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A long term strategy for bonds
Old 12-10-2014, 06:06 PM   #1
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A long term strategy for bonds

The Variable Maturity strategy has been around for some years. Larry Swedroe mentions it in his bond book and DFA Funds among others use a variant of it (to select individual bonds within a fund, I think). Basically it involves going out longer on the yield curve if one gets sufficiently compensated by higher yields.

Why would this be of interest? Well people including yours truly keep asking themselves what bond fund maturities are reasonable right now. This gives one an easy framework to decide for oneself. Basically one goes out further in time (intermediate bonds, maybe 5 year duration) if one gets at least 0.20% per year better yield (20 basis points per year). Otherwise one stays in shorter maturities. The 20 bp/yr number is not really critical. That is, the results are not terribly sensitive to the selection of the parameters in this sort of strategy.

Example: Currently the 5 year Treasury yields 1.56% and the 1 year Treasury yields 0.20%. This means one gets (1.56 - 0.20)/4 = 0.34%/year or 34 bp/year to extend out. Since this is well above 20 bp/year, one buys the intermediate Treasuries.

One could use this 5 year & 1 year Treasury yield curve signal as a template to move between a fund combo like for example Vanguard Total Bond Market and Vanguard Short Term Index.

I think to use the VM strategy one should:
1) Be willing to do a monthly yield check
2) Be willing to switch between a short term and an intermediate term bond fund
3) Not be sensitive to tax implications of a once per year on average switch

So does the VM work well? Well I think the answer is yes for the Treasuries. Here is a table with 60 years of data summarized. These returns are real returns. It shows that from 1954 to present the 5 year Treasury gave 2.0% real return. The VM strategy gave a 2.5% real return.

Both strategies did great in the last 33 years from 1981 to now. But notice that the VM strategy did much better in the rising rate environment prior to 1981. For me that is a big concern that can maybe be addressed here -- a rising rate environment that might give lousy bond returns over a period of years. Also the VM strategy should help navigate a future inflationary period should we get that. For a retiree this is a big worry I think as one does not necessarily have 30 years to see many cycles.



The table assumes a 15 bp/year advantage to make a switch to intermediate bonds. After a switch one stays in the fund for 3 months before testing each month for a switch. This results in about 0.7 trades/year. So yes, you cannot set and forget with this method.

Here is a somewhat involved chart. The blue bars are the basis points per year spread between the 1 year and 5 year Treasuries. The red signal indicates trades with high meaning we are in 5 yr Treasuries and low in 1 year Treasuries. The black line (right axis) is the 5 year Treasury yield. As you can see we are in a very low territory right now.



I did this analysis for my own purposes. It is kind of involved for some but I thought I'd put it out here. Might help someone. At least it is a context for thinking about one's bond strategy.
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Old 12-10-2014, 07:09 PM   #2
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I have staggered maturities in my fixed income allocation, but the bulk of them are intermediate, and then some cash, some short-term (2.5 years) very high quality.

Historically, I don't think long-term bonds ever compensate for their inflation-adjusted volatility, at least not according to the papers I studied in 1999. So I've (mostly) avoided those - I have a mini bond fund with a 7 year average duration.

I do some general analysis to check my bond funds. It goes something like this:

I currently assume that in 5 years, 2019, the 5 year treasury will finally reach 3% (2.84% - latest futures). That represented an average 0.26% rate rise per year when I calculated this around Dec 2nd. I then compare the SEC yield of each bond fund against the annual loss of NAV a 0.26% rate rise would cause. How much a fund yields above that, I consider the "headroom". If it's negative, the the fund will likely give negative returns under the above scenario. Otherwise, total return will be positive, even if barely so.

Right now the short-term funds have the least "headroom" indicating they aren't quite as good value as the intermediate at the moment. But that's assuming rates rise the same across all maturities. I expect rates will rise more for the short-term which is what usually happens in a Fed tightening cycle.

I don't actually do anything with this analysis, I just use it to set my expectations.

I think there are "total return" type bond funds that play the yield curve as you describe, but to a more limited extent. I expect my diversified bond fund managers are doing this to some extent already as I notice duration drift in my intermediate funds. And the new "unconstrained" bond funds that are quite aggressive playing the curve.
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Old 12-11-2014, 09:46 AM   #3
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Audrey I'm sure you have things under control and will do just fine with that long term approach to intermediate bonds. All I've read confirms that long term bonds do not pay one for the risk. I'm going to run some similar analysis on the 20 year Treasury just for fun -- it's a very rainy day today here in Northern California.

