Maximum Bond Upside

Discussion of the Bond portion of the Permanent Portfolio

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tarentola
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Re: Maximum Bond Upside

Post by tarentola » Thu Dec 08, 2016 11:56 am

dualstow

Yes, the European long bonds also performed well recently as in the US. My Euro long bond ETF (MTF.PA from Lyxor) is still showing a 25% profit despite being 12% off its recent high.

In Europe we don't have the same range of analytical tools for Euro ETFs and funds, so all my backtests refer to US investments. In Portfolio Visualizer, I simply took their category Intermediate Treasuries, for which PV uses the Vanguard ITT fund VFITX which is 5.6 years' duration. There is also a 10y Treasuries (duration 8.9y) category in PV, which not surprisingly gives results virtually identical to the ITT.
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Re: Maximum Bond Upside

Post by tarentola » Thu Dec 08, 2016 3:08 pm

barrett

Thanks for the info. Peaktotrough offers different rebalancing options, which may explain the difference from Portfolio Visualizer.

Yes, the long bond added 0.5% more CAGR to the portfolio since 2000. But for the 25 previous years, the CAGRs of portfolios with 30y PP and 10y PP were virtually identical - respectively 9.94% and 9.77%.

So I hope you understand my concern. The long bond did outperform the 10-y significantly but not enormously since 2000, and did not outperform before 2000. In 2000-2016, the Fed Funds rate dropped from 5% to 0.5%, a situation which is unlikely to be repeated and will probably be reversed.

For fun, I compared in Portfoliovisualizer the PP with long bonds (duration 17.9y), intermediate bonds (5.6y) and short-term bonds (2.8 y). To my surprise, their respective CAGRs and maxDDs are all within one percentage point of one another (see below). Maybe any old bond duration will do!

So I think my original question stands: why be exposed to the interest rate risk of long bonds if they provide no consistent extra return? Why use long bonds in the PP when shorter duration bonds would expose you to only one-third (or even one-sixth!) of the interest rate risk, while reducing portfolio performance only slightly, if at all? Or to put the question the other way round: is the small and uncertain gain from using long bonds (rather than intermediate bonds) worth tripling your interest rate risk?

(1977-2016, 5/25 rebalancing, CAGRs 8.34%, 7.88% and 7.60% for PPs with long, intermediate and short-term bonds respectively)
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Re: Maximum Bond Upside

Post by dualstow » Thu Dec 08, 2016 3:17 pm

tarentola wrote:For fun, I compared in Portfoliovisualizer the PP with long bonds (duration 17.9y),
We're supposed to sell long bonds when they have fewer than twenty years to maturity (Yes, I wrote maturity not duration) in order to maintain that volatility. The flip side of that means that we may end up selling just as interest rates rise and value gets halved. ??? :)
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Re: Maximum Bond Upside

Post by barrett » Fri Dec 09, 2016 5:23 am

dualstow wrote:
tarentola wrote:For fun, I compared in Portfoliovisualizer the PP with long bonds (duration 17.9y),
We're supposed to sell long bonds when they have fewer than twenty years to maturity (Yes, I wrote maturity not duration) in order to maintain that volatility. The flip side of that means that we may end up selling just as interest rates rise and value gets halved. ??? :)
If value is really getting "halved", then you're likely replacing some of those bonds you just sold with higher coupon bonds. Not telling you anything you don't know but I wouldn't mind holding something that's got a bit more yield. The higher yielding bonds are also less volatile with more potential upside. Just trying to see how much I can squeeze into one post that is already known to you, Dualstow.
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Re: Maximum Bond Upside

Post by dualstow » Sat Dec 10, 2016 10:12 am

( Started this soon after your post, but I guess I got called to dinner as I found it unfinished on my screen later )
barrett wrote:If value is really getting "halved", then you're likely replacing some of those bonds you just sold with higher coupon bonds. .
You're absolutely right, barrett, but I think it will feel painful to lock in the loss. You could buy shares of Wells Fargo after your original shares drop 50% and it'll feel like a bargain, but that doesn't make it easy to sell those original shares.
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Re: Maximum Bond Upside

Post by buddtholomew » Sat Dec 10, 2016 12:02 pm

Is it too early to hear from CraigR who usually chimes in to say if your equities are high and your bonds are low, it may be a good time to look at rebalancing.

