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Author: PoliceJockey Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35365  
Subject: "Long Bond" - buying and rolling Date: 2/12/2006 10:41 AM
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Folks,

Warning: new to the notion of bonds and thinking about investing (so therefore quite ignorant).

Last year in an article in Forbes, Gary Shilling, long-time exponent of the long bond (25, 30 year Treasuries, for example) said:

I've recommended the long bond repeatedly since I started writing this column in 1983. Some readers may recall the review of long-term Treasury performance in my Feb. 22, 1999 column. I said then that if you had bought a 25-year zero coupon Treasury at the 1981 rate peak and rolled the money into another 25-year each year to maintain its long maturity[empasis added], you would have comfortably outperformed someone buying the S&P 500 at the index's low in July 1982 and reinvesting dividends. I've updated those calculations. The Treasury investors would have earned 21% a year to a mere 15% for the S&P investors. Our hypothetical zero buyer would have turned $1 into $93.

Apart from the general investing philosophy for doing so, what exactly
is the technique for buying and rolling these instruments? Is there a nuts and bolts "How-To" available?

Thanks for any guidance,

PJ
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Author: pauleckler Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15345 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/12/2006 11:18 AM
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PJ, previous posters have noted the Treasury Department operates a buy direct program (on a website I think) where individuals can buy Treasury bonds. That is the place to start.

However, I would urge caution. First, a 30 year bond is very long maturity for most of us. (They are best suited to corporations, institutions and mutual funds.) Yes, they are as safe as the govt, but if you ever need the money you must sell them on the open market at whatever dealers choose to offer. Middlemen can eat up your profits if you are not careful. Its much better to choose a collection of shorter maturity bonds so you can decide to reinvest or make adjustments according to changing needs.

Similarly, those with small sums to invest, say under $50K, probably would be better off in bond funds than owning Treasuries. Even I-bonds are probably a better deal for most.

Secondly, the article you cite to me was written by an air-head. Bond ownership in the period cited was good because interest rates were falling from all time highs. Remember those 20% interest rates at the end of the Carter administration? History is not going to repeat itself. Interest rates are rising. They are not likely to fall anytime soon--til the end of the business cycle. And the high interest rates we had were caused in part by the savings and loan scandal. That is not likely to repeat itself.

So I would be inclined to do lots of homework before listening to that author.

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Author: pauleckler Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15346 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/12/2006 11:20 AM
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Oh, and zero coupon Treasuries are not offered by the US Treasury. They are instead derivative products called STRIPS, which are sold through brokerage houses. So check with your broker if you really want zeros.

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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15347 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/12/2006 11:37 AM
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"Secondly, the article you cite to me was written by an air-head. Bond ownership in the period cited was good because interest rates were falling from all time highs. Remember those 20% interest rates at the end of the Carter administration? History is not going to repeat itself. Interest rates are rising. They are not likely to fall anytime soon--til the end of the business cycle. And the high interest rates we had were caused in part by the savings and loan scandal. That is not likely to repeat itself."

Paul is being much too kind. If people believe this kind of stuff themselves, that makes them airheads. Writing what must be deliberately misleading columns for major financial publications verges on criminal negligence.

There are reasons for holding Treasury Bonds (or Treasury Inflation Protected Securities) in your portfolio—pros and cons versus CDs or some other low risk of default options depends on your personal and market circumstances. But with current, still historically low (though up a little from bottom) yields, you need to be thinking about buying and holding to maturity, which means your return will just be the dividends (interest). The only time you can get those big, S&P 500 beating returns, is if you buy long bonds, especially 30-years, when interest rates are very high, then you can sell for a nice capital gain when interest rates decline. I wish I'd bought 30-year Treasuries in 1982 (unfortunately, not only was I clueless, I didn't have $1000 to my name). I wish I'd bought them in 1992. 2006, only if you want to lock in a 4.5% return for 30 years, or count on a deep recession or international crisis getting you an escape time, if interest rates plummet.


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Author: WendyBG Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15350 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/12/2006 12:45 PM
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I recently addressed a similar question, in the context of buying long bonds to protect a portfolio from deflation, on the Mishedlo Board.

http://boards.fool.com/Message.asp?mid=23692933

http://boards.fool.com/Message.asp?mid=23694027

I urge you to look up the links, showing the real return of long bonds (over the last 50 years), and the tutorial on bonds (start with the linked elementary, then go to the advanced).

When you learn more about the risks of the long bond, you will find that the others who responded to you are right: investing in the long bond, at this time, gives a small investor uncompensated high risk.

Wendy

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Author: PoliceJockey Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15354 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/12/2006 2:36 PM
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Thanks much to Paul, Lokicious, and Wendy (and, wow, what a great FAQ-bie for the newbie, 2old).

I really didn't expect such a quick response since I myself am often unable to access the boards in a regular fashion.

The genesis of my question derived from reading one of the essays in John Mauldin's new book, Just One Thing, which includes essays about all sorts of investment ideas from all sorts of investors. Gary Shilling's chapter on the long bond posits that it will eventually drop to about 3% over the next several years, which he thinks represents the bottom. His view, which he "backs up" with lots of graphs and tables, of course, bucks the trend and is based on essentially a deflationary thesis. He supports his thesis by describing such forces as global restructuring, Central Bank worry over inflation, super-cheap mass retailing worldwide, deregs, globalization-fueled excess supply, and, my favorite, US consumers switching from borrowing and spending to saving.

I must admit that I like contrarian ideas, though that does not mean I apply them indiscriminately (or at all). The idea that the US consumer would save, too...geez, that should have been a red flag to his whole argument!

Thanks again for all of your intelligent responses and fft,

PJ



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Author: WendyBG Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15355 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/12/2006 3:37 PM
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If you are a contrarian, with an interest in deflation, you might want to check out the Mishedlo board.

There is a lot of good macroeconomic discussion, on the Mish board.

Mish and I disagree about inflation. He is a firm deflationist. I believe that inflation is inevitable, even if deflation occurs, in the short term, because the government's ballooning entitlement expenditures will force it to create a huge amount of fiat money (that is, money that isn't supported by real assets, such as gold, or real increases in productivity).

Wendy

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Author: theHedgehog Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15356 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/12/2006 3:57 PM
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Mish and I disagree about inflation. He is a firm deflationist. I believe that inflation is inevitable, even if deflation occurs, in the short term, because the government's ballooning entitlement expenditures will force it to create a huge amount of fiat money (that is, money that isn't supported by real assets, such as gold, or real increases in productivity).

Deflation destroys wealth and erodes the ability of the government to levy taxes. No government purposely enters a deflationary period. The goal is measured inflation.

