Category: Personal Finance

Opportunities in the Muni Meltdown

Reading Time: 5 minutes

First, some personal news. My wife and I have been blessed with our first child, so I’ve been a lot less active on here lately. That said, I’ve been watching the turmoil pretty closely in the market. In particular, the bond market is starting off with one its worst years ever… and it is only April…. And it is happening when the S&P trades off, which is atypical. 

I’ve written before about how bonds probably have a place in your portfolio, despite what you may think of as a low yield. They offer a hedge. Last time I wrote this of course was the last Fed tightening cycle. You would’ve done quite well buying bonds at that time, actually. 

I write this today, treasuries are up, stocks down, with people forgetting about inflation for the moment and fearing whatever other flavor of the month they can dream up of (hard landing in China, War in Europe, Japan devaluation, global recession). 

Despite the barrage of headlines on inflation, I think the risk that still few are talking about is the bust on the other end as the Fed does begin to tighten as demand cools. I wrote about it in my bull-whip post,  and I think a lot of what we are seeing right now can be traced to supply chain issues.

Oil and commodities are a bit different, as they are rising due to the capital cycle playing out as well as another supply chain issue called “war.” Oil price increases, to some extent, is a bit different than just general inflation. 

That all said, as the Fed does slow things down, how many containers of goods are heading here right as demand softens considerably? Hm.

I won’t dwell on this because I doubt I will convince many people one way or another. From my vantage point, I’ll end by saying I am seeing a lot of normalization (or at least things not getting worse) right into a hiking cycle. 

Carnage in Munis

The PIMCO intermediate muni bond ETF is down ~7.5% YTD and the iShares muni ETF is down almost 8%.

That’s tough when starting yields were low. Heck, a 30-yr treasury issued in May-2020 is down 43 points from issuance. Tough when the coupon is 1.25% and the yield is still below 3%.  

However, the carnage leads nicely into what I am looking at buying.

I am in the highest tax bracket and live in Massachusetts. If I can find a 4% yielding MA Muni bond, that’s like finding a near-7% corporate bond. Out of state, a 4.0% muni is still like looking at a 6.2% corporate, as the table below shows.

It isn’t simple to make that comparison, though. High-yield (read: junk bonds) are currently yielding about 6.5%. So finding a corporate bond with equivalent yield to a Massachusetts General Obligation bond isn’t quite apples-to-apples (MA GO bonds are rated AA). 

Can we find any bonds that meet these criteria? 

Part of the “problem” of getting these yields in muni land is you have to accept long term maturity risk, i.e. duration. However on the flipside, locking in a 7% corporate tax equivalent for a long period of time also seems attractive to me.

Further, many Americans own real estate like myself, with 30 year mortgages locked in below 3%. So again, finding a 4% completely tax free bond seems like an attractive use of capital when I am technically short a 3% mortgage at the same time. Let me break down three interesting examples that I found in my search:

Dulles Toll Road (CUSIP: 592643DG2)

The second bond example is the DC Dulles toll road bond. This bond is backed by the revenues generated from the toll road to the Dulles airport of which there are few low congestion alternatives. At 81.625, this bond yields 4.1% to maturity. 

Revenues in 2021 were already coming back to 2019 levels, which supports that this road (and airport) are relatively resilient. Omicron did throw results under the bus compared to budget, but the trend back is obvious. 

For context, 2020 operating revenue declined by 38.2% vs. 2019. Bad, but not “completely shut down” bad.  

You could buy the first lien bonds, but I like the sub notes (third liens) for several reasons. First, the 1Ls are 0% coupon and I’m not going that far (yet). Plus, lien has a segregated reserve fund. The first three liens are funded at the lesser of the standard three prong test: 10% par; 125% average annual debt service (AADS) or 100% maximum annual debt service (MADS).

