When does AA = Greater Fool Theory?

[Closet_Gamer]

As I watch US government yields implode, and even flirt with negative territory, I start to wonder at what point holding to an asset allocation becomes a version of the greater fool theory?

Asset allocation/rebalancing is about managing risk and hopefully creating some counter-cyclicality.

But what about when an asset class just becomes non-sensical?

Paying someone to hold your money is (to me) crazy. Put it in your mattress. Or a CD.

So, if you keep that asset in your portfolio (or add to it), you must be thinking that the value of the asset will potentially go up to offset a future loss elsewhere.

But if that asset goes up...it means someone just bought into an even bigger negative yield. You found your fool.

Are we at the point where anyone holding federal debt should just buy CDs or otherwise admit they are really playing the market and hoping for a greater fool?

 

[njhowie]

Indeed!

Purchasing bonds with extremely low or negative yields equates to the purchaser (with a brain that works) having the expectation that rates go even lower (more negative).

When yields are extremely low (I say under 2% for bonds), the argument "Well at least it's something" does not hold water, because there is (default, among other) risk in all bonds and I do not believe 1.x% or lower sufficiently compensates the bondholder for that risk.

It's generally a mistake to chase yield. Risk has a way of being underestimated.

 

[USGrant1962]

I lump CDs, money markets, cash, and bonds together on the Fixed Income side of my Equity/FI AA. Unlike equities, FI vehicles have a yield that is predictive of their returns for their particular maturity (setting aside reinvestment and default risks). Because of this, IMO it is reasonable "market time" FI by looking at yields versus maturity versus your particular situation/timeline.

So switching from negative yield bonds to cash-like vehicles is reasonable and in my mind is still within the FI side of AA.

 

[brewer12345]

Switch to high grade corporate bonds. Spreads have blown out so you will get decent yield.

 

[njhowie]

Switch to high grade corporate bonds. Spreads have blown out so you will get decent yield.

What do you consider "decent yield" and "high grade"?

I'm looking at Fidelity's fixed income chart this morning and for 10 and 20 year A/A rated bonds they are 4.0%, higher rated will still only get you 3% at 20+ years.

The jump in yields happens going to Baa/BBB where they are significantly higher at 7% to 9% from 9 months out to 30+ years. However, there has been lots of discussion regarding BBB ratings for some time now, in that many/most are overrated and are really of lower quality. My suspicion is that is why the spreads take a significant jump moving from A to BBB.

For anyone who does decide to pick up BBB bonds at this time, caution should be exercised. The economy will very likely be weakening the remainder of this year, and there will be defaults on lower quality debt.

 

[Freedom56]

What do you consider "decent yield" and "high grade"?

I'm looking at Fidelity's fixed income chart this morning and for 10 and 20 year A/A rated bonds they are 4.0%, higher rated will still only get you 3% at 20+ years.

The jump in yields happens going to Baa/BBB where they are significantly higher at 7% to 9% from 9 months out to 30+ years. However, there has been lots of discussion regarding BBB ratings for some time now, in that many/most are overrated and are really of lower quality. My suspicion is that is why the spreads take a significant jump moving from A to BBB.

For anyone who does decide to pick up BBB bonds at this time, caution should be exercised. The economy will very likely be weakening the remainder of this year, and there will be defaults on lower quality debt.

I would not and do not trust the rating agencies. These are the same agencies that rated subprime debt AAA before the 2008 crisis. Little has changed. You need to look at each company on a case by case basis. Consider Exxon Mobile, which is rated AAA/AA+. This is a company that has to issue debt or sell assets just to support it's dividend. Why is it rated AAA or AA+. There are many companies that are rated high yield or junk that have much stronger fundamentals. Occidental Petroleum is rated BBB but their one year notes are currently yielding over 10% now down from 16% two days ago. Obviously the market doesn't believe the rating agencies. Boeing bonds are still rated Baa1/A and they are in an perilous cash flow situation. Boeing has been issuing debt to pay its dividend.

The strategy I use to get better yields is to float your cash in a money market fund and time your purchase of bonds when there is a market sell-off. The other is to avoid sectors that are not suitable for investing such as energy, retail, industrial, mining, and focus on stable growing sectors such as technology, healthcare, pharma, telecom and financials.

