Permanent Portfolio 25% Bond Allocation FAQ
The Permanent Portfolio allocation is 25% stocks, 25% bonds, 25% gold and 25% cash. In this series of posts we’re going to talk about how to implement each one of these components to take advantage of the economic cycles of Prosperity, Inflation, Recession and Deflation.
This FAQ is divided into two sections: Short Answers and Long Expanded Answers. If you don’t want to know the details then just read the Short section and skip the Long Expanded section. This page will be updated from time to time as more common questions and answers are needed.
In this series we talk about the 25% bond allocation and how it protects you from deflation and helps during prosperity.
Short Answers
Is there a Harry Browne Radio show that discusses some of the topics in this FAQ?
He covers some of the topics in this FAQ in these shows:
Why do I want to own bonds in my Permanent Portfolio?
Bonds help out under various economic conditions to protect the Permanent Portfolio. Under times of prosperity when the economy is stable and growing bonds provide a steady income stream in addition to the growth of stocks. When markets go through deflationary gyrations that are bad for stocks and gold in the portfolio, bonds can go up greatly in price offsetting losses in these other assets.
What kind of bonds should I own in the Permanent Portfolio?
You only want to own the highest quality long term bonds you can buy. For US investors that means you only want to purchase US Treasury Long Term bonds because they have no credit, default or call risk.
What is credit or default risk in bonds?
Credit or default risk is the possibility the bond issuer may not pay back the bond holders (aka. going bankrupt).
Credit risk can show up by a rating agency downgrading a bond issuer and this will spook investors who will demand higher interest rates to compensate. This will drive down existing bond prices. The bond issuer may still be able to pay the bond, but investors fearing the higher risk of default will want more compensation to hold onto the bonds.
Default risk is the possibility that the issuer may simply go bust and not pay anyone except for maybe pennies on the dollar during the bankruptcy liquidation (if that).
Most bonds have credit and default risk and this is priced into them as higher interest rates. However the US Treasury bonds are considered extremely low risk of defaulting because the government can always tax people or print money to pay off the debt. As a result, US Treasury bonds pay lower interest than other types of bonds because the risk of holding them is lower.
When you say “Long Term Bonds” how long do you mean?
Any bond 25-30 years to maturity is perfectly fine for the Permanent Portfolio.
Do I need to hold the bond for the entire time?
No. You will sell the bonds when they have 20 years left of maturity under the Permanent Portfolio strategy. You will then buy new 25-30 year bonds to replace them. This is a simple process that any broker can handle for you in a matter of minutes (or seconds). The bond markets buy and sell bonds of all different maturities constantly and you aren’t obligated to hold a bond until it matures.
What is deflation?
Deflation is a general contraction in the prices in the economy due to a shrinking of the money supply. As opposed to inflation, under a deflation scenario every dollar you hold becomes worth more and can therefore purchase more. Prices under deflation are falling, sometimes rapidly, and the economy will be suffering as the new lower price levels move through the market.
Why own bonds for deflation?
Bonds with a long maturity will go up sharply in value during times of deflation because market interest rates will be falling. Falling interest rates means that bonds you hold that pay a higher interest go up in value because the payments are worth more. Under deflation the general market interest rates will fall, sometimes rapidly. This is good for certain types of bonds.
For example if you own a bond paying 5% a year for 30 years and the new market rate for bonds falls to 3% a year for 30 year bonds then your 5% bond is more valuable to investors. After all, if you were a buyer which would you rather own: A bond paying 5% for 30 years or a bond paying 3% for 30 years?
If they were the same price you’d of course want the 5% bond. However the market would never let this price disparity exist. Instead what happens is your 5% bond price goes up in value until the effective payout matches the 3% bonds in the market over 30 years.
The rule you need to remember is this: Bond prices move opposite to interest rates.
If rates go up, bond prices go down. If rates go down, bond prices go up.
How else do bonds help a portfolio?
Economic uncertainties that are hurting stocks will sometimes help bonds as investors look for safe places to put their money. You could see bond prices go up therefore even if there isn’t necessarily deflationary forces in effect yet.
Bonds also provide an income stream through their interest payments. The income from the bonds can be reinvested into the portfolio to compound.
What economic conditions will hurt bonds?
The #1 enemy of long term bonds is inflation.
Inflation causes interest rates to rise as the value of the currency declines. This is because holders of the falling currency want more interest to offset their risk of the money losing value faster than they can earn a return.
Under conditions of rising interest rates (such as inflation), bond prices will fall. Under rapidly rising interest rates (such as really bad inflation) bond prices may fall very sharply. After all, if you own 5% 30 year bonds and investors can buy 10% 30 year bonds on the open market why would they want yours unless you give them a big discount?
Bad inflation can not only cause bond prices to fall 25, 30, 40, 50% or more, but the money they are paying you in interest payments is also depreciating. Inflation therefore is a double blow to bond holders.
What assets in the Permanent Portfolio protect me from bond losses if rates go up due to inflation?
Under bad inflation situations the gold allocation in the Permanent Portfolio will go up sharply in price and should offset the bond losses you’d experience. This is what happened in the 1970’s when inflation was double digits and bond holders were being badly hurt. A portfolio that held gold offset all losses in the bond allocation and actually turned a profit during that time.
There are no guarantees of course, but this is what the economic forces should ultimately reflect over time.
Can I hold Long Term Treasury Inflation Protected Bonds (aka. TIPS) instead of nominal Treasury Bonds?
No you can’t. TIPS are designed to respond to inflation. They will not provide the spike in price that nominal Long Term Treasury bonds will during deflation. You should only buy nominal Long Term Treasury Bonds, not TIPS, for the Permanent Portfolio.
Can I hold Municipal Bonds instead of nominal Treasury Bonds for the portfolio to save on taxes?