There are a few attractive covenants (iii and iv matter for these bonds). Rates charged for the toll road must provide net revenue in a fiscal year of at least (I) 200% maximum annual debt service (MADS) of all first senior lien bonds, (ii) 135% debt service of all first senior and second senior lien bonds, (iii) 120% debt service of all first senior, second senior and subordinate lien bonds and (iv) 100% debt service of all outstanding bonds. 

According to the financial disclosures they also have over 2,000 days of debt service costs on hand in cash and there are limited capital improvement projects on the horizon. We could have another pandemic for 6 years and they could still pay interest.

In essence, there is decent coverage here.  

However, due to the pandemic and a development project, this bond is rated A- (but wrapped by Assured Guaranty). I think travel will resume and has already resumed post pandemic and this seems like a strategic asset.  

I am BTFD. 

Mass 2% GO Bond (CUSIP: 57582RN93)

The Massachusetts 2% GO Bond due 2050 (I know, I know, that’s far out but hear me out), was recently trading at 95-100 cents on the dollar. Currently, they are trading at 65 cents on the dollar for a 4% yield to maturity.

This is backed by the full faith and credit of the state of Massachusetts, which I am willing to bet on.

One problem with munis like this is that buying them significantly below par opens up excess discount taxes. These rules are somewhat absurd, but if you buy a muni bond too far below par you may have to pay ordinary income taxes on the discount to par value. That said, in a world where these bonds have some chance of going back to par within the next 10 years. I’d gladly pay that tax.

By my estimates, I could see the potential for a 10% IRR using the assumption that they could go back to 2021 prices at some point in the next 10 years. 

Charlotte Water & Sewer (CUSIP: 161045QQ5)

The last bond is another Charlotte Water & Sewer revenue bond (CUSIP: 161045QQ5). This yield is lower, at 3.70% YTW, but this is a AAA bond (what is the US Federal Gov’t again?). That’s like buying a 5.75% AAA corp bond or a 4.90% treasury. 

Charlotte is a large, growing populace. The raw water sources are ample and the water treatment plants have an average 29 year life remaining. Net revenues are growing, debt is falling, and this also has about 500 days of cash on hand. Did I mention it was AAA? 

Tax loss Harvesting: How to Reap the Most Rewards

Reading Time: 4 minutes

Tax loss harvesting is something I tend to think about after a strong year of equity returns. I find myself asking if I should reduce risk in some names or at least re-balance the portfolio. The problem is that this can create significant capital gains.

That said, if you are like me, you probably have some investments that did considerably well this year and some that have done not so well (they generated losses). We can use those poorer performing investments to help offset our capital gains, reduce our taxable income, and even compound our earnings at a better rate, all things being equal.

My goal of this post to provide examples of tax loss harvesting scenarios that will allow investors to not only understand the concept better, but also save money.

The basics are simple – an investor typically sells a stock or fund that has losses to offset another investment she is selling that will result in a gain. Let’s lay down the tax rules first so we’re all on the same page:

  • The long-term capital gain/loss tax rate is typically 15%. However, if you are in the 10-12% tax bracket, your capital gains rate is 0%, but if you are in the 37% bracket, it is taxed at 20%. The analysis herein will assume most people fall in the 15% bracket.
  • The short-term capital gain/loss is taxed at your income tax rate. Short-term capital gains can therefore be quite expensive. If you think it is fine to hold out for a year and a day, it might be worth it to do so. However, never let the tax tail wag the dog – if an investment could plummet, its best to take your winnings an move on.

An important thing to lay out in the beginning before we get into examples: short-term capital losses are worth more because they are taxed at the higher rate. That means they are best to apply to your short-term gains or long-term gains, rather than, for example, applying a long-term loss that is taxed at 15% to a short-term gain that could be taxed at 37%.