I can either buy LTT's from cash or sell from stocks with no tax implications as I have carryover losses from gold.

So the question is whose buying LTT's?
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Re: Maximum Bond Upside

Post by buddtholomew » Sat Dec 10, 2016 12:08 pm

tarentola wrote:barrett

Thanks for the info. Peaktotrough offers different rebalancing options, which may explain the difference from Portfolio Visualizer.

Yes, the long bond added 0.5% more CAGR to the portfolio since 2000. But for the 25 previous years, the CAGRs of portfolios with 30y PP and 10y PP were virtually identical - respectively 9.94% and 9.77%.

So I hope you understand my concern. The long bond did outperform the 10-y significantly but not enormously since 2000, and did not outperform before 2000. In 2000-2016, the Fed Funds rate dropped from 5% to 0.5%, a situation which is unlikely to be repeated and will probably be reversed.

For fun, I compared in Portfoliovisualizer the PP with long bonds (duration 17.9y), intermediate bonds (5.6y) and short-term bonds (2.8 y). To my surprise, their respective CAGRs and maxDDs are all within one percentage point of one another (see below). Maybe any old bond duration will do!

So I think my original question stands: why be exposed to the interest rate risk of long bonds if they provide no consistent extra return? Why use long bonds in the PP when shorter duration bonds would expose you to only one-third (or even one-sixth!) of the interest rate risk, while reducing portfolio performance only slightly, if at all? Or to put the question the other way round: is the small and uncertain gain from using long bonds (rather than intermediate bonds) worth tripling your interest rate risk?

(1977-2016, 5/25 rebalancing, CAGRs 8.34%, 7.88% and 7.60% for PPs with long, intermediate and short-term bonds respectively)
You miss a lot of the picture if you look at returns over that time period. Look at individual years where the PP would have sustained outsized losses without the LTT exposure. It's difficult to stick to the plan if one is concerned with volatility on an annual basis.

Another thing that usually gets forgotten is the 25% allocation to STT's. 50/50 produces a duration similar to intermediate term treasuries. Barbell vs. Bullet. Supposedly, a barbell will perform better in a rising interest rate environment. Believe me, I know I'm a bodybuilder.
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Re: Maximum Bond Upside

Post by Alanw » Sat Dec 10, 2016 1:11 pm

I started PP in 2011. Held my nose and bought LTT's at 4.25%. Have rebalanced twice out of LTT's since. Who would have guessed? If you hit a rebalance band, stick to the plan.
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Re: Maximum Bond Upside

Post by dualstow » Sat Dec 10, 2016 1:14 pm

I feel glad that I sold some of my long bonds prematurely. I did not hit a rebalancing band but had considered selling the lot of them when TLT hit the 120s again and my best bonds were at 40% profit. It was like getting years worth of interest payments up front...except I didn't sell the best bonds. O0 Sold the breakeven ones.
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Re: Maximum Bond Upside

Post by Alanw » Sat Dec 10, 2016 1:41 pm

This year will be my first RMD. Sold TLT at 136 to rebalance into cash. When one asset in PP is either up or down quite a bit, it is a good idea to check rebalance bands. A little luck doesn't hurt either.
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Re: Maximum Bond Upside

Post by tarentola » Sun Dec 11, 2016 3:41 am

buddtholomew wrote:
You miss a lot of the picture if you look at returns over that time period. Look at individual years where the PP would have sustained outsized losses without the LTT exposure. It's difficult to stick to the plan if one is concerned with volatility on an annual basis.

