Bonds vs Deflation

[lordmetroid]

Harry Browne put forth in his theory that long term bonds will be highly sought after in times of deflation. With the current meager rates, can bonds still work as a hedge against deflation or have the instrument become kaput?

[buddtholomew]

Nothing has changed with respect to LTT's role in the PP.
Others have calculated that the 30-year treasury can only return +/- duration x current yield (excluding reinvestment). Please correct me if I am mistaken.

[Dieter]

This real return.  Deflation of 1%

+1% to long term real rates.

Short term rates 0-ish or less real (-1% to start, before fees.)

Stocks probably drop (deferred purchases as items cheaper in the future; companies reduce prices and salaries; future earning projections down not up.)

Existing debt, issued with at least some assumed inflation, becomes more onerous; more defaults as earning less to pay back debt.
    (Mortgage, Car, Corporate, Student Loan, ....)

So more people buy Int/Long treasuries, increasing their price (or if they don't buy, you have the increased real yield.)

So less money being spent == more deflation causing more [see above]

Gold does whatever (assumed down, but who knows if there is flight to perceived safety out of other assets.)

If deflation 3%+....

At least, how I think about it.

[Pet Hog]

As LTT rates approach zero, there is less and less upside potential.  Without using fancy bond price equations, I look at it this way:

Right now US 30-year treasury bonds have a yield of 2.83%.  $1000 compounded over 30 years at this rate would equal $2310 eventually.  If yields went down to zero, someone might be willing to buy your $1000 bond for $2309 just to make $1 profit over 30 years.  That means there is a chance of doubling your investment (at most, a 131% gain).  And doubling a component of the PP should induce rebalancing if you use 35/15 bands.

But if today's yield of 30-year treasuries were, say, 1%, a $1000 bond would get you $1348 after 30 years (compounded, i.e., reinvested).  So, at most, you could gain 35% on your investment if yields went to zero.  That's not a lot of upside potential.  (But lots of downside risk if rates were to increase.)

So as LTT yields approach zero in a deflationary environment, the bonds will increasingly resemble cash (i.e., maintain their face value with little volatility, much like 1-year treasury bills do today).  Would they still act as a hedge against deflation?  Not as much as they would if yields were higher.

Another way of looking at it is that rebalance bands should be tightened when LTT yields get lower.  Or that LTTs should make up a greater percentage of the PP to magnify the effect of their lower volatility.  Does that make sense?

[drumminj]

But if today's yield of 30-year treasuries were, say, 1%, a $1000 bond would get you $1348 after 30 years (compounded, i.e., reinvested).  So, at most, you could gain 35% on your investment if yields went to zero.  That's not a lot of upside potential.  (But lots of downside risk if rates were to increase.)

So as LTT yields approach zero in a deflationary environment, the bonds will increasingly resemble cash (i.e., maintain their face value with little volatility, much like 1-year treasury bills do today).  Would they still act as a hedge against deflation?  Not as much as they would if yields were higher.

One thing to consider in this equation, if the limited potential upside has one thinking of just holding cash, is the bank 'bail ins' we've seen elsewhere in the world. 

My presumption (possibly wrong), is cash sitting in US Treasuries would be immune from this, and thus be subject to less risk not just due to treasuries being safer than FDIC-insured deposits as HBB stated, but also from the risk of being treated as a creditor to banks.

Really, the fiscally conservative/responsible folks are just screwed in the current environment.

[barrett]

As LTT rates approach zero, there is less and less upside potential.  Without using fancy bond price equations, I look at it this way:

Right now US 30-year treasury bonds have a yield of 2.83%.  $1000 compounded over 30 years at this rate would equal $2310 eventually.  If yields went down to zero, someone might be willing to buy your $1000 bond for $2309 just to make $1 profit over 30 years.  That means there is a chance of doubling your investment (at most, a 131% gain).  And doubling a component of the PP should induce rebalancing if you use 35/15 bands.

But if today's yield of 30-year treasuries were, say, 1%, a $1000 bond would get you $1348 after 30 years (compounded, i.e., reinvested).  So, at most, you could gain 35% on your investment if yields went to zero.  That's not a lot of upside potential.  (But lots of downside risk if rates were to increase.)

So as LTT yields approach zero in a deflationary environment, the bonds will increasingly resemble cash (i.e., maintain their face value with little volatility, much like 1-year treasury bills do today).  Would they still act as a hedge against deflation?  Not as much as they would if yields were higher.

Another way of looking at it is that rebalance bands should be tightened when LTT yields get lower.  Or that LTTs should make up a greater percentage of the PP to magnify the effect of their lower volatility.  Does that make sense?

