Bonds Shmonds
No, not the soon-to-be former San Francisco left-fielder. Actual bonds.
I’ve been using an online asset allocator to balance my portfolio. And of course, it recommends a hefty allocation of bonds (19%, if you’re curious). But in this current environment, is there ANY reason to invest in bonds?
Bonds return an average of what, say 6-7%? I’m guessing here. Meanwhile, CASH returns 5% right now, which is pretty darn good. Sure, bonds add diversity and lower vol, but they’re still somewhat positively correlated with stocks, while cash has almost no vol and zero correlation to the market.
So I’m asking you: Shouldn’t I just invest my bond allocation in Citibank e-Savings? I’m really asking. (And if the answer is still No, then which ETF?)
article on correlation between equity and debt
i don’t think i understand this article fully, but my take away: b/c of more liquity through CDS’s, corp bonds and equities are more closely correlated and are not as distinct asset classes as previous models suggest. however, collaterialze and govt debt (along with other non-corp bonds) do provide more the kind of diversification historically found in bonds.
i’m not sure how asset alloators work, but my (uninformed) guess is that a portion of it is implicity based on historical performance (long run average, historical default rates, etc). if you take a certain view of the market at a particular time, i could see how one’s asset allocations are different from what the model spits out. (beefcake?)
the reason i don’t want to put anything in corporate bonds is because i’d rather take more volatility and return since i have a longer investment horizon (though this should be priced into the asset allocator, i guess). i’d rather wait with cash (especially at these rates) and wait for more opportunistic times to invest in equities. but that implies i don’t think the market is rational.
question: does the decision to buy or sell a stock depend on your relative risk tolerance to the market, and does it affect how “rational” the market is? for example, hypothetical situation where 99% of the population is over 65 years old. they don’t want as much volatility (read: equities) because they need cash in the near term. demand and prices drops. but the 22 year-old straight out of college has a higher risk tolerance. all else being equal (DCF of company’s future incomes, whatever way you want to value it, etc) is the market “irrational” in the situation because of a skewed demand scenario despite individual investors acting rationally based on their risk tolerance? would the artifical depression in prices imply that more old people add more equities to their portfolio because the risk/return at that moment is the wise decision depsite a desire for lower volatility?
This is timely. I was just thinking to myself that I am in desperate need of some careful financial planning. TL, wasn’t this your business in a prior life? The asset allocator you linked to is helpful, but my real concern is diversifying my home equity investment. Anybody seen an online asset allocator that takes real estate into account?
Look: Corporate bond expected returns cannot be below T-bill expected returns unless something is seriously, seriously wrong with the market. T-bill expected real returns are currently high relative to historical averages. That means that expected real corporate bond returns are also currently high relative to their historical averages.
So you have two risky assets (corporate bonds, equities) that are positively correlated with each other, but not perfectly so. If you’re a mean-variance investor, you want to hold some combination of both of them to maximize your expected Sharpe ratio, and mix with T-bills to achieve your desired risk level.
Remember, too, that the real T-bill rate is not that high. Inflation is a notch under 4% right now, and T-bill yields are a bit over 5%. I’m not entirely sure, but it sounded from the tenor of your comment that you might be suffering from some money illusion. Nominal interest rates were lower a few years ago, but so was inflation. In the post World War II period, real interest rates have been remarkably stable. The standard deviation of the real risk free return is well below 1% a year.
I don’t know the ETF market well, but a Vanguard bond index fund is a good choice if you decide to go with a mutual fund.
FiftyFive: You’re absolutely right that the asset allocator must be relying on some sort of historical numbers and assumptions about how those historical numbers correspond to future returns.
You’re also right that how much stock you hold depends on your risk tolerance relative to the market. If you’re more risk tolerant, you’ll hold more stock than the “typical” investor. This has nothing to do with market irrationality. There’s no arguing with preferences. If the population as a whole becomes more risk averse, the risk premium will increase, as it properly should to compensate the investing population for taking on that risk. And you’re right that the equity holdings of the elderly in your example won’t drop quite as much as if the equity premium stayed constant, because the increased reward for equity holding will offset some of the increased risk aversion effect.
The author of the article you linked to doesn’t seem to know what he’s talking about. Take, for example, Chart 2, which is “evidence” that bond-equity correlations are rising over time. Interestingly, they’re about as high at the end of the chart sample (2005) as they are at the beginning (1998). If we extended the chart back 60 years (which is pretty easy to do), you’d probably see that these correlations are cyclical, which would put the kaibosh on his claim that developments in derivatives markets are what’s driving this recent run-up in the correlation.