Hedge

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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15357 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/12/2006 4:08 PM
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PJ,

The "how to" is to pick the most volatile of fixed income instruments and then cherry pick highs and lows to prove your point.

This is a paper argument as bad as those trying to sell stock picking systems that "market time".

The instrument he is taling about is one of the longer federal tools. Age to maturity is one of our risk factors because of the uncertainty about the future. Over the next 30 years where are rates going to go and where are they going to end? No one has that crystal ball. This makes longer instruments more risky and thus more volatile in response.

Zero's keep all the interest within the note, its not paid out in coupons twice a year like other treasury products. This makes the instrument volatile because all the money is at risk to time and interest rate changes.

This authors argument is no different then saying "if we bought AMZN or Yahoo(whatever) on date X and sold on date Y we would all be filthy stinky rich. See just look at the three color chart."

jack

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Author: WendyBG Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15359 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/12/2006 6:07 PM
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<Deflation destroys wealth>

Actually, deflation increases the value of cash. During the Great Depression, anyone with cash saw their purchasing power increase. My grandmother told me that land and property were cheap, and she wished she could have bought...but she was short of cash, as were the desperate sellers.

It is inflation that destroys savers, by eroding the value of every saved dollar.

Deflation may be said to destroy wealth, if one's wealth is in assets whose value is dropping. However, if your house value is dropping, so is everyone else's...so the exchange value doesn't change.

Deflation also makes it difficult for businesses to prosper, since buyers hold off purchases, waiting for prices to drop.

< and erodes the ability of the government to levy taxes. No government purposely enters a deflationary period. The goal is measured inflation.>

Yes, we agree on this.
Wendy


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Author: theHedgehog Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15360 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/12/2006 7:08 PM
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<Deflation destroys wealth>

Actually, deflation increases the value of cash.


Not if you have debt. The government has debt. In fact, all governments have debt. Governments depend on tax revenues to pay that debt. If the money supply contracts (deflation) how will it pay those debts? Can you imagine having $13 Trillion outstanding in treasuries and reducing the debt supply as well? Sorry, but I stand by my original statement. Deflation destroys wealth.

My grandmother told me that land and property were cheap, and she wished she could have bought...but she was short of cash, as were the desperate sellers.

Yes. Nobody was able to purchase anything, because nobody had money. It may be true that if you're sitting on a mountain of cash (not stocks, not bonds, not gold, but actual dollar bills) you'd benefit from deflationary policies. But, in point of fact, no-one actually sits on cash.

It is inflation that destroys savers, by eroding the value of every saved dollar.

What does savings have to do with wealth? What will happen to the bank that has your savings, in a deflationary economy? They are going to have trouble servicing their debt to you, as well as their debt to their other creditors. And, on a very fundamental level, savings for you is a debt for the bank. Can the bank really service the debt on their debt of $100,000 to you, as well as the thousands of other savers in their accounts? It's hard to imagine. Does the phrase "run on the bank" mean anything to you?

Deflation may be said to destroy wealth, if one's wealth is in assets whose value is dropping. However, if your house value is dropping, so is everyone else's...so the exchange value doesn't change.

The value changes if you're also losing the rest of your investments due to inflation and can't service your debt.

Here's the deal. Debt is owed in yesterday's dollars. It doesn't matter whether the money supply inflates or deflates. It doesn't matter whether your dollar will now buy you 5 Big Macs instead of just the one. If you owe $5000, that's what you owe. It doesn't even matter if the debt is someone else's savings. It's still owed at the previously inflated amount, not at the currently deflated amount.

Deflation destroys wealth by removing investment capital that should have been paying off existing debts.

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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15361 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/12/2006 9:07 PM
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The 30-year Bond's peak yield was about 14.68% in October '81 (monthly date). It got down as low as 4.2% (legacies) last May and July. So, ignoring taxes and the huge amounts of compounding (although at much less than 14.68 for most of the time), you'd have gotten that much yield the whole time, and had you chosen to sell at the low yield, you'd have averaged over 18% for 25 years (or so), once you factored in your sales price (of course, then you'd be reinvesting at a pittance)—please, not, I didn't cruch the numbers for the sale, just approximating.

Barring another bout of hyperinflation followed by fiscal responsibility, this isn't going to happen again.

There's a big difference between being a commonsense contrarian, like ignoring Wall Street hype about why valuations don't matter anymore when the NASDAQ is out of control, and pushing decisions linked to misleading history, in this case suggesting that these past returns on long bonds have anything to do with what might come in the future.

Most of us on this board are contrarians in the sense that we don't buy into the what me worry claims that the economy is fine and personal and government debt don't matter—this time is different. I don't take charting seriously in the stock market, but I have no doubt that it can trace short term patterns and tipping points in a market dominated by momentum traders. Treasury bonds are different. There is certainly a huge amount of trading in bonds, but there are many non-trading forces that determine supply and demand for debt securities (like the Chinese government and the Social Security surplus). And the economic forces, notably internationalization of the labor market, that have strong deflationary implications, are countered by the trade imbalance, which could lead to dollar devaluation (inflationary on imports) and the inevitable increases in energy costs. Most of us are being contrarian by being cautious in all our investment decisions, since predicting is probably harder than ever. Buying 30-years on the premise that 3% is likely is bad guesswork.

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Author: DrTarr Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15362 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/12/2006 9:36 PM
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As has already been pointed out - This is a smoke and mirrors approach to investing. Yes, if you had bought 25 year - zero coupon instruments at that time and rolled over to a new instrument each year your return would have been phenominal. But this is using the best period in time to present the case.

If you had bought Microsoft at the same time (OK a couple of years later when they went public) the intial adjusted cost would have been $0.09 per share. It is at $26.69 today, That's some where in the neighborhood of 33% return - each year. Or to put it in their terms.

Our hypothetical [MSFT] buyer would have turned $1 into $297

Now, given the information you have been given, you can easily see there is a time and a place for buying and rolling bonds. It can be incorporated into a portfolio and given a certain allocation. You can certainly purchase bonds on Treasury Direct or you can go to the secondary market. Even Yahoo has a bond screener and then directs you to a bond desk. Remember, you will be selling these in the secondary market so always watch the "bid/ask" spread cause the middle-women love to skim off a good portion.

Another avenue which may work out is a bond fund - this depends on the amount of time you expect to hold the fund and the rate of turnover to adjust the income stream from "unrealized" to actual dividends. (Please note a 1% drop will not result in the drastic 30% increase mentioned by Wendy - but you may get about half that for a 30 year duration) These can be purchased through many of the discount brokers - ie Ameritrade.

