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or how rich can get richer Cedars Hill Group — September 16, 2025 — Portfolio construction is like building a house, if you only build with cheap materials, you will not have the most robust house. While this may appear on the surface like mental gymnastics to justify buying tech stocks it’s not and it's also not a rant against value investing. What hopefully unfolds from here is a nuanced approach that I recently gained a deeper appreciation for and wanted to share but also reinforce in my own mind... Cedars Hill Group — September 16, 2025 -- Portfolio construction is like building a house, if you only build with cheap materials, you will not have the most robust house. While this may appear on the surface like mental gymnastics to justify buying tech stocks it’s not and it's also not a rant against value investing. What hopefully unfolds from here is a nuanced approach that I recently gained a deeper appreciation for and wanted to share but also reinforce in my own mind. I recently wanted to buy duration to balance out other risky bets in my portfolio but not having a view on the direction of rates presented a challenge. My intuition is that the market is leaning a bit too far ahead of what the Fed will actually do, absent a sharper economic slowdown, and at the same time I think the long end of the curve simply doesn't offer an attractive risk-reward tradeoff. I think that most non-professional investors think of bonds as solely income vehicles, but they also provide a duration risk component which causes the price of the bonds to move up and down with interest rates. They might look to buy bonds choosing based on the highest yielding ones without realizing they are taking on significant duration risk (and other risks depending on the type of bond). Duration risk introduces all sorts of complexities into the fixed income opportunity set while also creating opportunities for the discerning investor. I was looking to get long both treasury duration and crude oil in equal risk dollar proportions. What this means is that if an average daily move in crude oil is 1% and an average daily move for the 5-year treasury yield is 5bps I wanted to own enough 5-year treasuries so that both positions would create a similar impact to the bottom line of my portfolio. For example, if my crude position is 10% of portfolio MV an average daily move would cause 10bps of up or down movement in my portfolio. Therefore, I wanted to own enough treasuries to cause a similar 10bps move in my portfolio. When deciding which bonds to buy I had to pick a point on the curve, and each point has a different duration and would require a different amount of bonds to buy. I decided on the 5-year treasury because it was the shortest part of the curve with some duration. Twos have duration but they are more closely tied to FOMC policy, whereas fives include some intermediate term growth and inflation expectations that are more closely correlated with crude oil. After having put this trade on I saw a LinkedIn post from Skyler Weinand at Regan Capital about how rich the belly (5-10yr treasuries) are and I instantly thought "oh crap." But I also remembered putting on many trades based on similar analysis and not having it work out, so I decided to walk through the intuition behind both approaches and double check my intuition-based trade. Here is the screenshot from Skyler's post:  Source: Regan Capital What he is doing here is rolling forward one year, assuming the only thing that changes is time (ie. that the 5-year one year will be a 4-year and so on). Then he tallies up what your total return would be from holding each point on the curve. The yield part of the return is easy, but determining the price change requires determining the 1-year forward yield for each tenor and then calculating any price change in the bond assuming the yield on that bond in one year ends up being the 1-year forward. If the forward rate is higher that means the price of the bond will go down over one year and vice versa. This analysis provides a richer view of the opportunity set on the yield curve because it factors in how the shape of the yield curve impacts bond returns. An important caveat here is that the forward rates are not really market expectations of forward rates, they are merely the average future yield inferred from the spot yield curve (Harley Bassman is the rightful source of this distinction and you will find him referencing this in many of his posts which are all fantastic reads; this is the latest one where I found him citing this). That being said, the spot yield curve does reflect market expectations for growth, inflation, monetary, fiscal policy, etc. which does flow downstream into forward rates. Skyler's analysis shows that the worst returns in one year will come from the 10-year, 7-year, and then the 5-year. Interestingly the 30-year offers a better forward return because the curve has been steepening and at a certain level the yield today more than offsets any future price decline. On the short end, where the curve remains inverted it is a bet on the pace of rate cuts. You get a higher yield in cash, but that yield can change very quickly, so you have a tradeoff between how long you lock in a certain yield versus receiving a higher yield in cash today. I’ve always thought of this tradeoff in relation to volatility. You can sell implied volatility when it trades above realized, but eventually realized is going to increase and you will lose. It’s the old bird in hand versus two in the bush. Sometimes it makes sense to buy vol when it’s trading above realized because of events or other considerations, and the same logic holds true in the bond market. In the hyper-competitive financial markets, most of the time the first order analysis is not enough; you need to think multiple moves ahead. When the curve is pricing in Fed rate cuts there is a reason just like there is a reason that implies trade above or below realized, and we need to think about the second order effects. In the bond market we have an inverted curve on the short end and a steepening curve on the long end. The inflection point is in the belly where short-term and long-term expectations collide. Over the next six-to-twelve months there is simply less uncertainty absent any exogenous shocks but the further out we go the more uncertainty we have. If you look at the forward rates in Skyler’s table, you will see that the whole forward curve is in backwardation with shorter yields lower than higher yields. This means that after a drop of about 50bps the curve and economy will normalize. If we get a surprise the effect will be felt most in the belly because that is where there is the most potential for the actual path of interest rates to diverge from the forward rates. The key assumption the market is making is that any downturn and resulting drop in yields will be short-lived. If investors saw a drop in yields as deflationary, we would not see the steepening of the long end of the curve and the forward curve would not be as steep. When the curve is flat forward yields are not significantly different than spot yields and hold less information value. When the curve is steep, forward rates tend to be higher than spot rates which makes owning duration look unattractive and increases uncertainty because there is more change priced into the market. On one hand the market is pricing in the very specific scenario of a cyclical downturn which leads to a short-lived drop in rates and on the other hand it is pricing in greater uncertainty in this outcome. This contrast is the beauty of bond math; there are these crosscurrents that counterbalance each other and present unique risk-reward propositions. Today’s market pricing optically makes the belly unattractive. It is like when the equity market expects a pullback and bids up put skew which makes call spreads look cheaper, the market is begging you to stay in cash or the long end and offering you favorable pricing to do so. In this case we can determine that the belly of the curve stands to benefit the most from a unexpected drop in yields because it is pricing in the greatest increase in forward yields relative to spot yields. Employing Pascalian Reasoning we can intuit a few different macro scenarios that are otherwise very difficult to do with your standard interest rate model. If you believe the forward curve, then you should keep your money in the front end because that is going to deliver the highest total return. If you think we see an upside surprise in the economy then you want to stay in cash because yields will move higher across the curve, likely in a bear steepening move. In this scenario, you would also be better off not in cash but in a risky asset that is not pricing in higher growth, like crude oil. If we get a downside surprise the curve will likely steepen with the belly outperforming. Cash is the superior investment in two of the three scenarios but that only considers fixed income investments. Expanding the opportunity set to risky assets we see that cash is the best investment only when the forward curve is correct. When the forward curve is not realized it happens because growth and inflation surprise in one direction but in either case the long end is not the best performing investment. The long end will outperform if we start pricing in disinflation or deflation and the curve flattens. While this is certainly possible, you are not getting paid good odds to make this bet today, for that to be the case we would need to see the curve significantly steeper. Therefore, even though the belly is optically rich, if you want to own duration that is still the best place to be because it is pricing in the largest expected increase in yields. Comments are closed.
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