What and how much cash?

JohnWinder

There are a lot of good observations and sensible strategy in what's written. But..

Linton said:

Generally most private investors dont hold safe bonds for their 15 or 50-year return.  If you are solely investing for that time frame why hold significant bonds at all? 

Agreed, but if you're going to hold bonds or cash for 15 years, might as well choose the one with the higher return prospects. Whey hold bonds at all for a 15 year time frame? Some don't like the volatility of equities I suppose.

The 'theory' is that the longer a loan is made for (long bonds vs short bonds vs cash) the higher the interest it should earn. So one prefers longer than shorter until one gets to the point where bond duration exceeds the time remaining before you need to cash in (and no longer have exposure to interest rate risk). For a 15 year investing horizon, it makes theoretical sense to own a bond or fund that has a duration of 15 years - it should have a higher interest payment than a shorter duration security(ies), and mature when you need the money back. Cash, as an alternative, only makes sense if you think you can time the market or predict where/when interest rates are going. I don't have confidence I can do that. We've heard of the 68 economists whom to a man/woman got it wrong: https://www.marketwatch.com/story/yes-100-of-economists-were-dead-wrong-about-yields-2014-10-21

jamesd said:

 For bonds to continue rising, interest rates would need to continue falling. Since they have already gone to zero and negative in some developed economies there's limited scope for that to happen.

This situation is temporary and has happened only two or three times in the last hundred or so years.

Many of us were stunned when interest rates became negative. I guess there's a limit on negative, but what is it and why? Rhetorical question only.

Anyone holding a bond fund now should be praying for interest rates to rise. As the fund's bonds mature they are replaced by higher paying bonds. After a time similar to the duration of the fund, you start to get ahead of where you were before the interest rates rose, in terms of fund returns. Bring it on.

jamesd

JohnWinder said:

jamesd said:

 For bonds to continue rising, interest rates would need to continue falling. Since they have already gone to zero and negative in some developed economies there's limited scope for that to happen.

This situation is temporary and has happened only two or three times in the last hundred or so years.

Many of us were stunned when interest rates became negative. I guess there's a limit on negative, but what is it and why? Rhetorical question only.

Anyone holding a bond fund now should be praying for interest rates to rise. As the fund's bonds mature they are replaced by higher paying bonds. After a time similar to the duration of the fund, you start to get ahead of where you were before the interest rates rose, in terms of fund returns. Bring it on.

That's an unwise approach because it means suffering the capital losses in the fund from the bonds it already holds, because they immediately fall in value to pay a yield matching the new interest rate. The effect is greatest for long duration bonds. If you do want bonds now they should be of low maturity in short-dated bond funds.

The situation is highly unusual and betting on it continuing and investing in bonds with that assumption doesn't look wise.

The total investing timeframe and bond durations aren't linked in normal mixed portfolios, though someone using a bond ladder would be particularly vulnerable to interest rate changes in the longer durations of that ladder..

JohnWinder

That's a fair comment, but it's an unwise approach only if, as you hint, the duration of the bonds is greater than your investing time frame. I suppose it could also be unwise if the bond curve plotting yield vs duration was not its usual up-sloping, but I think it is now.

So, if you've a 20 year investing horizon, buy a bond fund with a 25 year duration if you're a bit of a gambler seeking the higher yield (than a 15 year fund) and don't mind taking a hit if interest rates rise for more than 5 years. Otherwise buy bonds/funds with a sensible duration ie one that matches your investing horizon; and I would suggest, not one that matches your guess about what the future of interest rates is because that's too hard even for the experts. And we're currently talking about someone aged 56 years.

Interesting, or not, to back test on portfolio visualiser portfolios of either 60/40(in bonds) or 60/40(in cash) over many different length periods starting at different times over the last 50 years. Obviously, the return with bonds was better unless you consider periods of only 3 or 4 years; but the volatility with bonds was more frequently better as well, with smaller falls and smaller standard deviation of returns. On the occasions when the cash based portfolio was less risky, the risk differences were so small as to be insignificant.

