Treasury STRIPs

Four Reasons You Should Not Be Trading Treasury STRIPs

What do you do when things don’t go your way or you have a setback?

Recently I’ve had a number of decisions at work simply not go my way. I would call them 50/50’s, and none have accrued to my side of the ledger. In the great scheme of things they’re not big life issues; my family and I are healthy, we’re well compensated at work and the kids are happy (as far as one can tell with teenagers!). But it’s been a string of sucker-punches to the gut that’s really hurt. 

 

I don’t love talking about failures, and it’s actually pretty hard to write about these things without lapsing into corny platitudes like “dust yourself off”, “fight another day” etc. But I can’t deny my ego is bruised. 

So to my huge surprise I’ve taken a real interest in trail running. And it’s helped!

 I hate road running, and running in general, but now I’m running 10K through the woods. 

I think it’s the primal nature of running through mud and seeing rocks and tree roots zoom by underfoot. It’s also like a bath for my mind and I come out feeling mentally refreshed. 

What do you do when life has dealt you a bum card? (See? More corny cliches!)

Let’s get down to work!

One of my running companions!

Recap on Part 1

Hopefully you have read Part 1 – Why Treasury STRIPs Have No Place In Your Portfolio. But don’t rush off if you haven’t! You can read it after this part. 

I observed that a number of people were getting excited about investing in long maturity Treasury Bonds (a type of which is called “STRIPs”). The pitch was the following:

Look at the size of that discount! That’s an enormous discount for buying a certain return over the future. You are absolutely guaranteed around 3% return currently because these things are safe as houses and backed by the full-faith and guarantee of the US Government making them safer than a savings account. But you wanna know the best thing? If rates fall then the price of these things will rocket and you could make a killing! So best case is you make an absolute killing, and the worst case is you make a certain return. It’s win-win!

I observed that there were two parts to this pitch. 

My first post dealt with the first part, holding a STRIP to maturity (bad!), and this post will deal with the second part. Logical huh?

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Reason 1 - Timing Is Hard

Long maturity Treasury bonds (and especially 30 year STRIPs) are extremely volatile. Their market value goes up and down very rapidly. 

Do you think stocks can be volatile? Yeah?

Well 30 year STRIPs are really volatile. 

Take a look at the chart below that compares the ups and downs of the S&P500 (red) with a 30 year STRIP ETF (blue). Don’t worry about the fact that stocks outperformed the bonds, just look at the magnitude of the changes. Long STRIPs have movements of +/- 40% is a matter of months or even weeks. 

Treasury STRIPs

So clearly if rates do fall then you have the prospect of your STRIP rallying in value and being in a nice position. But it does not last long! You need to quickly take advantage of that and quickly sell. 

You have no time for indecision and you don’t know when rates will turn and take away all those gains. 

Reason 2 - You Have to Sell!

Note that you have to sell at some point. Recall Part 1 where we discussed that holding the STRIP to maturity was an investment fail (very low return, extreme illiquidity, lost opportunity cost, high inflation risk and loss of purchasing power). 

So at some point you need to sell, you cannot afford indecision because holding to maturity is a fail. 

Bonds are not like stocks. If a stock goes up 40% and then does nothing for 30 years you get a 40% return. But a STRIP will only return the final principal, and we saw in part 1 that the equivalent return is currently a paltry 2.6% per year (nominal). 

So you are running out of time. Every year that goes past is a year closer to simply receiving the maturity value, and as the bond’s maturity shortens it gets less sensitive to rates. So the chance of a large windfall diminishes every year. 

Reason 3 - Predicting Rates is Hard!

The investment rationale relies on rates going down and the value of the STRIP will rapidly rise in value. 

This might happen. 

Or it might not. 

I really don’t know. 

However I can say with certainty that ‘experts’ have a problem forecasting future interest rates. Here is a collection of four different pictures I’ve found that neatly shows the inability of either experts or the market as a whole to predict the direction of interest rates. 

 

Treasury STRIPs
Treasury STRIPs
Treasury STRIPs
Treasury STRIPs

You may have seen some economic indicators to suggest an upcoming recession. You may have seen some articles on CNBC sounding the market crash sirens. It’s quite possible that if these come to pass then rates may fall and your STRIP gains value. 

But the market as a whole has also seen these indicators, and has also seen these CNBC articles.

Which is precisely why long STRIPs are the most expensive they have been in a generation. They are expensive because other investors are taking a similar view to you. 

Which is not a reason to do the trade – but just be aware that you are not coming with any new and profound views – they are all being priced into the market. 

Reason 4 - You Really Have to be Fast!

You might think that I am down on long STRIPs. However they do have one really great feature. 

They are negatively correlated with stocks in a crash. Which simply means that when there is a considerable amount of market uncertainty and fear, then people tend to buy Treasury bonds and their value soars. This is called a ‘flight to quality‘. 

So there is no doubt that they provide great diversification to equities. 

But I’ll repeat myself. You need to sell! You can’t hang on to them until maturity (sad!). 

So you have to take your winnings quickly and be decisive. Note that you also need a plan for investing the proceeds. Don’t keep it in cash – I’ve already written about the inefficiency of keeping ‘Dry Powder‘. 

But… don’t dismiss the psychology that will hinder your decision making here. There are a number of things that need to happen to make this optimal. Let me spell it out in detail:

  • The market tanks, your stocks get killed but the value of your STRIPs go through the roof.
  • You need to sell your STRIPs. 
  • Your overwhelming bias will be to hang on to this one winner in your portfolio.
  • If you do sell you then have to invest the proceeds in something.
  • Are you then brave enough to invest in stocks that are blowing up around you?
We all think that in a crash we will calmly and rationally follow the above steps with perfect timing. But forgive me if I’m somewhat skeptical….
 
