For long-term investors with a dedicated portion of their portfolio in bonds, Rocky believes that there’s currently an opportunity to reduce exposure — without reducing return.
The “trick” is to extend maturities with a portion of their bonds, and to put the balance of their exposure in cash. This is called a bar-bell trade (named after the exercise equipment) — and the steepest yield curve in 30 years (see chart) provides a rare opportunity to do this trade.
Here’s an example of the mechanics.
An investor has $100,000 in the Vanguard Intermediate Term Investment Grade Bond Fund. This fund yields 3.1% and has an average duration of 5.3 years.
If the investor sells that fund, and buys $58,000 of the Vanguard Long Term Investment Grade Bond Fund which yields 5.4% with a duration of 12.9 years and puts the other $42,000 in FDIC insured money market funds yielding 1.0%, a number of virtuous things can happen:
1) If nothing happens, the cash yield of his portfolio has increased by a little bit. Before the re-allocation, his portfolio was producing $3100 in income, and now it’s producing $3500 in income.
2) The investor has increased his cash balance, and since no one really knows what the future will hold, it’s always good to have lots of cash. If interest rates rise , the investor will be able to put the cash to work at higher yields.
3) If interest rates rise, the yield curve is likely to flatten (based both on history and standard economic theory). That is, short-term rates “should” rise more than long-term interest rates. So, even though the re-allocation results in a longer duration (7.48 versus 5.3), in most scenarios this risk is overstated. Also, the risk is lessened due to the 42% cash cushion. So the practical increase in duration should be less than the theoretical increase.
4) The investor has sold the portion of the bond market that is being levitated by the Federal Reserve and purchased a portion of the bond market which is being set by market forces. (Most of the Fed’s purchases are under 7 years in maturity.) So, when the Fed stops buying or reverses its purchases, the re-allocation should have less market risk in the short maturities that usually rise the most during tightening cycles.
5) With short rates at zero, there’s nowhere for rates to go except up. However, if the USA is in a Japanese-style depression, the only yields that can still decline are the ultra-long maturities, and one might experience a “bull market flattener”. (This is a low probability event.) Due to its modestly increased duration and position on the yield curve, the re-allocation would likely outperform nicely during a bull market flattener. Additionally, the stock market will be weak in this scenario, and the 48% cash balance might be useful for purchasing some stocks at much lower prices.
Where does this strategy look worse? If all interest rates across the yield curve move higher by the same amount , then the modestly increased duration can cause an underperformance, and if the yield curve steepens even more, there can be an underperformance. Remember: Rocky isn’t suggesting to just move out the yield curve with the same amount of money… It’s important to tuck about 48% of the portfolio away in safe money market funds . Remember also that when rates rise, bond prices decline. So if interest rates rise a lot, all bond investors will lose money. The underlying theme to this re-allocation is “less exposure — same return.”
[Disclosure: This is NOT investment advice…see the Disclaimer at the top of this page! It’s just something that Rocky noticed and investors should think about. It’s also an observation that the yield curve is steepest its been in 30+ years. If the 30-year bond keeps rising in yield — and the Fed keeps rates at 0%, then this strategy will not be attractive. There’s no reason to think that today marks the maximum steepness. Lastly, Rocky doesn’t have an opinion about when rates will rise; but they eventually will. But as Keynes supposedly said, “In the long run, we’re all dead.” ]
Rocky “demonstrates” that the TSA’s backscatter x-ray screening may be “deadlier” than the terrorists — unless the terrorists succeed in blowing up an airplane every few years.
From this generally accepted statistic:
A typical dental X-ray exposes the patient to about 2 millirems of radiation. According to one widely cited estimate, exposing each of 10,000 people to one rem (that is, 1,000 millirems) of radiation will likely lead to 8 excess cancer deaths. Using our assumption of linearity, that means that exposure to the 2 millirems of a typical dental X-ray would lead an individual to have an increased risk of dying from cancer of 16 hundred-thousandths of one percent. Given that very small risk, it is easy to see why most rational people would choose to undergo dental X-rays every few years to protect their teeth.More importantly for our purposes, assuming that the radiation in a backscatter X-ray is about a hundredth the dose of a dental X-ray, we find that a backscatter X-ray increases the odds of dying from cancer by about 16 ten millionths of one percent. That suggests that for every billion passengers screened with backscatter radiation, about 16 will die from cancer as a result.
Rocky notes that the phrasing of this statement is horribly misleading!
He observes that there are 600 million airline passengers per year. Source: http://www.transtats.bts.gov/
That means an incremental 10 people will die each year from cancer due to backscatter screening. Since 9/11 (and before the backscatter technology was implemented) there were no successful terrorist attacks on US planes. If one extrapolates this trend, the statement that the TSA is more deadly than the terrorists is both bizarre and true!
