CRUS, Cirrus Logic, which makes audio chips which trades essentially as an AAPL derivative, has broken out today strongly following a positive report from the Semiconductor Industry Ass'n that business has turned. I take this as a sign that AAPL is "probably" headed to new highs as well. I had gotten lucky and sold most of AAPL around $620+ after A) Cramer called it the stock of the century (I exaggerate only slightly) and then the DOJ e-books lawsuit was filed.
I have been scaling back into the fruit big-time. First intermediate-term target: $690-700 by year-end. Rationale: After FY Q3 earnings are released in about 5 weeks, TTM 12 month earnings could be $45. 15-16X those earnings gets one to about that range. I would also note that Value Line's "value line" places AAPL's "fair value" around $900 as of today.
Am selling my last 14-year Treasury Strip at a 9% return, good in that this one was not bought till late in the rally. My rule of thumb with trading zeroes is that I sell if I net 3 year's worth of interest payments on the trade. Especially so when it's a zero that pays you nothing to own it.
Showing posts with label zero coupon bonds. Show all posts
Showing posts with label zero coupon bonds. Show all posts
Monday, June 18, 2012
Tuesday, May 31, 2011
Merrily Rolling Down the Yield Curve
Your humble and chronically bemused blogger drank the Kool-Aid today and added a substantial amount of a specific type of bond to his IRA holdings, transforming zero-yielding cash into a zero-coupon Treasury bond of 8 years duration. This was done while continuing to hold a substantial percentage of our family savings in gold and while being aware that the MIT Billion Prices Project is showing a price inflation rate that makes my 2.64% implied annual yield a loser in real terms.
(Do I contradict myself? Very well, then I contradict myself.)
Here is the thinking behind my latest speculative foray into bonds.
Basically this is a play for modest capital gains.
First, one must understand that when one buys a bond, one's broker will quote you a yield. But the reality is that the transaction is one in which price is the reality. The yield you are quoted is, forsooth, a derived value. It is not a toxic derivative as in CDO-squared sorts of derivatives, but it is a derivative value. In the case of most bonds, which pay coupon interest periodically before the borrower is supposed to return the invested principal, computation of effective yield is more complex than most people realize. One has to make assumptions about such matters as reinvestment returns on the interest payments, for example. Furthermore, standard bond tables assume that the interest is reinvested at the coupon rate of the bond. In a world where short-term money yields nothing, however, that calculation ends up overestimating the real return that a lender receives.
If one's goal in purchasing a bond is to attain a capital gain, the purest bond is one that pays no interest and thus does away with the reinvestment problem. This bond, commonly called a zero-coupon bond, trades at a price with a yield that can be computed with a compound interest calculator. Here is how to make lemonade with zero coupon bonds. First, one should have a non-callable bond. You have to be confident of the maturity date.
This is where Treasuries are almost unique in bond land.
Next, you want a positive yield curve, which is one in which the annual yield is higher as the duration of the bond increases.
So when I called up the broker today, I asked for the prices and yields on 7 and 8 year Treasury bonds. They were about 84 and about 81 respectively, correlating with yields of 2.44% and 2.64%. I purchased some 8 year (2019 maturity) bonds at around 81. What this means is that assuming los Federales are still in business in 8 years, they promise to pay me $100 for each $81 worth of bonds today, but they will pay me nothing till then. Annualized that's about 2.6% yearly. However, if I want to make a similar investment but want $100 back in 7 years rather than 8, I will have to fork over $84 today.
Let's now look forward one year. Let us say that for whatever reasons, the yield curve is unchanged. In that case, I will then be the owner not of an 8 year bond, but rather I will own a 7 year bond. All things being equal, the value of my bond will have risen from 81 to 84. Taking the fractions into account, my 2.6% bond today will rise 4.0% in value (from 81.18 to 84.47). It's a form of financial alchemy, in a sense. All I need to get a 1-year return almost equal to the return from lending money to the government for 30 full years is for the interest rate structure to simply not change.
This sort of activity is called rolling down the yield curve. It is one of the SOPs among bond portfolio managers.
In making this bet, I am taking the point of view that the Economic Cycle Research Institute is correct in its call for Treasuries rather than stocks or industrial commodities as preferred investments in the months ahead. In this scenario, we should remember that as recently as November last year, the 5-year Treasury traded with a yield below 1.1%. And that was merely in the setting of a growth slowdown, at a time when gold and silver prices had already been surging for months. What if there is a full-blown global industrial downturn, with oil in the $60-80/barrel range and copper at $3/pound or less? And perhaps silver at $25/ounce again, or lower? Who knows where the herd will take Treasury prices in the seemingly unending cascade of financial asset inflation that has been occurring for decades?
In that (quasi-)recessionary scenario, there is the potential for this boring debt instrument to return 5-10%, possibly in as little as 6 months.
Of course, there are numerous risks to this approach, most obviously the one that price inflation makes this 2.6% yield look trivial. My answer to that is ownership of gold so long as interest rates are at or below the general price inflation rate, no matter what the economic cycle is doing. I would then supplement that by adding economically sensitive, "weak dollar" assets when economic activity appears to be troughing or accelerating. But in a world where there are central authorities who are determined to make savers pay to recapitalize financially weak financial institutions by forcing them to receive rates on money in the bank that are below the rate of price inflation, one thing is mathematically certain.
Pitiful as a yield of 2.6% may be, it is greater than zero.
In a world where little except the air we breathe is cheap, beating zero with the chance for capital gain due to a possible major deceleration of economic activity seems reasonable to me.
Copyright (C) Long Lake LLC 2011
(Do I contradict myself? Very well, then I contradict myself.)
Here is the thinking behind my latest speculative foray into bonds.
Basically this is a play for modest capital gains.
