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Long duration treasuries


valuecfa
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If you're looking at a rising interest rate environment...then why?

 

I expect to see the 10 year well below 3 percent at some point in the next 6 months, despite the taper and taper talk

 

I was just going to make a post on long dated treasuries (10 and 30 year).  IMO, they are pure speculation.  The thesis is that the price should move.  However, people would not be happy holding these to maturity and collecting the yield to maturity.  That to me is speculation.

 

It doesn't seem like a value play.  It's a macro call/speculation.

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If you're looking at a rising interest rate environment...then why?

 

I expect to see the 10 year well below 3 percent at some point in the next 6 months, despite the taper and taper talk

 

Valuecfa,

I am of the same opinion as you, but buying the long bond today would be an exercise in market timing.

 

I can't come up with a good estimate of the price of the long bond with all the macroeconomic shenanigans around us.

 

It could be a very profitable trade, but luck would have to play a larger role than skill.

 

my 2¢

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Guest wellmont

Buffett said that if you could pick where interest rates are headed you should trade interest rate futures. why mess around with long term bonds? :)

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Buffett said that if you could pick where interest rates are headed you should trade interest rate futures. why mess around with long term bonds? :)

 

I believe Buffett buys bonds too, and manages Berkshire's duration risk according to his view on where interest rates are likely to go.  Duration management is an important tool in fixed income investing. I think the better value on the yield curve is at the 10yr plus maturity

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I think it would make more sense to increase cash, because I can't imagine how the long term rates will go down if the economy improves. If the economy goes bad, then I have cash to put to work when prices go down. Getting the long term treasury bet wrong can result in pretty big losses and I can't predict the economy with high confidence, so I rather pass and wait for an easier pitch than to take a position.

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Guest wellmont

Buffett said that if you could pick where interest rates are headed you should trade interest rate futures. why mess around with long term bonds? :)

 

I believe Buffett buys bonds too, and manages Berkshire's duration risk according to his view on where interest rates are likely to go.  Duration management is an important tool in fixed income investing. I think the better value on the yield curve is at the 10yr plus maturity

 

pimco sees it as ten and under.

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Depends who at Pimco you are talking to. I'm going to a Pimco presentation in about 2 weeks, and I happen to be friends with this particular manager that's giving it, and he said much of his presentation will focus on the value in 10yr + maturity munis

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Hoisington lays out the "investment" case for long bonds unite nicely in their latest letter. Basically low nominal growth and low inflation warrant a 2% 30 year bond.

 

Linked is the letter I believe you are referring to: http://www.hoisingtonmgt.com/pdf/HIM2013Q2NP.pdf

 

I'm not sure I buy the low inflation argument. His thesis is that there is no evidence of any forces which could raise inflation. Commodities are cheap and the USD is strong. However these are both backwards looking observations, there is no argument of why commodities will stay cheap and the USD will stay strong.

 

I agree more with his arguments on GDP as the playing field for innovation and GDP drivers increases with each passing day. Somehow I don't buy that the most productive thing society can create these days is iPad apps...

 

Put this together and I have no real thesis on where interest rates will or should be. How much free capital is there in the system, is the real question.

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I've been short the long bond futures for some time now.  I've also sold TLT options puts/calls for income and to manage the trade's risk level.  I'm up about 10.5% in a year and a half (on the notional behind the futures)...pretty good run considering that implies a 10.5% loss for the longs, who are getting paid a coupon (implying the capital loss is higher once backing out coupon income).

 

For what its worth, at this point I've been selling TLT puts reducing my net short exposure, and I'm looking to exit the trade completely in the near future.  At 2.5%, shorting the long bond was asymmetrical; low risk/high reward potential.  At 4.0% the trade is no longer asymmetrical IMHO.

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Instead of speculating with long term bonds, there are several high yielding, mid duration CEFs that yield 7-9 percent and trade at a 6-8 percent disount to NAV. That's less risk with a pretty good return if you're right.

 

I don't think the high yield market is attractive and prefer duration risk to credit risk. Likely there is no catalyst for nav gap to close on most CEFs

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Instead of speculating with long term bonds, there are several high yielding, mid duration CEFs that yield 7-9 percent and trade at a 6-8 percent disount to NAV. That's less risk with a pretty good return if you're right.