Let’s finish this section with a technical chart to support the assertion that STRIPs provide diversification to equities in a crash. 
Treasury STRIPs

The above chart is bit hard to grasp at first so I have highlighted three areas. The first thing to note is that they are not plotting the correlation of equity returns to the value of STRIPs, they are instead plotting the correlation to yields. And yields move inversely to STRIP prices. So let’s cut to the chase, and in summary:

  1. Region 1. This says that there is a really strong correlation between STRIPs going up when the equity market tanks. Exactly the kind of behavior STRIPs buyers want to see! But the correlation is quite short-lived – a 5 day correlation. So you need to move fast!
  2. Region 2. This says that in relatively normal markets there is not much correlation between STRIPs prices and stocks. 
  3. Region 3. The correlation disappears when you extend the timescale to a modest 30 days. So I’ll say it again, you need to move fast! ok?

What did you think? Did I get it totally wrong on long STRIPs in your opinion? I know some of you have bought short/medium duration STRIPs. How did you decide when to sell them? Did you hold them to maturity? Note that the story is a little different if you hold a STRIPs ETF and not individual bonds, but that’s another post…

And, tell me what you do to overcome the regular setbacks we get in life. I’m interested to hear!

Author Bio: I started actuary on FIRE as I did not see any actuaries taking a prominent role in the personal finance area and wanted to remedy a shortage of actuary jokes and write for those that appreciate rigor with fancy charts. In my regular day job I advise corporate US on investment and retirement strategies. I’m a qualified actuary, investment adviser and have a PhD in mathematics and reserve the right to have the occasional math post. 

9 thoughts on “Four Reasons You Should Not Be Trading Treasury STRIPs”

  1. I think STRIPS are well beyond the acumen of the average investor, especially the average indexer. Index investing as a strategy is largely designed to win, and relies on the fact the market at least in this country tends to go relentlessly up, and that is almost entirely based on economic productivity, rule of law, and trusting the business masters of the universe will look out for your “investment”. It has damn little to do with you and your acumen as a tycoon. STRIPS and similar (commodities) are trading and betting vehicles NOT investment vehicles. Understanding them is like pulling up to the black jack table in Vegas. You can win in Vegas if you understand the shifting odds (Bayesian) as the cards fall, and you understand betting strategy. The house starts with a 10% advantage. By choosing correctly you can improve those odds to 52:48 in favor of the house, and if you choose and bet correctly the odds flip 51:49 in favor of you. Play 51:49 long enough and you can make a lot of money but the house is not stupid. Once your skill is discovered you are invited to leave. So playing with STRIPS and other high volatility vehicles will snuff you out with one wrong move.

    It’s not to say you can’t be a winner but to win you HAS TO KNOW HOW TO PLAY THE GAME because real money and sudden death is on the line. You can’t go lower than zero or in this case just getting your money back with a dab of interest so STRIPS have a lower limit that’s better than Vegas or Corn futures, but knowing the game is not trivial at lest that’s my experience. Trading rules are paramount to risk management as is market timing. Opportunity is evanescent. Too much risk and work for me.

    There is an interesting fact about neurology. There are 2 centers in the brain one controls risk aversion and the other reward seeking. Risk aversion dominate behavior 4:1. It’s pretty hard to get someone to jump out of a perfectly good airplane. Reward however does modify the 4:1 to a lower number. The rush of falling can over ride the risk aversion and lower aversion to 1:1 or even to reward seeking (cocaine use in the face of criminality and a ruined life). Variability in risk aversion for example is the basis of advertising. The point of advertising is to change your risk aversion and get you to cough up the dough. Same is true with investing in reverse. You’ve been making money thinking you are warren buffet and suddenly that market craps a little. Your risk aversion goes sky high and your ability to take appropriate risk is frozen because that’s how your brain is wired PERIOD do not think your neurology is something special. If you have a trading plan, just follow the plan. It will take care of the risk for you. If you don’t your pretty much screwed because risk aversion is not rational it is sub rational and very powerful. You are not warren buffet despite your delusions otherwise. There is a huge literature outlining risk reward behavior and neurology.

    1. One other thing, I specifically own GLD as a hedge. GLD tends to go high when stocks go low in a crash and gives you something high to sell in bad markets. If I sell high I buy low later. I use bonds to store value from appreciating stocks by selling a little each year on the way up another buy low sell high strategy. Come the crash I sell the excess value in the bonds and buy low. I don’t think about it, the plan is mechanical, pre-determined and always cycling between buy low sell high.

      1. actuary on FIRE

        Gold is a whole area I’ve not written about. I really don’t think there is a “risk premium” to be earned there. It just seems so much of a crap shoot over the long term and I’m sceptical that it actually delivers real returns. But there is no doubt the value rises in crises. So as you say if you need something to sell in high markets then this could work as a mitigant to sequence of risks in the drawdown phase. (But I remain skeptical of its use in the accumulation phase)

        1. No argument on the accumulation phase and risk premium but I’m in the spend down phase. My risk no longer belongs to my employer but is entirely mine. My portfolio is open to withdrawal and SOR is real.

    2. actuary on FIRE

      I think that’s a very fair summary. Part 1 dealt with the potential market beta benefits of STRIPS as a buy-to-hold investment. Conclusion was it’s not a great deal for a 30 year note.

      This part 2 deals with the alpha part of trading STRIPS. Conclusion, as you summarize, is that it’s a gamble with a small lower bound and no informational advantage for the investor.

  2. Financial Freedom Countdown

    Totally agree and I find it very dangerous that the average mom and pop investor has started buying treasuries hoping to unload their “bags” to the next person as they expect interest rates to fall. This has got to be the most crowded trade of 2019

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