TLT (and other long duration bond funds/ETFs) sensitivity to rising rates

I just read this recent article on Investopedia. I have learned to take some of what they say with a grain of salt but I thought this was spot on and was easy to understand. In addition to what Marc has been saying about TLT, it too gives some background on why rates have continued to march lower to where they are now. Finally, it gives a an idea of where else to look for comparable yields with lower duration (risk):

http://www.investopedia.com/articles/etfs-mutual-funds/060916/tlt-why-low-interest-rates-dangerous-investors.asp

It seems to me that the price of bond ETFs is driven not by rate changes so much as it is the expectation of rate changes. If true, then does TLT remains a viable short term hedge during market downturns, when the likelihood of rate increases are lower?

David - There was once a saying that a manager will never be fired for buying IBM. I think the same holds here, in other words you will never be fired or criticized for being anti-TLT. P123 now has a lot of alternatives for TLT in the hedge module so people who are risk-adverse can choose another hedging instrument. However, be sure to understand the correlation to stocks before doing so. We know that TLT has a negative correlation, I’m not sure about corporate bonds in a bear market, perhaps someone out there has studied this. One also has to take into consideration the higher risk of default for corporate bonds, lower liquidity, etc.

As for the possibility of Fed raising interest rates, well good luck on that. I know that the central banks want to raise rates, not for our sake, but to demonstrate that they are still relevant. We are not in an economic environment that will respond to monetary policy. Remember the famous quote by Einstein that you can’t solve today’s problems with the same thinking that got you to this point.

Both Japan and Europe are in deep do do. Japan is so desperate that helicopter Ben recently flew there to hold private meetings with Abe. Europe has its own problems with Italy banks about to make Greece look like a child’s playground, the immigration problems, and upcoming EU exit referendums.

As for the USA, we can listen to the “things are great” media talk, perhaps this is election foreplay, who knows? But the reality is something different. Here is a quote from a recent Mauldin letter:

"Bank of America, which knows a thing or two about credit card usage, said its aggregated data of Bank of America debit cards and credit cards showed particular weakness in four retail areas:

Department stores: down 4.0%
Teen/young adult stores: down 4.6%
Home goods: down 3.6%
Electronics: down 3.0%"

Steve

Steve, I think your point about corporate bonds is a good one. My guess is that buyers of debt will chase the highest yield with the lowest risk, within reason and legal bounds. So my feeling is that corporate debt will track government debt since it is the next alternative/competition.
But it would be good to hear someone’s take on corporate bonds.
I have been grappling with this myself a lot recently. What other asset classes can be added to stocks to give steadier returns over the next 10 years? The permanent portfolio says very short term bonds (cash), long term bonds and gold. Due to a variety of reasons, two of the three are suspect to me. So for me right now, it is a lot of cash + dividend/nondividend stocks. I use Vanguard for my broker and they are constantly reminding me that I need bonds. I don’t know…the markets are all !@#$% up…!

Ran a quick SIM of holding TLT since 94. Correlation with SP500 was -0.26 versus 0.21 for LQD in the same period. Junk bonds (HYB) are even worse at 0.45.

It’s that negative correlation that’s so valuable and so hard to find right now.

It’s left me with more money in real estate and gold than I’d otherwise have.

Do you use a REIT fund/ETF for real estate?

Corporates have a positive correlation

Yeah, I invest in individual reits. I find it’s not hard to spot the stinkers, and with a small universe of them here in Canada, you can beat the reit indexes without much difficulty, just by not buying the ones overly saddled with debt. Plus there is a little diversification available within reit types (commercial, multi-family, offices, nursing homes). Some of them hold properties outside NA.

They’re still correlated with equities though, and quite rate sensitive, even when it’s unwarranted.

hmmm. thanks.

I see the comments about corporate bond funds (like LQD) being positively correlated as well.

Stop right there. Discard the sim. The results were driven by an interest-rate regime that is, with 100% certainty, done and gone.

No, no, no, no, no.

Correlation is nothing more than a historical report card of the way different number series moved relative to one another during a specified measurement period. But each number series had reasons for moving as it did. Sometimes, we can’t articulate all or even any of the reasons. But other times, we can and in this ciurcumstance, we must consider and account for what we know,even if it means rejecting the conclusion we might have been inclined to draw from a naive correlation computation. Re: long-term fixed income, see . . .

That’s it for a bit . . . waiting to start jury duty . . . :frowning:

Jury duty! HaHa. I’m feeling sorry for the defendant already.
Steve

Marc is absolutely right.

As we all know, interest rates have been falling since 1982. That is why long term treasuries have over performed.

This chart is from Prof. Siegel “Stocks for the long run” 5th edition
Real (inflation adjusted) total (dividends and interest payments reinvested) Returns on U.S. Stocks, Bonds, Bills, Gold, and the Dollar, 1802–2012

As you can see.
In rising interest and inflation environments stocks outperform in the long run. (red line)
In falling interest environments bonds “outperform” (green line) Actually bonds only outperformed since 2000

Now the question is, will we get inflation and rising interest rates in the long run (next 20 years)?
Will all the QE finally find its way into main street?