Example #1: Using capital losses to offset gains

Simple example. You have a $10,000 gain on ABC stock and also a $10,000 loss on XYZ stock. You sell ABC and XYZ to net each other out. Assuming a 15% tax rate, this saved the investor $1,500 (15% x $10k gain). Further, let’s say you take that saved income and earn 5% per year on it over 5 years (i.e. opportunity cost). That means you would also have an extra $414 after 5 years.

Example #2: Repurchasing the sold shares & avoiding wash sales

If we build on Example #1, we should discuss the “wash-sale rule.” This rule prevents someone from selling a stock for a loss for taxes and then immediately buying it back. The IRS requires you to wait 30 days before you can buy it back. 

Let’s say the price of XYZ stock is still $90 after we wait 31 days, so we buy it back at the same price we sold. Over the next 5 years, our analysis was correct and it appreciates to $150.

Good outcome, right? We have a $50k gain on our investment, less what we owe in taxes ($7.5k), but also have what we saved in taxes from Example 1.

So are we in a better position? What if we didn’t sell XYZ in the first place?

We would have owed $1,500 in taxes in Example 1 and would not have benefited from the $414 time value of money.

As you can see below, it paid off to take the loss, despite having a bigger taxable gain in 5 years from the sale date.

That said, the total amount saved isn’t really that great. Don’t get me wrong, I would take an extra $414 dollars if it fell from the sky, but there must be a way to improve these results.

Avoiding the wash sale rule

One type of loss that is harder to measure is the loss associated with being out of the market as you wait to buy the security back. 

However, you can buy a fund or security that achieves the same goal of that security as long as it is not “substantially identical” to the existing security. For example, you could sell the S&P500 ETF and buy an actively managed large-cap fund and face no issues.

Therefore, you can still be in the market and benefit while you wait. 

Example #3: Think Short Term

While I am sure most people here view themselves as somewhat long-term investors, it is important to think short-term when it comes to tax losses. 

The tax code says that long-term losses first offset long-term gains and short-term losses offset short-term gains. Anything left over will go to offset other gains. 

The LEAST tax efficient thing to do would be to use short-term losses to offset long-term gains. That is because the difference in tax rates can be around 15 percentage points.

In other words, I could have used my short-term losses to offset a short-term gain that I owe tax on at a 35% rate. But instead I am using them to offset something I owe tax on at 15% rate.  

The table below attempts to show this. I sell AAA for $10k gain and BBB for a $10k loss, saving myself from $2k in taxes. However, BBB was worth $3,500 in taxes, so I missed $1,500 dollars in tax savings. 

What asset allocation performed best over time?

Reading Time: 7 minutes“Past performance is not indicative of future results” you say as you read this post. But it can be a tool for analyzing what asset allocation performed the best.

The markets are particularly tough to apply history to, though, because of the wide amount of factors involved. Interest rates, valuations, and broad based sentiment are very hard to control for. Imagine looking at the performance of the market in 1938, but not factoring some how for investor sentiment in a world about to enter WWII.

However, to think we can’t learn anything from studying history is non-sense.

Today, I’ll be taking a look at what performed best over recent cycles in the equity market and walking through some of the take-aways I have. Feel free to share your results as well in the comments! I’ll be using which has some great tools.

My father is currently entering retirement and asked for some advice on how to manage his portfolio. As a retiree, he needs growth, but also needs to weather the downturns a bit better than the normal investor.

As such, I thought I’d take a look and see, “What asset allocation of sectors performed best over the past 2-3 business cycles?

This brings up the concept that I call, “Win by not losing“. Let me explain. A lot of people enter the market thinking that they need to buy high growth stocks and want to ride the tidal wave in order to get rich. And quick.

But as we saw from the tech bubble, that can quickly go against you. While you may make a lot of money early on, if your portfolio declines by 50%, you need to go up 100% to be back to breakeven after that.

I don’t believe in timing the markets, but I do believe a good asset allocation can help performance in a variety of markets.

Alright, let’s head over to portfolio visualizer and I am going to go to their portfolio optimization section. Here, we can backtest how different allocations of sectors would have performed over different time periods. The great thing about this tool is we can also select what we want to optimize the asset allocation by.

