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Estimating the stock/bond risk premium
Old 11-25-2008, 03:11 PM   #1
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Estimating the stock/bond risk premium

In another thread laurence asked me about my long bond strategy. In case there's general interest, or just for amusement, I thought to share it here

The idea is that during some periods investing in declining interest rates is more profitable than investing in stocks given the risk premia of stocks. Here's a paper on the idea

http://www.membersocieties.org/austi...shed_Study.pdf

For example, from 1982-2000, an investor who bought 30 year zeros and rolled them over YOY, enjoyed 4.2 times what the investor in the S&P500 enjoyed. Unfortunately this is privately paid research I can't post, and even more unfortunately I wasn't investing back then!

At any rate we're in another little period here, with stocks declining and the long bond up 20%+ over the same period. All it takes is investing for economic growth (stocks), or guessing we have to suffer some economic decline (bonds).

PS - those Hoisington folks are geniuses. They've beaten general bond market returns for 20+ years. If you want an education read their investment updates at

Economic Overview

enjoy!
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Old 11-25-2008, 03:50 PM   #2
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For example, from 1982-2000, an investor who bought 30 year zeros and rolled them over YOY, enjoyed 4.2 times what the investor in the S&P500 enjoyed. Unfortunately this is privately paid research I can't post, and even more unfortunately I wasn't investing back then!
Well, the S&P 500 had a compound annual return of about 17% over that time period. I would guess that running a bond portfolio with a duration of nearly 30 would be more risky than running a levered index fund with a beta that would equate those returns.
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Old 11-25-2008, 04:14 PM   #3
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After the tech crash, I sold most equities and reinvested in Ginnies & Fannies - earning a cool 9%. I no longer have any Fannies, but most of my portfolio is in Ginnies - in fact, I bought into another pool last week @6%. Anyway, my limited exposure to equities (after October 08) doesn't really concern me because of the ranches I have invested in - since 02 they have doubled in value. Ever vigilant, but gosh almighty, I wish it were "easier". I could use a vacation or a little less "excitement" in my life.
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Old 11-25-2008, 04:18 PM   #4
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Prices are inversely related to yield. So you're saying that if you know that yields are going to plummet, then bonds are a good buy? Really?

The risk premium on equities has decreased, but it hasn't gone negative.
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Old 11-25-2008, 07:35 PM   #5
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Quote:
Originally Posted by Architect View Post
In another thread laurence asked me about my long bond strategy. In case there's general interest, or just for amusement, I thought to share it here

The idea is that during some periods investing in declining interest rates is more profitable than investing in stocks given the risk premia of stocks. Here's a paper on the idea

http://www.membersocieties.org/austi...shed_Study.pdf

For example, from 1982-2000, an investor who bought 30 year zeros and rolled them over YOY, enjoyed 4.2 times what the investor in the S&P500 enjoyed. Unfortunately this is privately paid research I can't post, and even more unfortunately I wasn't investing back then!

At any rate we're in another little period here, with stocks declining and the long bond up 20%+ over the same period. All it takes is investing for economic growth (stocks), or guessing we have to suffer some economic decline (bonds).

PS - those Hoisington folks are geniuses. They've beaten general bond market returns for 20+ years. If you want an education read their investment updates at

Economic Overview

enjoy!
I'm not sure what you're recommending here. 30 yr bond yields (as well as all US Treasury debt) are at extremely low levels. In other words their prices have been bid way up in the flight to safety. So buying them right now is extremely risky as a long term strategy because those rates are bound to drop dramatically (prices down) as things return to normal. Deflation is the current concern but I wouldn't bet on those rates staying at these levels. The time to buy would have been before all this when rates were higher and then driven down. I'd be very worried if I were in long bonds right now.

Buy low, sell high
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Old 11-25-2008, 09:24 PM   #6
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Prices are inversely related to yield. So you're saying that if you know that yields are going to plummet, then bonds are a good buy? Really?

The risk premium on equities has decreased, but it hasn't gone negative.
Where I stand the risk premium has increased. Equities crashed, T bonds went up, ipso facto the risk premium has increased.