 

I don't think the high yield market is attractive and prefer duration risk to credit risk. Likely there is no catalyst for nav gap to close on most CEFs

 

Its not necessarily "high yield" (I.e. junk bonds) just because it's higher yielding. Many of these funds are picking up dollar denominated foreign debt, mid term duration, at prices below par. And since you're buying below NAV, you get another boost to yield. Many also employ leverage. A fund could feasibly yield 7-9% on mid grade foreign bonds that sport a coupon of 5-7% with leverage and the 8% discount to NAV. I'm not saying these are AAA rated entities but it's not like they're B either. You're picking up currency and a little extra credit risk in exchange for lower interest rate risk.

 

Check out doubleline's CEFs. They've been hammered but it's because the used to trade at a 10% premium.  The NAVs are only down 6-7% during the spike. The discount you're buying them at now is already pricing in another 100+ bp rise. If that happens,  the 8% yield is all yours and the discount disappears.  Did I mention they're 20% in cash too to reinvest in a rising rate environment? 

 

Its not a sure thing,  but is far more attractive to me then showcasing on long term bonds that are highly leveraged to interest rates with no diversification and no margin of safety. 

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Buffett said that if you could pick where interest rates are headed you should trade interest rate futures. why mess around with long term bonds? :)

 

I believe Buffett buys bonds too, and manages Berkshire's duration risk according to his view on where interest rates are likely to go.  Duration management is an important tool in fixed income investing. I think the better value on the yield curve is at the 10yr plus maturity

 

He does, but he is also not capitalized with 100% equity like most of us. 

 

I'd rather wait for a better spot then try to get some short term MTM gains on the 10 year.  But that's just me.  GL.

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Buffett said that if you could pick where interest rates are headed you should trade interest rate futures. why mess around with long term bonds? :)

 

I believe Buffett buys bonds too, and manages Berkshire's duration risk according to his view on where interest rates are likely to go.  Duration management is an important tool in fixed income investing. I think the better value on the yield curve is at the 10yr plus maturity

 

He does, but he is also not capitalized with 100% equity like most of us. 

 

I'd rather wait for a better spot then try to get some short term MTM gains on the 10 year.  But that's just me.  GL.

 

You are probably right. Wait for a better opportunity if it comes. I'm only talking about "beginning" to extend duration(approx 5% of portfolio) not making it your core position within you fixed income allocations.

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Buffett said that if you could pick where interest rates are headed you should trade interest rate futures. why mess around with long term bonds? :)

 

I believe Buffett buys bonds too, and manages Berkshire's duration risk according to his view on where interest rates are likely to go.  Duration management is an important tool in fixed income investing. I think the better value on the yield curve is at the 10yr plus maturity

 

He does, but he is also not capitalized with 100% equity like most of us. 

 

I'd rather wait for a better spot then try to get some short term MTM gains on the 10 year.  But that's just me.  GL.

 

You are probably right. Wait for a better opportunity if it comes. I'm only talking about "beginning" to extend duration(approx 5% of portfolio) not making it your core position within you fixed income allocations.

 

Not necessarily directed at you but:

 

I think of equities as long duration (at least 10 year and probably closer to thirty year).  Why is the solution to the extending duration problem not to buy equities?  Is PG, MDLZ, or DEO a better relative value then the 10 year?  At least you should be somewhat inflation protected, right?

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If you're looking at a rising interest rate environment...then why?

 

I expect to see the 10 year well below 3 percent at some point in the next 6 months, despite the taper and taper talk

 

I was just going to make a post on long dated treasuries (10 and 30 year).  IMO, they are pure speculation.  The thesis is that the price should move.  However, people would not be happy holding these to maturity and collecting the yield to maturity.  That to me is speculation.

 

It doesn't seem like a value play.  It's a macro call/speculation.

 

I've been thinking about this a bit. I know several people that have shorted long dated treasuries lately and have been doing very well. I think the talk of winding down QE3 has spooked the markets and treasuries are trading off of technicals rather than fundamentals.