Screenshot 2019-02-16 at 4.34.09 PM

We need to select funds that capture each sector of the market. Unfortunately, ETFs haven’t actually been mainstream for that long, so funding sector ETFs that go back to 1985 is impossible. I can go back to 1999 though by selecting these funds:

  • XLV – Healthcare
  • XLF – Financials
  • XLE – Energy
  • XLU – Utilities
  • XLB – Materials
  • XLI – Industrials
  • XLY – Consumer Discretionary
  • XLP – Consumer Staples
  • QQQ – Tech
  • FREEZ – Real estate (no ETFs went back this far, so am using a fund)
  • FSTCX – Telecom (No ETFs with enough history. IYZ goes back to June 2000)
  • SGGDX – Gold (again, not ETFs)

This gets us enough history to go back to January 1999. That’s important because we can capture the end of the tech bubble, the early 2000’s recession, the recovery over the mid-2000s, the boom up until 2007, the great financial crisis, and the bull market since then (while also capturing all the wobbles in between including the european debt crisis fears, the interest rate fears, the commodity collapse, and so on). Would I like more history? Of course, but this will make do.

I will first equal weight all 12 of these funds (e.g. 8.33% each) and seek to find the “maximum return with the minimum volatility”. I will set the maximum volatility at 15% also make it so each fund is a minimum of 2.5% and a maximum of 25% (except gold, I will cap at 15% for practical purposes).

Realistically, we need a parameter like this because we can’t know if energy for example is going to tank in 2015/2016 after being super stable from 2011-2014. Housing during the 2000s too is another example. As such, we have to allow for some diversification.

I am not including global ex-US funds, but you can if you’d like. I may do this as a follow up post.

January 1999 – January 2019

Alright, in your mind, how do you think this asset allocation will perform against the S&P 500? For context, here is the current breakdown of sectors:

Screenshot 2019-02-16 at 4.58.25 PM

How does our equal-weight asset allocation stand a chance without the massive secular growth story of tech?

Well, lets take a look:

Screenshot 2019-02-16 at 5.05.38 PM

Wow… the equal weight portfolio crushed the S&P… Investing $10k in the S&P500 would have turned into $30k, but the equal weight was nearly $45k. But the red line crushed both. It ended with $54k in value.

What in the world did it allocate to?? I have to admit, I would not have guessed this:

  • Real Estate – 25%
  • Consumer Discretionary – 25%
  • Tech – 15%
  • Gold – 15%
  • Everything else – 2.5%

When looking at the annual returns for each asset class it starts to make sense. When tech was taking a beating in 2000 and down 36%, real estate was up 30%, so early on this diversifying factor helped. In 2008, people jumped to buy gold in panic, which also helped. I am a bit surprised the healthcare, staples and utilities were not weighted hire for their defensiveness qualities.

Screenshot 2019-02-16 at 5.17.22 PM

Let’s change the time series.

January 2005 – January 2019

 Why this time frame? Because it feels relevant. The fed is raising rates (as it was then) and it is closer to being late in the cycle than being in the early part of the cycle (as it was then, thanks to my hindsight vision).

Again, I just want you to try to guess what would have outperformed against our equal weight portfolio. Spoiler alert: it crushed us.

Screenshot 2019-02-16 at 5.22.32 PM.png

The equal weight performed on par with the S&P, but the weightings of this portfolio really separated from the pack in around 2014 or so.

Screenshot 2019-02-16 at 5.24.33 PM.png

Ah, now it makes sense. Tech comes into the fold and starts crushing the rest of the market. An overweight in this sector definitely added to the out-performance of late (FANG).

I also think this might be impacting consumer discretionary to a certain degree given Amazon’s weighting in that index (it currently sits at ~21% of the XLY index weighting!). Healthcare performed well in 2008 and then experienced strong growth since then.