Great post, Pet Hog, but you lost me at the very end. When yields are really low on long bonds I want a lower percentage of them in my portfolio, not a greater percentage. Their heavy lifting has already been done by the time yields get really low (of course, everyone has to decide what "really low" is). I'm just not a PP purist if LTT rates get close to zero. At a certain point there is just too little upside potential and a heap of downside potential. Here in the US though the long bond seems fairly priced to me. There seem to be lots of deflationary signs around the world so I am still comfortable holding them. I would feel differently if our yields were closer to those seen in Japan or Europe.

But I'm also happy to be talked out of feeling this way if I see a good argument to the contrary.

[Pet Hog]

Another way of looking at it is that rebalance bands should be tightened when LTT yields get lower.  Or that LTTs should make up a greater percentage of the PP to magnify the effect of their lower volatility.  Does that make sense?

Great post, Pet Hog, but you lost me at the very end. When yields are really low on long bonds I want a lower percentage of them in my portfolio, not a greater percentage. Their heavy lifting has already been done by the time yields get really low (of course, everyone has to decide what "really low" is). I'm just not a PP purist if LTT rates get close to zero. At a certain point there is just too little upside potential and a heap of downside potential. Here in the US though the long bond seems fairly priced to me. There seem to be lots of deflationary signs around the world so I am still comfortable holding them. I would feel differently if our yields were closer to those seen in Japan or Europe.

But I'm also happy to be talked out of feeling this way if I see a good argument to the contrary.

I could be completely wrong, and I haven't done any mathematical analysis, so this is just my opinion.  If we were in a deflationary period, and perhaps we are, then bonds would have done very well ("heavy lifting," as you say), and they now would have limited potential for upward growth.  If my earlier analysis is correct, LTTs would have become another cash-like, low-volatility component of the PP.  That leaves just two volatile assets: gold and stocks.  The general consensus is that both would suck in a deflationary environment.  There would be few, if any, positive forces acting on the PP and it would be very difficult to eke out a positive nominal return (although the real return might still be 3-6%).  For example, if I predict that stocks and bonds might both fall by 10%, while LTTs will return only 5%, then I would want to overweight LTTs in my PP, even though my nominal return would be paltry at best.

Alternatively:  Some say that the PP works because its three volatile assets move in a non-correlated manner and we can profit from that volatility by taking advantage of long-term reversions to the mean.  But if LTTs' yields fall too low, then they won't be as volatile and will have less impact on the PP's performance -- bonds won't be much of a hedge and would be unlikely to breach a rebalancing band on the upside.  If we want our bond holdings to be just as volatile in our PP as stocks and gold, then we will have to own more of them.  MachineGhost, in particular, has posted many times on risk-parity PPs, coming up with different asset allocations that balance out volatilities.  In a low-yield environment, you want more of the boring assets.  Last year, for instance, more cash and bonds would have helped the PP, but not by too much.

That's how I see it.  But, again, I could be wrong.  I'm sticking to 4x25 for now.

[rickb]

One thing to consider in this equation, if the limited potential upside has one thinking of just holding cash, is the bank 'bail ins' we've seen elsewhere in the world. 

My presumption (possibly wrong), is cash sitting in US Treasuries would be immune from this, and thus be subject to less risk not just due to treasuries being safer than FDIC-insured deposits as HBB stated, but also from the risk of being treated as a creditor to banks.

Really, the fiscally conservative/responsible folks are just screwed in the current environment.

You're not wrong (cash in Treasuries will not be treated as bank assets - since they're not).  So, yes, holding cash in the form of short term Treasuries rather than FDIC-insured deposits will keep you out of any potential "bail-in" hanky panky. 

The only scenario where you get screwed holding Treasuries is US government default.  This is classically unthinkable, but with complete nut-jobs (like Cruz) having a non-zero chance of being the next POTUS we might want to start thinking about the unthinkable.

[buddtholomew]

One thing to consider in this equation, if the limited potential upside has one thinking of just holding cash, is the bank 'bail ins' we've seen elsewhere in the world. 

My presumption (possibly wrong), is cash sitting in US Treasuries would be immune from this, and thus be subject to less risk not just due to treasuries being safer than FDIC-insured deposits as HBB stated, but also from the risk of being treated as a creditor to banks.

Really, the fiscally conservative/responsible folks are just screwed in the current environment.

You're not wrong (cash in Treasuries will not be treated as bank assets - since they're not).  So, yes, holding cash in the form of short term Treasuries rather than FDIC-insured deposits will keep you out of any potential "bail-in" hanky panky. 

The only scenario where you get screwed holding Treasuries is US government default.  This is classically unthinkable, but with complete nut-jobs (like Cruz) having a non-zero chance of being the next POTUS we might want to start thinking about the unthinkable.

How close are we in the U.S. to having bail-ins become a reality?
I too am concerned with the likelihood of this occurring.
Vanguard recently re-opened their Treasury MM.
Perhaps now is a good time to consider exchanging bank cash for MM yielding nothing.