First, one must understand that when one buys a bond, one's broker will quote you a yield. But the reality is that the transaction is one in which price is the reality. The yield you are quoted is, forsooth, a derived value. It is not a toxic derivative as in CDO-squared sorts of derivatives, but it is a derivative value. In the case of most bonds, which pay coupon interest periodically before the borrower is supposed to return the invested principal, computation of effective yield is more complex than most people realize. One has to make assumptions about such matters as reinvestment returns on the interest payments, for example. Furthermore, standard bond tables assume that the interest is reinvested at the coupon rate of the bond. In a world where short-term money yields nothing, however, that calculation ends up overestimating the real return that a lender receives.
If one's goal in purchasing a bond is to attain a capital gain, the purest bond is one that pays no interest and thus does away with the reinvestment problem. This bond, commonly called a zero-coupon bond, trades at a price with a yield that can be computed with a compound interest calculator. Here is how to make lemonade with zero coupon bonds. First, one should have a non-callable bond. You have to be confident of the maturity date.
This is where Treasuries are almost unique in bond land.
Next, you want a positive yield curve, which is one in which the annual yield is higher as the duration of the bond increases.
So when I called up the broker today, I asked for the prices and yields on 7 and 8 year Treasury bonds. They were about 84 and about 81 respectively, correlating with yields of 2.44% and 2.64%. I purchased some 8 year (2019 maturity) bonds at around 81. What this means is that assuming los Federales are still in business in 8 years, they promise to pay me $100 for each $81 worth of bonds today, but they will pay me nothing till then. Annualized that's about 2.6% yearly. However, if I want to make a similar investment but want $100 back in 7 years rather than 8, I will have to fork over $84 today.
Let's now look forward one year. Let us say that for whatever reasons, the yield curve is unchanged. In that case, I will then be the owner not of an 8 year bond, but rather I will own a 7 year bond. All things being equal, the value of my bond will have risen from 81 to 84. Taking the fractions into account, my 2.6% bond today will rise 4.0% in value (from 81.18 to 84.47). It's a form of financial alchemy, in a sense. All I need to get a 1-year return almost equal to the return from lending money to the government for 30 full years is for the interest rate structure to simply not change.
This sort of activity is called rolling down the yield curve. It is one of the SOPs among bond portfolio managers.
In making this bet, I am taking the point of view that the Economic Cycle Research Institute is correct in its call for Treasuries rather than stocks or industrial commodities as preferred investments in the months ahead. In this scenario, we should remember that as recently as November last year, the 5-year Treasury traded with a yield below 1.1%. And that was merely in the setting of a growth slowdown, at a time when gold and silver prices had already been surging for months. What if there is a full-blown global industrial downturn, with oil in the $60-80/barrel range and copper at $3/pound or less? And perhaps silver at $25/ounce again, or lower? Who knows where the herd will take Treasury prices in the seemingly unending cascade of financial asset inflation that has been occurring for decades?
In that (quasi-)recessionary scenario, there is the potential for this boring debt instrument to return 5-10%, possibly in as little as 6 months.
Of course, there are numerous risks to this approach, most obviously the one that price inflation makes this 2.6% yield look trivial. My answer to that is ownership of gold so long as interest rates are at or below the general price inflation rate, no matter what the economic cycle is doing. I would then supplement that by adding economically sensitive, "weak dollar" assets when economic activity appears to be troughing or accelerating. But in a world where there are central authorities who are determined to make savers pay to recapitalize financially weak financial institutions by forcing them to receive rates on money in the bank that are below the rate of price inflation, one thing is mathematically certain.
Pitiful as a yield of 2.6% may be, it is greater than zero.
In a world where little except the air we breathe is cheap, beating zero with the chance for capital gain due to a possible major deceleration of economic activity seems reasonable to me.
Copyright (C) Long Lake LLC 2011
Monday, October 11, 2010
Why Short Duration Treasuries Are Overvalued but Long-Term Treasuries May Be a "Buy"
Just as it can be more properly argued that it is a market of stocks rather than a stock market, certain parts of the bond market can be bubbly and others be reasonable buys. An obvious example came in the wake of the Lehman-AIG market disruption, where the 30-year Treasury yield collapsed to 2.6% just as yields on sub-investment grade bonds soared. Anyone who invested bravely in the asset with the depressed price (high yield) did much better than anyone who bought Treasuries at their high prices (low yields).
It appears that a milder version of that phenomenon could be set up to happen in bond-land.
Before reading on, you may wish to look at the nearby long-term chart of interest rates in Japan.
(Click on chart to enlarge.) I will refer to it later.
Please also consider an excerpt from a blog from 2005 by the then not-so-well-known blogger Calculated Risk, in which he commented on then-Chairman Greenspan's "conundrum" speech regarding the failure of long Treasury rates to increase as much as expected as the Fed engaged on its tightening regimen:
But I think the PRIMARY reason for Greenspan's conundrum is that the economy is weaker than it appears. Using GDP growth and unemployment, the US economy is healthy. But the level of debt (both consumer and government), the real estate "boom" that seems based on leverage and loose credit (see Volcker's recent comments), and the poor employment situation (especially the low level of participation) indicate an unhealthy economy. I believe this recovery is being built on a marshland of debt and the bond market is reflecting this weakness.
By the way, here is CR's below-consensus view nowadays:
I expected a sluggish recovery in 2010, so I thought the unemployment rate would stay elevated throughout 2010 (that was correct).
Going forward, I think the recovery will stay sluggish and choppy for some time and I'd guess the unemployment rate will tick up in the short term and still be above 9% later next year.
I more or less agree with CR though I may be a bit more bearish than he.
So the predicate for the following discussion is the view that while economic jiggles upward are to be expected, too many data points simply point to a general stagnant trend for the pace of business in this country for me to argue against accepting that stagnant trend as the New Normal.
Despite that New Normal and the fact that 0.5% interest rates on 3-year money are crisis lows and reflect a poor state of business affairs, let's consider how extreme the market's estimation of fair value for interest rates in the "out years" has become. As first Mr. Greenspan and then Dr. Bernanke led the Fed's long slow interest rate-raising campaign, the "conundrum" of a flattening yield curve caught their eye. At the interest rate peak in mid-2007, more or less all rates from 1 day to 30 years were identical at around 5.25%.