 

My understanding of treasuries is their interest rate should be tied to the fed funds rate, plus inflation expectation, with a small bit of premium tacked on. A recent Gross quote:

 

"Yields have adjusted by too much. While T.V. and the press focus on 10-year Treasuries at 2.55% as their guiding star, subjective stabs by yours truly or anyone else are difficult day to day. The technicals, as Mohamed has written, can dominate while the fundamentals are flushed to second page priorities. When analyzing the fundamentals though, I like to point to a "North Star" that is as permanent as possible within the context of current market instability. Tapering aside, if the Fed has consistently informed the market that its policy rate - Fed Funds at 25 basis points - will stay there for a substantial period of time even after the end of QE, then to my eye, Fed Funds will not increase until at least mid-2015 and even then subject to a consistently strong economy that produces 2%+ inflation. I wonder if we can get there in this decade to tell you the truth. But the beauty of this North Star Fed Funds sextant is that it can be rather directly observed in futures markets, either for Fed Funds or for Eurodollars, which are a close companion. Right now, Fed Funds futures markets are predicting a 75 basis point yield in 2015, and Eurodollars validating a similar conclusion. That would suggest a mispricing, despite the obvious caveat of professional observers that some of the 75 is a surcharge for potential volatility. In any case, if frontend curves are up to 50 basis points cheap, then intermediate curves - the 10-year Treasury - may be as much as 35 basis points too cheap. They belong in our opinion at 2.20% instead of 2.55%."

 

 

http://www.cmegroup.com/trading/interest-rates/stir/30-day-federal-fund.html

 

The May, June, July '15 Contract still at  70, 75, 81.5 basis points restrictively. (take 100-quote) Taking a 25 point volatility premium this implies fed rates will be between 45 and 57 bp in mid 2015. The Fed has stated they will keep rates where they are (0-.25%) until that time. The 10-yr is trading based of technicals right now while the futures market (which is the indicator of the fundamental fed lending rate) is not moving at all. He wrote this when the 10-yr was at 2.6%, its now at 2.9% and the fundamentals still have not changed.

 

The Fed has expanded their balance sheet 400% (if my memory serves) since 2008 and has not been able to manufacture inflation over 2%. It would seem the Fed slowing down their QE is going to cause further downward pressure on inflation. Inflation will come when the economy improves to the point that wage growth takes place. The Fed's QE has only caused price increases in the stock market and housing. A recovery for those at the top, but an appreciable trickle down has not yet taken place. 

 

To sum everything up, I think long dated treasuries are a good place to be if you believe inflation will persist <2% or head lower over the long term. I'm not sure buying longterm treasuries is speculative at this point. As Gross pointed out, treasuries are fundamentally overvalued right now. With inflation <2%, the fed funds rate around .25% until mid 2015, and the stock market in a strong rally due in part to QE, I suspect treasuries are in a short term correction right now. The 10-yr at 2.55% to Gross's 2.35% over the next couple years is a good bet. If there is a hard correction in equities once the Fed start pulling QE; rates are likely headed below 2%. 

   

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1. white from BIS, Hoisington and others have written papers explaining why QE does not work, that it works less well over time as distortions cause increasingly greater harm and is not effective in lowering long term rates.

 

2. Banks make more money with a steeper interest rate curve.

 

3. Long term rates have dropped each time QE ended.

 

4. Mortgage issuance is much slower as demonstrated by the WFC layoffs. Perhaps banks have a lesser problem with excess MBS supply.

 

5. We seem to be following Japan's path with continued silly government spending and increasing government control over the allocation of assets by pension funds, banks and insurance funds.

 

6. EU banks are a mess and little is being done to fix it such as closing banks. So when the theft of deposits starts you can expect capital moving to the US much of which will flow into bonds. Watch out because the theft will cause such a strong emotional revulsion that initially the loss of confidence in the government sector will likely cause government bond rates to rise before the deflationary effects of wealth evaporating causes long term rates to drop.

 

7. Profits are poor for many sectors so a stock market correction will move more capital into treasuries.

 

I plan to buy long term treasuries when QE ends then watch for trading opportunities arising from bail-in. I expect bail-in will happen next in Greece. the strong reaction likely won't happen until it hits a core country like France as people realize the central banks are losing control. The Fisher deflationary spiral means that once bail-ins start they will spread and can't be stopped until confidence is restored.

 

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