 

[OldShooter]

@Closet_Gamer, the implicit premise in your question is that you are a trader not an investor. That's fine, but remember that you are playing with the big boys when you enter that game. Maybe there are greater fools among them, but it is also the case that they have more information on the issues, the markets, and the trends, than any amateur.

DW and my approach is to buy bonds planning to hold them to maturity. Barring defaults, which are statistically rare in investment grade bonds, we know what we're getting and have no concerns about what the bond market thinks about them. Boring. Boring. Boring.

 

[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.

 

[daylatedollarshort]

There was a time after 2008 that TIPS yields shot up due to deflation fears. Of course in hindsight they were a great buy at that time. I'm remembering that scenario for this recession and will maybe buy more this time around.

 

[OldShooter]

There was a time after 2008 that TIPS yields shot up due to deflation fears. Of course in hindsight they were a great buy at that time. I'm remembering that scenario for this recession and will maybe buy more this time around.

We bought very serious six-figures in TIPS in 2006 IIRC. 2% of 2026, which were the longest, lowest coupon, we could find. It was our judgment (still is) that high inflation was our biggest risk in retirement. Low probability, high impact in risk management jargon. Once bought we pretty much forgot about them. But when interest rates tanked, those TIPS went to about 150% of our cost. Good luck, not genius. We still own most of them but have cut back some as our time horizon is now shorter.

Something that many do not understand about TIPS is that the coupon interest rate is paid on the inflated value of the TIPS not on the face value. So if inflation over 20 years causes the TIPS value to double, the % interest paid is also double what the coupon says. So a 2% TIPS becomes a 4% TIPS.

 

[NW-Bound]

You would think that with the efficient market, one could not find good deals like the above.

 

[OldShooter]

You would think that with the efficient market, one could not find good deals like the above.

I look at the EMH as a baseline, with Richard Thaler et al's behavioral finance adding spices to varying degrees. Lots of spice on the equity side right now. Here is a pretty good video with Thaler and Fama discussing: https://review.chicagobooth.edu/economics/2016/video/are-markets-efficient A little long at 42 minutes maybe but very enjoyable to watch the two Nobel winners discuss the subject.

More to the point for bonds, however, I am increasingly reading articles with concern that many bonds are quite illiquid on a short-term basis. Too many issuers, too many issues, low quantities, etc. for any kind of efficiency. The concern is that this illiquidity will bite if there is a bond fund selloff.

Efficient markets generally feature well standardized commodity products like #2 Durum wheat or pork bellies or metals, buyers and sellers who know each other, and pricing transparency. That works well for equities but doesn't seem to fit the bond market. That said, I am really not a bond guy so YMMV.

 

[NW-Bound]

I read through the transcript, because the video is too long.

In the end, this is Farma's conclusion: "In general, it would be useful to know to what extent all economic outcomes are due to rational and irrational interplays. We don’t really know that."

And how does one disagree with that? Hence, when I see something happening, I have to ask "Is that rational or irrational?"

The answer may not be easy to obtain, but I always ask.

 

[OldShooter]

Yes, what Fama said is pretty much what I said in the post above yours. I think it's a pretty widely held belief.

That transcript, though, is pretty heavily edited. Another important thing (not in the transcript) happened at about 3:30 where Fama and Thaler agreed that the EMH is a good working model for investor decisions. I interpret that as saying that the EMH is a good starting point for us.

But, again, their context is equities as is almost all of the research I have read on passive vs active investing. I'm not sure anyone has good research on whether passive investing is best for bond funds. The best I have seen is in the SPIVA reports and there, IIRC, the superiority of passive strategies is not clearly demonstrated for bond funds. Really, even whether the EMH is useful in the highly fragmented and opaque world of bonds might be up for debate.

 

[NW-Bound]

Yes, what Fama said is pretty much what I said in the post above yours. I think it's a pretty widely held belief...

I agree that when you see what looks like a super good deal, you have to ask if there's something you may be missing. It applies to more than the stock market. It is also some guys selling some merchandise at the street corner, a used car salesman, etc...

Still, occasionally I ran across some good deals. The genuine bargains of course do not happen daily.

