US bonds as a hedge: it’s com­pli­cated

Financial Mirror (Cyprus) - - FRONT PAGE -

F. Scott Fitzger­ald noted that the test of a first rate in­tel­lect was be­ing able to hold two op­pos­ing ideas, yet still func­tion. The same could be said of any in­vestor who as­pires to fol­low a rules-based port­fo­lio man­age­ment strat­egy. In­evitably, such rigor oc­ca­sion­ally re­quires messy com­pro­mises with re­al­ity as is now the case in the US bond mar­ket. Such is my dilemma as I try to broadly fol­low three rules:


This has to be the start­ing point and re­lies on the “golden rule” that in the long run, long-dated govern­ment bond yields al­ways con­verge to­ward the nom­i­nal struc­tural growth rate of the US econ­omy; the proxy for this mea­sure is the 10-year mov­ing av­er­age of the an­nual growth rate. My val­u­a­tion model in­cludes as a sec­ond vari­able the one-year Fed funds rate. When ac­tual yields are at least one stan­dard de­vi­a­tion above the level im­plied by the model, then in­vestors should pre­pare for yields to de­cline and ex­tend port­fo­lio du­ra­tion. Con­versely, when yields are one stan­dard de­vi­a­tion or more be­low the level sug­gested by the model, then du­ra­tion should be re­duced. Presently, yields are well be­low the model-in­di­cated target, al­though not yet into out­right “over­val­ued” ter­ri­tory.

When the read­ing on my US re­ces­sion in­di­ca­tor de­clines be­low -5, there is a fairly high chance that the US econ­omy will for­mally move into con­trac­tionary ter­ri­tory (cur­rently the in­di­ca­tor is at -7). And since govern­ment bond yields tend to fall sharply in re­ces­sions, prepa­ra­tion for such a sce­nario would nec­es­sar­ily in­volve a length­en­ing of du­ra­tion and a shift to higher qual­ity bonds as re­ces­sions typ­i­cally are ac­com­pa­nied by a huge blow-out in spreads. In the chart such pe­ri­ods are shaded pink.

In the event that yields on long-dated bonds are up 22% YoY then the mar­ket is deemed to be “over­sold” and his­tor­i­cally this has been a good time to ex­tend du­ra­tion; such pe­ri­ods are shown with green shad­ing in the in the chart. In the event that yields have fallen -22%, then the re­verse is true as de­noted by blue shad­ing. In late June US trea­suries en­tered such over­bought ter­ri­tory.

From 2010 to the sum­mer of 2015 my US bond rec­om­men­da­tions were based al­most ex­clu­sively on val­u­a­tions and over­bought/over­sold mea­sures. These pro­duced ad­vice to sell trea­suries in late 2012, buy them in late 2013 and then sell them again in early 2015. What changed from mid-2015, how­ever, was that my US re­ces­sion



in­di­ca­tor started to flash red. This sit­u­a­tion called ex­ten­sion of du­ra­tion, es­pe­cially to pro­tect the com­po­nent of a bal­anced port­fo­lio.

So with US long bonds be­ing over­bought and close to over­val­ued ter­ri­tory, I face a dilemma. Long-dated trea­suries have hugely out­per­formed equities since the emer­gence of the US re­ces­sion sig­nal last year, yet such an eco­nomic out­come would point to bonds be­ing held as a hedge.

Be­ing a coward, my ap­proach over the last year to more chal­leng­ing val­u­a­tions has been for in­vestors to shorten du­ra­tion to about seven years. The prob­lem with such a cau­tious strat­egy is that it lessens the off­set­ting power of the hedge. Hence, to be con­sis­tent in my ad­vice, logic dic­tates that short­ened du­ra­tion should be ac­com­pa­nied by a shift in the rec­om­mended bal­anced port­fo­lio al­lo­ca­tion from a 50:50 po­si­tion to 60:40 in favour of bonds.

I will con­fess that this last sug­ges­tion is based more on in­stinct than par­tic­u­lar rules. Yet, when even the best rules con­tra­dict each other, dif­fi­cult choices need to be made. Fitzger­ald had a point. for an eq­uity

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