Monday, April 9, 2012

Remembering fixed income asset classes at a cocktail party

Guest post by TheDealer

One day you find yourself at a fairly boring cocktail party in town. You've had a couple of drinks and just as you are about to sneak out of there, a gentleman with a bushy mustache you've met earlier (and for the life of you, can't remember his name) approaches. "So Sarah", he says. "I hear you are in finance." You know what's coming now; he's going to be looking for some stock tips. Will just tell him "AAPL" - maybe he'll go away. But to your astonishment he asks a strange question. "Sarah, which fixed income asset class has had the best returns over the last couple of years?" All of a sudden you notice a bunch of other people staring your way, fascinated by this unusual question. But you know the answer because you've analyzed your fixed income ETFs.

Fixed income asset class returns over the past two years as measured by the corresponding ETFs  (in parenthesis)

Your answer is "Long term treasuries of course. A 35% return over the past couple of years." Now more people at the party are listening. "Yeah," you tell them. "Equities only did 23%, under-performing treasuries". The gentleman with the mustache takes another drink, and after staring at you for a while asks another strange question. "So Sarah, since you know so much about fixed income, tell me which asset class has been the most volatile in the last couple of years?" Now you start thinking back to your ETFs and you want to say High Yield bonds. But then you remember the pain you took on the TLO short roller coaster after Bill Gross "suggested" it.

Fixed income asset class annualized daily volatility over the past two years

And it comes to you: "Also long term treasuries. The most volatile fixed income asset class in the past two years." The people standing around you are quite surprised. Someone says "How can the be?". But you remember your volatility chart and answer - "That's right, long term treasuries experienced over 15% annualized volatility. The next most volatile asset class was convertible bonds - only because these bonds have an equity-like component"

Now more people from the party have surrounded you to learn all they can about fixed income (they must all be Baby Boomers thinking about retirement). And you figured you look like a hero having recalled all this cocktail trivia. And just as you get ready to triumphantly exit, the mustached man, having clearly had one too many, asks in a loud voice: "Hold on there Sarah. One last question".

Now you have a decision to make. You walk out and feel pretty good about your knowledge of fixed income or you stay and answer one last strange question, risking being embarrassed. But you stay because this has become a challenge. "OK Sarah, here goes," he says. "Which fixed income asset class has had the best performance on a risk adjusted basis in the last couple of years?". You think to yourself - this guy has lost his marbles. But now you can't just walk away - too many people at the party want to hear your answer.

So you try to do some quick arithmetic in your head dividing the returns by the volatility numbers (the poor man's Sharpe ratio). You keep getting an answer that doesn't seem very intuitive - long-term treasury returns on a risk adjusted basis actually weren't that great. A few other asset classes come to mind that did  considerably better. You give the a short answer: "Mortgage bonds and corporate bonds outperformed treasuries on a risk adjusted basis". People are now duly impressed.

Two year returns over the annualized volatility (rough ranking of risk adjusted returns)
You leave the party, redo the math, and satisfy yourself that you knew the answers (except for the fact that intermediate treasuries also did quite well on a risk adjusted basis). But now you know you are absolutely ready for the next cocktail party - no matter how strange the questions are (or the people for that matter).
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