However, if the terrorists successfully blow up an airplane, it simultaneously makes the backscatter look comparatively safer and the TSA look comparatively worse.
[Disclosure: This is a great illustration of how statistics can be manipulated to prove one’s point — even if the point is silly.]
Rocky always looks for an “edge” in his market speculations, but rarely finds one.
In contrast, Rocky always looks for an “edge” in his brownies, and often finds one. As any brownie aficionado knows, the crispy, chewy edges are the best part of a brownie. Rocky’s technique is to cut the crispy, delicious edge from around an entire brownie pan, and leave the gooey middle bulk for lesser mortals.
This habit always drove Rocky’s daughter crazy, as she would bake a gorgeous fresh pan of brownies — and return to find all of the crust surgically removed and only mutilated innards remaining.
Rocky’s daughter gave her dad a birthday present that solved the problem: The Baker’s Edge Brownie Pan. This cleverly designed pan has a maze shape, so that every brownie has a chewy, crispy edge. Rocky thought the invention to be brilliant and dubbed it “his best birthday present ever.” (Except for the birthday when Trophy Wife rented a full-size excavator for a day, and Rocky and his friends dug some holes for fun.)
Here’s the amazon.com link to the brownie pan:
[Disclosure: The first batch of brownies was magnificent. Every brownie had two crispy/chewy edges, and some brownies had three edges!]
Rocky’s read a lot of information and mis-information regarding Quantitative Easing. This may be the best and clearest discussion of the issues and is worth a read:
[Disclosure: Rocky rarely agrees with Professor Landsburg, and finds some of his philosophies to be morally objectionable. Nonetheless, the Professor does a good job explaining the pros and cons of QE2 in his article.]
Back by popular (or unpopular) demand, Rocky asks his readers, “What’s this food?” As always, the winner will receive a unique prize of dubious monetary value.
Hints: This food was purchased at the local Whole Foods Store. It’s certified organic. They are a dried fruit. And this fruit is mentioned in a popular children’s book.(In the Humbert Household, Whole Foods is not-so-affectionately known as “Whole Wallet” … which is a reference to its prices. But they sure have some wierd stuff!)
[Disclosure: “Big Al” won the last Name-this-Food contest with a correct guess of a British Pub Pickle&Cheese Bap. If this were the Publisher’s Clearing House Sweepstakes, Big Al would be ineligible. But this isn’t the Publisher’s Clearing House Sweepstakes, and Big Al is invited to participate!]
WARNING: THIS POST MAY BE UNSUITABLE FOR ANIMAL LOVERS AND RODENTS!
Upon waking this morning, Rocky set his clock back, and checked his Trendnet TVIP312 Low-Light WIFI Surveillance Camera. The computer showed a motion detection “event” at 2:00am. (To be precise, it’s unclear whether the event occurred at 2:00am or 1:00am, since the TVIP312 documentation doesn’t disclose the timing algorithm when the clock moves off Daylight Savings Time.)
More important than the precise time of the “event” was the result of the event. Rocky discovered that the wily mouse, which had previously escaped unscathed with all of the peanut butter bait, (see blog post below) foolishly returned to the empty trap. Hoping to find more food, he carelessly stepped on the trigger.
There is a moral here: don’t lick the plate clean! (Jack Spratt take note. http://en.wikipedia.org/wiki/Jack_Sprat )
Round 2 Result: By a unanimous verdict, Rocky wins the round and the fight. (The mouse went down for the count.)
[Disclosure: Rocky found a second deceased mouse cum trap off-camera. He won this battle, but the war continues.]
The NY Times reports regularly on illegal aliens crossing into the USA. However, there’s another insidious immigrant invasion underway: mice invaded Rocky’s basement!
The “cute” little rodents know better than to come upstairs where the cats will pounce. So they party in the basement and in the walls.
Rocky set several mousetraps, and discovered the bait disappeared within fifteen minutes. Multiple times. Trophy Wife accused Rocky of being dumber than a mouse! His manliness challenged, he set up a nightcam video surveillance and caught the clever critters red-handed. He figures that if he can understand their “M.O.,” he can out-smart them.
Rocky will spend the evening watching “Caddyshack,” while he plans his next move.
By unanimous decision: Round One goes to the mouse.
[Disclosure: During a recent trip to London, Rocky and his family attended the longest running play in history: Agatha Christie’s “The Mousetrap.” Rocky hopes that his mousetrap doesn’t require sixty years.]