No you can’t do this either. The tax savings is not as large as some may believe because Treasury bond interest can’t be taxed by the states. Even if you do save some on taxes, municipal bonds have credit risk. Even worse they have call risk which means they won’t respond the same to market conditions as Long Term Treasury bonds will.
In the case of severe deflation, many municipal bonds paying a higher interest rate can be called back by the issuing agency away from bond holders. Therefore the bonds you think you held to offset portfolio losses due to deflation are no longer available to you. You’ll get your money back, but you’ll have to scramble around for new bonds along with everyone else right at the time you don’t want to be buying bonds (you’ll be paying a premium price in that type of market).
The tax savings of municipal over Treasury bonds is not enough to offset the capital appreciation Treasury Bonds have in bad markets. Please go down to the Long Expanded answers section and see the chart comparing these various funds to see what is meant by this.
How do I buy US Treasury Long Term Bonds?
There are three basic ways:
- At auction from the Treasury.
- On the secondary market.
- Through a bond fund.
How do I buy US Treasury Long Term Bonds at Auction?
Buying bonds at auction from the Treasury can be done in two primary ways:
- Open an account at Treasury Direct to make the purchase.
- Use your mutual fund company or broker to make the purchase.
Treasury Direct is a service of the US Treasury that allows individuals to participate in the auction and buying process of Treasury bonds of all types. Treasury Direct accounts can be set up like any brokerage account and your bond purchases will be held in custody for you by the service.
Brokerages can purchase bonds at auction as well. You should check their website or speak to a representative to find out the process.
What bond fund can I use to purchase Long Term Treasury Bonds?
There is only one at this time that is acceptable for use in the Permanent Portfolio:
iShares Treasury Long Term Bond ETF (Ticker: TLT)
This is the only bond fund that Harry Browne mentioned as being acceptable in his radio shows. It’s also the only one I’ve seen since that fits the primary criteria for bonds in the Permanent Portfolio:
- It only holds 100% US Treasury Long Term bonds.
- It only holds bonds with maturities over 20 years.
Not only this, but this bond fund is very cheap which is a requirement in any bond fund because the returns from interest tend to be low and you don’t want your profits being eaten up by high management fees.
Any brokerage or mutual fund company should be able to buy this bond ETF for you.
Why not use other bond funds?
Most bond funds have several problems for the Permanent Portfolio:
- They don’t own 100% US Treasury Bonds – Many mix in other government agency bonds, corporate bonds or repurchase agreements which is not acceptable.
- They don’t own long enough maturity of bonds – The Permanent Portfolio strategy needs very long term bonds to balance out other assets in the portfolio.
- They’re market timers – Many try to time the market and shift around bond maturities to increase performance (which fails).
- They charge too much – Bond funds usually have low yields. If you pay a manager 1% in fees and the fund yields 4% a year then you’ve given 25% of your profits away (4% – 1% management fee = 3% to you). It doesn’t sound like much, but it adds up through the years.
Should I purchase the bonds directly or use a bond fund if I have the choice?
It’s always better to own the bonds directly either through Treasury Direct or your broker. It’s one less layer of things to go wrong in the portfolio. Also, it’s cheaper because you won’t be paying management fees to own long term bonds which you only sell every 5-10 years in the portfolio.
However, if you have no other choice due to various reasons (e.g. your retirement plan doesn’t allow direct bond ownership or you feel uncomfortable doing it yourself), then you may use a fund. The iShares TLT fund is still an excellent choice in this situation and the costs are reasonable.
Can I use an actively traded bond fund for the Permanent Portfolio instead of direct bond ownership or a long term bond index fund?
No you can’t.
You don’t want a bond fund manager moving between long, short, intermediate, corporate, junk or whatever other kind of bond they think they need to beat the market. The Permanent Portfolio needs US Treasury Long Term bonds for specific reasons and you can seriously compromise the protection if you use an actively managed bond fund.
This rule is not flexible. Do not break it.
My retirement plan doesn’t offer any suitable long term bond index funds. What can I do?
This is an unfortunate problem for many workers. Index funds are not as profitable for mutual fund companies who like making big fees on actively managed funds. As a result, many 401(k) and IRA plans don’t offer index bond funds.
In this case you have few choices:
1) Move your IRA to someplace like Vanguard that has index funds and allows you to purchase bonds at auction or the secondary market easily.
2) Ask your retirement plan administrator to make bond index funds available either by requesting them from the 401(k) custodian or if necessary moving the company 401(k) plan to a new custodian that does offer them.
3) Use the funds that you have to the best of your ability.
If you are forced into option (3) (and many are), then try to look for the following in your funds that you do have:
- Lowest expense ratio possible.
- Uses US Treasury Bonds only.
- Has the longest maturity US Treasury Bonds available.
- Won’t be actively managed with someone shifting around bond maturities as they feel is appropriate. You want static maturity targets in the bond fund.
What’s the recap?
- The Permanent Portfolio owns Long Term bonds to protect against deflation, but also help somewhat during prosperity.
- Credit risk, default risk and call risk should be avoided with your bonds – Bonds are for safety, not speculation.
- The best bonds to own for deflation protection are US Government Long Term Treasury Bonds.
- Do not purchase TIPS, Municipal bonds, high-grade corporate bonds or junk bonds.
- You should purchase bonds with a maturity of 25-30 years.
- You will hold the bonds until they have 20 years left of maturity and then sell them to buy new 25-30 year bonds.
- Bonds can be purchased from the Treasury directly or through any broker for a nominal fee.
- If you need or want to use a bond fund then use the iShares Treasury Long Term (Ticker: TLT) ETF.
- Never use an actively traded bond fund if you want to own a fund. Only passive index funds are allowed.
- If your retirement plan doesn’t offer a suitable long term bond fund then find the one with the longest term bonds available or move your money to another fund provider if you can.
Long Expanded Answers
How can credit, default and call risk impact bond performance?
