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.

There are many myths about investing. One of the most popular myths is that “Stocks always beat bonds.” Therefore, the thinking goes, investors should overweight stocks in their investment portfolio if they want to generate higher returns. 

Well, as Harry Browne would have said: “The best kept secret in the investing world: Almost nothing turns out as expected.”

When I was restructuring my investments several years ago and considering the Permanent Portfolio I did quite a bit of my own research. And you know what I found? Stocks in fact do not always beat bonds. Or, I should say, they don’t always beat bonds on your particular time table. 

Sure, perhaps if you look back 200 years you can make a case that stocks have a better chance of beating bonds. After all, there is more risk so theoretically there is more reward. But individual investors don’t have a 200 year time horizon. Most don’t have even a 50 year time horizon. For many people their investment horizon before they need that money for retirement purposes is more like 20 to 40 years. When you look at time slices of the market from this perspective it is clear that stocks can in fact lose to bonds in total returns.

Recently, researcher Robert Arnott looked back over the last 40 years and discovered that during this time (when you factor in 2008′s abysmal performance) that bonds in fact did beat stocks. He wrote about it in the article: Bonds: Why Bother?

Now I think he’s using some data mining to make his point, but it’s still something interesting to consider.

This image summarizes his findings that bonds have in fact beat stocks over extended periods of time in US history:

Can bonds beat stocks? Sure they can. Image Source: Index Universe

Other points Arnott found were:

• From 1803 to 1857, stocks floundered, giving the equity investor one-third of the wealth of the bond holder; by 1871, that shortfall was finally recovered. Oh, by the way, there was a bit of a war—or three—in between. Forget relative wealth if you owned Confederate States of America stocks or bonds. Most observers would be shocked to learn that there was ever a 68-year span with no excess return for stocks over bonds.
• Stocks continued their bumpy ride, delivering impressive returns for investors, over and above the returns available in bonds, from 1857 until 1929. This 72-year span was long enough to lull new generations of investors into wondering “why bother with bonds?” Which brings us to 1929.
• The crash of 1929–32 reminded us, once again, that stocks can hurt us, especially if our starting point involves dividend yields of less than 3 percent and P/E ratios north of 20x. It took 20 years for the stock market investor to loft past the bond investor again, and to achieve new relative-wealth peaks.
• Then again, between 1932 and 2000, we experienced another 68-year span in which stocks beat bonds reasonably relentlessly, and we were again persuaded that, for the long-term investor, stocks are the preferred low-risk investment. Indeed, stocks were seen as so very low risk that we tolerated a 1 percent yield on stocks, at a time when bond yields were 6 percent and even TIPS yields were north of 4 percent.
• From the peak in 2000 to year-end 2008, the equity investor lost nearly three-fourths of his or her wealth, relative to the investor in long Treasuries.

What Arnott re-confirms is that the reality of investing is this: Assets you think should outperform in a market may not do so for quite some time. He also stated:

In our asset allocation work for North American clients, we model the performance of 16 different asset classes. In September 2008, how many of these asset classes gave us a positive return? Zero. How often had that happened before in our entire available history? Never.

Isn’t it amazing how many things that are never supposed to happen in investing do happen more than anyone ever thought possible? That’s one of the things I loved about Harry Browne’s writing and investing philosophy: He never took the unexpected for granted.

How this relates to the Permanent Portfolio is simple: You should hold a portfolio of diversified assets and not try to predict what the future is going to bring. Inside this framework you need to be sure you rebalance your asset allocation periodically. This allows you to capture gains and buy out-of-favor assets before the masses in the market move in to run up the prices in a fit of euphoria or fear. 

With respect to the Permanent Portfolio, your bonds should only be US Treasury Long Term Bonds. They were selected for a reason (no credit risk and powerful returns under deflation) and proved their worth in 2008 saving the portfolio from suffering any serious loss. If you want to find out why you should only hold US Treasury Bonds in the portfolio (or any portfolio), please see the Bond FAQ. 