Shameless: You should check out the recently introduced CME housing futures. You can buy a hedge against San Francisco housing prices falling there. Unfortunately, the market is not very liquid right now, so it might not be a good deal at this point. An alternative hedge is to buy put options on the tech sector in general. San Francisco housing prices have probably a good deal of correlation over low frequencies with tech stock prices. And because most of your wealth is your human capital, and because you’re working in VC, your human capital returns are also highly correlated with tech stock prices — which is all the more reason to buy puts on tech indexes.
that article was written by the head (or at least used to be the head) of fixed income at state street. i hope no one has money managed by them.
The article quality may be par for the course. I’ve been to a few finance practitioner conferences now, and I haven’t been so impressed. Homeboy has a Ph.D. It’s typically (although certainly not always) the bottom half of the Ph.D. class that goes to work for banks. The mistakes this guy was making in his article reminded me of the mistakes bad Ph.D. students make in their research. (OK, now this blog really does have to remain anonymous, or I’ll get in trouble.)
So, your ten-word answer would be something like:
“Your 5% return is an illusion. Invest in bonds, dumbie.”
my $0.02 on the corp bond market, i think spreads are too tight for the relative risk. too much cash chasing too few assets. not as bad as it was 6 months ago, but still too tight.
Look: Yes, the 5% return is an illusion, but that doesn’t necessarily mean invest in bonds. Equities are a bizarrely good deal, so if it’s expensive for you to leverage, there’s an argument for simply holding 100% equities. One of my colleagues invests all of his liquid wealth in an ETF that charges him like 70 basis points for doing nothing up leveraging him up to 200% equities. One of the things about finance is that the more you know, the more you realize that you know very little. The only thing you could get all finance economists to agree upon is that you should diversify. Pretty much every asset allocation has some fairly compelling story that could justify it.
FiftyFive: Equities are a bizarrely good deal, and its analogue in the bond market is that junk bonds are a bizarrely good deal (although not as good as equities). The high spreads are hard to justify given the default rates, and even the liquidity premium.
yeah, junk bonds are a much better deal than high grade. my comment was more about current state of market, not so much about long term investing. like saying the equity market is overvalued and is due for an adjustment.
there’s an ETF that uses leverage? which company?
Another late post, but I’ve been rebalancing lately.
Beef mentioned an index that provides de facto leverage for you. Here is one such fund: ProShares Ultra S&P500 (SSO)
Attempts to double your S&P returns (and losses). 95bps expense.
Click for historical chart, vs. S&P 500
Click for TheStreet.com article
The 95 bps is an understatement of the strategy’s expense. If the ETF really did deliver double the S&P 500 net return with no tracking error (before its 95 bps fee), there would be a violation of no-arbitrage. To see this, read TheStreet.com’s article on this fund, where the author walks through how, in a no-tracking-error scenario, a 50% SSO 50% Treasuries would outperform a 100% S&P 500 portfolio because you get the extra interest from your 50% cash holdings.
So it must be the case that the strategy’s cost is the 95 bps plus whatever it costs the ETF to generate the leverage. I skimmed the prospectus, and it’s not particularly transparent how they’re generating their leverage. Since the ETF’s inception, the S&P 500 is up 12.67% and the ETF is only up 18.23%. In fact, if you think about it, even getting close to twice the S&P 500’s return is an unattainable goal unless your borrowing costs are zero. If you could borrow at commercial paper rates, you would be long 200% the S&P 500 but short 100% paper, so even without the expenses and tracking error, your long position would have to clear ~5.35% before it made up for the borrowing costs.
Of course, there’s no way you could actually borrow 100% of your portfolio at commercial paper rates, because even a slightly negative S&P 500 return means that you can’t repay your loan.
I stand corrected on SSO’s poor tracking of the 200% S&P 500 benchmark. What the chart I was looking at didn’t reveal is that there was a huge dividend paid on 12/20/06. Counting that dividend, SSO comes pretty darn close to the benchmark. (27.4% vs. 29.2%, assuming counterfactually that the dividend wasn’t reinvested.)
So now I’m really curious how they manufacture this product. There’s no way you would ever put $1 in the S&P 500 rather than $0.50 in SSO and $0.50 in T-bills. What’s keeping no-arbitrage from being violated?