For historical purposes, please be aware that through much of the 1800s, short-term interest rates were generally higher than long-term rates. This reflected such factors as productivity gains, generally under a gold or bimetallic monetary system. As the Japanese experience the past decade reflects, though, prices may fail to rise even under a non-metal-based (i.e. "fiat") monetary system.
What is the message of Mr. Bond today?
Well, the 2-year bond is at 0.35% yearly, the 3-year at 0.52% and the 5-year at 1.10%. Using a simplified model of implied bond yields farther out the curve, one can calculate as follows.
The 30-year Treasury bond yields 3.75% each year for 30 years. Thus a $100 investment in this bond at "par" of $100 per bond provides a gross total of $112.50 in interest payments over 30 years.
If one were instead to purchase a 3-year Treasury note, one would receive about $1.50 gross over 3 years for every $100 invested (lent to the government), or a "grand" total of $4.50 over the 3 years. It hardly seems worth bothering (especially when credit card companies that have bank subsidiaries are offering FDIC-insured yields of 1.3-1.5% even today). Subtracting interest income over 3 years from that obtainable for 30 years gives income attributable to years 4-30, In those final 27 years, one would receive $111, spread evenly over each year. This computes to about 4.1% yearly.
Turning to a comparison of the first 5 years of the yield curve vs. the final 25 of a 30 year stretch, under current rates one accepts 1.1% a year for 5 years. Similar math to the above would imply a 4.28% yield yearly for the terminal 25 years.
Let's look at matters differently. To choose 5 year paper over 30 year has one certainty. At the end of 5 years, the investor of $100 in a 5-year note will have earned $5.50. He/she will have $105.50. The investor in the 30-year bond will have earned almost $18, or about $12 more. The first investor will be more than $12 behind the proverbial eight-ball (to mix a numerical metaphor). It will not be so easy to find the right investment for the next 25 years just to come out even with the buy-and-hold investor in the 30-year bond.
The numbers get more interesting as we go farther out on the curve. If the 20-year Treasury yields 3.2% today, then it pays $64 in interest per $100 over that 20 years. Subtracting that from the total payout to the 30-year holder implies an average yield for years 21-30 (the final 10 years of the 30-year bond) of 5.1%.
Voila! We are nearing the rates extant in 2007.
A back-of-the-envelope guesstimate is that the bond market is implying a 5.5% yield is proper for year 30 on its own.
In other words, the long bond is in no bubble whatsoever. It is the low-yielding front years that are wildly overvalued (under-yielding).
Well, all this guessing about the "right" interest rate in the out years is absolute conjecture on the part of the bond market. The truth is that the bond market has little more idea than you or I what economic conditions will be like a year or two from now, much less many years out. Japan scenario? Greece (though with a printing press)? U. S. 1970s, with bear markets for both stocks and bonds? Everything good?
The truth is that we really don't know what will happen from one day to the next. One summer day several years ago, I left home and about 10 minutes later walked into the doctors' lounge to grab some coffee before seeing my hospital patients. The TV showed that an accident had occurred in downtown New York; an airplane had just hit one of the World Trade Centers. Since that time, the Fed has almost never voluntarily pushed the Fed funds rate above CPI, in contrast to its policy of most of the prior 2 decades; and the U. S. has been on a semi-war footing even despite the election of a "peace" candidate in 2008.
The world changed during my brief commute to work. Two-three years from now could be another eternity, just as the past few years has been.
The current trend is the Japanese one. Zero interest rate policy ("ZIRP") is resorted to as an emergency measure by the central bank. The acute emergency ends, but chronic illness emerges. Zero or near-zero interest rates continue to anchor longer and longer maturities toward zero. Meanwhile, market participants continue to rationally expect a reversion to the interest rate mean. This has been the Japanese experience, and to date nothing other than hope for better times has occurred in the U. S. to differentiate us from them.
Let us look again at the chart of interest rates in Japan. After the yield on the 5-year note fell to new lows in 2001-3, the 30-year actually fell more in yield than the 10-year. Whenever the yield gap, in absolute and percentage terms, was wide, it paid to buy the 30 year.
Why should it be different here and now? Because we have nukes and they don't?
In addition, there is a specific potential catalyst for outperformance of the long bond. That is the expected "QE2", or further expansion of the Fed's balance sheet, a/k/a yet more money-printing, with the now unconcealed primary purpose (per the NY Fed's executives in recent speech(es)) of keeping financial asset prices above fair value. (In other words, trickle-down economics . . .)
It is known that the public has been rebalancing its portfolio from stocks toward bonds, but the bonds it has been buying are almost entirely short-to-intermediate term securities, or so it has been reported. Thirty years ago, bonds were known as certificates of confiscation. In my humble opinion, that's likely what 5-year notes are today. Apparently the public is nervous about the long term future for interest rates and is so nervous it is moving heavily toward the short end. Where the public is nervous, it's usually a good idea to think about being a contrarian.
Getting back to the potential catalyst for a rapid and large drop in long-term rates, what if Dr. Bernanke took a quick look at the interest rate curve, saw the record or near-record absolute and relative spread between the 2-year and the 30-year bond, and between the 10-year and the 30-year bond, and said the following any time in the near future?
"The yield curve is too steep. The Fed is going to target the 10-year yield at modestly below its current level but believes that a more appropriate level for the 30-year bond is at most 3%, which provides a positive return after targeted inflation of 2% with utmost security of principal and is thus a yield that is fair to both the lender and to the Treasury."
There would be a rush to the long bond, of course. Now here is where the arithmetic gets interesting. A drop in interest rates of 75 basis points on a zero coupon bond for a 30-year security from 4% to 3.25% (rates on zeros are higher than rates on par bonds that pay interest) gives a price change of the zero coupon security from $30.80 to $38.30; quite a percentage move.