Here’s an interesting question… How would our top picks from the last backtesting performed in this back testing? Well, when you take out the performance of real estate early on from the year 2000, it puts it on track with the S&P500 (though it did perform well early on in the cycle).

Screenshot 2019-02-16 at 5.35.31 PM.png

Let’s take the gloves off. Allow me now to show the results of an asset allocation that may surprise you, but will hopefully tie things together. I want to allocate my portfolio in a way that I “win by not losing”. Here’s my allocation selection:

  • 25.0% Consumer Staples
  • 22.5% Healthcare
  • 15.0% Utilities
  • 10.0% Tech
  • 10.0% Gold
  • 2.5% Everything Else

This is called “Portfolio 1” in the chart below and “Portfolio 2” is an equal weight of the sectors. I’ve selected re-balancing annually to keep the weights in check.

Over a long period of time, this crushes the S&P, which we’ll look at. It doesn’t seem to make much difference vs. an equal weight tough.

Screenshot 2019-02-18 at 12.48.23 PM.png

One stark difference though is that portfolio 1’s worst year was much better than the other two. So portfolio 1’s asset allocation protects from the downside. 

Screenshot 2019-02-18 at 12.50.01 PM.png

So let’s look how this performed starting from 2005 instead of 1999.

Here the performance difference is much more stark and you can start to visually see why. Take a look back at the most recent sell off in Q4’2018. Portfolio 1 barely ticked down while the equal weighted and S&P500 suffered greater losses.

Screenshot 2019-02-18 at 12.52.32 PM

Last but not least, lets say again you think we are late in the cycle, but want to stay invested to meet certain fiscal goals. The analogue here is 2005 – late in the cycle and a recession looming a couple years out. Let’s see how stark the performance is up close, from beginning of 2005 to the end of 2012.

Screenshot 2019-02-18 at 1.00.07 PM

This is the most important slide to me. To me, it highlights that someone who played good defense ended up recouping their losses in the crises much faster than the S&P500 (which still did not make it back to its high watermark over this period).

Obviously, some of these sectors such as Utilities and Consumer Staples have benefited from lower interest rates over the past 30 years and its something to consider for asset allocation going forward. However, in a year when rates moved up considerably, these sectors still provided cover in 2018 (outperforming the S&P’s year by 110bps and suffering only a 7% drawdown compared to the 13.5% drawdown from Oct to December 2018 suffered by the S&P.

I’m going to end with a cliche and say sometimes, the tortoise (consumer staples) beats the hare (insert the “it” growth sector here). And maybe asset allocation should be set up that way too.

Diversification: What worked in 2018 and comparing that to what worked in 2008

Reading Time: 2 minutesNo surprises here, when volatility reared its head throughout 2018, the “safety” classes outperformed risk. That should make intuitive sense, especially when considering the S&P500s 18.7% return in 2017 (and 21.4% when including dividends).

But as we all should know, it pays in the longer term to have some diversification. If anything, I prefer to have some asset classes that zig while everything else zaggs. For example, in 2018 the S&P was down ~5% for 2018 when including dividends.

But looked at what happened right when volatility hit (as a reminder, 2018 was not a good year for bonds up until that point… the 10 year treasury yield had moved up to 3.25% in October). Long-term treasury bonds nearly erased their losses and the aggregate bond index eked out a small gain. Purchasing power maintained.

asset class returns

As I shared in my post on Ray Dalio’s All Weather portfolio, I like to see what worked in the last recession as it may provide an indication of what worked then and what will work in the next recession. Obviously, history does not repeat itself, but there is a pattern here: good times – risk stocks outperform. Bad times: people fly to quality. The important thing is being the right sport before everyone else does.

So lets look at what would have preserved purchasing power the best in the last cycle. I want to see what did well in 2008.

