What am I really paying for?

Originally published on November 9th, 2016

Government bonds have been the go to asset to hedge out equity risk for the past 20 years. This is understandable due to the combination of a negative correlation to equities and a positive expected value coming from both the term premia and the expected path of interest rates. When evaluating bonds as a hedge, these are the two questions you must answer: will the negative correlation hold in the next bear market? And how much am I paying (or receiving) for that hedge relative to the potential protection?

Johnny Utah has an uncanny timing. Any time I receive a question from him, on subjects ranging from markets to vacation destinations, I know something big will happen. Or rather, with strict statistical evidence (3 occurrences count as statistically significant right?), I can now affirm that Johnny Utah knows what is on the mind of Mr. Market. With fixed income markets blowing up left right and centre over the past two weeks, I got this email from him (with my edits):

“Couple of questions for you:

  • Will 30 year bonds provide the same magnitude of protection as it has in previous equity bear markets?

  • Is there a potential for 30 year bonds not to rally since interest rates are at or close to 0?

  • Should I expect 30 year bonds to sell off if the Fed starts raising rates again?

  • Isn’t the long end driven more by inflation and do you expect inflation to go much higher?”


In the response below, I’ll use the 10-year bond as an example, just because the data is more easily accessible, but everything is roughly similar for the 30-year bond.

Before answering the first question, I will answer the implied one: Is there any reason to believe that the negative correlation between bonds and equities will continue? First a bedtime story.

Once upon a time, in a kingdom long disappeared, a king sat on his throne, overlooking his vast empire. From where he sat, he could see all his serfs going about their day without being noticed. On sunny days, he would just look out and admire what he believed to be his creation. But on days where the weather would turn cold, he would come out and yell to the populace that there was no need to worry. He would scream until the cold draft was over. This would be the only time when his serfs would notice him, going back about their busy day as soon as the king stopped yelling. The serfs started believing the king had magical powers and could turn a cold morning into a sunny afternoon.

But as the king got older, he felt the cold weather more acutely. His yelling, which used to be a yearly occurrence, became more frequent, first monthly, then daily, then hourly, until the only thing the serfs were doing was watching him yell.

Ok now say your prayers and kiss your Greenspan goodnight.

Being modern serfs, we listened to the king and changed our portfolios to take into account his yelling. We moved away from an unlevered 60/40 portfolio to a levered portfolio with two anti-correlated assets. We settled in the land of risk parity, where you hedge out your equity risk with a “put” option that carries positively. But over time, we forgot why this “put” option carries positively.

This positive carry is made of two components with very fancy academic names: the risk neutral yield and the term premia. The risk neutral yield is composed of the expected string of short term interest rates over the life of the bond while the term premia is a compensation for locking up your money for the life of the bond and being wrong on the path of short term interest rates. Graphically, the 10 year yield you know can be decomposed into the following time series.

When you are buying bonds you are taking a view on these two components. Zooming into the post GFC era, it’s easy to see where the returns have come from.

The implied path of short term interest rates has stayed relatively stable since we reached the zero “floor” and started rising with the tapering of asset purchases. The term premia on the other hand has shifted lower, reaching negative levels in late 2014. Now, let’s take a second to reflect on what a negative term premia means. If a positive term premia represents a compensation for locking up your money without complete knowledge of the future path of interest rates, then a negative term premia must represent the payment you make for the privilege of locking up your money without complete knowledge of the future path of interest rates. Funny, no?

What can you make should interest rate expectations move back towards 0? A back of the envelope calculation tells you that you can potentially make 1% in yield terms from a compression in the implied path of short term interest rates. For that privilege, you are currently paying ~10bps in the form of a negative term premia. That’s what a so-so deal looks like. As a quick reminder, pre GFC, you could expect to make 3.5% in yield terms from a compression in the implied path of short term interest rates, while receiving ~50bps of positive term premia. That’s what a good deal looks like.

Tying it all in, for your bond portfolio to protect your equity portfolio, you need the following to happen:

  1. The correlation between bond prices and equity prices stays negative

  2. Expectations of rate hikes revert to pre-taper levels

  3. No move higher in the term premia


Even if you get each of those right, you can still expect a little less than a third of the return you would have gotten pre-GFC. Seen another way, you would have to lever three times as much to get the same protection. Not the kind of risk I would want to take.

I would use the same methodology to estimate what kind of sell-off you should expect should the Fed start hiking rates again, decomposing it both into the implied path of short term rates and the term premia. As mentioned in The limits of control, I find it interesting that the recent sell off in global bonds has come from a re-adjustment in the term premia, and not from any move in the future path of short term interest rates.

Finally, should we expect higher structural inflation? The current narrative sure seems to believe that we are in for a cycle of inflation due to increased fiscal deficits. I’ve given my view cyclically (higher due to base effects and commodity rally), but I don’t have a good view structurally. I nonetheless know what I’m looking at.

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