Another thing that usually gets forgotten is the 25% allocation to STT's. 50/50 produces a duration similar to intermediate term treasuries. Barbell vs. Bullet. Supposedly, a barbell will perform better in a rising interest rate environment. Believe me, I know I'm a bodybuilder.
Budd

I am accept that there have been years, particularly recent years, when LTT was the best performer, but I am deliberately looking a the long term. I was very glad to have LTTs in my PP. I am glad to accept LTT volatility on an annual basis if it serves some purpose, but the backtests show the big picture: that a PP could have the same performance with equal portfolio volatility by using MTTs instead. The LTTs' own annual volatility could be bearable, but what precipitates my concern is the seeming inevitability of rising interest rates, taking away the LTTs' tailwind.

As you say, the barbell effect of the cash may mitigate the effect of rising interest rates, but the backtest includes 25% MTTs not 50%, so the barbell is still there, just a bit lower, to mix metaphors, and the results are more or less the same as for 25% LTTs.

I tried to be a bodybuilder myself, but I have to call it weight training as I seem to be too ectomorphic to gain much (like some of my VP investments).
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Re: Maximum Bond Upside

Post by dualstow » Sun Dec 11, 2016 9:45 am

Ha! I was an ectomorph until ~age32, but my stomach seems to be reinvesting in itself.
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Re: Maximum Bond Upside

Post by buddtholomew » Sun Dec 11, 2016 9:47 am

I'm at 9% BF after the holidays ;D
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Re: Maximum Bond Upside

Post by buddtholomew » Sun Dec 11, 2016 9:59 am

General consensus is to add additional cash to dampen volatility and reduce fixed income duration.
I may advocate this approach since I like holding cash.

I also hold ITT's in retirement accounts so see the benefits of bullet vs. barbell daily.

I'm probably the idiot that will be the last one holding LTT's but I've found the PP and will stick to it, which includes rebalancing.
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Re: Maximum Bond Upside

Post by dualstow » Mon Dec 12, 2016 9:30 am

I like the new Budd!
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Re: Maximum Bond Upside

Post by tarentola » Mon Dec 12, 2016 12:38 pm

I did a backtest comparison of the PP, comparing it to a portfolio where ITTs replace LTTs. Results from Portfolio Visualizer.

In a backtest period 1981-2016, a (standard) PP with 25% long-term treasuries beats a PP with 25% intermediate-term treasuries. CAGRs:
with 25% LTTs: 7.41%
with 25% ITTs: 6.88%
with 25% STTs: 6.49%

The difference between CAGRs is only about half a percent. Using 25% short-term treasuries loses another half a percent. MaxDDs varied little between bond durations. I conclude that in the last 35 years, bonds of almost any duration would have given the PP a respectable CAGR. 1981-2016 is a 35-year period of falling interest rates.

The period 1972-1980 is the only multi-year period in PV's available data (1972-present) when interest rates rose, from 5% in November 1971 to 20% in December 1980. For the bond durations, the order of success is reversed. ITTs beat LTTs. (Data for STTs were not available as early as 1972.) CAGRs:
with 25% LTTs: 13.17%
with 25% ITTs: 14.50%

Using 25% ITTs beats 25% LTTs by 1.33%. Conclusion: the PP with shorter-duration bonds did better when interest rates are rising, and worse when interest rates were falling. I also compared the two in portfoliocharts.com, and the ITT version beat the LTT PP in 8 out of 9 years in the 1970s. (I can't work out how to post the image.)

The argument for longer-term treasuries in the PP is that their higher volatility compensates for the volatility in stocks or gold. So let's have a look at volatilities. Here are CAGR, MaxDD and Sharpe ratio for LTTs and STTs (alone, not in a PP) 1972-1980:
100% ITTs : 4.87%, -10.70%, -0.26
100% LTTs : -0.55%, -21.77%, -0.89

LTTs are more volatile than ITTs, no surprise there. And LTTs suffered more than ITTs as rates rose, no surprise either. But within the PP, the higher volatility of the LTTs did not compensate for their lower CAGR in 1972-80, when interest rates were rising.