The way I'm planning on using the VM strategy is to move between funds like DODIX (Dodge & Cox Income) for intermediate and VFSUX (Vanguard Short Term Investment grade). I have data for 1989 to the present, 25 years. It shows that VM gave the same returns as just staying in DODIX. But this was a declining rate period with the 5 year Treasury going from 8.2% yield (the good old days) to its current 1.5%. That's not going to happen again.
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Old 12-11-2014, 10:11 AM   #4
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Yes, I let my fund managers handle the tactics. DODIX is my core intermediate holding.

I use VBISX as the short-term holding. That is deliberately selected for its very high quality nature - it tends to go up when stocks and corporate bonds get slammed.

DODIX was horribly slammed in 2008, but then recovered brilliantly as the credit crisis resolved. If you held it then, you remember.

Interesting analysis. Thanks for sharing it!
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Old 12-12-2014, 05:11 PM   #5
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Quote:
Originally Posted by Lsbcal View Post
So does the VM work well? Well I think the answer is yes for the Treasuries. Here is a table with 60 years of data summarized. These returns are real returns. It shows that from 1954 to present the 5 year Treasury gave 2.0% real return. The VM strategy gave a 2.5% real return.
Do you know if there are rules of thumb regarding corporate (and credit risk) in the context of this VM strategy?
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Old 12-13-2014, 09:50 AM   #6
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Part of the way I'm planning on using this is as a template to move between DODIX and VFSUX. Both of these include credit risk. So if the strategy called for the 5yr Treasury one would use DODIX and if 1yr Treasury one would use VFSUX.

The data shows that between Jan 1989 and Nov 2014 the nominal returns were 7.1% for DODIX/VFSUX versus 5.6% for the 1yr/5yr Treasuries. So credit risk was rewarded. For DODIX alone during this period the return was 7.2%. So a very small decrease in returns was seen for the broadly declining rate environment where the 5yr Treasury went from 9.1% down to 1.5%.

In a broadly rising rate environment the VM strategy would probably give better returns then the intermediate bonds alone. Wish I had data for the 1954 to 1980 period to show this. If we look at a short rising rate period from Jan-04 to May-06 (5yr Treasury went from 3.2% to 5.0%) the nominal returns were 2.6% for DODIX/VFSUX and 1.8% for 5yr/1yr Treasuries.
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Old 12-13-2014, 11:07 AM   #7
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This might be on interest, article on how to play a flattening yield curve:

Bond Trading 201: How To Trade The Interest Rate Curve — Bondsquawk
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Old 12-13-2014, 04:31 PM   #8
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I like this concept but should one be useing the 7 year treasury and 1 year treasury for comparables if using the Vanguard total bond fund? The average maturity of that fund is longer than 5 years I thought, wonder if that would change results?
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Old 12-13-2014, 05:34 PM   #9
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People interested in bond predictions should read Gundlach's latest presentation - a lot of good perspective and food for thought: Jeffrey Gundlach Webcast, December 9 - Business Insider
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Old 12-13-2014, 05:59 PM   #10
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There may be some misunderstanding of the variable maturity strategy here. This is not really a predictive strategy, i.e. one is not guessing how the yield curve will change out in time. One is only using the current day's yield curve.

This is what one smart Boglehead had to say about it:
Quote:
The key is, the best indicator of future bond prices (and therefore yields) are today's prices (yields), allowing you to take term risk when you expect to be rewarded, and minimize it when the expected return is less. Unless you know you'll need the money immediately, it makes little sense to stay ultra-short/cash when yields are steep, or go longer term (5yrs) when yields are flat or inverted.
The VM strategy uses today's yield curve which is the total market's best estimate of future risks.
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Old 12-13-2014, 06:10 PM   #11
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Originally Posted by Running_Man View Post
I like this concept but should one be useing the 7 year treasury and 1 year treasury for comparables if using the Vanguard total bond fund? The average maturity of that fund is longer than 5 years I thought, wonder if that would change results?
I think you should be looking at the average duration. Here are some current ones:
VBTLX (Total Bond Mkt) = 5.7 yr
VFITX (Intermediate Treasury) = 5.2 yr
DODIX (Dodge & Cox Income) = 4.1 yr (actively managed, duration somewhat variable)
the 5 yr Treasury at current 1.5% yield = 4.8 yr
the 7 yr Treasury at current 1.9% yield = 6.6 yr

So currently the Total Bond Mkt is midway between the 5yr and 7yr Treasury. The 5yr is closer to my target fund of DODIX which admittedly varies duration a little over time as it is actively managed.

I would guess the results using the 7 yr Treasury would not be that much different.
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