Also, if you look at the article posted, it is completely out of date, and uses S&P yields, PEs and bond yields that are no longer relevant.

ha
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Old 11-26-2008, 09:11 AM   #7
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Well, the S&P 500 had a compound annual return of about 17% over that time period. I would guess that running a bond portfolio with a duration of nearly 30 would be more risky than running a levered index fund with a beta that would equate those returns.
Bonds have more inherent risks than equities, and always will have.
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Old 11-26-2008, 09:15 AM   #8
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Bonds have more inherent risks than equities, and always will have.
Dude, you must have written your own definition of risk. I guess that is OK, but it does make it hard to discuss finance with others.

Ha
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Old 11-26-2008, 09:32 AM   #9
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For example, from 1982-2000, an investor who bought 30 year zeros and rolled them over YOY, enjoyed 4.2 times what the investor in the S&P500 enjoyed.
Interesting factoid. But it's also important to note that the Effective Fed Funds rate peaked at around 19% in 1981, declining to 6% by 2000. With the funds rate currently at 1%, recreating the performance from '82-'00 in bonds is virtually impossible.
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Old 11-26-2008, 09:44 AM   #10
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Partially true. In 1981 the long bond was 16% or something, and it had to come all the way down to 8% to halve. Last year with it at 5%, it merely has to shave 2.5 points to halve. The run from 5% to today's 3.5% has given - I don't know - maybe a 40%-50% return? It's still got legs, because it's starting from a lower point, and this time unfortunately stocks are running in the opposite direction.

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Interesting factoid. But it's also important to note that the Effective Fed Funds rate peaked at around 19% in 1981, declining to 6% by 2000. With the funds rate currently at 1%, recreating the performance from '82-'00 in bonds is virtually impossible.
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Old 11-26-2008, 10:09 AM   #11
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Dude, you must have written your own definition of risk. I guess that is OK, but it does make it hard to discuss finance with others.

Ha
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I was soliciting a statement to get a response from OP. Sorry it didn't work. Fact is, historical data has limited use to me in today's market. There's an old finance tale about the long bond yields being the "tail wagging on the dog". What it means is that the whipsaw in long bond yields can be breathtaking.

What is the risk of being in equities? Market risk is pretty much number one, right?

What is the risk of being in bonds? Numerous, but not limited to inflation risk, opportunity risk, interest rate risk, etc, etc.

There seems to be an inherent flaw in nearly every academic study I read. Because it's "easy", everyone uses the S&P 500 index as a benchmark for things. Then you can throw in the fact that a fair number of these studies conveniently forget reinvested dividends. Quite convenient to make the numbers work, don't you think?

I don't know ONE person who is 100% invested in JUST the S&P 500, do you? I would like to know how those investment results turn out when you throw them up against an adequately diversified portfoio............
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Old 11-26-2008, 10:12 AM   #12
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Interesting factoid. But it's also important to note that the Effective Fed Funds rate peaked at around 19% in 1981, declining to 6% by 2000. With the funds rate currently at 1%, recreating the performance from '82-'00 in bonds is virtually impossible.
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Partially true. In 1981 the long bond was 16% or something, and it had to come all the way down to 8% to halve. Last year with it at 5%, it merely has to shave 2.5 points to halve. The run from 5% to today's 3.5% has given - I don't know - maybe a 40%-50% return? It's still got legs, because it's starting from a lower point, and this time unfortunately stocks are running in the opposite direction.

Stocks are going to lose another 50% in the next 10-20 years? I don't even know what your point is.

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Old 11-26-2008, 10:19 AM   #13
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Stocks are going to lose another 50% in the next 10-20 years? I don't even know what your point is.
There is no point.......
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Old 11-26-2008, 10:20 AM   #14
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Partially true. In 1981 the long bond was 16% or something, and it had to come all the way down to 8% to halve. Last year with it at 5%, it merely has to shave 2.5 points to halve. The run from 5% to today's 3.5% has given - I don't know - maybe a 40%-50% return? It's still got legs, because it's starting from a lower point, and this time unfortunately stocks are running in the opposite direction.
You need an Andex chart........
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Old 11-26-2008, 10:21 AM   #15
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Partially true. In 1981 the long bond was 16% or something, and it had to come all the way down to 8% to halve. Last year with it at 5%, it merely has to shave 2.5 points to halve. The run from 5% to today's 3.5% has given - I don't know - maybe a 40%-50% return? It's still got legs, because it's starting from a lower point, and this time unfortunately stocks are running in the opposite direction.
But duration doesn't work that way . . . the 50% decline in yield from 16% to 8% has a 511% larger impact on the price of a 30 year zero than a decline from today's 3.5% yield to 1.75% would.

