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soliloquy on the long bond

In the process of trying to design an effective portfolio, I've come across quite a bit on the function of the long bonds - ala Ray Dalio all weather - and boy that looked good on a risk-adjusted basis.

Obviously, there isn't near the level of potential appreciation during a flight top quality type event such as 2008 - simply because the rates are so much lower than they were in 2007. What type of instrument can play that role in a portfolio given the financial landscape in 2019?

Am I wrong to feel like we could see a much higher rate environment approaching, and adjust the long bond exposure as necessary? Forecasting rates in the short term seems very very difficult, but the regime where the long bond turns very north on yield (south on price) seems like a seismic change of some kind.

Thanks for bringing back the forum! always appreciate the insight.

Hi Amtrader,

Really good question. I really like the All Weather approach and modeled Countercyclical Indexing in part based on it. The way I think of long bonds in a portfolio is that they're one of the few forms of insurance in a portfolio that pay YOU to own them. This makes them a particularly unique hedge. Here's some other hedges and potential pros/cons:

1) T-Bonds - lots of interest rate risk, probably the only reliable hedge in a stock downturn and not as good of a hedge as when rates are high (as you noted).

2) Gold - Tends to be correlated to commodities, decent hedge in downturns as a safehaven, relies largely on the psychological aspect of gold as money.

3) Puts and shorting - expensive insurance, the only truly inverse hedge, relies on timing, will bleed you in the long-term.

4) VIX calls - see above.

5)  Cash - too similar to T-Bills in my opinion, usually just a real return drag on the portfolio.

6) Some FX positions (like USD and Yen) - Relies on timing, generates no real return, expensive in that you're basically holding a non-interest bearing form of cash.

Dalio blends a lot of these together in his Risk Parity strategy so he gets better hedging than a lot of other strategies do. But he's using futures so he gets the exposure at a lower cost. I tend to think he overcomplicates it and that the average investor can get insurance without having to incur the higher potential taxes and fees of owning all those positions. Long bonds play a particularly important position for the average investor. I mean, if you've got a relatively long time horizon (5 years plus) then you should be able to wait out some pricipal volatility in your bonds. But most people are too impatient. They're sitting around watching CNBC and looking at annual statements expecting a 10 year bond to do something inside of a 1 year period that it's literally not structured to do. Short-termism kills most investors.

I hope that helps!

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche

The level of rates won't matter for the hedging function a long-term bond needs to perform in a risk off, flight to safety scenario due to convexity.  Just make sure "long-term" is indeed long-term.  5 years is not it; 30 years is.  If you look at the PP, it is a blended cash and long-term barbell so the effective duration is actually equivalent to an intermediate bond.  Most analyis of history back far enough will show that intermediate bond exposure is ideal from a risk-reward standpoint.  Indeed, I think Roche even proved that in a post once.  When talking about "intermediate" and "long-term", though, it implies an avoidance of credit & economic risk, so it's never proper to use corporate bonds for hedging purposes.  That only works in extreme edge cases like going off the gold standard or hyperinflation.