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!
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.
PART 2 - If interest rates fall before maturity then you can sell it and make a fat profit
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.
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.
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?
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:
- 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!
- Region 2. This says that in relatively normal markets there is not much correlation between STRIPs prices and stocks.
- 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.