  • The blue line is a 60/40 portfolio of stocks and the Barclay’s Agg index (bonds)
  • The red is a selection of assets that performed the best with minimum volatility (more on this below)
  • The yellow line is simply the S&P500

2008 comparison

Surprisingly, this is the breakdown of what constitutes the red line may not be intuitive. It is made up of:

  • 40% S&P500
  • 26% long term treasuries
  • 14% gold
  • 12% MLPs
  • 8% high-yield bonds

The treasuries clearly helped perform then, both from a flight to quality in the Great Recession as well a compression in interest rates. As you can imagine, this would have allowed you to sell some outperforming asset classes (i.e. treasuries) and buy underperforming assets (stocks).

The same is true for 2018. Having some exposure to bonds would have given you the privilege and opportunity to buy stocks!

The yield curve inverted… How should we allocate our fixed income portfolios to profit

Reading Time: 7 minutesAs I write this, the yield curve is about to be inverted.

I was taken aback today when I saw that 3-month LIBOR is now sitting at 2.6%. As a reminder, LIBOR is the rate that other banks will lend funds to each other on a short-term basis. It is often used a benchmark interest rate for other loans, for example corporate loans will typically be set at LIBOR + some spread.

For a long time coming out of the crisis, LIBOR didn’t matter that much for these loans since there was a floor set at 1%. As such, and L+200 loan would be 1% (the floor) plus 2.0%, to equal 3% yield. Now however, that loan would yield 4.6% due to move up in LIBOR. It has moved up as the Fed has raised short-term rates which in turn impacts other rates of similar maturities.

If we look at the 10 yr rate today however, obviously a much longer-term bond/rate than 3-month LIBOR, we can see the yield is still just ~3.2%. What this tells us right off the back is that the spread between long-term bonds and short-term bonds is very narrow. Said another way, the term structure of interest rates, or the “yield curve” must be very flat.

In a healthy market, the yield curve will typically slope upwards and to the right as investors demand higher rates of interest for longer-term investments. You want to be paid for the unknown for a longer period of time.

Yield 1

However, when the yield curve flattens people often wonder whether the yield curve will become inverted — when short-term rates actually will exceed long-term rates.

This is often viewed as a harbinger of a recession. The reason it’s a recession predictor is that every recession since 1970 has been preceded by an inverted curve.

In addition, a rise in short-term rates pulls back on the capital available on the “fringes” of the economy (e.g. entrepreneurs). At the same time, expected deflationary pressures in the long-term may push long-term rates down. The combination of these factors results in an inverted yield curve and is easy to see why this would indicate a looming recession. (Note, though, this is a small sample size of predictors and there is no perfect predictor out there!)

Ray Dalio wrote in “Principles for Navigating Big Debt Crises” that,

“Typically, in the early stages of the top, the rise in short rates narrows or eliminates the spread with long rates, lessening the incentive to lend relative to the incentive to hold cash. As a result of the yield curve being flat or inverted… people are incentivized to move to cash just before the bubble pops, slowing credit growth…”

Yield 2
Inverted yield curve

10-2 spread and recessions
10-2 spread vs. recessions

A look at prior 10-2 year spreads:

I decided to look at other instances when the spread between the 10 and 2 year were this tight and what the right investment decision at the time would be.

Below are four different instances when the spread between the 10 year and 2 year yield were as tight as it is now and what unfolded few years or months. Note, I start each the 10 and the 2 year yield at 100 and mark the change in yield over time (since price data isn’t available) which is charted on the left-hand side. The right-hand side and in gray is the spread between these two rates (the “10-2 spread”), essentially showing the data another way.

10-2 410-2 310-2 210-2 1

What may or may not be surprising is that in most cases, the yield on the 2 year tightens more than the 10 year by a dramatic amount in percentage terms. Why that may not be surprising is that the Fed uses short-term interest rates to dictate monetary policy and historically, that has had a less pronounced impact on long-term rates.

Since yields move in an inverse relationship to prices, this points to price appreciation for bonds in each of the cases.

