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Author: trptrade Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35345  
Subject: Re: Flipping Bonds for Fun & Profits Date: 11/29/2009 11:18 AM
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"What Treasuries (as a proxy for interest rates) might or might not do is irrelevant to the portfolio.... The price fluctuations caused by the changes in interest-rates don’t concern me, because they don’t directly affect the payment of coupons or the return of principal."

Don't confuse using Treasuries (as a proxy for interest rates) with inflation.

Consider this (obviously hypothetical) situation:

Interest rates are at 1% for 1 year bonds. Overnight, we get 100% inflation (effectively all prices double, understanding that price increases and inflation are not perfect substitutions). The next day, the market perceives future inflation at 1% for 1 year bonds.

Interest rates (and thus bond prices) have not changed, but your value crashed. This is because current interest rates are the market's perception of future inflation. TIPS, on the other hand, would double in that scenario (at their next principal correction), since they measure real inflation.

Why does that matter? Because it highlights a situation where interest rates and inflation move differently. Treasuries can be used as a proxy for interest rates, but you need different maturities in order to protect against inflation.

Two scenarios specifically to your comment about price fluctuation:

If you have an infinitesimally small spike in interest rates from say 1% to 8%, then the price fluctuations are not a problem. They are - as Graham points out - price fluctuations not value fluctuations.

However, if interest rates step up from from 1% to 6% over a 10 year period on a 10-year bond, then you might have a problem - you may have negative return against inflation. "Might" because this scenario can't be measured in isolation (more below)

Some would distinguish longer term moves as inflation risk; distinctly separate from short "jitter" of interest rate risk (trying to distinguish the difference between the loss of value caused by inflation vs. the price fluctuations caused by interest rate changes)

"I think laddering is an expensive, ill-conceived defense. What should be bought on the basis of value is what should be bought, letting maturities happen as they might. The net result, paradoxically, is a very tightly runged ladder when the whole portfolio is considered."

Fully investing in anything "cold turkey" or making rapid moves to transition is dangerous. In the same vein, intentionally building a ladder in the course of a few days, weeks, or perhaps even months is an expensive, ill-conceived defense.

However, building a portfolio that is diversified in maturities is a good defense against inflation risk.

A few scenarios again to explain:

If you have an infinitesimally small spike in interest rates from say 1% to 8%, and you are attempting to capture that spike, then you're trading (or speculating). Recap: These quick spikes should be ignored, because they are interest rate risk (price fluctuation), not inflation risk (value fluctuation).

However, if interest rates step up from from 1% to 6% for 4 years on a portfolio that has *nothing* that matures during those 4 years, then you might have a problem relative to inflation risk.

Might, because there are other factors. If you are just starting to invest, and your "new" investments are still material compared to the portfolio (say you're at 25% invested 75% cash and moving to 75% invested over 4 years), then you will have significant funds to capture the higher yields and protect against that inflation. The same "it's not a problem" scenario goes if you have high current income relative to portfolio value (typically in your 20s, perhaps 30s for some), because you will still capture the higher yields.

The ugly scenario is all 10+ year bonds and near (or in) retirement, thus little relative ability to capture the higher yields. One hopes people don't do that. :)

Tom
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