When does AA = Greater Fool Theory?

[Vincenzo Corleone]

Quote:

Originally Posted by Gumby At the trough of the 2008/09 great recession, the spread between 10 year AAA corporates and US Treasuries was 2.47%, meaning US corporate bonds were trading as if almost every AAA company was going to default. I thought that very unlikely, so in March 2009, I put about $100k of cash into LQD and made approximately 33% principal return over the next 4 years (plus the interest), until I got sold out on my trailing stop. The same yield spread is currently 1.98% If you don't believe there will be widespread defaults by AAA companies, it may be a good time to buy LQD.

What am I not understanding? According to Yahoo! Finance, 49.33% of the bonds LQD holds are rated BBB. Only 3.18% of the bonds LQD holds are rated AAA.

Edit: Another source (iShares.com - https://bit.ly/2xxTBGG) - 47.01% of the bonds LQD holds are rated BBB. Only 2.61% of the bonds LQD holds are rated AAA.

[Gumby]

My wording was confusing and for that I apologize.

The point is that the yield spread between all corporates and treasuries widens substantially in times of stress and narrows when things calm down. I looked at spreads of AAA versus treasuries primarily because that data is readily available, but the principle applies to all corporates. Spreads as high as today are quite unusual and, I think, probably overblown, meaning that I don't think there is really as high a default risk as is priced into the market. Accordingly, there is a chance of greater principal returns in corporates, especially as I don't think treasury rates will be rising anytime soon.

To take advantage of this mis-pricing, you could choose any ETF that contains corporates, not just LQD.

[Vincenzo Corleone]

Quote:

Originally Posted by Gumby My wording was confusing and for that I apologize. The point is that the yield spread between all corporates and treasuries widens substantially in times of stress and narrows when things calm down. I looked at spreads of AAA versus treasuries primarily because that data is readily available, but the principle applies to all corporates. Spreads as high as today are quite unusual and, I think, probably overblown, meaning that I don't think there is really as high a default risk as is priced into the market. Accordingly, there is a chance of greater principal returns in corporates, especially as I don't think treasury rates will be rising anytime soon. To take advantage of this mis-pricing, you could choose any ETF that contains corporates, not just LQD.

I got it now. Thanks for clearing that up for me.

[Spock]

Most negative yielding bonds are held expecting yields to drop even further.
After subtracting inflation, the real yield on cash/MM's is also negative.
The other angle is when the focus is on the return OF principle vs. the return ON principal.

[OldShooter]

Quote:

Originally Posted by Closet_Gamer ... More to your point though: are you saying you think a TIPS bond, even with a nominal negative yield, is always a good bet b/c of the inflation kicker? ...

No. I don't use words like "always" or "never" in an investing context. In fact, with apologies to the Efficient Frontier devotees and to those who love to play with the plethora of retirement calculators, I think that production of a two-digit probability number is prima facie evidence of a garbage-in, gospel-out device. The only sure thing about those two-digit numbers is that they are wrong, but no such device AFIK ever provides error bounds. Probably because they have no idea what they are.

OK, that said, if I had to decide today I think that TIPS would probably be the best bet.

First, the whole point of negative interest rates is to stimulate inflation. So the objective of the exercise is implicitly to increase the nominal value of TIPS. Granted, an increase in real value would be preferable but a nominal increase is better than no increase at all.

Second the standard YTM calculations, when applied to TIPS, do not produce a YTM at all. They produce a lower bound on YTM. To the extent that there is any inflation, the YTM rises. I have never seen a YTM number for a TIPS that specifies an inflation rate assumption, but that is what you need in order to predict YTM. Implicitly, then, the YTM numbers you get are assuming zero inflation.

Third, the biggest part of looking at long bonds is inflation expectations. With TIPS this is unnecessary and it pretty much eliminates crystal-balling the yield curve. Less guesswork = increased certainty of results.

So, I'll stick with "probably" and "probably not" to predict the future. And even that is probably due to overconfidence. As various famous people are claimed to have said: "It is difficult to make predictions, especially about the future."

[COcheesehead]

A month ago I thought my bond buying days were over for awhile, but things change.
There were some compelling opportunities in muni’s last week. I bought some in the 2-6 year range right around a 3% yield. They went fast, but with the market doing a dance right now, those may pop up again.
I stay clear of bond funds. I buy individual bonds and hold to maturity. No NAV erosion then.
I also broaden my view of bonds and look at fixed income as a whole. There are more opportunities than just “bonds”.

[Closet_Gamer]

Quote:

Originally Posted by OldShooter No. I don't use words like "always" or "never" in an investing context. In fact, with apologies to the Efficient Frontier devotees and to those who love to play with the plethora of retirement calculators, I think that production of a two-digit probability number is prima facie evidence of a garbage-in, gospel-out device. The only sure thing about those two-digit numbers is that they are wrong, but no such device AFIK ever provides error bounds. Probably because they have no idea what they are. OK, that said, if I had to decide today I think that TIPS would probably be the best bet. First, the whole point of negative interest rates is to stimulate inflation. So the objective of the exercise is implicitly to increase the nominal value of TIPS. Granted, an increase in real value would be preferable but a nominal increase is better than no increase at all. Second the standard YTM calculations, when applied to TIPS, do not produce a YTM at all. They produce a lower bound on YTM. To the extent that there is any inflation, the YTM rises. I have never seen a YTM number for a TIPS that specifies an inflation rate assumption, but that is what you need in order to predict YTM. Implicitly, then, the YTM numbers you get are assuming zero inflation. Third, the biggest part of looking at long bonds is inflation expectations. With TIPS this is unnecessary and it pretty much eliminates crystal-balling the yield curve. Less guesswork = increased certainty of results. So, I'll stick with "probably" and "probably not" to predict the future. And even that is probably due to overconfidence. As various famous people are claimed to have said: "It is difficult to make predictions, especially about the future."

Very interesting. Thanks!