Let us take the Japanese experience. If 5 years from now, a zero coupon security purchased yielding 4% turns into a bond (at that time a 25-year bond) yielding 2.5%, the price will be $54 (from $30.80, to remind you).
If at any time within those 5 years the yield drops that much, the annualized return will be greater, even if the price is less than $54.
Aside from Fed action, why might the long Treasury be a fundamentally attractive investment for individuals, especially for tax-deferred accounts such as IRAs?
Might the U. S. actually "walk the walk" of fiscal prudence? Might the authorities, after all the fruitless manipulation of monetary aggregates, get back to where they once belonged and accept the obvious principle that aiming for price increases is harmful to the people they are supposed to serve, and primarily only benefits the financial class?
Might some form of hard money serve as the chosen solution to ratify most of the unsupportable promises known as debt and social obligations the Feds have willing taken on?
Might the government actually go to a peace economy?
In any case, back to supply and demand, and to fundamentals of return adjusted for changes in the general price level ("real" return). Here is a link to a Morgan Stanley estimate of outstanding Treasuries by duration. There are not a lot of long-duration Treasuries. The yield spread is large. A buyer of a 5-year Treasury at 1.1% could get creamed simply by an average of 3.5% price inflation per year, whereas the buyer of the long Treasury would (pre-tax) be holding even and the buyer of the zero coupon bond would be accruing perhaps, after all is said and done, a small positive return yearly.
Thus, in conclusion, there are potential capital gains that might accrue soon to the purchaser of long-term Treasury bonds, with said possible gains being leveraged via purchase of zero-coupon instruments; and there is greater protection from inflation over the next few years by purchases of those types of bonds rather than the short-intermediate duration vehicles to which J. and J. Q. Public have reportedly been flocking.
Some caveats:
1. Anyone reading this who is not a regular reader of my posts would not be aware that I have spent weeks and many months criticizing the monetary authorities for unfair and inappropriate printing of mass quantities of money. I have published a series of on-line articles describing various ways in which I have been investing significant portions of my financial assets to try to protect them from the ravages of all this money-printing; principal among them is gold (I have blogged favorably about gold since winter-spring of last year). Here is a link to the first of that series, on September 8
2. For taxable accounts, well-chosen tax-exempt municipal bonds may provide the optimal risk-reward for buy-and-hold bond investors rather than Treasuries. This discussion of Treasuries unfortunately is in the context of my post titled We Are All Speculators Now, from September 20.
3. Investing is risky, speculating is risky, and purchase of long-term bonds entails a commitment to, well, the long term, even if a profitable sale of the bond is hoped for in the shorter term. The potential for gain entails meaningful potential for loss, especially adjusted for possible sustained rapid rises in living costs.
4. Nothing herein or in any of my on-line posts should be construed as investment advice to any person, as opposed to simple commentary and conjecture. Reasonable efforts have been made to present economic and numerical data as accurately as possible, but please take nothing for granted and do your own math and research as appropriate to your level of interest.
Copyright (C) Long Lake LLC 2010
This piece will present the case for investing in long-term Treasuries while at the same time believing that the 5-year and under space is significantly overpriced and therefore bubble-like in valuation.
A stock analogy to this argument came in the late 1990s. The average NYSE stock actually peaked in 1997-8, but the DJIA peaked at the end of 1999, the NASDAQ in March 2000 and the S&P 500 later in 2000. Yet many stocks bottomed in March 2000, such as homebuilders and many industrial companies. It was as if people ran from the port (tech) side of the ship to the starboard (anti-tech) side of the stock ship at the same time.
It appears that a milder version of that phenomenon could be set up to happen in bond-land.
Before reading on, you may wish to look at the nearby long-term chart of interest rates in Japan.
(Click on chart to enlarge.) I will refer to it later.
Please also consider an excerpt from a blog from 2005 by the then not-so-well-known blogger Calculated Risk, in which he commented on then-Chairman Greenspan's "conundrum" speech regarding the failure of long Treasury rates to increase as much as expected as the Fed engaged on its tightening regimen:
But I think the PRIMARY reason for Greenspan's conundrum is that the economy is weaker than it appears. Using GDP growth and unemployment, the US economy is healthy. But the level of debt (both consumer and government), the real estate "boom" that seems based on leverage and loose credit (see Volcker's recent comments), and the poor employment situation (especially the low level of participation) indicate an unhealthy economy. I believe this recovery is being built on a marshland of debt and the bond market is reflecting this weakness.
By the way, here is CR's below-consensus view nowadays:
I expected a sluggish recovery in 2010, so I thought the unemployment rate would stay elevated throughout 2010 (that was correct).
Going forward, I think the recovery will stay sluggish and choppy for some time and I'd guess the unemployment rate will tick up in the short term and still be above 9% later next year.
I more or less agree with CR though I may be a bit more bearish than he.
So the predicate for the following discussion is the view that while economic jiggles upward are to be expected, too many data points simply point to a general stagnant trend for the pace of business in this country for me to argue against accepting that stagnant trend as the New Normal.
Despite that New Normal and the fact that 0.5% interest rates on 3-year money are crisis lows and reflect a poor state of business affairs, let's consider how extreme the market's estimation of fair value for interest rates in the "out years" has become. As first Mr. Greenspan and then Dr. Bernanke led the Fed's long slow interest rate-raising campaign, the "conundrum" of a flattening yield curve caught their eye. At the interest rate peak in mid-2007, more or less all rates from 1 day to 30 years were identical at around 5.25%.
For historical purposes, please be aware that through much of the 1800s, short-term interest rates were generally higher than long-term rates. This reflected such factors as productivity gains, generally under a gold or bimetallic monetary system. As the Japanese experience the past decade reflects, though, prices may fail to rise even under a non-metal-based (i.e. "fiat") monetary system.
What is the message of Mr. Bond today?