When investors get scared in a bad market they’ll shun anything with risk. If they think the stock market has too much risk of loss, the corporate bond market has too much risk of default and municipal bonds are risky due to call privileges they’ll flock to Treasuries for safety.
You saw this happen in late 2008 when the stock market crashed and, fearing widespread deflation combined with credit problems, investors sold everything and bought Treasury Bonds for protection.
The chart below shows the year 2008 and a Long Term Treasury Bond Fund (Ticker: TLT) vs. Vanguard’s Long Term Corporate Bond Fund (Ticker: VWESX) vs. Vanguard’s High Yield Corporate Bond Fund [aka. Junk Bonds] (Ticker: VWEHX) vs. Vanguard Long Term Tax Exempt Bond Fund (Ticker: VWLTX) vs Vanguard Treasury Inflation Protected Securities Fund [TIPS] (Ticker: VIPSX).
You can see that when the stock market was crashing and deflation was feared that Treasury Long Term bonds went up nearly 35% in value while Long Term Corporate bonds lost -5% (down -20% at the worst), High Yield Bonds (aka. Junk Bonds) dove a painful -30% in value, Long Term Tax Exempt bonds sank -10% and TIPS were down -7% by the end of the year.
(Click on chart for larger view. Chart courtesy of stockcharts.com)
US Treasury Long Term Bonds ETF (Ticker: TLT) in red (up about +35%)
Vanguard Investment Grade Corporate Long Term Bonds (Ticker: VWESX) in dark blue (down about -5%)
Vanguard Treasury Inflation Protected Securities (TIPS) Bonds (Ticker: VIPSX) in light blue (down about -7%)
Vanguard Long Term Tax Exempt (Ticker: VWLTX) in magenta (down about -10%)
Vanguard High Yield Corporate Bond (Ticker: VWEHX) in green (down about -30%)
In the above it’s clear to see that when credit and call risk showed up in Fall 2008, people were paying premium prices for Treasury Long Term bonds over corporate long term bonds, junk bonds and municipal bonds. TIPS, which respond only to inflation and not deflation, provided no diversification benefit under this scenario.
The end result was that owning Treasury Long Term bonds in the Permanent portfolio allowed investors to harvest those gains and offset almost all stock market losses in 2008.
What about buying high yield bonds (aka. Junk bonds) to get some extra interest and diversification?
NO! Bonds are for safety and not speculation. Buying higher risk bonds means you are “chasing yield” and this can be dangerous because higher rewards ALWAYS means higher risk.
If you need your bonds to protect you during a bad market you don’t want them to be subject to credit or default risk. Junk bonds (aka “High Yield Bonds”) have very high credit and default risk. They are one of the worst investments to own. You get all of the volatility and risk of stocks but none of the upside potential. They also are also heavily taxed if you are unable to shelter them. Lastly, you don’t get the protection of quality bonds when you need them.
During 2008 when the credit crisis hit many junk bond funds sank by 30% in value! Here’s a chart below of their performance against high quality US Treasury Long Term Bonds:
(Click on chart for larger view. Chart courtesy of stockcharts.com)
Long Term Treasury Bonds are in red. High Yield bonds are in blue.
Imagine owning High Yield bonds thinking they would protect you in a bad market only to see the fund sink by 30% along with your stocks. That’s not the kind of diversification you need in the Permanent Portfolio.
Isn’t after tax yield all that’s important for bonds?
It’s only half of the issue. There are three ways to make money on investments:
1) Dividend
2) Interest
3) Capital Appreciation
Stocks can provide growth with dividend payments and capital appreciation (through an increase in share price).
Yet bonds can provide growth through interest payments and capital appreciation (through an increase in bond price).
Many people looking at bonds focus too much on the yield (interest payments) of the bonds and not enough on how they may move under market forces. Treasury Bonds are somewhat unique in the bond market because they move so powerfully to interest rates. This response is shown in a decline in yield, but a rise in price (capital appreciation) in certain times.
In 2007 for instance Long Term Bonds started off yielding about 5%. By the end of 2008 they yielded below 3%. Rates on Long Term Bonds fell a measly 2%. That’s not a big deal right? And someone looking at these numbers in 2007 may have dismissed Long Term Treasuries as being a bad deal at 5%. Perhaps they used their money instead to purchase corporate or municipal bonds trying to get extra after-tax yield.
Yet people who bought Long Term Treasury bonds in 2007 and held onto them through 2008 saw them appreciate in value by 30-35%!
That’s what a measly 2% drop in yields can do for US Treasury Long Term bonds in the Permanent Portfolio.
Since there is no rule that says you need to hold onto Treasury bonds until they mature, what smart investors did was rebalance and sell off the excess profits in their Long Term Treasury Bonds by the end of 2008 to bring their bond allocation back down to 25% of the portfolio. They then moved the money gained to other parts of their portfolio that were lagging (such as stocks).
In other words, the fact that the yield on the bonds in 2007 seemed low was only one piece of the calculation. Many investors focus on yield and forget that high quality bonds also have capital appreciation in certain markets. Not only this, but chasing higher yield means you are always taking on higher risk. There is no free lunch in economics. In 2008 that risk showed up for many bond holders.
I’ve heard from some analysts that the US Government may default one day and I shouldn’t own their bonds. How can I avoid this risk?
This is a remote risk because the US Government can always tax people or print money to pay their debt. Neither is a good solution, but they won’t “default” in the traditional sense. Your 25% gold allocation in the Permanent Portfolio is a solid hedge against this situation if it should occur though. Also keep in mind that governments all over the world engage in the same activity constantly so there really is no place to hide from it.
Also this has been predicted for decades now. In fact, Harry Browne wrote a book in 1989 that talked about risks of debt to the US called The Economic Time Bomb. Do you know what his answer was to protect you against this possibility? That’s right, diversify into the Permanent Portfolio strategy and don’t worry about it.
When you say the US Government can print money to pay off bond debt isn’t that bad?
