Taking a dive into bond markets.
Is the 40% allocation to Bonds overrated ?
To investors,
The traditional 60-40 allocation can be questioned to today’s economic situation, particularly the 40% bond allocation. During time of crisis, investors sell their stock and buy treasuries to look for safety pushing yields to fall and bond price to increase. Most recently, FED’s buying spree of treasuries pushed long term yields close to the zero bound. Long term treasury rates are lower than the targeted inflation rate of 2%, meaning that investing into a 30Y treasury bond with a yield of 159bps is actually loosing you money in real terms by -41bps. Declining yields are signalling to the market a potential recession as more buyers are pouring their money into treasuries for safety. So, why would anyone hold long term treasuries through maturity to earn 159bps? Especially if the holding period is greater than 7 years. Far better investments do exist, with returns above to the 30Y treasury yield. Let’s take the equity premium (the difference between the dividend yield and the risk free rate), today’s premium is favouring equities, meaning that it is better to invest into equities than treasuries. As an example, the current dividend yield of APPLE stock (Ticker: AAPL) is at 74bps in contrast to the 78bps of the 10Y treasury. However, investors are still buying treasuries because of convexity.
5Y, 10Y, 30Y U.S treasury yields.
Treasuries are profitable with convexity.
Before talking about convexity, let’s look at bonds basics. As you may already know the relationship between bonds and interest rates is inverse. Let’s take a 2Y bond on AAPL delivering a coupon of 10% semi annually on a par value of $1000. Each 6-month you will receive $50 coupon payments during 2 years and if you hold the bond to maturity you will receive the principal of $1000. Now, if interest rates increases to 15%, another buyer comes to the market and says that the bond you own is giving 10% and the market is offering 15%, why would I buy your bond? The owner of the bond decides to sell his bond below the par value to $900, the bond is selling at a discount. The same logic is applied when interest rates goes down to 8%, the owner of the bond is asking to the potential buyer, why would I sell my bond at 10% while the market is offering 8%? The owner of the bond decides to sell his bond at $1200 at a premium. This is a more intuitive view to understand the inverse relationship between bonds and interest rates. Another key concept is duration, it measures the change in bond price due to a percentage change in interest rate. The convexity is derived from duration and measures the rate of change of the duration to changes in interest rates. So if interest rates are falling, the price of the bond increases, meaning a positive convexity and inversely a negative convexity. The longer term maturities have a higher increase in percentage term in comparison to the ones with short to mid term maturities. From a macro standpoint, the only reason to be exposed to treasuries should be convexity, to profit from price increase with changes to interest rates. The future convexity of treasuries should also increase, especially from FED’s buying trough quantitative easing, as it is likely that the FED will continue QE. The isShares Barclays 20+ Year Treasury Bond ETF (ticker:TLT) allows investors to be exposed to longer term treasuries. Another alternative to traditional treasuries is investment grade bonds trough the iShare Iboxx (ticker:LQD) to have exposure to the fixed income market. However, for the moment I will stay put and not deploy cash to any Bond ETF.
TLT and LQD, YTD Performance.
Having 40% exposure to the bond market to today’s economic landscape is not the right thing to do, especially when yields are close to zero. Thus reducing the exposure to 25% 20% is appropriate, especially if the inflation scenario plays out. Treasuries are only profitable with convexity and not yield anymore.
Hope you learn something and have a nice day.
-Aman
**Disclaimer**
The information contained herein is for informational purposes only. Nothing herein shall be construed to be financial legal or tax advice. The content of this Newsletter is solely the opinions of the writer who is not a licensed financial advisor or registered investment advisor. Purchasing stocks, Bonds, ETFs and crypto currencies poses considerable risk of loss. The speaker does not guarantee any particular outcome. Past performance does not indicate future results.