Well, the 2-year bond is at 0.35% yearly, the 3-year at 0.52% and the 5-year at 1.10%. Using a simplified model of implied bond yields farther out the curve, one can calculate as follows.
The 30-year Treasury bond yields 3.75% each year for 30 years. Thus a $100 investment in this bond at "par" of $100 per bond provides a gross total of $112.50 in interest payments over 30 years.
If one were instead to purchase a 3-year Treasury note, one would receive about $1.50 gross over 3 years for every $100 invested (lent to the government), or a "grand" total of $4.50 over the 3 years. It hardly seems worth bothering (especially when credit card companies that have bank subsidiaries are offering FDIC-insured yields of 1.3-1.5% even today). Subtracting interest income over 3 years from that obtainable for 30 years gives income attributable to years 4-30, In those final 27 years, one would receive $111, spread evenly over each year. This computes to about 4.1% yearly.
Turning to a comparison of the first 5 years of the yield curve vs. the final 25 of a 30 year stretch, under current rates one accepts 1.1% a year for 5 years. Similar math to the above would imply a 4.28% yield yearly for the terminal 25 years.
Let's look at matters differently. To choose 5 year paper over 30 year has one certainty. At the end of 5 years, the investor of $100 in a 5-year note will have earned $5.50. He/she will have $105.50. The investor in the 30-year bond will have earned almost $18, or about $12 more. The first investor will be more than $12 behind the proverbial eight-ball (to mix a numerical metaphor). It will not be so easy to find the right investment for the next 25 years just to come out even with the buy-and-hold investor in the 30-year bond.
The numbers get more interesting as we go farther out on the curve. If the 20-year Treasury yields 3.2% today, then it pays $64 in interest per $100 over that 20 years. Subtracting that from the total payout to the 30-year holder implies an average yield for years 21-30 (the final 10 years of the 30-year bond) of 5.1%.
Voila! We are nearing the rates extant in 2007.
A back-of-the-envelope guesstimate is that the bond market is implying a 5.5% yield is proper for year 30 on its own.
In other words, the long bond is in no bubble whatsoever. It is the low-yielding front years that are wildly overvalued (under-yielding).
Well, all this guessing about the "right" interest rate in the out years is absolute conjecture on the part of the bond market. The truth is that the bond market has little more idea than you or I what economic conditions will be like a year or two from now, much less many years out. Japan scenario? Greece (though with a printing press)? U. S. 1970s, with bear markets for both stocks and bonds? Everything good?
The truth is that we really don't know what will happen from one day to the next. One summer day several years ago, I left home and about 10 minutes later walked into the doctors' lounge to grab some coffee before seeing my hospital patients. The TV showed that an accident had occurred in downtown New York; an airplane had just hit one of the World Trade Centers. Since that time, the Fed has almost never voluntarily pushed the Fed funds rate above CPI, in contrast to its policy of most of the prior 2 decades; and the U. S. has been on a semi-war footing even despite the election of a "peace" candidate in 2008.
The world changed during my brief commute to work. Two-three years from now could be another eternity, just as the past few years has been.
The current trend is the Japanese one. Zero interest rate policy ("ZIRP") is resorted to as an emergency measure by the central bank. The acute emergency ends, but chronic illness emerges. Zero or near-zero interest rates continue to anchor longer and longer maturities toward zero. Meanwhile, market participants continue to rationally expect a reversion to the interest rate mean. This has been the Japanese experience, and to date nothing other than hope for better times has occurred in the U. S. to differentiate us from them.
Let us look again at the chart of interest rates in Japan. After the yield on the 5-year note fell to new lows in 2001-3, the 30-year actually fell more in yield than the 10-year. Whenever the yield gap, in absolute and percentage terms, was wide, it paid to buy the 30 year.
Why should it be different here and now? Because we have nukes and they don't?
In addition, there is a specific potential catalyst for outperformance of the long bond. That is the expected "QE2", or further expansion of the Fed's balance sheet, a/k/a yet more money-printing, with the now unconcealed primary purpose (per the NY Fed's executives in recent speech(es)) of keeping financial asset prices above fair value. (In other words, trickle-down economics . . .)
It is known that the public has been rebalancing its portfolio from stocks toward bonds, but the bonds it has been buying are almost entirely short-to-intermediate term securities, or so it has been reported. Thirty years ago, bonds were known as certificates of confiscation. In my humble opinion, that's likely what 5-year notes are today. Apparently the public is nervous about the long term future for interest rates and is so nervous it is moving heavily toward the short end. Where the public is nervous, it's usually a good idea to think about being a contrarian.
Getting back to the potential catalyst for a rapid and large drop in long-term rates, what if Dr. Bernanke took a quick look at the interest rate curve, saw the record or near-record absolute and relative spread between the 2-year and the 30-year bond, and between the 10-year and the 30-year bond, and said the following any time in the near future?
"The yield curve is too steep. The Fed is going to target the 10-year yield at modestly below its current level but believes that a more appropriate level for the 30-year bond is at most 3%, which provides a positive return after targeted inflation of 2% with utmost security of principal and is thus a yield that is fair to both the lender and to the Treasury."
There would be a rush to the long bond, of course. Now here is where the arithmetic gets interesting. A drop in interest rates of 75 basis points on a zero coupon bond for a 30-year security from 4% to 3.25% (rates on zeros are higher than rates on par bonds that pay interest) gives a price change of the zero coupon security from $30.80 to $38.30; quite a percentage move.
Let us take the Japanese experience. If 5 years from now, a zero coupon security purchased yielding 4% turns into a bond (at that time a 25-year bond) yielding 2.5%, the price will be $54 (from $30.80, to remind you).
If at any time within those 5 years the yield drops that much, the annualized return will be greater, even if the price is less than $54.
Aside from Fed action, why might the long Treasury be a fundamentally attractive investment for individuals, especially for tax-deferred accounts such as IRAs?
