A reader asked about why it’s recommended investors own their Long Term Treasury Bonds directly for the Permanent Portfolio allocation vs. using a mutual fund.

Two words: Manager Risk

This is the idea that the people managing your investments can make decisions that hurt performance out of bad luck or recklessness. Remember: Nobody cares more about your money than you do.

The bond allocation for the Permanent Portfolio says that 25% of your money should be in US Treasury Long Term Bonds. These bonds offer low credit risk as the US Government can always tax people to pay creditors or (worst case) print money to cover the payments. That makes them the safest type of bond US investors can own. They are much safer than corporate bonds and municipal bonds.

This matters because you can buy and hold Treasury Bonds directly and not have to worry about the risks other bonds pose. When you own Treasury Bonds directly your money is under your control and you know exactly how it is being used. Further, you save money as you aren’t paying a fund manager a fee to own such low risk bonds for you.

Now, let’s consider bond funds vs. owning bonds directly. Fund managers often have leeway in how money is deployed if you read the fund’s prospectus.  This is important for something like the Permanent Portfolio whose strategy relies on the investor to hold US Treasury Long Term Bonds with no credit risk at all times. You don’t want managers in your bond fund moving things around based on what they think the market will do. This can blow the protection of your bond allocation to pieces if they make a wrong call. You also don’t want them swapping out your ultra-safe Treasury Bonds with less safe securities in an attempt to boost returns. This can also get you into big trouble as we’ll explore below.

I’ve read fund prospectuses from various “Treasury” bond funds that were loaded with non-Treasury securities. For instance, the Vanguard Long Term Treasury Bond Fund will hold a minimum of 80% in US Treasury bonds and the remaining 20% can be government agency bonds, repurchase agreements , and even mortgages!

Here is what the fund says specifically:

The fund invests at least 80% of its assets in U.S. Treasury securities, which include bills, bonds, and notes issued by the U.S. Treasury. The fund is expected to maintain a dollar-weighted average maturity of 15 to 30 years.

  • The fund reserves the right to invest in repurchase agreements, contracts in which a bank or securities dealer sells government securities and agrees to repurchase them on a specific date and at a specific price.
  • The fund may invest in futures and options contracts, which are traditional types of derivatives, when they allow a transaction to be completed at a better price than by purchasing actual bonds. However, the market value of futures contracts will not constitute more than 20% of the fund’s assets.
  • The fund reserves the right to invest, to a limited extent, in collateralized mortgage obligations, which are moderately vulnerable to mortgage prepayment risk.
  • The fund may lend its investment securities to qualified institutional investors for the purpose of realizing additional income.

(emphasis added)

This fund is not 100% Treasuries at all as the name would imply. It’s at best 80% Treasury and you are relying on the managers of the fund to make good calls on the other 20% of the assets.

Personally, I get jittery when fund managers start doing cute things that differ significantly from the job I hired them to do. In my mind, the job of a Treasury Bond Fund should be to hold only Treasury Bonds. If I wanted to own mortgages I’d go out and buy a fund that owns them. I also am not interested in loaning out my bonds to realize additional income. If I wanted additional income I would have bought riskier bonds that paid more interest (realizing that I’m taking on more risk). Some of these other activities they are engaging in are vague enough to raise further questions as well in terms of risk.

But this is Vanguard – The premier index investing company. These bond managers can’t possibly make mistakes, right?

Well in 2002 the managers of the Vanguard Total Bond Market index fund had events go sour on them when WorldCom and Enron ran into problems (largest bankruptcies in US history at the time). The fund ended up lagging the index for that year and it should serve as a warning to those who believe that fund managers can’t make mistakes.

As stated in their 2002 Index Bond Funds Report Pg. 5:

At that time, our funds had larger stakes than their indexes in several subsectors. In particular, at a subsector level we had heavier weightings in bonds issued by telecommunications and energy-trading companies. These groups were hit extremely hard by the WorldCom bankruptcy, the Enron scandal, and accounting irregularities at a number of other companies.

(emphasis added)

All I can say is if mistakes like this can happen at Vanguard they can happen anywhere.

Yet, Vanguard is saintly compared to others. In 2008 there were bond funds that lost 30% or more in value when the credit crisis happened. Investors in these funds took large losses when they thought what they had were safe bonds. You just can’t read the name of a fund and assume what’s going on inside it. You have to read the fine print.

If you own your Treasury Bonds directly you need not worry about any of this. You are in control and aren’t going to take unnecessary risks. Are you going to purchase futures contracts instead of actual Treasury Bonds? No. Are you suddenly going to wager a portion of your money on higher yielding government agency bonds that are not guaranteed by the Full Faith and Credit of the US Government? No. Are you going to wake up one day to see that the US Treasury Bonds you owned are now collateralized mortgage obligations? No. You’re going to be holding 100% Treasury bonds in your own account and don’t have to worry if someone is doing something risky with your money.

If you can’t own bonds directly due to your own circumstances (such as a retirement plan that doesn’t allow it), or you just don’t feel comfortable managing them, then iShares Treasury Long Term Bond ETF (Ticker: TLT) is something to consider. This is a reasonable alternative to direct ownership (although it can never be as safe as direct ownership) and holds nearly 100% of their funds in Long Term US Treasury Bonds. Their prospectus gives them only a little leeway to go outside of this basic mission.

If you can’t get TLT then use the Vanguard Long Term Treasury Bond fund (Ticker: VUSTX). It’s better than most despite its warts (although I think Vanguard should adopt a strategy similar to iShares TLT and knock it off with this other stuff they are doing). Fidelity’s Spartan Long Term Treasury Bond Fund (Ticker: FLBIX) appears comparable to Vanguard and perhaps a little better as they try to stick to Treasury Bonds exclusively. After that, I recommend you do your own careful research before investing in any bond fund. The preference is, as always, to have a fund that only holds Treasury Bonds and is not shifting around maturities with active management. By the way, a fund with the word “Federal” in the name may not be Treasury Bonds either. It could be loaded up with government agency bonds which may or may not have the Full Faith and Credit guarantee of the US Treasury. These agency bonds are not the same as Treasury Bonds and shouldn’t be confused with them.

An exception: If you can’t buy Treasury bonds directly, can’t own them through a fund, or have objections to owning Treasury bonds on ethical grounds, then you probably should use a fund – A cheap long term corporate bond index fund. Why? Because non-Treasury bonds all have credit risk and you need to spread your money out as far as possible to prevent taking a serious loss on a concentrated bet if the company issuing the bond goes kaput. In this case, you should use an index fund with the lowest possible costs you can find. Look into the Vanguard products for a corporate bond fund that holds long term bonds. These types of funds hold bonds from many different companies to spread out the risk. This is not as good as owning Treasury bonds, but if that’s all you can do it’s better than not owning any bonds.

To close, own Treasury Bonds directly if you can. If you can’t, then try your best to find an inexpensive index fund that holds as much in long term Treasury Bonds as possible without too much monkey business going on behind the scenes. You may have to roll up your sleeves and read the dry prospectus, but it really will be well worth your time (and money) to know what your bond fund is doing under the covers.

Related posts:

  1. Permanent Portfolio 25% Bond Allocation FAQ