I would suggest you look back through these posts on this board and find some of the Bonds FAQ's that have been created - Thanks to the diligent efforts of Loki and others. This is a good place to gather some knowledge on the topics of bonds / FI and should make some light bulbs go on. After that feel free to come ask more questions.

While we will typically digress to other things - deflation destroys some types of wealth, usually in the mix we answer the OP quetions.

DrTarr


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Author: WendyBG Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15363 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/13/2006 2:27 AM
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I wrote: Actually, deflation increases the value of cash.

You wrote: Not if you have debt.


When I said "cash," I meant actual cash, as in a positive net worth. No debt! If you have cash, deflation is good. Cash will buy more.

True, debt becomes more onerous, with deflation...but debt is not cash, as anyone with a mailbox full of bills can tell you.

It may be true that if you're sitting on a mountain of cash (not stocks, not bonds, not gold, but actual dollar bills) you'd benefit from deflationary policies. But, in point of fact, no-one actually sits on cash.

No one?? No one?? In point of fact, I am sitting on a mountain of I-Bonds, T-Bills, CDs and money market funds...which, as far as I am concerned, are equivalent to cash (except they pay interest). No debt. No mortgage, auto loans, credit cards...no debt.

Therefore, I am better prepared for deflation than most people, although I believe that inflation is the likelier scenario.

<Does the phrase "run on the bank" mean anything to you?>

Does the phrase "FDIC" mean anything to you? It's the reason I never keep more than $100,000 in any single bank.

The value changes if you're also losing the rest of your investments due to inflation and can't service your debt.

No debt. The result of 25 years of LBYM.

Deflation destroys wealth by removing investment capital that should have been paying off existing debts.

In my opinion, investment capital should be invested in productive, profitable endeavors, not in paying off existing debts. Existing debts should be paid off by cash flow...and should be avoided, if cash flow will not cover them.

Deflation is bad for the economy, it's true. That's why the Fed will inflate, to avoid it.

<Can you imagine having $13 Trillion outstanding in treasuries and reducing the debt supply as well? Sorry, but I stand by my original statement. Deflation destroys wealth.>

I can't imagine the debt being reduced. I think it will grow, dramatically. I think the government will increase the money supply, to pay for the growing debt. I believe that this will increase inflation, which will destroy wealth.

Not to sound stubborn ;-), but deflation doesn't destroy wealth, if one's wealth is in cash...in fact, cash will buy more, in deflation. Just ask Mish :-).

Deflation will destroy debtors, because they will have to pay their debts in more-valuable dollars. Inflation destroys savers, because it destroys the value of our dollars.

Wendy











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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15365 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/13/2006 9:45 AM
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Just a quick approximation of what a 4.5% 30-year T-Bond would be worth in 5 years under different prevailing interest rate scenarios:

If rates dropped to 3%, you could sell a $1000 bond for about $1395, which combined with 4.5% over the first 5 years would give you an annualized return of about 8.3%

If rates went up to 6% and you had to sell, you would get about $605 of your $1000 face value back.

If rates went up to 8% and you had to sell, you would get about $75 for your bond (an 8% bond over 25 years would earn almost $1000 more, after compounding than a 4.5% bond),

Hope this puts risk/reward into perspective. Even if rates did drop to 3%, returns would not come close to the 14% plus of bonds bought in '81 or '82. If rates rise, which, contrarian thinking aside, is a scenario supported by more factors over the medium to long term, the best that can hoped for is sitting on a 4.5% bond for 30 years.


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Author: markr33 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15367 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/13/2006 10:54 AM
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Just a quick approximation of what a 4.5% 30-year T-Bond would be worth in 5 years under different prevailing interest rate scenarios:

If rates dropped to 3%, you could sell a $1000 bond for about $1395, which combined with 4.5% over the first 5 years would give you an annualized return of about 8.3%

If rates went up to 6% and you had to sell, you would get about $605 of your $1000 face value back.

If rates went up to 8% and you had to sell, you would get about $75 for your bond (an 8% bond over 25 years would earn almost $1000 more, after compounding than a 4.5% bond),


Using a straight line, no compounding, no FV, these values seem farfetched to me. It seems to me that from a current income perspective, that 4.5% bond at 3% prevailing rates would be worth about $1500, and that same 4.5% bond at 8% prevailing rates would be worth $562.50 (not $75). Am I missing something (other than compounding)?

Hope this puts risk/reward into perspective. Even if rates did drop to 3%, returns would not come close to the 14% plus of bonds bought in '81 or '82. If rates rise, which, contrarian thinking aside, is a scenario supported by more factors over the medium to long term, the best that can hoped for is sitting on a 4.5% bond for 30 years.

I think the risk/reward must also account for the likelihood of either scenario. It seems to me that the 8% scenario is more likely than the 3% scenario for long bonds. Of course, many folks disagree, and I've been wrong before.

Mark [not a bond expert, not even a bond novice]

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Author: vickifool Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15369 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/13/2006 11:01 AM
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Similarly, those with small sums to invest, say under $50K, probably would be better off in bond funds than owning Treasuries. Even I-bonds are probably a better deal for most.

Why?

Vickifool



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Author: WendyBG Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15370 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/13/2006 12:24 PM
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Someone wrote: Similarly, those with small sums to invest, say under $50K, probably would be better off in bond funds than owning Treasuries. Even I-bonds are probably a better deal for most.

Vicki asked: Why?


I presume that whoever wrote the statement above referred to the liquidity of bond funds, and the fact that you can often open a bond fund, with small assets.

However, I disagree with the above statement.

I think that you should learn about the basics of bonds vs. bond funds. Then, you should weigh your personal need for liquidity (how immediately will you need the money?) against the different types of fixed-income, non-mutual fund possibilities.

Bond funds have one disadvantage: the Net Asset Value (NAV) drops, if prevailing interest rates rise. The longer the duration of the bond fund, the more the NAV will drop. This can cause you to lose money, if interest rates are rising.

Some other types of fixed-income instruments (I-Bonds, CDs) have one disadvantage: they are not as liquid as a bond fund. To avoid losing interest, you have to hold them to maturity. For example, if you have an I-Bond, and need the money in less than a year, you can't get it.

Bonds (Treasuries, corporates, etc.) can be held to maturity. However, if you need the money, you can sell them on the secondary market. If you sell them, during a period of rising interest rates, their value can be lower than you paid, so you can lose money.

The answer to this: figure out when you will need your money. Keep a good e-fund of liquid money (I like 1 years' income), in a money market fund. For you investment (non-e-fund) money, it's quite reasonable to buy CDs and bonds, not mutual funds.