This indicates to me that the dominant factor in the alleged superiority of LTTs over ITTs in the PP is not volatility, but the direction of interest rates. The dictum that LTTs are a bet on falling interest rates seems to hold, even within a PP.

Interest rates are probably going to rise soon, or at least stop falling. Like Budd, I am still holding my LTTs, but I think any future bond purchases will be ITTs. Given that the PP is intended as an all-weather portfolio, I see no evidence that LTTs are the better choice.
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Re: Maximum Bond Upside

Post by ochotona » Mon Dec 12, 2016 12:41 pm

tarentola wrote:I did a backtest comparison of the PP, comparing it to a portfolio where ITTs replace LTTs. Results from Portfolio Visualizer...

This indicates to me that the dominant factor in the alleged superiority of LTTs over ITTs in the PP is not volatility, but the direction of interest rates. The dictum that LTTs are a bet on falling interest rates seems to hold, even within a PP.

Interest rates are probably going to rise soon, or at least stop falling. Like Budd, I am still holding my LTTs, but I think any future bond purchases will be ITTs. Given that the PP is intended as an all-weather portfolio, I see no evidence that LTTs are the better choice.
Thanks for the insights.
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Re: Maximum Bond Upside

Post by stuper1 » Mon Dec 12, 2016 2:57 pm

tarentola wrote: Interest rates are probably going to rise soon, or at least stop falling.
How long have we been hearing that? It sounds like your crystal ball is a lot clearer than mine. Could you please give us a date fixed?

Have you seen where long-bond yields are at in other countries? Is there some reason that US yields couldn't go that low?
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Re: Maximum Bond Upside

Post by buddtholomew » Mon Dec 12, 2016 6:44 pm

dualstow wrote:I like the new Budd!
Ha! Thanks DS.

Tarentola, thanks for the back-testing.
Switching from LTT's to ITT's would have sounded more appealing about 20% ago if I had seen these outcomes.
I would have expected a higher premium for increasing term than the meager .5%
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Re: Maximum Bond Upside

Post by tarentola » Tue Dec 13, 2016 3:11 am

stuper1 wrote:
tarentola wrote: Interest rates are probably going to rise soon, or at least stop falling.
How long have we been hearing that? It sounds like your crystal ball is a lot clearer than mine. Could you please give us a date fixed?

Have you seen where long-bond yields are at in other countries? Is there some reason that US yields couldn't go that low?
Stuper

I could be branded a heretic for questioning the value of long-term bonds in a PP, but I don't want to be a market- or interest-rate timing heretic.

To answer your questions: 1. Years. 2. 14 December 2016 ie tomorrow at the Fed meeting (probably - we will soon find out). 3. Yes, I live in one of them. 4. No.

But my answers don't matter. Anything is possible. My conclusion was that any outperformance of LTTs over ITTs in the PP is attributable to bond interest rates falling, not to LTT volatility. Personally I am not willing to chase that slight outperformance by assuming that for the life of my PP, interest rates will continue to fall.

For fun I did a backtest comparison 1981-2016 of a standard 4x25% PP with a portfolio of 100% ITTs and one of 100% LTTs. CAGR, MaxDD, Sharpe Ratio
PP 4x25% : 7.41%, -13.40%, 0.48
100% ITTs : 7.93%, -6.47%, 0.65
100% LTTs : 9.89%, -16.68%, 0.54

Believe it or not, the clear risk-adjusted winner is 100% ITTs. Or the winner is LTTs if you don't mind the DD. For thirty-five years. What?, I hear you cry. Why are we bothering with the PP and with this forum, when we could just invest in ITTs?

You know the answer - 1981-2016 was a period of falling interest rates. Could be called cherry-picking, although 35 years is a big cherry - an investment lifetime for many. To avoid more heresy charges, let's pick the other cherry, 1972-1980.
PP 4x25% : 13.17%, -11.49%, 0.62
100% ITTs : 4.87%, -10.70%, -0.26
100% LTTs : -0.55%, -21.77%, -0.89

And the PP wins. ITTs were positive, but would not have beaten inflation which was well above 5% for most of the seventies. This is why we are bothering with the PP. It works whether interest rates are rising or falling.