Yes. That’s where inflation originates is the over-printing of money. The US Government will likely never “default” on their bonds in the traditional sense. What they’d likely do is simply print so much money to make the dollar worthless. At the extreme they could start printing out $1,000,000 bills and handing them out to bond holders. At this level of inflation the money would be worthless (it probably couldn’t even buy a cup of coffee), but technically they didn’t “default” because you were paid. You were just paid in worthless paper, but you were paid.
In this case the gold in the Permanent Portfolio would be worth a fortune as people fled for the exits out of the Dollar. So even though at the extreme your bonds are worthless, you’d probably find that the gold protected you from virtually all real losses in your portfolio.
Again this is an extreme example, but if the government started printing money to bring inflation to 10%, 20%, 50% or higher each year it would be really bad for your bonds, but the gold allocation would do very well under this scenario.
What is the secondary market and how do I buy US Treasury Long Term Bonds on it?
The secondary market is simply the place where you buy existing bonds that are not from a treasury auction directly. These bonds may have various maturities from the longest 30 years available to very short maturities.
Brokerages and mutual fund providers can often purchase bonds on the secondary market very easily during any trading day. US Treasury bonds are very liquid and trades are simple and straight forward. Again, contact your brokerage or mutual fund provider for more information on purchasing Treasury Long Term Bonds.
What about owning International bonds?
International bond funds have significant currency risk because they won’t be denominated in your local currency (e.g. European bonds may be denominated in Euros but you live in the states where you use Dollars). Currency risk means that if the US dollar is strong but the international currencies are weak you could lose money on your international bonds even if they go “up” in value.
For instance let’s say you own some international bonds yielding 5% a year. During the year though the dollar has a strong rally and goes up in value 20% against other currencies. At the end of the year you will find that yes you received your 5% payment, but because the dollar went up so much in value the bond fund price may be down -15% (5% appreciation minus the 20% depreciation due to the dollar increase). Situations like this could happen during times of deflation or disinflation in the US.
Likewise, you could be in a situation where the dollar sinks and your international bonds go up greatly in value due to the exchange ratio favoring foreign currencies. This may happen during times of inflation in the US that are hurting the dollar. However since you own gold in the portfolio to protect you from inflation this really isn’t a boon to you because you’ve weakened your protection from risks of deflation.
Some people believe there is benefit from diversifying their currencies into foreign bonds. This may be true with other strategies but under the Permanent Portfolio there is no need to diversify your currency exposure because you own a large allocation to gold already which does this (gold is currency neutral and stands on its own). The only thing you do by owning international bonds is weaken your deflation protection in the portfolio.
I morally object to owning US Treasury Bonds. What are my other options and risks associated with them?
If you morally object to loaning money to the US Government then your primary option is to own a high quality long term corporate bond fund. Since default risk is a primary concern with owning corporate bonds, you want to make sure you only own the highest AAA rated bonds and you own them from many companies to diversify your risk against bankruptcy from a single issuer. The best way to assure this is with a high quality passively managed bond index fund. Avoid actively managed bond funds at all costs.
The Vanguard Long Term Investment Grade bond fund (Ticker: VWESX) is a good choice for an inexpensive and well run long term corporate bond index fund.
Again you must be aware that you are sacrificing your deflation protection by making this decision over using US Treasury LT bonds. See the references to 2008 above to understand the risks involved.
Where can I read more about this topic?
From the book Fail-Safe investing:
Fail-Safe Investing
about 1 year ago
craig, thanks for this great resource! my main question is around where i should locate the bond portion of my portfolio. i’m assuming it should be placed in a 401k or an IRA. i currently have a taxable account, a roth IRA, a rollover IRA from past employers, and a 401k with my current employer. i know i can purchase the bonds through my brokerage for any of the first three accounts, but what would you consider the best approach? also, more generally, should the 100% of the permanent portfolio be allocated across different types of accounts? in other words, can i have the stock and bond portions in an IRA while gold and cash are held in a taxable account, for example? i’m just curious as to the logistics of how this would work… thanks!
about 1 year ago
Mark,
You’ll want to shelter your bonds if you can. The general order of how to put assets in a tax shelter is this:
1) Bonds/Cash
2) Stocks
3) Gold
So put your bonds and cash in the tax deferred first. Then put your stocks. If you still have room you can put in some gold, but it’s also a good idea to keep some gold out of the shelter and under your more direct control if you can. Gold has a high collectible tax of 28% on gains when sold, but because it doesn’t generate interest or dividends it is not terrible to hold in taxable compared to the other assets. Stocks in a broad based index fund are also not terrible to hold in taxable. Bonds however are tax heavy and it’s best to avoid paying taxes on the income generated unless you are a retiree and are using that income for living expenses anyway.
You can spread the portfolio across accounts to take advantage of tax shelters and spread your risk among brokerages. Shelter the most expensive assets first (cash and bonds). You should also consider keeping some cash outside your retirement savings for emergency purposes so you don’t have to pay large penalties to access it if you need to.
If you have any serious tax questions it’s best to talk to an accountant or qualified tax attorney. Everyone’s situation is different and the advice I’m giving is general. I’m not a financial advisor and am just telling you how I would structure things based on my experience.
about 1 year ago
where it gets tricky for me is that my taxable account is money with a relatively short time horizon, like 5 years or so (i’ll need to withdraw a substantial sum for a down payment on a house). on the other hand, the 401k and IRAs will not be drawn from for another 30+ years until i retire, so i’m thinking that i might need separate asset allocations for each account.
i suppose i could set up the retirement account as follows:
33% cash
33% bonds
33% stocks
and keep an amount equal to that 33% in gold in a taxable account (or stored, whatever). this way i’d have the proper 4-way split, but the gold would be held outside the retirement account. does that seem sensible? the only question would be how best to maintain the remainder of the taxable account — money that would be withdrawn in the short term…
thanks again for all your suggestions!
about 1 year ago
Craig,
I’m in the same predicament as Mark. I currently have my long-term bonds (VUSTX) in a Vanguard Roth IRA; S&P 500 Index (FUSEX) in my Fidelty 401K; Gold in a GoldMoney taxable account.
