Tuesday 31 August 2010

Bond bubble- a sterile debate on semantics

Much ink has been spilt over the question of whether government bonds are in a bubble or not. The bond bubble believers love to cite stats along the lines that bonds are witnessing inflows at the same pace as equity funds did during the TMT bubble.

The bond lovers respond an asset with a finite life and no hope of limitless capital gain can’t really be a ‘bubble’, and beside they argue the ‘fundamentals’ warrant current valuations. (i.e. inflation is low and will remain so).

However, to me this is largely a sterile debate over semantics. The issue shouldn’t be whether bond are a bubble or not, but rather are bonds a good investment or not? Ben Graham defined “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative”.

Do bonds offers long term investors a sensible level of return? I’ve always thought that in essence bond valuation is a rather simple process (at least one level). I generally view bonds as having three components: the real yield, expected inflation and an inflation risk premium.

The real yield can be measured in the market thanks to inflation-linked bonds. In the US, a 10 year Tip is trading at just under 1%. Expected inflation can be assessed in a variety of ways. We could use surveys, for instance, the Survey of Professional forecasters shows an expected inflation rate of just under 2.5% p.a. over the next decade. In contrast, the nominal bonds minus the TIP yields implies a figure of more like 1.5% p.a. The inflation swap market is implying a 2% p.a. inflation rate over the next ten years.

The inflation risk premium (a risk premium to compensate for the uncertainty of future inflation) is generally held to be between 25bps and 50bps. Given the uncertainties surrounding the impact of monetary and fiscal policy I’d argue that using the high end of that range seems reasonable.

Using these inputs a ‘fair value’ under normal inflation would be around 4%. Of course, this assumes that the current market 1% real yield is itself a ‘fair price’. This seems like a questionable assumption to me. In the UK we have a longer history of index linked bonds – introduced in 1986. The average yield since the introduction is 2.6%, in the last decade the average real yield has been 1.5%. Given this ‘parameter’ uncertainty is would be reasonable to say that ‘fair value’ for 10 year bonds is somewhere in the range of 4-5%.

The current 2.5% yield on the US 10 year bond is clearly a long way short of this. So unless you believe that Japan is correct template for the US (i.e. inflation will be zero for the next decade), government bonds don’t offer an attractive return as a buy and hold proposition.

Another way of looking at this problem is to ask how much weight the market is putting on a ‘Japanese’ outcome. Let’s assume three states of the world (a gross simplification, but convenient). In the ‘Normal’ state of the world bonds sit at close to equilibrium, say 4.5%. Under a ‘Japanese’ outcome yields drop to 1%, and under an inflation outcome yield rise to 7.5% (this assumes a 5% inflation rate).

The table below lays out my own estimates (kind of an agnostic view, with a prior biased towards the ‘Normal’ but cognizant of the other two risks), then bond should yield around 4.4%. I can then tinker around with the probabilities to generate something close to the market’s current pricing. In essence, the market is implying a 70% probability that the US turns Japanese. 

Bond Yield

JM Probabilities
Market implied
Expected Yield


It is possible to build a speculative case for bond investment (i.e. riding the deflationary news flow down), however, as ever this leaves participants with the conundrum of  Cinderella’s ball  as described by Warren Buffett “The giddy participants all plan to leave just seconds before midnight. There is a problem though: They are dancing in a room in which the clocks have no hands!” Personally I prefer to stick to investment rather than speculation.

Wednesday 25 August 2010

Latest paper - A man from a different time

My latest paper - A man from a different time - on dividends and dividend swaps is avialable from www.gmo.com

Friday 20 August 2010

Reports of the death of mean reversion are premature

This was originally written for the FT, but they seem to have gone the same way as so much media and are dumbed down these days - they said it was too technical (after sitting on it for more than a week). So I'll post it here in:

In a recent article [1] Richard Clarida and Mohamed El-Erian of PIMCO argued that the ‘New Normal’ offered at least five implications for portfolio management.

