Monday, October 15, 2012

Not Much of a Grand Finale. What if We Go To 0?

When I ask the question “What if the US 10 year goes to 0?", most do not know the effect, the catalyst, or if 0 has ever happened before.  The math is fairly simple to do in Excel or with an old-school calculator, but let’s use RQuantLib to do the pricing and then use LatticeExtra with some slight adjustment in SVG.  RQuantLib spits out a total return of 17% if we go to 0 by the end of October, which seems like a decent amount until we look at on a chart.

From TimelyPortfolio

Mildly impressive, but the move is almost undetectable on a log scale.

From TimelyPortfolio

Throughout history, we have really only one good reference point in Japan whose 10 year went very briefly to 0.47%, but we need to remember that was in extended deflation in which stocks and real estate lost 90%.  That 17% return if we go to 0 (actually much less since 0.47% 0.43% was the stopping point) is not all that helpful in this devastating environment.

Even more strange is that the move we experienced over the last 15 months is greater than the potential move from here to 0.  On a six month change in yield chart, the 2% from April to 0% in October seems perfectly normal if we forget about the starting point.

From TimelyPortfolio

Similarly, a 12 month rolling total return chart does not reveal anything odd.

From TimelyPortfolio

However, starting point is critical.  Instead of subtracting ending from starting yield, ending yield/starting yield is more appropriate at this critical level.  Now we can see how unusual the move really is.

From TimelyPortfolio

If you are buying bonds to protect/benefit from a disastrous, deflationary “end of the world”, please be aware that best case you make a fairly measly 17%.  Just moving back to where we were Spring 2011 would mean a bigger loss than the absolute best case.

THIS IS NOT INVESTMENT ADVICE.  ALL OF THE ABOVE IS SIMPLY FOR ILLUSTRATION.

R code from GIST: (do raw for copy/paste)

6 comments:

  1. Very nice post, klr - thanks very much... pcc

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    1. thank you for all the R tools that you have given us. I made some small changes to the text to hopefully clarify my message.

      Struggling to find gaps that I feel have not been covered by the masters of the universe.

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  2. thx for the post, always enjoy your work. how did you get that red dotted line? can't seem to get that working?

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    1. got lazy and just did in SVG/Inkscape. Could have done in R, but chose speed over R purity. If any readers are motivated to do this, feel free to show the world.

      Thanks for reading and commenting.

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  3. Hi klr - Interesting insights. I am wondering if you can write a post in future with your insights on how you would evaluate and track a system performance ongoing basis i.e., to determine if a system is on track or loosing its edge and need to be shelved.

    I understand one cannot be certain about a equity dip (i.e., just a bigger draw down vs system no longer effective). But I am curious what statistical techniques do quants use to aid in this process and how often do they perform this tracking (say for a system with typical trade duration of few days).

    Regards

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  4. Hi klr,

    Sorry to come out of the blue like this on an old post, but I found your site while trying to build a cumulative bond return/reinvested coupon calculator based on Shiller's GS10 data (I've had one going on the S&P 500 data for a while: http://dqydj.net/sp-500-return-calculator/ )

    I have a question about your usage of the function 'FixedRateBondPriceByYield'. I wrote a similar function in javascript, but, best I can tell for arbitrary dates where I would 'sell' a treasury based on the Shiller data, using the current prevailing yield is a hack, and would only be valid if the yield curve was flat. Do you have any suggestions for how I could better value, say, a 10 year treasury expiring 3 months late in 1946 than using the GS10 'current quote'?

    My best idea was to try to figure out 1 year constant maturities, curve fit, and interpolate... but this is the first time I've tackled treasuries so I wondered if you knew something better?

    Regards,

    -PK

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