This may not be a great predictor since you can imagine the spread widening as long-term rates gap wide and short-term rates move less, such as a long-term change in the inflation assumptions. However, given demographics and a technology changes resulting in long-term deflationary pressures, this currently seems unlikely to be the case to me.

Should we be adding long-term bonds or short-term bonds to our exposures:

Does it make sense to buy short term bonds today, which are yielding ~2.98% or the 10 year, which is yield 3.24%?

At first, I would clearly say buying a 2 year bond makes a lot of sense. You’re getting paid the same as the 10 year essentially and we know rates will go lower, driving bond prices up. However, we must remember that interest rate risk cuts both ways.

Let’s run through some scenarios by comparing the purchase of a 2 year bond and re-investing the proceeds after 2 years into another 2 year bond. We will compare this to holding a 10 year bond for a total of 4 years.

First, I’ll go through what I personally think is most likely to happen.

We undoubtedly are later in the business cycle and when we inevitably enter a recession, I think the fed will once again lower short-term rates to help the economy with a softer landing and to spur investment. I have written a bunch of posts on why I think lower for longer is here to stay, even though that is not a popular opinion (mentioned here and here and here).

As such, I show the 2 year rate moving to ~1.80% and the 10 year moving to 2.92%. I base these numbers off of the typical tightening we saw in prior cycle in the charts above. E.g. the 2 year yield comes in by about 40% and the 10 year much less (I assume about 10%, which is not as much as it has, but am being conservative). The result may surprise you.

The 2 year actually under-performs the initial coupon rate on an IRR basis given you must re-invest in a lower yielding security at maturity. On the flip side, the 10 year appreciates in value as rates move lower and you can sell it for a nice profit, for an IRR above the initial coupon rate.

Rates go down.PNG

I know what some of you are already thinking… OK that is great, but I think rates are going up, not down! Well for that scenario, we could look back to 1994 when the Fed abruptly raised rates.

10-2 5

I didn’t show this one before given the spread between the 10-2 was high and tightened over time (opposite than today). Recall in 1994, there was a great “Bond Massacre”, as Alan Greenspan who was the Fed Chair at the time, decided to let air out of the system to prevent an overheating of the economy (that really only had been out of a recession for a couple years).

Let’s look at the numbers if that were to occur. I assume the 2-yr rate moves higher to 4.47%, nearly 150bps higher than today and also 1.5x the current level and assume that the 10 year has a 80bps spread to the 2 year, which implies a 5.27% yield.

In this case, it is obviously advantageous to invest in the two year bond and roll over into a higher yielding bond for the next two years. However, it is also interesting to see that you don’t witness a negative IRR on the 10 year bond (and obviously if held to maturity, you still capture the 3.2% that you locked in a purchase).

Rates go up

To back this up, I used portfolio visualizer to show the results of either buying $10k of  10 year treasuries (Portfolio 1) or $10k of short-term securities in 1993 (Portfolio 2) and holding through 1995.  The 10 year dips below on performance for a bit, and then returns to outperforming.

10yr vs ST

Rates moving like this is an unlikely scenario for me to bank on for a few reasons.

One, it is hard for me to see an abrupt change in the long-term inflation assumption, which will cap long term rates. For example, if the “real yield” i.e. the yield in excess of long-term inflation is 1.7% today (3.2% less 1.5% inflation assumption) then the inflation figure would have to move up to ~3.6% for the 10 year to be priced at 5.3%, keeping the real yield figure flat.

Second, it would then be tough to see how a sharp rise in short-term rates doesn’t cause a significant tightening on the economy.

Bottom line: I hope this is helpful analysis for those making long-term asset allocation decision  for an inverted yield curve.

For me, interest rates could likely move up further, but it doesn’t mean that we should be significantly underweight long-term, high quality securities at this point in the cycle. Especially when it appears to be contrarian to do so…