I. Investing based on mean reversion will be less compelling

II. Risk on/risk off fluctuations in sentiment will continue

III. Tail hedging becomes more important

IV. Historical benchmarks and correlations will be challenged

V. Less credit will be available to sustain leverage and high valuations

Implications IV and V seem pretty reasonable to me. However, reports of the death of mean reversion are premature. I fear that the authors are confusing the distribution of economic outcomes with the distribution of asset market returns. The distribution of economic outcomes may well turn out to be flatter, with fatter tails than we have previously experienced.

However, asset markets have long suffered such a distribution; it has proved no impediment to mean reversion based strategies. In fact, the fat tails of the asset market have provided the best opportunities for mean reversion strategies. For instance, in equity markets the fat tails associated with unpleasant outcomes (poor returns) have generally occurred as high (sometimes ludicrously high) valuations have returned towards their ‘normal’ level, and the fat tails which we all love (good returns) have occurred as low valuations have moved back towards more ‘normal’ levels.

As long as markets continue to follow the second implication (as they have done since time immemorial) and flip flop between irrational exuberance and the depths of despair, then mean reversion (at least in valuations) is likely to remain the best strategy for long-term investors. (This also highlights the apparently contradictory nature of the first two implications that the authors point out). We don’t require long periods of time at equilibrium for mean reversion strategies to work, rather (and considerably less onerously) we simply require markets to pass through the equilibrium periodically.

As always, investors need to be mindful of the context of their investment decisions. It is always possible that we are standing on the brink of a shift in the level to which asset valuations mean revert. But that has always been the case. Only careful thought and research can work to try to mitigate the dangers posed by this threat. After all, if investing were both simple and easy, everyone would be doing it.

The third implication that tail risk hedging will become more important is and always has been true (much like the second implication). The prudent investor should always pay attention to tail risk – the new normal doesn’t alter that.

Ever eager to please, the ‘engineers of innovation’ (or should that be the ‘architects of destruction’?) are happily creating products to serve the new bull market in tail risk. Deutsche Bank is launching a long equity volatility index, while Citi has come up with a tradeable crisis index (mixing equity and bond vols, swap spreads and structured credit spreads). Strangely enough, Bloomberg reports that PIMCO is planning a fund that will protect investors in the event of a decline greater than 15%. Even the CBOE is planning a new index based on the skew in the S&P 500.

However, any consideration of the purchase of insurance should not be divorced from a discussion of the price of the insurance. Cheap insurance is wonderful, and clearly benefits portfolios in terms of robustness. However, the key word is that the insurance must be cheap (or at very worst fair value). Buying expensive insurance is a waste of time. I used to live in Tokyo and was constantly amazed that the day after an earth tremor the cost of earthquake insurance would soar, as would the demand!

You should really only want insurance when it is cheap, as this is the time when no one else wants it, and (perversely) the events are most likely. Buying expensive insurance is just like buying any other overpriced asset ... a path to the permanent impairment of capital. Rather than wasting money on expensive insurance, holding a larger cash balance makes sense. It preserves your dry powder for times when you want to deploy capital, and limits the downside.

So buy insurance when it's cheap. When it isn't and you are worried about the downside, hold cash. As Buffett said, holding cash is painful, but not as painful as doing something stupid!

In summary, the new normal may pose some issues for investors who have never bothered to study history (which is, of course, littered with many, many ‘new normals’). However, for those with perspective, prudence, patience and process, many of the same ‘eternal’ rules are likely to govern the game as they always have, come rain or shine. In essence, many of the implications are less the new normal, and more the old always!

[1] Uncertainty changing investment landscape, Market Insight, 2 August 2010

Thursday 19 August 2010

Guess who?

Which 'superficial' blogger (see http://behaviouralinvesting.blogspot.com/2010/07/barbie-does-economics.html) dared to utter these wonderfully insight words?

"The completeness of the [orthodox] victory is something of a curiosity and a mystery. It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. That it reached conclusions quite different from what the ordinary uninstructed persons would expect, added, I suppose to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty....But although the doctrine itself has remained unquestioned by orthodox economists up to a late date, its signal failure for purposes if scientific prediction has greatly impaired, in the course of time, the prestige of its practitioners. For professional economists...were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observation - a discrepancy which the ordinary man has not failed to observe. "


"Too large a proportion of recent 'mathematical' economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependence of the real world in a maze of pretentious and unhelpful symbols"

None other than the late great John Maynard Keynes