And so, one could argue, do ITTs. For more fun, 1972-2016 figures are
PP 4x25% : 8.55%, -13.40%, 0.51
100% ITTs : 7.31%, -10.70%, 0.43
100% LTTs : 7.71%, -23.12%, 0.31

Looking at the whole backtestable period, including the inflationary seventies, 100% ITTs provided a decent return and low MaxDD over the last 45 years. But that's enough heresy for one day.
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Re: Maximum Bond Upside

Post by grapesofwrath » Tue Dec 13, 2016 3:42 pm

Dumb question : how do you get an ITT performance with discrete treasury bonds and not a treasury fund ? i.e. Do you buy 10, 7 or 5 year treasuries and hold them to they mature or sell them earlier at a defined time ? Thanks.
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Re: Maximum Bond Upside

Post by stuper1 » Tue Dec 13, 2016 6:30 pm

tarentola wrote:
stuper1 wrote:
tarentola wrote: Interest rates are probably going to rise soon, or at least stop falling.
How long have we been hearing that? It sounds like your crystal ball is a lot clearer than mine. Could you please give us a date fixed?

Have you seen where long-bond yields are at in other countries? Is there some reason that US yields couldn't go that low?
Stuper

I could be branded a heretic for questioning the value of long-term bonds in a PP, but I don't want to be a market- or interest-rate timing heretic.

To answer your questions: 1. Years. 2. 14 December 2016 ie tomorrow at the Fed meeting (probably - we will soon find out). 3. Yes, I live in one of them. 4. No.
I'm confused about your answers. You give a date when interest rates are going to stop falling, and then you say that there is no reason that they can't go lower. So, which is it?

Here's the thing. One of the fundamental principles of the PP is that it is agnostic about the future. We really don't know what's going to happen in the future. The way I see it, yields could go up, or they could go down. They still have room to go down. Therefore, I continue to hold LTTs. Of course, you can do whatever you want with your money, but if you are going to replace LTTs with ITTs, then don't be surprised if you don't have much protection should a deflationary period arise. Another thing about the PP is that it is meant to be a set-it-and-forget-it portfolio, where you can set it up and go do other things for years at a time and not worry that it will be a mess when you get back to it. People who want to monitor and tinker more have more options.
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Re: Maximum Bond Upside

Post by whatchamacallit » Tue Dec 13, 2016 7:03 pm

Thank you for analysis tarentola

While I still have some LTTs , I am a heretic by only buying EE bonds in their place until we get back to 4%.
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Re: Maximum Bond Upside

Post by tarentola » Thu Dec 15, 2016 2:06 am

grapesofwrath wrote:Dumb question : how do you get an ITT performance with discrete treasury bonds and not a treasury fund ? i.e. Do you buy 10, 7 or 5 year treasuries and hold them to they mature or sell them earlier at a defined time ? Thanks.
I have never done this, but for LTTs Harry Browne suggested buying 30-year bonds and selling them when they had 25 years left to maturity. I suppose you could do something similar with shorter bonds.
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Re: Maximum Bond Upside

Post by Kbg » Thu Dec 15, 2016 6:29 am

tarentola wrote:
grapesofwrath wrote:Dumb question : how do you get an ITT performance with discrete treasury bonds and not a treasury fund ? i.e. Do you buy 10, 7 or 5 year treasuries and hold them to they mature or sell them earlier at a defined time ? Thanks.
I have never done this, but for LTTs Harry Browne suggested buying 30-year bonds and selling them when they had 25 years left to maturity. I suppose you could do something similar with shorter bonds.
You could mimic say ishares treasury funds. Buy at 7 sell at 3, 10/7, 20/10 or make up your own 15/10, 10/5 etc.
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