Wendy



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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15376 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/13/2006 4:18 PM
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Actually, deflation increases the value of cash.

As well as bonds and bond-like things like annuities and pensions.

During Japan's decade-long deflation, seniors citizens (on fixed incomes) did all right.

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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15377 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/13/2006 4:22 PM
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Does the phrase "run on the bank" mean anything to you?

Does the phrase "FDIC" mean anything to you? It's the reason I never keep more than $100,000 in any single bank.

If there is major deflation, banks will fail and so will the FDIC, and the government will not be able to bail it out.

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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15378 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/13/2006 4:32 PM
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Bond funds have one disadvantage: the Net Asset Value (NAV) drops, if prevailing interest rates rise.

Tradable bonds have the same disadvatage. The extra disadvantage that funds have is that the NAV does not rise as quickly when interest rates drop again.

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Author: WendyBG Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15380 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/13/2006 5:03 PM
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<If there is major deflation, banks will fail and so will the FDIC, and the government will not be able to bail it out.>

Failure of the FDIC is tantamount to default of the U.S. government. That is truly a doomsday scenario. I don't think it will happen.

The government can print as much money as it needs, to bail out the FDIC and failed banks. The subsequent inflation is a separate issue.

Wendy (not buying a tin foil hat, yet)

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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15381 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/13/2006 5:07 PM
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Failure of the FDIC is tantamount to default of the U.S. government.

The FDIC is an agency of the US government, not part of the government proper. Agencies have only an implied government backing (a line of credit at the Treasury that could be cancelled at any time).

A lot of people do treat agencies as having the same credit rating as the government, but others don't. (which is why there are "Federal" mutual funds, which include agency bonds, and "Treasury" mutual funds, which don't)

I agree that at the present time, the government can't afford to let the FDIC or other agencies fail. But if conditions change enough, it might become politically palatable.

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Author: theHedgehog Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15382 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/13/2006 5:13 PM
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*<If there is major deflation, banks will fail and so will the FDIC, and the government will not be able to bail it out.>

Failure of the FDIC is tantamount to default of the U.S. government. That is truly a doomsday scenario. I don't think it will happen.

The government can print as much money as it needs, to bail out the FDIC and failed banks. The subsequent inflation is a separate issue.*

I'm still unmoved by the assertion that deflation doesn't destroy wealth. There some special circumstances where a minority of the people would benefit from deflation, yes. But, it would be a stretch to say that any wealth had been created. The general wealth of a country would be destroyed by deflationary policies.

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Author: DrTarr Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15384 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/13/2006 10:25 PM
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I am not buying any tin foil hats yet either.

It will be interesting to see the results of coming out of this benign interest rate period and the effect on the banking system. There has not been a bank default for something like 600 days. While they (banks) have enjoyed some hefty profits of late, the ability of the Fed to adjust the risk premium these banks pay, based on that risk is a wonderful tool. And may provide enough of a cushion in the reserve to withstand some moderate defaults.

In both deflation and inflation certain types of wealth are created and destroyed. That is the reason for asset allocation across classes that can hedge these two environments. But always remember - the economy is like a car without a steering wheel, to much in either direction spells a bad time - but doomsday - Nay......

DrTarr





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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15386 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/14/2006 10:46 AM
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Vickifool quoted Similarly, those with small sums to invest, say under $50K, probably would be better off in bond funds than owning Treasuries. Even I-bonds are probably a better deal for most.

and then asked Why?

I'll refer you to the post 15263 on this board but the whole thread has useful information on the pro's and con's.

50k is a number to start with a place to begin the conversation. With 50k its easy to demonstrate how one can self diversify without getting eaten up by friction costs. But I tend to believe this really only applies to fully diversified funds and private bond portfolios. The safety of treasuries and their low friction costs make it easier for someone to diversify across maturities; thus one could divesify within the type with less money as long as the recognize the nature of their diversification.

jack

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Author: WendyBG Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15388 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/14/2006 11:38 AM
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< The general wealth of a country would be destroyed by deflationary policies.>

Yes, I agree.

Our only disagreement is a matter of semantics (the definition of words).

If you say, as Mike Shedlock (Mishedlo) does, that inflation is defined as an increase in the supply of money and credit, while deflation is the decrease of money and credit, deflation is certainly destructive.

With less money available (e.g. due to debt defaults), consumers can't spend as much, leading to economic slowdown. With less credit available, businesses can't borrow, to increase capacity.

The resulting economic slowdown is destructive to national wealth. Non-cash assets (such as homes and stocks) would lose value.

However, I have been defining inflation as a decline in the purchasing power of the dollar (as measured in the Consumer Price Index). Since I live in a "microeconomic" world, not a "macroeconomic" world, I tend to focus on my personal purchasing power. Inflation has wiped out 95% of the purchasing power of each dollar, over the past century. Inflation has persistently eroded the carefully saved dollars of LBYMers, instead giving a "free lunch" to profligate debtors.

Savers, who hold cash and equivalents, would benefit from deflation, as each dollar would buy more.

Since the U.S., at every level, has taken on record amounts of debt, deflation would hurt the majority.

However, the true wealth of nations depends upon capital formation and investment of saved resources. It is the savers, not the debtors, who paid for the factories and offices.

Deflation will help the savers, because each saved dollar will buy more.

I believe that it is about time that savers are rewarded for self-discipline. The overspending majority should learn to live within their means.

However, the pain of the correction would be so great that I do not believe that the Fed and the government would allow it. There are many fiscal stimuli that could be aimed at lower-income workers, who would spend the money, to stimulate the economy. (One such stimulus would be allowing mortgage interest to be deducted, outside of the standard deduction, since most lower-middle income homeowners' mortgage is less than the standard deduction. Another would be allowing renters to deduct their rent, just like mortgagers can deduct mortgage interest. This would target still lower incomes.)

This is why I don't think that deflation will be allowed to happen...or if it does, it will be very temporary.

Wendy



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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15389 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/14/2006 12:47 PM
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50k is a number to start with a place to begin the conversation. With 50k its easy to demonstrate how one can self diversify without getting eaten up by friction costs.

Post 15263 advocates diversifying over maturities when you're investing in Treasuries. (i.e. make a Treasury ladder)

Currently there are seven maturities of Treasury intruments that are generally available. With TreasuryDirect, there are no frictional costs. It seems to me that you get maximum diversification with $7000.

So why is $50,000 still the hard and fast the lower limit?

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Author: theHedgehog Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15390 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/14/2006 1:07 PM
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However, the true wealth of nations depends upon capital formation and investment of saved resources. It is the savers, not the debtors, who paid for the factories and offices.

