Whoah! The market has been crazy – right?
Not the stock market – I mean the bond market! The 10 year Treasury yield almost dipped below 1% at the time of writing and I fully expect it to go below at some point this year.
Bonds are up, up, up. And I don’t mean any kind of bonds, I mean the purest gold-plated bond in the universe – the Treasury STRIP.
A promise from Uncle Sam to pay you the bearer a single payment at a future date in exchange for a loan today. When the market goes nuts that’s where investors flock.
But should you be flocking or fleeing the STRIPs market right now?
Did you read a couple of articles I wrote last year on Treasury STRIPs?
‘STRIPs’ are simply very long maturity bonds and have the feature that they are very sensitive to interest rates. This makes them very sensitive to market downturns, and guess what? As the markets have cratered in February 2020 we have seen the value of STRIPs soar!
Great news if you bought them, but let’s dig into what to do next.
Recap
Have you read the important notes? It’s a condition of reading the blog.
I wrote two articles to address two very different investment behaviors for those that hold STRIPs. The first – Why Treasury STRIPs Have No Place In Your Portfolio – was addressed to those personal investors that were buying these long duration bonds to hold until maturity.
I argued that this was a poor use of your capital based on:
- Inflation risk
- Return expectations
- Liquidity and opportunity cost
Given where rates have recently gone then my view still holds.
My second article – Four Reasons You Should Not Be Trading STRIPs – was addressed to those who said “Whoah dude! When rates fall then these puppies are gonna shoot the lights out and we’ll make a killing!”.
I felt that most people would struggle with the decision as to when to sell their Treasury STRIPs for four reasons:
- Timing is hard
- You have to sell!
- Predicting rates is hard!
- You have to be really fast!
Bonds or Funds?
I don’t want to go into the different reasons why you might hold actual bonds or bond funds, but many STRIPs buyers were purchasing the actual bonds from the Treasury (actually brokers). This is important because bonds have a shelf life. They will eventually mature and their value converges to the face value.
Actually I’ve changed my mind, I will say a couple of words about bonds and bond funds. Many people don’t appreciate that bonds and bond funds behave quite differently and present you with different risks and rewards. This is unlike single stocks and stock funds. A stock fund really just behaves like a glorified stock, however a bond fund’s behavior does not closely follow that of a single bond.
This topic deserves its own article but suffice to say that bonds and bond funds can have their own place in your portfolio to achieve certain goals and you should be wary of any sneering anti-fund sentiment.
My point here is that over the last year STRIPs have gained in value by about 38%. But this gain will not be realized if you hold it to maturity. If you hold it to maturity you will instead earn around 3% a year (nominal) if you had bought it last year. If you bought one today you would only get about 1.7% a year (nominal).
You can only realize that gain in your bond’s value if you sell it – now!
The chart below shows performance year to date.
Selling?
Holders of STRIPs bonds are therefore faced with the decision of whether to sell their highly appreciated STRIPs.
Do you take the profits?
And where do you then invest those profits? Keep it in cash, plow it into the equity markets, or where else?
Do you hope rates continue to plunge and hold on for more profits?
Or wait?
Waiting is not an option. Remember that failing to act for the next 30 years results in a paltry nominal return with all the limitations I described in – Why Treasury STRIPs Have No Place In Your Portfolio.
You need to sell at some point and this is not an easy decision to make. I spent a few thousand words describing the issues in – Four Reasons You Should Not Be Trading STRIPs.
One item you may want to take into account is the current level of 30 year rates from a historical perspective. Remember that low rates imply a high market value for the bond. See the chart below.
Pretty low huh?
Another aspect to consider is the diversifying impact your STRIPs have on any stocks you may hold. See below for STRIPs and stock returns over the year to date.
STRIPs are great at diversifying the volatility in stocks. When stocks are zigging STRIPs are zagging – pretty sweet huh? You can see that behavior above where the performance of STRIPs and stocks is almost a mirror image.
So you could easily liquidate your STRIPs positions to mitigate your stock losses. This could be particularly beneficial if you are in the drawdown phase of your retirement and are concerned with sequence of returns.
There are a number of things to think about here and there are no easy answers. If you hold the physical STRIPs (rather than a STRIPs fund) then waiting to maturity will eek out a low nominal return. So selling before maturity is the answer. But is now the right time? And what do you do with the proceeds?
Let me know what you decide to do.
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.
I have to disagree that it’s always time to sell here. Yes if you don’t sell today the 38 percent is gone, but all the 38 percent tells you is the value related to reinvesting in itself over the next x years. Ie if you were to sell and buy another bond it would have the same net return profile as your existing strip. In that way it is fundamentally the same as a bond fund.
So the real answer is where do you intend to invest or use the money instead? Selling now only has value if the answer is not bonds or funds of a similar duration. If your asset allocation denotes you need to stay invested in bonds then the answer comes down to if you can get something like a special deal on a cd.
I’m letting my bonds ride as they are there for psychology and relatively easy access later in life, not return. That includes my one strip that matures next year.
Also strips are notoriously thin volume on the second hand market. You’ll get eaten alive on the spread.
I trade strip ETF’s, in fact all duration ETF’s in a FIDO Roth account. FIDO now allows trading those for free. I subscribe to a service that calculates a risk range around the price of the ETF and sell at the high end of the range and buy at the low end of the range, aka buy low sell high. The ETF’s now are behaving in a negatively correlated way. The S&P dropped 7% today my EDV and ZROZ are up 5%. TLT is up 3.5% and SHY up 0.5%. SHY is fed cut insurance. If the fed cuts it will rise. Since the ETF’s are in a Roth the trades are tax free and the fees are $0. The S&P is down 14.4% YTD and my trading Roth is up 23% YTD.
Strips are not an investment, they are a trading vehicle pure and simple. In a buy and hold portfolio you can use the range of duration as a means to boost returns. In the case of deflation (like now) long duration rules. In the case of relative inflation on a rate of change basis (like last year up to Dec) short duration rules, Moving from EDV to SHY and back or actually into cash (shortest duration) is a way to stay long bonds while boosting returns.
People look at bonds as if there is only interest to be gained, but zero coups provide a very useful means to diversify the volatility while still retaining volatility.
Crazy times. No way I’m selling anything! Holding on for the ride 🙂