive's chart suggests, 50% intermediates vs. ST/LT barbell is basically a wash.

[MediumTex]

Would the Mona Lisa look better if you put some hoop earrings on her?

I don't know, but since she has done so well without them I would be hesitant to change anything at this point.

[Lone Wolf]

Ok.  It makes sense to me that long-term would be better in prolonged deflationary periods.  Has the U.S. had any periods of prolonged deflation against which we can backtest?  None immediately come to mind.

Right.  The period that does come to mind (The Great Depression) had us on a Gold Standard.

It's also interesting to note that until 2008, we had no deflationary periods of any length to look at.  If you had sized up the PP before then, a backtest might have shown you that holding LT bonds at all was a waste of time.  Fortunately, when one came along, the Portfolio performed just like it was supposed to.

At any rate, I guess I'm just thinking out loud and wondering if switching to 50% intermediates would be a way to simplify an already-simple portfolio.  It's probably not necessary.  Nobody can predict the future, but based on the backtesting I've done, it seems like over a 30-40 year investing lifetime, as Clive's chart suggests, 50% intermediates vs. ST/LT barbell is basically a wash.

Could very well be true.  However, I am convinced that the 5-year approach isn't going to hold up as well under intense, prolonged deflationary pressure.  While we may not ever see such a situation, I'd just go with the instrument that we know would knock it out of the park (LT bonds.)

In all honesty, I'd expect Clive's version to do very well in the future.  However, I just feel much better when all my bases are covered.  If "it" (long bouts of deflation) happened in Japan, I can't rule out that it could happen here.  We have the good fortune of being able to hold LT bonds as protection, something the Japanese did not.

[moda0306]

To put some perspective on "long periods of deflation" we need to keep in mind that the rates of return on 30-year bonds take into consideration expected inflation... so though we haven't had a "long period of deflation" since 1982, the high inflation that were priced into the bonds (that didn't happen) has resulted in great returns for a LT treasury investor for the last 28 years.  It didn't take deflation, just prolonged disinflation.

So while a lot of people say, "why invest the same in a deflation asset as an inflation asset when inflation is so much more likely than deflation."  Answer: Expected inflation is priced into the nominal return of these LT bonds, and if inflation doesn't occur, or the expectation of inflation is lowered, then LT bonds will gain.  It doesn't take actual depression-esque deflation for LT bonds to perform.  Just a change downward in inflation realities and expectations.

[Lone Wolf]

Good point, Moda.  Big-time deflation is not the only time that LT bonds see some upswing.

However, when you do hit a hard deflationary period, LT bonds are probably going to be carrying the portfolio all by themselves while stocks and possibly gold crumble.  That is the one situation where nothing can replace LT bonds (at least ideally.)  It is when they become indispensable (at least IMO.)

[cowboyhat]

I like Clive's idea, but if you are working with a 401K account the 50% allocation of 5 year bond ladder is even harder to obtain than 25% long treasuries + 25% money market. I would need 3/4 of my assets outside my 401K.

[chrikenn]

Thanks for the discussion.  I have concluded I'll probably stick with the long-term bonds rather than going 50% intermediate.  Reasons being: 1) As pointed out above, we don't know exactly how things would react in a long period of deflation, but the long-term bonds are a safer bet than intermediate-term, and 2) even if we never see a period of prolonged deflation, having the ST/LT barbell gives me additional opportunities to tax-loss harvest  :D

[moda0306]

cowboyhat,

Good point.  Plus, Clive, your depression scenario used 20 year vs 25 or 30 year treasuries, and I assume t-bills are 1 year??... while I agree with Craig that 1-3 year fund is about as good as one can do with cash.

Maybe the combo of using 25 or 30 year treasuries and 1-3 year would tilt it slightly if not significantly back into the traditional PP's favor.

[Lone Wolf]

That is pretty cool info, Clive.  However, a few things.  You are measuring 10-year treasuries here, while you are recommending 5-year treasuries.  I think the difference could be pretty big.  (I like the sound more of the 10-year version myself, though I do worry about 1981 a bit.)

Also, like Moda points out, using 20 year treasuries vs 25 or 30's when measuring the PP is a skew in the wrong direction.  Browne has you selling them at 20 and buying them at 30.

Cowboy, excellent point on tax-deferred space being used more efficiently by the LT bonds as well.  I had not thought of that.  That's another mark in favor of LT bonds.

In addition, you are recommending a ladder.  This has some nice benefits but it's going to give you softer deflation protection.  Remember, this portion has to make up for suffering stocks and gold, so with bonds on average only 2.5 years from maturity you will have very little capital appreciation.  (If you go with the 10-year version, the average is 5 years, which is still less than I'd want.)

Don't get me wrong, I think that the 50% intermediate-term treasury approach is still a nice, robust allocation and will almost certainly do great going forward.  But I do believe that there are some (small) risks to laddering it.  In addition, I don't think 5-years have a big enough horizon on them.  Finally, having no cash or cash-like allocation (such as 50% in 10-year treasuries) is rough riding during a recession if the Fed slams the brakes on interest rates.

[MediumTex]

Also, as a practical matter, laddering takes away your ability to do PP "gadget plays" like using I-bonds for a portion of your cash holdings.