I not sure where to leave the Cash proportion (VMPXX). Should I leave it in my Roth IRA or should I leave it in a taxable account to serve as an emergency/long term savings account? I would greatly appreciate your input on this matter.
Thanks
about 1 year ago
Mark,
It’s going to be hard for me to give specifics. If you know you’re going to need money in the next few years then you’ll have to keep some outside of your retirement accounts to avoid the taxes and IRS penalties of early withdrawal. I would be inclined in this case to make that money I’ll need in such a short period stored in the cash allocation and not in something more volatile like stocks, gold or bonds. Any one of those asset could swing up or down strongly in value and this isn’t a good thing for a down payment savings, etc.
Cash in a good treasury money market fund is the better vehicle for these needs. You’ll have to suck up some tax costs, but that’s the price of knowing that money will be at the value you expect when you need it in a few years. IMO. I’d hate to see you for instance having 100% of your down payment in gold outside the IRA and see the value dive by 50% in a couple years. While long term the portfolio is designed to operate with these swings and rebalancing, for short-term savings goals this could be a problem because your cash would be locked up in the IRA and you’d be forced to withdraw to make your down payment to make up for the gold losses.
Joel,
Again it’s hard to say as each person is different. I think it is a good idea to have some cash as a stable value asset outside of the retirement accounts for immediate emergency access or when you know you’ll need it for a relatively future obligation. However some others disagree about holding cash outside the accounts and simply say you can sell down some stocks or gold that you hold outside the IRA if you need the money. My only problem with that is what I told Mark about the volatility of these assets vs. the relative stability (but slow growing) cash allocation. Each strategy has plusses and minuses. The cash outside the IRA gives you a known quantity at your disposal “just in case”. The cash in the IRA and stocks/gold outside is more tax efficient but the value you think is there could be swinging up and down with the markets so if you do need to access it and the markets are doing poorly then you’re selling out at low prices potentially.
about 1 year ago
I keep a cash “buffer” to meet unforeseen needs, or planned, large purchases (like a house) outside of my perm. port. allocation. This way I have my assets allocated among the four asset classes, but the money I may need for immediate purposes is separate.
about 1 year ago
I’m trying to remember a couple of things from the book “Failsafe Investing.” I assume that if you are dollar cost averaging into a permanent portfolio, you’d buy the 4 pieces no matter what the cost?
I’ve got a purchase of TLT coming up and I’m tempted to delay it due to the big runup in long term bond prices.
about 1 year ago
Stephen,
Harry Browne would have advocated just sticking to the plan.
Nothing is certain in this world, but if your bet on the bonds turns out wrong and they plummet in price as yields rise then the gold allocation should make up the difference.
Yet, if you are especially nervous then remember rule #16 of his golden rules to “err on the side of safety”. In this case, you may want to consider parking your money in the treasury MMF and slowly moving it into the LT bonds. This is market timing to a degree so it’s not the #1 choice, but if you are really nervous it may be your best option.
Remember that the portfolio is always going to have one asset doing well and one or more doing poorly during most economic climates. So you’re always going to be faced with this question. Now bonds are expensive. Next year it could be gold. The next year it could be stocks. Etc. That’s just how it works and why Harry Browne would just have you get the purchase over with and not worry about it. If you don’t own all the assets then you don’t have all the protection of the portfolio.
Harry Browne discussed the importance of maintaining a balanced portfolio in many of his radio shows. This show addresses your concerns directly if I recall:
http://www.crawlingroad.com/finance/harrybrowne/radio/05-04-17.mp3
about 1 year ago
Actually, parking it in the MMF/T bills is a good idea. I don’t normally hesitate when doing dollar cost averaging but wow, 33% last year for long term treasuries?
about 1 year ago
I am thinking of switching from TLT to EDV for my bond allocation. I remember that Browne didn’t recommend STRIPS (maybe that was in a radio show). As I recall he thought that the interest payments were vital to the value of the bond holding. EDV however yields more than TLT right now, has a much longer duration, and even has a slightly lower expense ratio.
I am not done with my research yet. One question I have is where does the money from to pay the dividend since the fund holds only U.S. Treasury STRIPS? Has anyone researched this ETF for the PP?
Thanks for blogging on this important topic Craigr!
about 1 year ago
Much longer duration? Average for EDV is 24.5 years (or 24.3, dang, already forgot) and average for TLT is 25.2 years.
about 1 year ago
Don’t use zero coupon bonds. The duration is much too long (30 years vs. 15 or so for nominal bonds). You may be confusing duration with maturity which are two very different concepts.
Also for taxable investors there are significant tax implications with imputed income. In other words, you’ll pay taxes for phantom income from the zero coupon bonds that you haven’t received yet.
Harry Browne mentioned using zeroes in the portfolio early on but later backtracked on his advice once these and other problems came to light.
TLT is fine to use. EDV is not.
about 1 year ago
Thanks for addressing my question. According to etfconnect EDV has an average weighted maturity of 24.5 years and an average duration of 24.3 years. TLT has an average weighted maturity of 25.66 years and an average duration of 16.01 years.
I can hold EDV tax free if I decide to go that route. It seems like in a deflationary environment you would want the longest possible duration you could get no? I definitely approach any variations on Browne’s advice with caution but I do like to understand all of the logic behind his wisdom. Right now I don’t quite understand what the drawback to EDV would be for a tax free investor…
Regards,
about 1 year ago
The use of Zero Coupon Bonds (Zeros) in the Permanent Portfolio is discussed on this page by cdgoldin:
http://www.bogleheads.org/forum/viewtopic.php?p=187859&highlight=browne#187859
Here is an excerpt which he quotes Harry Browne:
He points out that “zeros provide extra power during periods of falling interest rates, but they provide no extra leverage when yields are steady! At such times, a zero will increase in price at a rate roughly equivalent to the interest you would have earned on Treasury bonds. So the smaller investment in Zeros will lag behind the return you would have obtained with a full budget for conventional T-bonds.”