Might the U. S. actually "walk the walk" of fiscal prudence? Might the authorities, after all the fruitless manipulation of monetary aggregates, get back to where they once belonged and accept the obvious principle that aiming for price increases is harmful to the people they are supposed to serve, and primarily only benefits the financial class?
Might some form of hard money serve as the chosen solution to ratify most of the unsupportable promises known as debt and social obligations the Feds have willing taken on?
Might the government actually go to a peace economy?
In any case, back to supply and demand, and to fundamentals of return adjusted for changes in the general price level ("real" return). Here is a link to a Morgan Stanley estimate of outstanding Treasuries by duration. There are not a lot of long-duration Treasuries. The yield spread is large. A buyer of a 5-year Treasury at 1.1% could get creamed simply by an average of 3.5% price inflation per year, whereas the buyer of the long Treasury would (pre-tax) be holding even and the buyer of the zero coupon bond would be accruing perhaps, after all is said and done, a small positive return yearly.
Thus, in conclusion, there are potential capital gains that might accrue soon to the purchaser of long-term Treasury bonds, with said possible gains being leveraged via purchase of zero-coupon instruments; and there is greater protection from inflation over the next few years by purchases of those types of bonds rather than the short-intermediate duration vehicles to which J. and J. Q. Public have reportedly been flocking.
Some caveats:
1. Anyone reading this who is not a regular reader of my posts would not be aware that I have spent weeks and many months criticizing the monetary authorities for unfair and inappropriate printing of mass quantities of money. I have published a series of on-line articles describing various ways in which I have been investing significant portions of my financial assets to try to protect them from the ravages of all this money-printing; principal among them is gold (I have blogged favorably about gold since winter-spring of last year). Here is a link to the first of that series, on September 8
2. For taxable accounts, well-chosen tax-exempt municipal bonds may provide the optimal risk-reward for buy-and-hold bond investors rather than Treasuries. This discussion of Treasuries unfortunately is in the context of my post titled We Are All Speculators Now, from September 20.
3. Investing is risky, speculating is risky, and purchase of long-term bonds entails a commitment to, well, the long term, even if a profitable sale of the bond is hoped for in the shorter term. The potential for gain entails meaningful potential for loss, especially adjusted for possible sustained rapid rises in living costs.
4. Nothing herein or in any of my on-line posts should be construed as investment advice to any person, as opposed to simple commentary and conjecture. Reasonable efforts have been made to present economic and numerical data as accurately as possible, but please take nothing for granted and do your own math and research as appropriate to your level of interest.
Copyright (C) Long Lake LLC 2010
Friday, August 6, 2010
More Sort-of Bullish News and Bullish Price Action in Treasuries
Continued weak results on the employment front from the Bureau of Labor Statistics jibes with all sorts of other weak coincidental and forward-looking data. The ECRI's Weekly Leading Index is now marginally below that of one year ago, with its smoothed growth rate fairly deep in negative territory.
Diminishing growth expectations are reflected in rising prices for Treasuries, especially at the short end. Because mathematically a 10 year Treasury is ten 1-year Treasuries, but the peculiar way bonds are quoted means that the first year interest of a 10-year bond is currently almost 300 basis points above that of a short-term T-bill means that as the near-zero rate structure has spread to 2-year issues, yields up to 10 years are being pulled down by those buyers who continue to hide out in longer-term but short maturities. Even the 3-year Treasury pays only about 3/4% interest per year.
The reluctance of bond buyers to go long-term on Treasuries has led to a further widening of the record spread between 10 and 30 year issues. This is currently about 120 basis points. Nothing is guaranteed, but sophisticated bond buyers know that in a constant yield environment with an up-sloping yield curve, part of the total return is implied price appreciation. In other words, let us say one buys a 10 year bond to yield 3% per year. In one year, one now owns a 9 year bond, which in this hypothesized rate environment yields, say, 2.75%. The owner of the bond pockets the 3% return and now can sell the bond at a higher price.
As an example, a 10-year zero coupon bond yielding 3% yearly is priced at 74.41. A 9-year bond yielding 2.75% is priced at 78.34. Thus holding a 3% bond for one year under a constant interest rate environment gives a theoretical total return of about 6%. Magic!
This sort of math does not work on the flat part of the yield curve, however. Where the yield curve today is relatively flat is in the 25-30 year segment for Treasury zeroes. There the more speculative short-to-intermediate term attraction is the prospect that, for example, the 10-year yield stays stable and a 5:4 ratio of 30-year to 10-year yields returns. That would imply a 30-year T-bond yield of about 3.5% and huge capital gains for owners of long-term zero coupon Treasuries.
25-year zero coupon yields on U. S. Treasuries are about 4.2% today. That's the downside assuming no default. That compares with total alleged historical returns from the American stock market of 9% per year. That number does not include trading costs, however.
Zero coupon taxable bonds, such as Treasuries, fit best into tax-deferred accounts, as the implied yield is considered as taxable interest by the IRS. I have been personally shifting cash (otherwise now defined as trash) into zero coupon Treasuries lately, both in taxable and non-taxable accounts. Thus I am for the nonce buying into the Japan scenario rather than the Grecian aspect of the duality of Federal finances.
Caveat emptor.
Copyright (C) Long Lake LLC 2010
Diminishing growth expectations are reflected in rising prices for Treasuries, especially at the short end. Because mathematically a 10 year Treasury is ten 1-year Treasuries, but the peculiar way bonds are quoted means that the first year interest of a 10-year bond is currently almost 300 basis points above that of a short-term T-bill means that as the near-zero rate structure has spread to 2-year issues, yields up to 10 years are being pulled down by those buyers who continue to hide out in longer-term but short maturities. Even the 3-year Treasury pays only about 3/4% interest per year.
The reluctance of bond buyers to go long-term on Treasuries has led to a further widening of the record spread between 10 and 30 year issues. This is currently about 120 basis points. Nothing is guaranteed, but sophisticated bond buyers know that in a constant yield environment with an up-sloping yield curve, part of the total return is implied price appreciation. In other words, let us say one buys a 10 year bond to yield 3% per year. In one year, one now owns a 9 year bond, which in this hypothesized rate environment yields, say, 2.75%. The owner of the bond pockets the 3% return and now can sell the bond at a higher price.