No, it is the investors and creditors who paid for the factories and offices. Savers do nothing useful with their money, other than put into the care of others who will do something of value with it.

Wendy, money isn't lazy. It doesn't care who owns it, and it doesn't care whether it's borrowed or saved. It is still going to go somewhere and do something. Even if it's spent frivolously on a pair of pink fluffy slippers, it still goes on to the next person. Under your scenario, capital formation can only be accomplished by bankers. But, bankers don't generally start new businesses, open factories, or build offices. They can't. It's not their money. But, they can loan it to investors and businessmen who do.

And, don't forget the fact that businesses need customers. It's not important that customers' money come from saved money. It's only important that it is spent on the goods that the factories and offices produce. Without a willing, enthusiastic customer base, there is no industry.

Hedge

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Author: pauleckler Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15392 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/14/2006 2:37 PM
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[Similarly, those with small sums to invest, say under $50K, probably would be better off in bond funds than owning Treasuries. Even I-bonds are probably a better deal for most.

Why?

Vickifool]
=========

Yes, the issue is liquidity. If you buy small amounts of any bond, and you must sell before maturity (likely in the case of a 30 yr bond), the people who make the market for that bond are bond dealers, often working through the bond desk of a brokerage house. Even if the bond is listed on a major exchange, the amount quoted is available only to the largest investors, some say $1MM and up. So a small purchase, of say $5K, has serious liquidity issues. Yes, you can sell it, but the quote may be so low as to eat up most of your interest.

So bond fund is a better deal for most small investors. Also take a look at the trust preferreds listed on the NYSE. They are traded competitively as stocks but are in reality long bonds. You can trade them at market prices paying discount broker commissions.

Best way to own bonds for $50K and up is a laddered maturity bond portfolio. You will probably buy no bonds longer than 10 to 15 years. But you will have bonds steadily maturing. This gives you an income stream from interest and the ability to reinvest the funds and continue the ladder or divert the funds to some other need if need be. Hence, you have pretty good cash flow to cover many develpments, and can still sell the whole portfolio for cash if you need to.




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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15402 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/15/2006 11:34 AM
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So why is $50,000 still the hard and fast the lower limit?

I didn't say that, nor do I argue that.

50k is a number to start with a place to begin the conversation.

...

But I tend to believe this really only applies to fully diversified funds and private bond portfolios.


jrr7 writes
It seems to me that you get maximum diversification with $7000.

True you are fully diversified across all the Treasury maturities but it leaves no room for strategic emphasis nor does it leave room to diversify outside the treasury market. Diversification is not mechanical and shouldn't be approached that way. Even within Treasuries the longer end is more volatile. Can we honestly say because someone has spread 7k across the spectrum that it meets their diversification needs?

jack

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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15403 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/15/2006 11:39 AM
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True you are fully diversified across all the Treasury maturities but it leaves no room for strategic emphasis

"Strategic emphasis" isn't diversification; it's concentration.

nor does it leave room to diversify outside the treasury market.

I completely agree with that. There are some "trust preferred securities" (exchange-tradable, small-denomination bonds) and "internotes" out there, but not enough to really be diversified.

I can't think of any situation that would cause prices of Treasurys to go down and prices of corporate bonds to go up. The risk premium of corporates is already unusually low as it is. I'd think that it's more likely that the risk premium will widen, making existing corporates less attractive.

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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15404 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/15/2006 11:41 AM
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Hedge,

No, it is the investors and creditors who paid for the factories and offices.

Please distinguish between saver and investor. You seem to have a view of "savers" as passbook only folks. I don't think that definition fits any more. People are saving for retirment and their children's education, as two simple examples, using equity and debt funds.

Are the only investors the big money players: the fund managers, investments bankers, hedge funds and the like?

If so where do those categories of investors and debtors access money, as you say its not lazy it will find something to do nor did it pop out of thin air.

jack

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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15406 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/15/2006 12:04 PM
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I'd think that it's more likely that the risk premium will widen, making existing corporates less attractive.

a larger corporate risk premium is exactly what makes them attractive. We need to get paid for moving our money away from the good faith and trust of the U.S.Govt.

jack

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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15407 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/15/2006 12:35 PM
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I'd think that it's more likely that the risk premium will widen, making existing corporates less attractive.

a larger corporate risk premium is exactly what makes them attractive. We need to get paid for moving our money away from the good faith and trust of the U.S.Govt.

The key word in my original sentence was existing.

If the risk premium widens (as it should, and as I'm hoping for, but not betting on) then newly issued corporate bonds will be issued at a higher yield. The problem then is that existing corporate bonds bearing the lower yield will become less valuable. So I don't think it's worthwhile to buy corporates now, unless you can find super bargains.

I do not think it possible for the corporate risk premium to decline much further though (AAA's on average are already yielding less than bank CDs in all maturities)

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Author: spinning Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15409 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/15/2006 1:03 PM
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AAA's on average are already yielding less than bank CDs in all maturities

Does this mean that the market thinks it is more likely that FDIC insurance will fail than that AAA's will go bankrupt? Or are these rates set by purchasers who are not covered by FDIC insurance? Or something else?

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Author: theHedgehog Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15410 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/15/2006 3:05 PM
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Please distinguish between saver and investor. You seem to have a view of "savers" as passbook only folks. I don't think that definition fits any more.

Are you saying that there is no such thing as a traditional saver? I think you'd be surprised. But, I'm using the traditional meaning, here. Someone who puts their money in a savings account. I don't have problems with extending that to CDs, Money Market Funds, or even Savings Bonds --- any passive savings device.

Are the only investors the big money players: the fund managers, investments bankers, hedge funds and the like?

No, clearly not. I am an investor, and I'm not a big money player. The difference, in my mind is risk. If your money is in someplace that has no perceived risk, such as a CD etc from above, you are a saver.

If so where do those categories of investors and debtors access money, as you say its not lazy it will find something to do nor did it pop out of thin air.

Since money isn't lazy, what is the question? Are you an investor? Where do you access money? Isn't most of your money in the form of debt loaned to others, that's callable during business hours and payable in 3 days? If you have the traditional 3-6 months of cash, where do you have that? In a bank Money Market account?

My point is that in a thriving economy, one which has both adequate production and adequate consumption, credit is not a particularly bad thing for the economy. The money continues to exist within the economy, whether it's stashed in a CD (which is loaned out or invested by the bank) or used to buy a new HD TV. Given that, the money is available for investment in new businesses and office complexes.

But, I'm only interested in the general economy for this discussion, when I say that deflation destroys wealth. I have already said that there are some who will benefit from a period of deflation.