He further states, “As we’ve seen, there’s no way to know how much volatility zeros will add to a bond investment. When interest rates fell in 1985, the gains in zeros were roughly twice those of conventional bonds of similar maturities. But the next time interest rates drop, zeros may show more — or less — leverage.”
Another distinct disadvantage to zeros is that the imputed coupon interest is taxable each year, even though it is not received. Thus, zeros are more appropriate as an IRA investment, where the income tax is deferred — but then you lose the advantage of capital gains treatment of profits.
After presenting a great deal of detail in regard to the actual vs. theoretical performance of T-bonds and zeros, he concludes, “I don’t think it’s a good idea to use zero coupon bonds for the Permanent Portfolio — except for a few investors in special circumstances. Zeros are attractive for someone whose wealth is so tied up in illiquid assets that only a small part is available for diversification and balance. Zeros are an imperfect substitute for Treasury bonds, but for such an investor they can help to achieve a degree of safety….The additional leverage of zeros might be useful for a Variable Portfolio speculation…”
about 12 months ago
Craig,
I finally finished reading Harry Browne’s Why The Best-Laid Investment Plans Usually Go Wrong. Great book (although lengthy) which provides further analysis of the Permanent Portfolio concept.
After reading this book, I’ve decided to construct my portfolio how it should’ve been. I tried to cut corners for convenience but I realized that I may be exposing myself to unnecessary risk. So I finally opened a TreasuryDirect account and purchased 30 year bonds instead of using VUSTX and I bought 1-oz American Gold Eagle Coins instead of using Goldmoney.com.
As of today, my portfolio looks like this: 25% in S&P 500 Index at Fidelity 401K; 25% in 30-Year Bonds at Treasury Direct; 25% in 1-oz American Gold Eagles that are held in my possession (no counter-party risk); and 25% between VMMXX (VMPXX is closed) in my Vanguard Roth IRA and 52-Week T-Bills at Treasury Direct. I wish Treasury Direct would allow IRA accounts which would make the portfolio even more tax-efficient. How does my portfolio look, your advice would be greatly appreciated.
In Why The Best-Laid Investment Plans Go Wrong, Harry Browne recommended aggressive growth stock mutual funds which would beat the S&P 500 index during periods of prosperity. Why did he change his philosophy on this matter? If anything, I think it makes more sense to be in a aggressive growth stock fund since its highly sensitive to economic conditions like 30 year t-bonds. Also, what gold bullion coins should I buy? Is it only limited to American Eagles since they are issued domestically like Treasury Bonds. I want to purchase Canadian Mapleleafs & Austrian Philharmonics but I’m not sure if these coins will negatively affect the portfolio like purchasing eurobonds will.
Thanks for all your help and keep up the good work.
Joel
about 11 months ago
craigr, Thanks for the great job you are doing. All my friends that I discuss the HB program with show concern at investing in LT bonds saying that rates can only skyrocket now and bond value will decrease. His tapes suggest just go into the program at any time regardless of what portion is doing good or bad. On a $100000. bond portion just what happens to the bond price on a 1, 2, 3, 4% up or down change on the interest? Are there other factors that will influence the bond price? I am getting very close to moving my cash into the HB program but having a problem pulling the trigger. Thanks for your reply.
about 11 months ago
Donald,
Bond duration shows you how they’ll move as interest rates move. Duration is different than maturing. For instance a 25-30 year bond will be around a 15 year duration for sake of argument. Each year in duration means the bond price will move the same percentage in price.
For instance on a duration of 15 years of a LT bond if the interest rates go DOWN 1% in the market then the price of the bond goes UP 15%. Pretty good eh? But if the interest rates go UP 1% then the bond price goes DOWN 15%!
Likewise on shorter term bonds they may have a duration of 6 months to 1-2 years. So the interest rates can adjust much less dramatically. A six month duration for instance means the prices will change only about a half percent or so plus or minus. And with most bond funds, if you hold it long enough the price will eventually recover so it’s hard to lose a lot of money in very short term Treasury bonds most of the time (although inflation can still eat away at you over the longer term).
So there is a lot of leverage involved in longer term bonds which is why you need a powerful inflation hedge like Gold which can offset any potential losses if rates go up quickly.
Other factors that influence the bond prices other than inflation may be a general flight to safety in bad markets. This was the hallmark of 2008 which saw not only deflationary threats emerge (which is great for LT bonds) but also people fleeing from anything with credit risk and buying Treasuries. This is why HB only advocated holding Treasury bonds. They are very safe compared to alternatives.
Re: Having a problem pulling the trigger.
I understand. Have you thought about just using the permanent portfolio for a part of your allocation and once you feel comfortable with how it’s working move the rest over? That way if you think you’re going to get into trouble you only committed, say 10 or 20% of your savings to the idea?
about 11 months ago
Thanks for the reply. Where can I find a graph of the LT interest rate changes going back many years. I have no idea of how large a swing can take place. According to your numbers above if the rate goes up 4% I could expect a $60000. loss????? on a $100000. bond allocation. Is that right???
about 11 months ago
It’s not quite that bad, but it can be dramatic if rates go up. Remember that the bond is still making payments to you, even if it is at a rate lower than the market rate. Also each year the maturity decreases and this lowers the volatility as well. These offset some of the impacts, but not all of them.
I found a calculator on the web that allows you to input various factors to see what would happen to bond values if rates go up or down:
http://www.hedge-hog.com/sub/applet/applet5.html
You can put in a face value of $1000, years to maturity of 25, your theoretical bond rate (the yield you bought the bond, say 4%) and then put in higher or lower current market rates to see what would happen.
