40% Of Your Assets In…OTM Options?

The treasury issues EE Bonds that yield 3.5% guaranteed if held for 20 years. In the interim, they are totally illiquid.

Meanwhile 20-year US treasuries yield 1.5% if held to maturity. However these are liquid, so you can sell them anytime.

Is it worth giving up 2% per year for the liquidity?

In How Much Extra Return Should You Demand For Illiquidity I explore this question and what it depends on. There are other examples of how other investments are priced based on their liquidity. I provide 2 frameworks to consider as you try to price liquidity.
Applying the logic to the current environment
Putting your money in a lockbox for 20 years to earn 3.5% per year might sound attractive if you decide liquidity isn’t worth much to you. Especially when the equivalent liquid treasury only yields 1.5%.

But as @econompic shows, there is no period in the last 75 years that if you looked back 20 years at stocks did you only earn 3.5% per year.

It’s reasonable to point out that stocks are not bonds so the comparison is made of straw. But the counter to the counter is that if you are putting the money in a box and throwing away the key for 20 years, then the comparison is not crazy. A significant benefit of bonds comes from the ability to rebalance. But with a 3.5% bond trapped in a box you lose the option to rebalance.

So we are stuck with that 1.5% bond. It’s nearly cash. Let’s not sugarcoat this. Bonds at current pricing are just an option on deflation. And the premium is all extrinsic value since they have negative real returns. Since they are now an option that you pay for in real terms, they are no longer an investment but an insurance policy. Once you see it like that, you have to wonder if their appropriate allocation size should be more commensurate with that line of thinking. Would you put 40% of your portfolio in option hedges? I didn’t think so.

Is anyone still putting 40% of their portfolio in bonds? Asking for an industry.

Leave a Reply