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Consider two people (Alice and Bob) who have some money each month to save and invest in government bonds of their own country (because they want it to be liquid, and have the smallest risk of default).

  • Alice will always invest and reinvest her money in the lowest yield bond available.

  • Bob will always invest and reinvest in bonds with the highest yield.

Both of them willing to swap bonds when an owned bond's bid yield is smaller than another bond's ask yield (so they won't lose on the swap) and the swap brings the yields to the desired direction. So lower for Alice and higher for Bob.

Now here is my dilemma:

In normal circumstances Alice will invest in short term bonds and stay near the current interest rate levels all the time. During the rare yield curve inversion events, Alice will buy long term bonds as her short term bonds mature gradually all her investment go to the long term zone till the inversion persists, locking in high yields for a long time. Alice rarely have the opportunity to swap, because her bond mature quickly.

Bob normally keep buying long term bonds. So his money generally yield much higher than the current interest rate levels. But if interest rates rise his old investments are locked in can't be swapped out, and may fall below the current interest rates. When the yield curve becomes inverted, then he can switch to short term bonds which yield a lot during that times, this time he can win some on the swaps and all his investments become refreshed on a high rate when the yield curve again turn back to normal.

So which strategy provides higher returns in the long run (eg. when done for 10-20 years till retirement)? So far I'm playing Bob's but it's not too late to change if evidence suggests Alice's way is better.

  • How would inflation-indexed bonds be handled here? While they may have a low yield, there would be principal adjustments that could make for tricky calculations. How would zero coupon bonds be handled in this situation? – JB King Nov 23 '14 at 23:12
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My recommendation is not to pursue anything. Set up a set of index funds that hits the balance of risk and reward you're comfortable with, and settle for market rate of return. Trying to beat the experts doesn't even work for the experts.

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Smallest risk of default would depend on where Alice and Bob live I suppose, but lets assume they are in a lower yielding nation where default is not a big concern. Remember for instance that Greece was a lower yielding nation at one point and that the US has defaulted before.

Let's start with Bob because he is easier to analyze. Yield curves inversions generally pre-date recessions which is generally not so good for Bob as rates tend to drop during recessions and he will be at the short end of the curve so his bonds will be less sensitive. However, he will generally get higher yields in good times to make up for this, but these higher yields come with a price in that he is generally much more sensitive to yield changes and can get much larger swings in portfolio value.

First off as JB mentioned Alice would likely own inflation-linked (IL) bonds. Which behave fairly differently from Bob's bonds. However, to keep this simple lets say they live in a place without IL bonds or IL bonds are not a consideration. Then generally Alice has lower yielding bonds in good times but may do very well when the fed steps in during a crisis.

So, who wins in the long run? Likely Christi who owns a mix of a broad index of stocks and bonds in a risk mix where she wouldn't have to sell in downturns. Especially, as Christi wouldn't have to pay the trading costs of moving her whole portfolio between long and short bonds. Between Bob and Alice however Bob would likely win in the long run as the markets generally reward risk taking in the long run. Still inflation (even without the IL bonds) and general rate trends (long-term rates are historically low right now) could have Bob losing for uncomfortably long periods.

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As one of the answers described, its going to depend on many factors and the environment at the time. But there is no sure way to know which strategy is better, if any are at all. I would say over several hundred years the strategies would be equally as profitable. In a free market the longer dated bonds would be priced lower (higher yield) because they are higher risk. And over a long enough time period that higher risk may end up resulting in that bond being worth less, or maybe nothing at all. In a free market, price discovery would factor all this in, and the two strategies would become equal. The same is true for the price during inversion events

Having said that, we dont live in a free market. With central bankers monetizing debt in so many countries, sometimes investing in short term bonds, including US treasuries, is a guaranteed way to lose purchasing power, as these yields are below inflation and sometimes even negative.

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