But the main point is that if inflation drives market interest rates up dramatically (say to 7, 9, or 10+%) then yes LT bond prices will get hammered – badly. However a LT bond yield in the 10% range would mean inflation was quite bad and stocks are probably doing poorly as well. In that case you’re hoping that gold will be able to pull everything upwards.
I know this is scary stuff to think about, but I’d also say that Japan has had LT yields in the 2% range for the last decade at least and perhaps longer. So even if we think bond yields are as low as they can go, they can always go lower. The markets are not predictable!
about 7 months ago
Craigr,
Thanks for the great job you are doing. With respect to the PP bond allocation, can you address why you would hold US Treasury Bonds instead of GNMAs? As you know, GNMAs also eliminate credit risk. Yes, there is some pre-payment risk, but all things being equal they seem like a better long-term deal.
Keep up the good work.
about 7 months ago
Ralpert,
GNMA have pre-payment risk as you point out. If we get a long period of very low interest rates you may find performance of GNMAs affected as people refinance. US Treasury LT bonds do not have this call-like risk (some were callable once in the early 1980s but that was when interest rates were well over 10%). I’d stick to US Treasury LT bonds and not get fancy. You don’t want to introduce any type of risk into your bond allocation. There are many times in the market when the bonds are all you’ve got performing well and you don’t want anything that can jeopardize that safety when you need it most.
about 7 months ago
Hi Craig,
With Treasury MM funds closed it seems like the next best choice is to put your cash into a short term treasury fund so you at least don’t have credit risk. Since that lengthens the maturity of your bonds and thus increases their volatility would one dial back the LT treasury allocation by ~5% to compensate?
Thanks for all your work!
Kevin
about 7 months ago
Kevin,
It comes down to duration. Near term cash should be put into a Treasury MMF if you can do so (I understand the problems of this today). I also understand your desire to throttle back the LT bonds to compensate for the additional duration of the ST bonds. It’s a hard call because yes there is interest rate risk in the ST bonds, but not that much more than a typical Treasury MMF (duration of a MMF is perhaps six months and a ST Treasury fund is 1.5 years so you’re talking one year duration difference). What you give up with the lower LT bond allocation is performance if we continue to experience deflation in the markets. But since you’ll balance this out with cash held in ST Treasuries the impact may not be so bad as long as you are aware of why you are making this temporary move. However I’d try to get some cash in a Treasury MMF as soon as I could if it is for near-term living expenses.
about 7 months ago
Thanks Craig!
Vanguard ST Treasury avg. duration is 2 years, the other fund I am using (American Century) is 1.72. I have looked and looked for Treasury MM funds both at Schwab (where I am now) and at Vanguard (where I ultimately want to be) and everything is closed.
I am going to dial back the LT Treasuries to 20% for now and institute the full PP allocation the minute Treasury MM funds are open. I personally think a long term deflation scenario is highly possible and will be happy to have the full allocation to the long bonds.
Thanks again!
Kevin
about 7 months ago
Craig — any answers for Joel’s post of March 15? I have similar questions.
about 7 months ago
Brian,
For some reason I didn’t see his comment. Let me offer a quick answer:
Re: “In Why The Best-Laid Investment Plans Go Wrong, Harry Browne recommended aggressive growth stock mutual funds which would beat the S&P 500 index during periods of prosperity. Why did he change his philosophy on this matter?”
I can’t be sure, but I suspect he discovered that it’s very hard to beat the S&P 500 index with actively managed funds. The S&P 500 index (just like the Total Stock Market) moves in lockstep with the general market so you have the purest play for stocks you can get. Further, you run less chance of getting into trouble if an active fund manager makes a bad call and causes you to lag the markets during very good years.
Re: “If anything, I think it makes more sense to be in a aggressive growth stock fund since its highly sensitive to economic conditions like 30 year t-bonds.”
Some people have suggested using Small Cap Value in a play to own an “aggressive” stock fund. I’m not convinced of this because value stocks can lag the market for years before outperforming. But you may want to consider it as long as you’re using an index fund with low costs.
Re: “Also, what gold bullion coins should I buy? Is it only limited to American Eagles since they are issued domestically like Treasury Bonds. I want to purchase Canadian Mapleleafs & Austrian Philharmonics but I’m not sure if these coins will negatively affect the portfolio like purchasing eurobonds will.”
I think if you stick to American Eagles, Krugerrands or Maple Leafs you’ll be fine. When you get into the less circulated foreign coins you can have a problem with them being easily recognized. The benefit of the American Eagles is they are actually legal tender in the US. So while you wouldn’t want to spend them for the face value (the gold value is worth much more than the face value on the coins), they can be held in IRA, etc. for IRS purposes if you needed. They are also most easily recognized in the US.
about 5 months ago
Craig,
Talking about LT bond fund choice: do you think TLT could be replaced by Fidelity Spartan L/T Treasury Bond fund (FLBIX) for those with Fidelty? The ER is just 0.05% higher, but no need to pay buy/sell commissions.
Thanks
about 5 months ago
The FLBIX fund as a duration of 11.9 years vs. the duration of TLT of 15.27 years. So if rates go down by 1% the FLBIX fund will go up about 12% and the TLT fund will go up about 15%. So there is a loss of some volatility there for your bonds.
But if commissions are eating you alive then this fund looks like it could be OK to use. The Fidelity Spartan class generally have low costs and are index funds which is a good thing. The other option is to pool your money perhaps quarterly or a little longer in your cash allocation and do TLT purchases at a discount broker a few times a year or less. At around $10 a trade, you can use this method to control costs but not impact portfolio performance too badly.
about 1 month ago
Craig,
Great website. I’ve listened to all Harry Browne’s radio shows and read
two of his books. And after all that I still have a question about
bonds.