As an example, a 10-year zero coupon bond yielding 3% yearly is priced at 74.41. A 9-year bond yielding 2.75% is priced at 78.34. Thus holding a 3% bond for one year under a constant interest rate environment gives a theoretical total return of about 6%. Magic!
This sort of math does not work on the flat part of the yield curve, however. Where the yield curve today is relatively flat is in the 25-30 year segment for Treasury zeroes. There the more speculative short-to-intermediate term attraction is the prospect that, for example, the 10-year yield stays stable and a 5:4 ratio of 30-year to 10-year yields returns. That would imply a 30-year T-bond yield of about 3.5% and huge capital gains for owners of long-term zero coupon Treasuries.
25-year zero coupon yields on U. S. Treasuries are about 4.2% today. That's the downside assuming no default. That compares with total alleged historical returns from the American stock market of 9% per year. That number does not include trading costs, however.
Zero coupon taxable bonds, such as Treasuries, fit best into tax-deferred accounts, as the implied yield is considered as taxable interest by the IRS. I have been personally shifting cash (otherwise now defined as trash) into zero coupon Treasuries lately, both in taxable and non-taxable accounts. Thus I am for the nonce buying into the Japan scenario rather than the Grecian aspect of the duality of Federal finances.
Caveat emptor.
Copyright (C) Long Lake LLC 2010
Tuesday, December 8, 2009
How Can the Threat of a Ratings Downgrade Send Prices of a Bond Higher? (It Can't.)
The following excerpts from a Bloomberg.com article demonstrate anew the uselessness of much of what passes for financial reporting:
Dec. 8 (Bloomberg) -- Stocks, gold and oil fell, Treasuries advanced and the yen and dollar strengthened as credit-rating companies highlighted the risk of government deficits and German industrial production unexpectedly dropped. . .
Moody’s Investors Service said today deteriorating public finances in the U.S. and U.K. may “test the Aaa boundaries.”
Of course, for the Moody's comments to make sense, gold should have risen and the price of Treasury debt fallen.
Not that rising prices for Federal debt make a lot of sense, but this is what has happened in slow-growth Japan and may represent the Fed's exit strategy. The Fed owns truly massive amounts of low-yielding mortgage-backed securities and if the 10-year Treasury goes under 2% with a stabilized if slow-growing economy, the Fed can be made whole.
The fact that essentially no one believes that this scenario is going to happen means that it is not priced into the Treasury market. Right now, par 10-year Treasuries do not yield what your broker tells you they yield, because there is zero reinvestment income. Thus they yield less than you think. On the other hand, zero coupon (or stripped) Treasuries trade cheap to par bonds, and probably yield around 4% with no reinvestment issues. Thus you may be able to purchase for $67.50 a zero coupon Treasury that will be worth $100 in ten years: an aggregate 50% return given 4% compounded annually. In five years, you will have a 5-year bond and if interest rates have not changed from now to then (who knows which way they will go?), you will have received more than a 4% annual return due to capital appreciation.
Zeros and strips are taxed on the annual unrealized interest, so taxable accounts interested in them should consider munis. For retirement accounts, most people are grossly underinvested in Treasuries and other highly secure income vehicles, and zeros/strips are a sensible part of a diversified tax-deferred portfolio.
No matter what tortured explanations for small prices changes the media propound to sell advertising and to induce people to generate commissions by trading.
Copyright (C) Long Lake LLC 2009
Dec. 8 (Bloomberg) -- Stocks, gold and oil fell, Treasuries advanced and the yen and dollar strengthened as credit-rating companies highlighted the risk of government deficits and German industrial production unexpectedly dropped. . .
Moody’s Investors Service said today deteriorating public finances in the U.S. and U.K. may “test the Aaa boundaries.”
Of course, for the Moody's comments to make sense, gold should have risen and the price of Treasury debt fallen.
Not that rising prices for Federal debt make a lot of sense, but this is what has happened in slow-growth Japan and may represent the Fed's exit strategy. The Fed owns truly massive amounts of low-yielding mortgage-backed securities and if the 10-year Treasury goes under 2% with a stabilized if slow-growing economy, the Fed can be made whole.
The fact that essentially no one believes that this scenario is going to happen means that it is not priced into the Treasury market. Right now, par 10-year Treasuries do not yield what your broker tells you they yield, because there is zero reinvestment income. Thus they yield less than you think. On the other hand, zero coupon (or stripped) Treasuries trade cheap to par bonds, and probably yield around 4% with no reinvestment issues. Thus you may be able to purchase for $67.50 a zero coupon Treasury that will be worth $100 in ten years: an aggregate 50% return given 4% compounded annually. In five years, you will have a 5-year bond and if interest rates have not changed from now to then (who knows which way they will go?), you will have received more than a 4% annual return due to capital appreciation.
Zeros and strips are taxed on the annual unrealized interest, so taxable accounts interested in them should consider munis. For retirement accounts, most people are grossly underinvested in Treasuries and other highly secure income vehicles, and zeros/strips are a sensible part of a diversified tax-deferred portfolio.
No matter what tortured explanations for small prices changes the media propound to sell advertising and to induce people to generate commissions by trading.
Copyright (C) Long Lake LLC 2009
Tuesday, October 27, 2009
More on Bonds, with Insights from Bill Gross
In Midnight Candles, PIMCO's Bill Gross says what EBR has been saying all year, which is that virtually all conventional financial instruments are overpriced in aggregate: stocks, bonds, and cash. PIMCO presents an interesting analysis that comes to the conclusion that all paper "wealth" in the U. S. is in aggregate overvalued by 100% vs. 50 years ago. Without getting quantitative, I agree. That's the underlying why gold has made sense to me all year. The authorities are making heroic efforts to keep the paper ship afloat. His brief missive is worth a read, philosophizing about getting old notwithstanding, especially when one looks at his photo on the Web page and realize that it took some serious plastic surgery for a 65-year old to look like that.