That suggests to me, that 'theory' or orthodoxy suggest bonds over cash, as does back testing in this case. The alternative approach relies on market timing. True, the earth looks flat, and that used to be the orthodoxy, and the past doesn't predict the future.

pip895

I think this comparison rather misses the point.  Those of us who are preferring cash over bonds have no particular intention of remaining in cash long term.  Bonds at some point in the next 20 years are likely to return to there normal yields.  At which point the cash in our portfolios will be used to buy bonds.  If I am wrong and bonds never return to “normal” yields then analysing what has happened in the past is pointless.  There is limited downside for those of us holding cash anyway at the yields on offer.  

In my opinion the risk of interest rates rising and inflation taking off is not being compensated for adequately in the rates on long term bonds and holding them to duration doesn’t help.  

JohnWinder

I respect that opinion, as we all have our own ideas of the lie of the land. But I'm not sure my analysis missed the point. As you say, bonds at some point are likely to return to normal yields; then you're going to move from cash to bonds. That's a type of market timing - anticipating a change in the market at some time in the future and investing accordingly. I allowed for that when I wrote that if one doesn't follow the 'orthodoxy', then the alternative is market timing. You as a cash holder, and I as a bond holder, both hope that time comes soon.

jamesd

JohnWinder said:

That's a fair comment, but it's an unwise approach only if, as you hint, the duration of the bonds is greater than your investing time frame.

I've edited my post to make it more clear that I intended no such hint. In more normal times medium and long bonds can be very useful in an entirely routine mixed equity and bond portfolio but their longer duration causes their capital value to move more when rates change up or down. That's because the capital loss has to be enough for the new price to deliver market interest rate.

Even if you're using a fifty year timeframe, now's a better time for cash and one to two year maturity bonds than fifteen to fifty years.

jamesd

JohnWinder said:

On the occasions when the cash based portfolio was less risky, the risk differences were so small as to be insignificant.

Which sources are you using for that? I'll look up mine as well.

JohnWinder

jamesd said:

Even if you're using a fifty year timeframe, now's a better time for cash and one to two year maturity bonds than fifteen to fifty years.

Yes, it might be, but we’d only know if we knew how interest rates were going to move, when and by how much.

If they rocket up tomorrow, you’re better off in cash today. If they stay flat for 3 years, you’re better off in bonds for the next three years, and then you’d be better or worse off than staying in cash for the next three years depending on how much they rose in three years time. If rates fall, you’re better off in bonds until they rise again past current levels, than being in cash. We just can’t know.
Of course, one could combine the probability of rate changes (likely: up) with their magnitude (likely: anyone can guess) and time course (likely: soon, but slow???) and conclude that the risk (magnitude of the financial consequences) we take by staying in cash now rather than being in bonds is so small that it’s better to take the risk with cash than the alternative option. And where you landed with that type of expected utility analysis would depend on your probabilities for rate rises, their magnitude, and some period of time as well. Beyond me to do that.

Specifically, on your 15 year maturity bonds, and this would be a good time to distinguish between bonds and bond funds; if I’ve got this right, if you had such bonds in a fund you’d have a duration of about 8 years. That’s a common duration for the ‘everyman’ bond funds many of us would hold. So you need about 8 years after a step change in interest rates (rising) to get the coupon compensation (from new bonds) for the capital value fall (in the fund’s value). That’s not too long for a 15 or 50 year investing time frame I would think.

JohnWinder

I used https://www.portfoliovisualizer.com/backtest-asset-class-allocation.

I chose 60% US equities, 40% intermediate treasury bonds or cash. Data starts from 1972, to present, with the choice of any periods within. The output display table gives maximum fall in crises, SD, Sharpe ratio, return etc.

Linton

JohnWinder said:

I used https://www.portfoliovisualizer.com/backtest-asset-class-allocation.

I chose 60% US equities, 40% intermediate treasury bonds or cash. Data starts from 1972, to present, with the choice of any periods within. The output display table gives maximum fall in crises, SD, Sharpe ratio, return etc.

Does it show these very useful values under conditions of <1% interest rates?  If not what use is the data?