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Less exposure, same return

November 22, 2010

The bottom green shows the 30yr/10yr yield curve steepness since 1980. It's a 3-sigma event.

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.”  ]

  1. allocator
    November 22, 2010 at 11:12 pm

    This is an excellent thought-provoking analysis Rocky. Thank you.

  2. November 23, 2010 at 12:19 am

    I just ran across this. It all sounds very logical, but I have no idea if there is any truth to it. Let me know what you think.


  3. November 23, 2010 at 8:05 am

    It’s a good moment to recite the “Serenity Prayer:”
    …May we have the serenity to accept the things we cannot change, the courage to change the things we can, and the wisdom to know the difference…”

    In the context of your video, that means, turn it off. Give your family a hug. And examine your portfolio carefully.

  4. November 24, 2010 at 12:22 pm

    It has recently occured to me (for the umpteenth time) that talking about politics is a waste of time. Thanks for the reminder.

    I asked my broker about this scheme of yours. He thinks the extra risk isn’t worth the $200 it would bring. I got the impression that you thought this would bring quite a bit more than $200.


  5. kim
    November 24, 2010 at 10:27 pm

    Charles I recommend your broker to go back to his Dale Carnegie books

  6. November 26, 2010 at 3:17 pm

    Charles: Ask your broker how he defines the change in “convexity” between the two portfolio choices. If he can answer this question without looking up the answer, and pursuasively articulate why he still holds his view that the re-allocation is inferior, you have an excellent broker. If he needs to look up the definition of convexity (and in particular, the convexity value of “cash”) then you should fire your broker, as he’s more interested in collecting fees and commissions than in delivering a portfolio that has less risk and/or more return.

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