If yes, then stocks will outperform bonds, just as from 1940 to 2000 (red line)

Or will we go Japan style liquidity trap with 30 years of deflation and negative 20 year government bond yields.
Now I personally think we will not go Japan style, but even if we would I have done a discounted cashflow calculation on 20 year bonds.
If the us 20yr treasury yield falls from 1.9% to Japanese -0.03%, then the us 20 yr treasury would rise round about 39%
So that is the “best case” scenario for bonds.

I know, I’m not talking about returns, I’m talking about the relative difference in past correlation to equities between corporate vs government debt.

Even in a future rising rate environment though, don’t you think TLT will continue to be negatively correlated with equities, except for rather sudden NAV drops right around each rate hike? Sure, overall returns will be awful, but will shorter term negative correlations continue?

Buying and holding long term bonds is looking like a very bad idea right now, but i wonder if holding TLT shorter term (during market downturns) still offers some utility.

When I started this thread it was really about using an asset long term to mitigate the zig-zags of equities. I personally have given up on timing algos so I don’t think about market timing any longer. I try to just allocate a certain portion of my overall portfolio to equities and then mitigate short term downcycles with other assets. But finding those other assets, other than cash, has become a challenge.

All - We all know that if you buy Treasury Bonds and hold for the duration your investment will increase by the yield on the TBonds. Now what do you think a person in Japan close to retirement should do? Buy equities? Would that be wise? He can hold Japanese TBonds at zero % yield and risk default. Or he can hold US TBonds for 1.5% (or whatever the yield is currently) and make this interest over the next 20 years, guaranteed! If the USD appreciates, then he makes even more! Now why doesn’t he short Japanese TBonds and buy US TBonds? Shorting the Japanese is free money to be used elsewhere as the only direction yields are going in Japan are down. Now lets say there are millions of people in Japan nearing retirement. Now, lets apply the same argument to Germany.

Despite what anyone thinks, the demand for US TBonds is going to remain very strong for the foreseeable future. If the US raises interest rates on the low end, it will simply cause an inverted yield curve. The Fed Reserve doesn’t have control over long term rates.

BTW here is a GMO (www.gmo.com) asset forecast for the next 7 years:


What you need to know about Europe: Italy, Its Banks and the Future of the Euro

Steve

There is strong macroeconomic evidence that LT bonds should have negative correlation with equities, since bonds are priced discounting expected future interest rates, inflation and growth. Recently, this correlation has been moving much lower than historic average. If I have to guess, this is probably caused by stretched valuations in duration risk (i.e. very small or slightly negative premium of interest rates above inflation). For accepting such low premiums investors demand more protection, so basically now bonds are priced more like insurances.

Problem is when sudden spikes in bond yields happen, look at german market last year in April: 1% spike in interest rates and -8% in the stock market. If central bankers go too heavy in respressing yield, situations like this can happen.

I don’t think that an armaggedon is going to hit the bond market, but long term returns from now on will probably be low. For hedging purposes now I prefer long/short strategies (even in fixed income).

I agree with you in saying that US is one the best low risk fixed income market available for its yield. And a lot of investors (including me) are carry trading on that. But remember that extremely low levels of interest rates elsewhere are at a cost of undervalued currencies (namely Euro and Yen), so if you put in place an hedge that 1,5% becomes 0,7% for Euro and 0,9% for yen. Better than nothing, but not much attractive. And it can vary with short term interest rates movements.

It’s a simple problem: there are seriuos asset imbalances in the most battered banks, losses that someone has to pay. If the italian financial sector as a whole swallow those losses things will go relatively smoothly (except for future profitability of those banks), if a bail-in happens it will be more bumpy. But if banks go bankrupt it is usually the right time to buy more stocks… and maybe some german deposit if people begin to riot, but that is really unlikely even with some bondholder loss.

Riccardo -

How will the Italian financial sector swallow the losses when 18% of loans are nonperforming?

Out of curiosity, why are the Euro and Yen undervalued? I would agree that Germany would be undervalued if they left the EU, but the Euro itself?

More food for thought:

Steve

The reason behind Atlante fund is that healthier banks will bailout the worst ones. It could work as long as funding cost of debt will remain reasonable for higher quality banks and if the ECB will not demand higher capital buffers for non performing loans. It will take a lot to digest that bad debt, but over a decade it can be done.

https://en.wikipedia.org/wiki/Atlante_(private_equity_fund)

Lately the italian government recognized the issue and is trying to help by seeking to relax bail in rules. Even populist opposition parties are supporting the government effort on this.

http://www.ft.com/cms/s/0/86a137e4-4e8f-11e6-8172-e39ecd3b86fc.html#axzz4EwANR0Ge

Euro and Yen are undervalued compared to USD by relative PPP, probably in the 10-15% range. Higher interest rates in US and different patterns in monetary policy are causing that. I’m not saying tomorrow they will revert, but over the long term lower interest rates and inflation will be compensated by higher currencies.

Verdicts: Just a report on what happened in the past. Useful sometimes?