 

[Montecfo]

Efficient markets generally feature well standardized commodity products like #2 Durum wheat or pork bellies or metals, buyers and sellers who know each other, and pricing transparency. That works well for equities but doesn't seem to fit the bond market. That said, I am really not a bond guy so YMMV.

Not to hijack, but I am not sure how well it works for equities. The coronavirus was well known and widely ignored by US markets until 3 weeks ago, for example.

oil pricing was a legitimate shock.

 

[Closet_Gamer]

@Closet_Gamer, the implicit premise in your question is that you are a trader not an investor. That's fine, but remember that you are playing with the big boys when you enter that game. Maybe there are greater fools among them, but it is also the case that they have more information on the issues, the markets, and the trends, than any amateur.

DW and my approach is to buy bonds planning to hold them to maturity. Barring defaults, which are statistically rare in investment grade bonds, we know what we're getting and have no concerns about what the bond market thinks about them. Boring. Boring. Boring.

Actually, I'm very much an investor. I never trade. Ever.

I just think that when yields are zero/negative, you've left investing behind. You have two choices...you lose money because yields normalize. Or you hope the market decides its even more scared and drives yields further negative. Which just leaves you still owning something that has no return. Hold those bonds to maturity, and you lose money.

The big boys & corporations have too much money to park in cash or CDs. As retail investors, we don't have such constraints and swapping out near zero-or-negative yielding bonds for other Fixed Income or liquid investments may make more sense.

Said differently, I would never buy a discrete bond that had a negative yield. I'd stay in cash. If that's true for a specific bond, why wouldn't that also be true for a category of bonds?

 

[OldShooter]

Well I haven't thought much about buying bonds with negative yields. But would "cash" be any different short of being currency under the bed? It seems unlikely that MM yields would be positive or even zero. If they were then no one would buy the bonds.

Our TIPS mature in 2026 so we're good 'till then. At that point I'll buy more TIPS on the auction. Even if the YTM were to be negative the growth with inflation would still be there.

Re " ... hope the market decides ..." and " .. lose money because yields normalize ... " if I am holding to maturity I don't care about or watch the market. I have already made my decision to live with whatever YTM was offered. Worrying about the market is for bond fund people.

 

[Closet_Gamer]

Well I haven't thought much about buying bonds with negative yields. But would "cash" be any different short of being currency under the bed? It seems unlikely that MM yields would be positive or even zero. If they were then no one would buy the bonds.

Our TIPS mature in 2026 so we're good 'till then. At that point I'll buy more TIPS on the auction. Even if the YTM were to be negative the growth with inflation would still be there.

Re " ... hope the market decides ..." and " .. lose money because yields normalize ... " if I am holding to maturity I don't care about or watch the market. I have already made my decision to live with whatever YTM was offered. Worrying about the market is for bond fund people.

I don't use MM funds b/c I never thought the modest yield improvement was worth the risk a la 2008 when at least one fund "broke the buck." If this health issue morphed into a financial crisis, we could see that again.

Its hard hard to imagine straight up savings account yields going negative. That's a policy bridge that might send everyone over the edge. I don't see the FDIC or Fed allowing banks to do that. It would be an immediate run on the banks. When faced with something odd, my usual mantra is "stranger things have happened" but that might be the all time strange thing. I'd have to start saying, "Xyz is strange, of course there was that time that banks paid people less than sticking it in their mattress and yet people left money in the banks."

On individual bonds vs. funds...that seems like a perennial question and one that I've never quite worked out in my own head whether it really matters. My gut says I agree with the individual bond view you espouse, but legions of smart people have told me the math says otherwise. Dunno.

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?

Thanks.

 

[audreyh1]

I don't use MM funds b/c I never thought the modest yield improvement was worth the risk a la 2008 when at least one fund "broke the buck." If this health issue morphed into a financial crisis, we could see that again.

Just to point out that there were significant reforms in MM funds implemented by 2016, especially for the retail investor. Many now hold only US Govt paper. And you can even see the float. I’m far more comfortable with them today.

But they are already yielding below many FDIC insured high yield savings accounts, so not very interesting to me at the moment.

 

[Vincenzo Corleone]

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]

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]

... 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."