Hedge

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Author: DrTarr Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15412 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/16/2006 12:29 AM
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Currently there are seven maturities of Treasury intruments that are generally available. With TreasuryDirect, there are no frictional costs. It seems to me that you get maximum diversification with $7000.

So why is $50,000 still the hard and fast the lower limit?


_____________*,*_______________

Most on this board, I think, agree you do not really need $50,000 to diversify a bond portfolio - across time maturities - Here is the TOPS-

(Tarrs Own Personal Stance)

Lets say you forget about the long bonds, cause it is sounding like not many of you out there would buy them right now anyway. I am certainly not in line.

So, on Treasury Direct you can buy 1, 2, 3, 5 and 10 year notes. Lets not argue over its a bill its a note.

Well, this would give you a portfolio of bonds with a duration of ~4.27 years. That is nice, but if you bought one bond - Say a 5 year, your duration would be about 4.4 years. So, barring the boost in convexity from the heavy cash flow (maybe around .25% in the investors favor given a 1% change in interest rates) You are really just as diversified across maturities with the purchase of one bond!

Now the convexity means that for an increase in interest rates, the decrease in the price occurs at a decreasing rate as the interest keeps climbing. So the more convexity the better and we are doing with less. But with the purchase of only the one bond (Maturity) - you are not tied into the long end of the spectrum so you can hold the bond until maturity and as such not suffer the loss of face value as you try to sell it on the open market. So - rising interest does not seem to be a problem.

Lets look at decreasing rates. The value of your bonds on the open market would go up. Again, without the additional convexity you are not getting the increase but the difference - first is small. I calculate* .22% difference in value given a decrease of 1% in interest rates. And second, now be honest - how many of you would "trade" the bond and try and take out the additional value. Remember if you put it back into a bond, you really gained nothing.

So, going up or going down, the difference is small, but if you like to own the various maturities to help calm your nerves

As I recheck some numbers - a five year bond and a 1 year CD would be almost identical in characteristics as the "diversified" portfolio.

DrTarr
$2000 and maturities are diversified.



*Comparing a purchase today of a 1,2,3,5,10 year bond at the prevailing rates against the purchase of a single 5 year bond.


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Author: DrTarr Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15413 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/16/2006 12:34 AM
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No one?? No one?? In point of fact, I am sitting on a mountain of I-Bonds, T-Bills, CDs and money market funds...which, as far as I am concerned, are equivalent to cash (except they pay interest). No debt. No mortgage, auto loans, credit cards...no debt.

____________*,*___________

Recity Rec for Wendy - Good Girl!!

Just to add maybe another - I wonder how much of Intel's 13 Billion is in cash. OK, OK - they have about 2 billion in debt.


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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15414 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/16/2006 9:09 AM
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Doh!!!!

Obviously I didn't read it that way. My apologies.

jack

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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15415 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/16/2006 9:21 AM
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Does this mean that the market thinks it is more likely that FDIC insurance will fail than that AAA's will go bankrupt? Or are these rates set by purchasers who are not covered by FDIC insurance? Or something else?

My spin on this is that we are looking at two different aspects of the debt market and thus they behave slightly different. For our, little investor, purposes we tend to treat them as similar because what we want is a reasonable YTM.

The Macro picture is a bit different. Why are banks offering CD's with rates higher then most of the A ratings? The simple answer is that they are trying to borrow short and lend long in a profitable manner. Banks are trying to borrow at 4.?% and lend at 6.?% and squeeze their pennies out of that deal. The short end has been driven up by the Fed and their appears to be brewing competition for the savers dollar.

Corporates are primarily moved by two things: the treasury market of similar maturity and by industry/corporate issues. The Fed typically has some influence because the whole market often responds by shifting everything higher as the bottom is raised.

The treasury market has not shifted higher as the Fed has raised the bottom nor is there a prevalent concern about Corporates in general. This has created a very tight bond market.

Does that help?

jack

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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15416 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/16/2006 9:39 AM
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Hedge,

Thanky you for clarifying you definitions. I think that is one of the sticking points of the conversation.

My point is that in a thriving economy, one which has both adequate production and adequate consumption, credit is not a particularly bad thing for the economy.

There are many that will argue that the consumption portion of this model is out of balance. Its out of balance with production, which we see in a "trade deficit". It is also out of balance with income generation, 0 - to negative savings rate, huge numbers of HELOCs.

Now throw in the huge pile of "IOUs" the U.S. general account has with the SS system, which isn't recorded as part of the national debt. We have financed a great deal of current Govt. with credit that has yet to come due.

I also disagree that it matters little to the macro situation whether we buy a CD or a HD TV. One creates or maintains individual wealth the other is a depreciating asset the moment it leaves the box and thus wealth destroying. As inventory on the shelf it is a depreciating asset. The money paid for the product is extreamly diluted as dispursed along the chain.

How would the US economy look if we had more "savers" then we currently have? How would the US economy look if we had more "savers" then "spenders". (we'll ignore investors for the moment)

jack

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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15417 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/16/2006 9:48 AM
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I'm sorry, I've lost track of this thread, but I am confused about diversifying maturities on Treasuries. That's just laddering and should only require having enough capital to buy each maturity you want in minimum amounts ($1000 per bond at auctions). Other than the US government defaulting some point in the future, we aren't concered with diversification to spread out default risk, as with corporates.

There is an issue of how far out of a ladder is appropriate, which clearly depends on individual circumstances—as someone in his fifties knowing he will need someday to use principal not just income from bonds, I think it unlikely I would consider laddering up to 30-year bonds, even if the rates were attractive (which they are not), because of lack of liquidity. This is the place where, theoretically, a long bond fund would have an advantage, because it could buy 30-year bonds when rates were high (as in 1981-82) and a fund shareholder would have liquidity. I think it is worth understanding this theoretical advantage, should such a time ever come again, which I still think not unlikely, given the deficit, though my guess at this point is not until the SS surplus turns negative.

Where Jack and I disagree is on whether it is possible to get enough of a risk premium from lower-rated investment grade corporates (below AA) given the limited diversification possible with only $50,000. This is because we are looking at risk differently (I don't think one of us has to be right and the other wrong). I am looking at risk in discrete units: zero defaults for AAA and AA, 1 default for low investment grade, presumably 2 defaults or more below that, but junk needs to be thought of differently). Jack is looking at the probability of default and spreading it across the bonds (e.g., 50 bonds). The result is I would require a risk premium (higher yield above Treasuries) on low-investment grade bonds that is not realistically likely to happen, at least not with only $50,000 to spend, so I see bond funds as the best way to access the smaller premium from these bonds, presuming a much higher interest rate environment than now, where interest rate risk on bond funds less frightening. (Jack also thinks he can cut back the risk of default by careful selection of corporate bonds, but that goes beyond simply trying to average risk through diversification.)