Now if your argument is that relative outperformance will be driven by declining equity prices, that is a different story.
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Old 11-26-2008, 10:22 AM   #16
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:confused:I don't know ONE person who is 100% invested in JUST the S&P 500, do you? I would like to know how those investment results turn out when you throw them up against an adequately diversified portfoio............
Not certain, but I think that the Kaderli's stated that they were almost 100% invested in S&P index.

My point is not that bonds are safe, just tht equities are assumed to have a greater-than-zero risk premium, when benchmarked against ST treasuries. Any other assumption destroys MPT.

In practice, I believe that there are no investments, just better and worse speculations. IMO, at today's levels, LT treasuries are one of the worst speculations one could find.

Ha
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Old 11-26-2008, 10:28 AM   #17
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IMO, at today's levels, LT treasuries are one of the worst speculations one could find.
Ditto
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Old 11-26-2008, 11:11 AM   #18
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Let me try to quantify OP's original post with some data.

From the Ibbotson/Sinquefield data, from 1982-2000, the S&P 500 returned 16.9% per year compounded.

That means $1 invested in the S&P 500 grew to $19.43 over the 19-year period.

In his post, OP said that you would end up with 4.2 times as much money, if you followed a strategy of rolling 30-year zero-coupon Treasuries, so

4.2 x 19.43 = 81.60

For $1 dollar to grow to $81.60 in 19 years, it would have to realize a return of 26% per year.

Over this same time period, T-bills returned 6.3% per year.

Excess return on zero-coupon strategy = 26% - 6.3% = 19.7%

Excess return on S&P 500 index fund = 16.9% - 6.3% = 10.6%

Beta required to equalize returns = 19.7 / 10.6 = 1.86

So this means buying the S&P 500 on margin would have returned the same as OP's strategy. OP didn't show us the "proprietary" year-by-year data, but my guess is that it would not show a lower standard deviation of annual returns than that of holding a 1.86 beta S&P 500 over the same time period.

My conclusion is that, on a risk-adjusted basis, OP's strategy appears to have been, at best, no better than simply holding the S&P 500; and as others have pointed out, this was over an extra-ordinary period of secularly declining interest rates.
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Old 11-26-2008, 11:15 AM   #19
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My conclusion is that, on a risk-adjusted basis, OP's strategy appears to have been, at best, no better than simply holding the S&P 500; and as others have pointed out, this was over an extra-ordinary period of secularly declining interest rates.
In addition, the Hoisington article that advocated buying treasuries at low yields was based on a time period in the 19th century, well before the advent of the Federal Reserve.

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Old 11-26-2008, 02:49 PM   #20
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My conclusion is that, on a risk-adjusted basis, OP's strategy appears to have been, at best, no better than simply holding the S&P 500; and as others have pointed out, this was over an extra-ordinary period of secularly declining interest rates.
It is also based on a time period where the underlying drivers of treasury performance (chiefly an 800bp decline in treasury yields) simply can not be repeated. Meanwhile, according to Standard & Poors web site the S&P 500 index was trading at a 2008E P/E of 12.5x, as of 11/24/08, not too far from the 11.1x it was trading at on 12/31/82.

So on the one hand it looks as if 30 year treasury bonds are priced at levels that mathematically prohibits them from earning the types of returns enjoyed during the period from 1982 to 2000. While on the other it looks like equities are priced at levels where investors still could enjoy those higher returns.

Which is one way of saying the "risk premium" earned on long dated treasuries looks to be substantially lower than that of equities. Another dead give away is that the S&P 500 dividend yield is within striking distance of the 30 year treasury yield. Makes treasuries look "icky" . . . to use a technical term.

-------------

One final point. The risk / return profile of 30 year zeros is substantially worse today than it was in 1982. The upside is significantly lower while the downside is marginally worse. For example. If 30 year yields were to go to zero (the maximum upside), the 1982 bond would appreciate ~8,500% (assuming a starting yield of 16%). Today's bond would appreciate only 180%. However, if 30 year yields increase by 100bp, the 1982 bond would decline in value 29% vs a decline of 33% for today's bond.

While it was a great time to be a Treasury bond investor in 1982, it looks to be an absolutely lousy time to buy them now.
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