Jun

26

Bonds, from Hernan Avella

June 26, 2024 |

Bonds, especially long-term bonds, seem to be the most disliked asset class at the moment. However, they are not only great diversifiers but now might also be an opportune time to start investing in them or increase your current allocation. Here are a few considerations from my perspective:

- Duration Matching: Align the duration of your bonds with your investment horizon. Being relatively young, it makes sense for me to opt for longer durations.
- Capital Efficiency of Futures: Utilizing the capital efficiency of futures can be challenging with current borrowing rates. Nevertheless, if leverage is used productively, it can still yield benefits.
- Inflation Protection: Enhance your fixed income exposure with assets that are protected against inflation.
- 12M Stock-Bond Correlation is at max (as of 17 June):

There's a fourth dimension that complicates implementation. When examining term premiums, such as the spread between 30-year and 5-year yields, the benefits of long-term exposure are minimal—aside from the potential convexity benefits if rates significantly decline.

Furthermore, historical data indicates that long bonds have a lower Sharpe ratio compared to short bonds. However, short bonds lack sufficient volatility to effectively diversify an equity-heavy portfolio. Consider the hypothetical performance of buying short-term (~5 years) versus long-term bonds, adjusted for volatility:

Strategy CAGR Stdev Max DD Sharpe Corr w/ S&P 500
Short-Term Bonds 4.19% 4.81% -14.45% 0.39 -0.06
Long-Term Bonds 4.86% 11.11% -45.29% 0.27 -0.07
Leveraged ST Bonds 6.03% 11.11% -38.11% 0.37 -0.04

The question remains: Is it possible to 'have our cake and eat it too' by leveraging short bonds?

Big Al asks:

In your model, what is the implementation of "Leveraged ST Bonds"?

Hernan Avella answers:

Long VFTIX 2.35x, short 3M Bills as proxy to futures embedding financing costs.


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