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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15418 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/16/2006 10:11 AM
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I am confused about diversifying maturities on Treasuries. That's just laddering . . .

I'm going to disagree with both you and DrTarr on this. I appreciate Doc's math and do not disregard it. From a liquidity standpoint, even if the house needs to get hit by meteor for you to liquidate, diversification across maturities maters. Who knows how long the yield curve will remain flat. When it changes it will change the current value of the bonds within the port and that matters if you have to liquidate.

It is irresponsible of us to advise anyone to consider themselves diversified with two bonds of equal maturity. This doesn't mean they made a poor saving or investing choice but it isn't diversified. They are fully exposed to how the market treats that one maturity.

We cannot simply focus on a small box of tools like duration or duration+convexity. If we do then we think the tools are the thing rather than the thing being the thing. A football field is measured in yards but yards don't matter if points aren't scored. Duration is a yardstick, yardsticks are useful right up to 36" beyond that their use is limited.

jack

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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15419 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/16/2006 10:32 AM
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Does this mean that the market thinks it is more likely that FDIC insurance will fail than that AAA's will go bankrupt? Or are these rates set by purchasers who are not covered by FDIC insurance? Or something else?

I'd guess a combination of #2, and that these CD rates are only available at small banks that don't have access to the capital markets.

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Author: spinning Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15420 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/16/2006 10:34 AM
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My spin on this ... Does that help?

Thanks jack!

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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15421 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/16/2006 10:37 AM
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So, on Treasury Direct you can buy 1, 2, 3, 5 and 10 year notes. Lets not argue over its a bill its a note.

I have a hard time finding anything relating to 1-year investments on TreasuryDirect. It goes right from 6-mo to 2-year.

Well, this would give you a portfolio of bonds with a duration of ~4.27 years. That is nice, but if you bought one bond - Say a 5 year, your duration would be about 4.4 years. So, barring the boost in convexity from the heavy cash flow (maybe around .25% in the investors favor given a 1% change in interest rates) You are really just as diversified across maturities with the purchase of one bond!

That would simplify things but it means you are all concentrated in that one maturity, and thus have no chance of capturing higher rates that may become available, either now or in the future.

Also keep in mind average duration is not a complete measure of your risk.

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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15423 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/16/2006 12:42 PM
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"I'm going to disagree with both you and DrTarr on this. I appreciate Doc's math and do not disregard it. From a liquidity standpoint, even if the house needs to get hit by meteor for you to liquidate, diversification across maturities maters. Who knows how long the yield curve will remain flat. When it changes it will change the current value of the bonds within the port and that matters if you have to liquidate.

It is irresponsible of us to advise anyone to consider themselves diversified with two bonds of equal maturity. This doesn't mean they made a poor saving or investing choice but it isn't diversified. They are fully exposed to how the market treats that one maturity."

Jack,

If you are laddering, you will have bonds of different maturities. In laddering, you either break up a lump sum into bonds (or CDs) of different maturities, normally sacrificing yield to do so, but currently not since yields are flat, or you gradually build a ladder, in which case your earlier purchases have shorter remaining maturities, in the even you should have to sell. I certainly wouldn't advise using anything other than very short maturities for an E-fund, but by defintion, laddering is building a portfolio of different maturities, whether all at once or over time.


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Author: DrTarr Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15428 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/16/2006 8:17 PM
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Thank you all for not disregarding the math. But one point I would definitely like to clarify. The demonstration of duration was only to point out diversification across time can be achieved with one instrument versus one of each maturity. Time diversification boils done to duration - done. It does not deal with liquidity or especially with re-investment risk. (you can have the same duration but not the same re-investment risk/liquidity risk - easy cheesey) As Jack mentions duration is one of many tools. These two risks have to be viewed in a much different light and the viewer is the only one with the answers. A Bond trader does not see them the same as the institutional or the individual investor. And it does take more money to diversify these....

DrTarr



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Author: DrTarr Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15429 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/16/2006 8:33 PM
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That would simplify things but it means you are all concentrated in that one maturity, and thus have no chance of capturing higher rates that may become available, either now or in the future.

Yes, but/and you still have the locked in rate should rates go down. Another advantage/disadvantage of a single bond for individual investors is that the maturity will always be getting shorter so eventually you only have a duration 1 day. Of course on that day, interest rates will tank but - Again, this does not cover liquidity/market/re-investment/default risks.

DrTarr


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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15432 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/17/2006 9:53 AM
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The demonstration of duration was only to point out diversification across time can be achieved with one instrument versus one of each maturity. Time diversification boils done to duration - done.

I still have to disagree. Duration is an ESTIMATE. The value of the bond (or portfolio) almost certainly will behave differently, for one or more of the following reasons:

1. Duration assumes that all interest rates move in unison. They don't.
2. Duration is not linear, in two ways:
-a. Duration does not go down 1-for-1 with time. It does not even go down linearly with time.
-b. Duration is only a good estimate for small interest rate movements. For large interest rate movements, there will be nonlinear changes.

Thus, a bond that has a duration of 4.7 now may have a duration of 8 -- or of 2 -- sometime in the future. In order to keep your duration the same you have to constantly switch bonds (or buy & sell your existing bond offsetting it with cash).

I suspect, but haven't done the math, that a bond ladder has a better-behaved (and more accurate) duration than a single bond.

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Author: jackcrow Big gold star, 5000 posts Feste Award Nominee! Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15434 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/17/2006 10:23 AM
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Loki,

I'm really not trying to mince words honest. Laddering is a strategy. It can be used to help diversify or provide steady income or try to minimize yield change impacts. In truth it does all of the above but how we manage our ladder depends on what our goals are.

jack

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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15435 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/17/2006 10:42 AM
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Laddering is a strategy. It can be used to help diversify or provide steady income or try to minimize yield change impacts.

The purpose of laddering (with assumed rollovers) is to synthetically create a perpetual bond with a "free" embedded partial put option (that you exercise by not rolling over the bond).

What you hope for is:
- your duration stays stable
- your interest rate adjusts to prevailing interest rates (albeit with a bit of lag)
- you don't lose nominal principal
- your interest rate is close to (but hopefully higher than) bonds of a similar duration to the ladder

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Author: DrTarr Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15437 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/18/2006 12:02 AM
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Duration is an ESTIMATE

Correct. It (actually the modified duration) is the derivative of the bond price with respect to changes in the bond yield. As soon as there is an incremental change in either maturity or interest rate, the duration is changed.