I’m getting ready to buy my 26+ year Treasuries through Vanguard, and
this is where I’m stuck. I have $20,000 that I’ll need to put into long
term Treasuries (its currently just sitting in a money market). Do I
make a bond ladder by buying from the secondary market? Such as getting 5 bonds that are 27 yrs old, 5 that are 28 yrs old, and 5 that are 29
yrs old from the secondary market. And then in early Feb when the new
30 year T-bond come available buy 5 of them. Or do I just wait till Feb
and get 20 of the new issue $1,000 30 yr T-bonds and save about $100
that it costs in commission fees to get the secondary market T-bonds.
Vanguard charges me a commission only on T-bonds through the secondary
market, not new issues.
Everywhere it says make a bond ladder, but it doesn’t address what you
do when first setting up your portfolio. If you buy a ladder from the
secondary market, do you try and pick the bonds with the highest rate of
return? Eventually a ladder will develop over the years as I buy more
bonds, that’s easy to grasp. But what is the benefit of buying T-bonds
through the secondary market when you are setting up the initial
portfolio. My understanding is that if the secondary market bonds have
a higher rate of return than the current 30 yr T-bond, then they will be
priced more expensive, thus negating the benefit of having the higher
rate. Or do I have this wrong. If this is so, then it would only make
sense to buy the new 30 year issues in the beginning regardless of how
much money you have to start your investment with, and as the years go
buy continue to buy new bonds thus naturally creating a bond ladder.
One other question. Once I have the bonds in my Vanguard account, is it
easy to tell then they’ve gone up in price, like when I should sell off
the excess to rebalance. And when I do rebalance (like was needed last
year when treasuries zoomed up), do I sell off the ones with the highest
prices or the ones closest to 20 yrs left. I’m pretty sure I can do
this thing myself rather than having to use the TLT fund. For crying
out loud, I made it through medical school, you’d think I could figure
this out:) Well, my wife says I can’t load the dishwasher correctly
either so I have to keep humble.
Now if you have any suggestions on how to talk to family members who
think I’m nuts for investing in gold when “Money Magazine” and George
Soros just came out and said that it’s in a bubble– that would be
helpful. But regarding the inability of most anyone to make financial
predictions, I recently came across another website that tracked the
Gurus and their predictions: http://cxoadvisory.com/gurus/
Thanks again,
Rob
about 1 month ago
Hi Rob,
You can do a bond ladder if you feel like it. Or you can just buy them all at once and not worry about it. The biggest issue really is to make sure you sell them when they reach 20 years and buy new long bonds in the 25-30 year range to replace them. Bonds that go too short in maturity will not have the power to protect the portfolio in a serious deflation.
If you buy bonds on the secondary market, the bond desk will normally list the highest yielding ones first. The bond market is incredibly efficient, and the Treasury market probably the most efficient of them all. So there really is no difference how you buy them. The prices/yields adjust to reflect the market’s best value at the time.
Vanguard is simple to use for holding bonds. You use the Vanguard bond desk, select the bonds you want (listed highest yield/best price first). You buy the bonds and the funds clear your account a few days later. After that the bonds will show up in the Vanguard Brokerage half of your account. Interest payments are automatically swept into a money market fund you select. Prices are adjusted continuously. If you have any questions or concerns you may want to call up the bond desk and talk to them as they can answer any question you have as well as place orders. Selling bonds is just as easy. Takes about a minute or so once you know what you want to sell. As for which to sell for rebalancing, I’d sell the ones that have long term capital gains first regardless of maturity date. After that, I’d probably rebalance the shorter maturity ones first.
Re: Gold
Yes I know about the gold prices. I really don’t comment on them except to say that yes I’m aware of the publicity and I encourage readers to keep the asset rebalanced. Prices could go up to $2000 or drop to $200. I really don’t know. I’d like to make a prediction, but history has shown that I’m no better at these things than anyone else. If you are especially nervous about this asset then you can make a pact with yourself that you will buy X$ of it a month for the next X months and be absolutely fanatically religious about it and not turn it into a market timing maneuver. Otherwise just buy the stuff whole hog and don’t worry about it because over time if you are still making contributions and rebalancing it will all kind of work out. If gold drops far in price, then it’s likely that that your stocks and/or LT bonds are doing OK so the losses will be significantly dampened or maybe even not exist.
P.S. Don’t listen to George Soros or any guru. Even if he is right on the gold price, you need to remember that he made a good part of his fortune through currency speculation and could be saying things to help out his own positions. In fact, this goes for any big name investor you read about and ulterior motives. Again, Soros may be right on gold but that is a separate issue. The main issue is that Soros will be saying things to help out Soros no matter what the topic.
That link you posted has it right. Gurus cannot predict the markets. Ignore them and maintain a balanced and diversified portfolio at all times. As a doctor, look at stock gurus the way you’d look at some psychic coming in and “healing” a patient just by waving hands over them.
about 2 weeks ago
Regarding George Soros and his statement that gold is in a bubble, please read this article from BBC news (there are many other sources) from 18 Feb 2010 entitled “George Soros Doubles Gold Investment” http://news.bbc.co.uk/2/hi/science/nature/8521680.stm
Key quotes:
“US billionaire George Soros has more than doubled his investment in gold, despite calling it the “ultimate bubble” just weeks ago.”
“At the World Economic Forum in Davos last month, he said: “The ultimate asset bubble is gold.” However, he did not say whether he was investing in the precious metal.
But he also said that when he sees a bubble, “I rush out and buy.”
Perhaps he was “talking his book” in hopes to get gold prices to move momentarily down at the moment he was in the market to buy?
Here’s another quote not to pay any attention to:
Feb. 4 (Bloomberg) — Betting on declines in U.S. Treasury bonds is a “no brainer,” said Nassim Nicholas Taleb, author of “The Black Swan.”
“Every single human being should have that trade,” Taleb said at a conference in Moscow.
–
Looks like a good time to buy Treasury Bonds!