Specifically because all classes of paper "wealth" appear overvalued, it continues to make sense to yours truly to run with the hypothesis that a Japanese solution could be in our future: very low inflation for long enough to allow Treasury rates to drop further or at least to stay where they are, thus allowing banks to make money on their "carry trade" and allow the Fed to dispose of all its Treasuries and mortgage-backed at no worse than breakeven. The Fed is notoriously stingy and does not like to lose.
In the prior post, we discussed some rationale for Treasuries: if the underlying principal is no good, then we have bigger troubles, and one could at least own gold (and canned goods?).
For retirement accounts, owning a no-current income Treasury can make a lot of sense. This "zero coupon" or "stripped" par bond is purchased at a discount to the ultimate payback price of 100. The rate is computed by a simple compound interest program. A price of 50 for the zero coupon bond will give a higher rate of return the sooner it is paid off at 100. There are three benefits of the zero coupon bond. Here are the advantages:
1. No reinvestment decision with small amounts of interest (at today's rates). If you spend $10,000 to purchase a 4.5% 30-year standard bond at par, every six months you will receive $225 dollars. Try reinvesting that!
2. If rates drop, the mathematics of the bond mean that the price moves up faster than a standard bond that provides current income. So, a "zero" can be bought with the possibility of speculation in mind.
3. Stated yields are about 10% or more higher for zero coupon Treasuries than for par bonds; i.e., a 3.5% standard Treasury bond rate (which is what the media report) is often correlated with a 3.85-4.0% rate for a zero. Why is that? One reason is that it just is that way; the other is the following disadvantage of zeros:
The built-in appreciation is taxable even though one receives no current income. So more people only buy them in tax-deferred accounts.
This can be avoided by finding zero coupon municipal bonds. Another way to avoid this is to find a mutual fund that owns zeros on behalf of fund owners; but yield to maturity is notably lower with these vehicles than with bonds you directly own. American Century is the fund I use; one security of theirs to look at has the symbol BTTRX.
Strangely, the standard bonds that pay interest every 6 months are much safer should interest rates soar than are zeros. Let us say that you buy a 10-year Treasury and rates soar from 3.5% to 20% in one year. Yes, the market price of both bonds will plummet. If you invested $10,000 in a standard bond, you will receive $350 per year. If interest rates go to 20%, you at least can earn $70 per year off of that $350 (excluding taxes). It's not a lot, but that extra $70 can compound at very high interest rates for the life of the bond. With a zero, the value can go near zero.
Zeros are also less liquid than standard par bonds.
Overall, the less well-known zero coupon bonds are the simpler, higher-yielding bonds that also offer better profit potential should rates drop a lot. The path less taken in this case is the better one for people who do not need current income and are confident that they can afford to hold the bond till maturity.
Zeros are one way that yours truly is dealing with the highly abnormal financial environment.
Copyright (C) Long Lake LLC 2009
Specifically because all classes of paper "wealth" appear overvalued, it continues to make sense to yours truly to run with the hypothesis that a Japanese solution could be in our future: very low inflation for long enough to allow Treasury rates to drop further or at least to stay where they are, thus allowing banks to make money on their "carry trade" and allow the Fed to dispose of all its Treasuries and mortgage-backed at no worse than breakeven. The Fed is notoriously stingy and does not like to lose.
In the prior post, we discussed some rationale for Treasuries: if the underlying principal is no good, then we have bigger troubles, and one could at least own gold (and canned goods?).
For retirement accounts, owning a no-current income Treasury can make a lot of sense. This "zero coupon" or "stripped" par bond is purchased at a discount to the ultimate payback price of 100. The rate is computed by a simple compound interest program. A price of 50 for the zero coupon bond will give a higher rate of return the sooner it is paid off at 100. There are three benefits of the zero coupon bond. Here are the advantages:
1. No reinvestment decision with small amounts of interest (at today's rates). If you spend $10,000 to purchase a 4.5% 30-year standard bond at par, every six months you will receive $225 dollars. Try reinvesting that!
2. If rates drop, the mathematics of the bond mean that the price moves up faster than a standard bond that provides current income. So, a "zero" can be bought with the possibility of speculation in mind.
3. Stated yields are about 10% or more higher for zero coupon Treasuries than for par bonds; i.e., a 3.5% standard Treasury bond rate (which is what the media report) is often correlated with a 3.85-4.0% rate for a zero. Why is that? One reason is that it just is that way; the other is the following disadvantage of zeros:
The built-in appreciation is taxable even though one receives no current income. So more people only buy them in tax-deferred accounts.
This can be avoided by finding zero coupon municipal bonds. Another way to avoid this is to find a mutual fund that owns zeros on behalf of fund owners; but yield to maturity is notably lower with these vehicles than with bonds you directly own. American Century is the fund I use; one security of theirs to look at has the symbol BTTRX.
Strangely, the standard bonds that pay interest every 6 months are much safer should interest rates soar than are zeros. Let us say that you buy a 10-year Treasury and rates soar from 3.5% to 20% in one year. Yes, the market price of both bonds will plummet. If you invested $10,000 in a standard bond, you will receive $350 per year. If interest rates go to 20%, you at least can earn $70 per year off of that $350 (excluding taxes). It's not a lot, but that extra $70 can compound at very high interest rates for the life of the bond. With a zero, the value can go near zero.
Zeros are also less liquid than standard par bonds.
Overall, the less well-known zero coupon bonds are the simpler, higher-yielding bonds that also offer better profit potential should rates drop a lot. The path less taken in this case is the better one for people who do not need current income and are confident that they can afford to hold the bond till maturity.
Zeros are one way that yours truly is dealing with the highly abnormal financial environment.
Copyright (C) Long Lake LLC 2009
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