The value of the bond (or portfolio) almost certainly will behave differently

Correct. Duration is the linear estimate and the curve for a single maturity is different than for a portfolio of maturities. While the instanteneous rate of change is identical at a given point of interest rate and maturity, any change in these variables change the curve - thus the duration

Duration does not go down 1-for-1 with time.
Correct. Although it could, zero coupon bond. But otherwise, it goes down at an increasing rate.

Duration assumes that all interest rates move in unison.

Not exactly correct, Duration is a mathematical formula and makes no assumption about any rates. Duration is a simple statistic relating the average maturity of a bond or portfolio. It is however, an instrument to immunizing a bond or portfolio against interest rate risk. Thus gives "time diversification" in the sense of across multiple maturities. If the investor applies a single duration across multiple maturities, this can be a source of error which seems to be what you are saying, but this is not durations assumption.

that a bond ladder has a better-behaved (and more accurate) duration than a single bond.

This is some what in contrast to your previous point about interest rates moving in "unison" Which is in fact, one of the reasons a laddered portfolio is not more "well behaved" The other and most significant driver is the convexity is increased because of the time weighting of cash flows in a portfolio of maturities versus a single maturity. The higher the convexity, the farther off the linear estimation is.

Thus, a bond that has a duration of 4.7 now may have a duration of 8 -- or of 2 -- sometime in the future

Well, it can never go from 4.7 to 8, but if you hold on to the bond until maturity it will definitely pass through 2 at some point.

So, I am not sure how or what we are in disagreement. Is duration the end answer? I beleive I have posted several times it is not. Does it describe diversity across time, yes at a given instance in time when the duration of a single bond is equivalent to the duration of a portfolio of bonds they both have the exact same instanteneous rate of change.

Are there still different risks characteristics for each holding,

re-investment/liquidity/market/interest rates

Yep!

But for diversification across time, duration is the estimator. Can we be more precise, yep! How precise does the average investor want to get?

From my previous example,with duration and convexity, a 1% change in interest rates changes the value of the $1000 portfolio to $1046.81, while the 5 year $1000 bond is changed to $1044.45. But the real key is using this to compare changes against other durations. That is the test of time diversity. Not enough and interest rate decreases leave you hollow... To much and interest rate increases can kill ya!


DrTarr







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Author: DrTarr Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15438 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/18/2006 12:09 AM
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"free" embedded partial put option

_________________*,*________________

My OCD tells me this would be a call option.... LOL





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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15461 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/20/2006 10:23 AM
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Duration does not go down 1-for-1 with time.
Correct. Although it could, zero coupon bond.

...and stable interest rates.

Duration assumes that all interest rates move in unison.
Not exactly correct

You're right, I misspoke. I should have said something similar to "In order to use the duration number as a quick estimate to predict the price change of the bond given future interest rate moves requires that you assume interest rates will move in unison."

It is however, an instrument to immunizing a bond or portfolio against interest rate risk.

A bond buyer always has interest rate risk of one kind or another, unless he's holding some options (either a put option or a floor option)

This is some what in contrast to your previous point about interest rates moving in "unison"

Because with a portfolio of bonds, the duration behaves more like the naive expectation. I'm now beginning to see your point that a single bond can have the same interest rate risk as a laddered portfolio, as long as you have the right expectations.

You're right -- I don't think we disagree.

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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15462 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/20/2006 10:25 AM
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Holding a Put option = option to sell
Holding a call option = option to buy

You own the variable-rate bond and the option, you're able to redeem part of it at par any time a maturity date comes up. You have no guarantees about what price you'd be able to buy more of it at.

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Author: DrTarr Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15466 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/20/2006 1:04 PM
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Duration does not go down 1-for-1 with time.
Correct. Although it could, zero coupon bond.

...and stable interest rates.???

jrr.

We do agree, except on this I have a slight question.

If we are talking about straight "duration," then interest rates are irrelavent. The duration for a zero coupon bond is equal to the time to maturity. Duration is the weighted average of the times of the cash flow, there is nothing in the equation for interest rates. (no discount)

Now, if we are talking about a modified duration in some form, then I would be happy to get on the same page, this may be just a definition question, just let me know what you are calling duration.

And
Holding a Put option = option to sell
Holding a call option = option to buy

You own the variable-rate bond and the option, you're able to redeem part of it at par any time a maturity date comes up. You have no guarantees about what price you'd be able to buy more of it at.


The way I view this is that it is a call option; Here is why, when a bond matures, you do not have the right to decide if you want to redeem (sell) the bond - It is sold, you get the cash. What you do have is the embedded right to purchase (a call) the next bond. So, the cash flow gives the holder the right, but not the obligation to buy. If interest rates are up, then the call option due to maturity has paid off.

I can see looking at the bond par value as the floor, or minimum the same as would be provided by a put, but when maturity comes up, you do not have the right, but instead, you do have the obligation to sell as if you had sold a call. But, you do have the feeling of, you can always sell the bond for face value, the same as a put would give you, well in this instance - a European Put.

That is both sides of the coin, "European Put" on the old bond, Call option on the next in line bond.

DrTarr






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Author: jrr7 Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15470 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/20/2006 2:20 PM
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Duration is the weighted average of the times of the cash flow, there is nothing in the equation for interest rates. (no discount)

Now, if we are talking about a modified duration in some form, then I would be happy to get on the same page, this may be just a definition question, just let me know what you are calling duration.


You're right, I was being sloppy. I was thinking about a modified duration where future cash flows are discounted.

I disagree that there is an implied call option because you do not know in advance the price or yield that you wil be buying at. I had called it an implied put option because you do know in advance the price (par) that you will be selling at, but that's not right either. So my conception of a bond ladder as a synthetic variable-rate perpetual bond is flawed. Oh well, back to the drawing board.

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Author: DrTarr Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 15472 of 35365
Subject: Re: "Long Bond" - buying and rolling Date: 2/20/2006 2:41 PM
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But on the finest of notes, you do know what the strike price is. It is the cash from the maturing bond. True, you do not know what the yield will be. But that is the same for buying a call right now.

So, the call scenario is somewhat flawed in that you can only buy the bond, at the strike price.. either way,

You do not have to go to far back to the drawing board -

A bond ladder would be a "synthetic" bond. It would have characteristics similar to a single bond, just behaves on those characteristics in the aggregate. While it is created from the actual instrument so,,, synthetic?? I would say, could be. Because you end up with a "bond" that has charateristics you could not get with a single bond.

It would be a variable rate as interest rates go up and down, you would of course be lagging the end of the yield curve that you buy in at (say ten year bonds)

And if you left the money in - it would be perpetual

A synthetic variable-rate prepetual bond!

DrTarr



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