Just remember that myths such as “Stocks always beat bonds” may not be true when you need it to be. It may be that stocks are going to outperform bonds, cash and gold in the portfolio going forward. But then again they may not. The better strategy is to hold a balanced and diversified portfolio so you can profit no matter what the future brings.

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:

October 24, 2004 Radio Show

April 24, 2005 Radio Show

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?

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:

1. Open an account at Treasury Direct to make the purchase.
2. 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:

1. It only holds 100% US Treasury Long Term bonds.
2. 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:

1. They don’t own 100% US Treasury Bonds – Many mix in other government agency bonds, corporate bonds or repurchase agreements which is not acceptable.
2. 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.
3. They’re market timers – Many try to time the market and shift around bond maturities to increase performance (which fails).
4. 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?

1. The Permanent Portfolio owns Long Term bonds to protect against deflation, but also help somewhat during prosperity.
2. Credit risk, default risk and call risk should be avoided with your bonds – Bonds are for safety, not speculation.
3. The best bonds to own for deflation protection are US Government Long Term Treasury Bonds.
4. Do not purchase TIPS, Municipal bonds, high-grade corporate bonds or junk bonds.
5. You should purchase bonds with a maturity of 25-30 years.
6. You will hold the bonds until they have 20 years left of maturity and then sell them to buy new 25-30  year bonds.
7. Bonds can be purchased from the Treasury directly or through any broker for a nominal fee.
8. If you need or want to use a bond fund then use the iShares Treasury Long Term (Ticker: TLT) ETF.
9. Never use an actively traded bond fund if you want to own a fund. Only passive index funds are allowed.
10. 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

Economist Robert Higgs comments in the following piece about the prospect of inflation in 2009 and beyond:

The Fed versus the Banks: Who Will Blink First?

I have never been inclined toward touting doomsday financial scenarios. I raise the possibility now only because, as I consider the situation portrayed in the graph of excess reserves linked above, I am unable to foresee how the Fed and the Treasury can navigate through these treacherous waters – waters that their own previous actions have whipped to a foam – without creating terrible financial and economic harm. If the dollar survives the ministrations of Bernanke, Paulson, Bush, and the Obama gang, its survival will be something of a miracle.

Earlier in 2008 inflation fears were the bogeyman. Oil was at $150 a barrel (it’s now $40). Gold hit $1000 an ounce (it’s now in the $800′s). And the Dollar was at record lows against the Euro and other world currencies (it recovered greatly). The markets were sure that inflation was coming on strong. 

Ahhh, but Fall 2008 came and so did the popping of the Real Estate bubble. This caused a massive destruction of paper wealth that rippled through the financial markets taking out many large banks. By December, Long Term bonds (a powerful deflation shield) swapped places with gold, commodities and other inflation hedges for being the winning asset of the year. The US Dollar shot up in value at a rate never seen against the Euro. Deflation was on everyone’s mind and Long Term bonds proved their mettle as they powered ahead with 30-40% gains. This boost erased almost all market losses in the Permanent Portfolio strategy during the October/November stock crash.

Who would have thought that we’d start 2008 with the prospect of inflation only to end the year with our illustrious central bankers scrambling to prevent an all out deflation? The markets are like that though. Moody. Random. Unpredictable. 

But what should we do now?

Stick to the plan.

If you follow the Permanent Portfolio strategy you’ve probably done OK so far considering how bad the markets are. Perhaps you’re down only a couple percent compared to the 40% loss in the general markets. You dodged a bullet and may be feeling pretty good, but don’t get complacent!

During this time as stocks swooned your Long Term bonds have soared. You are probably finding that your bond allocation is now at or above your rebalancing bands in the portfolio. They could likely be 30, 35 or even 40% of your allocation. Yet, your stocks may have fallen by 40% and could be only 15% or so of your portfolio.

That’s not good. It’s now time to rebalance. 

If you are overweight on your bonds in the portfolio (e.g. they exceed 30-35% of your holdings), you should consider selling them down to 25% and using the proceeds to bulk up the other parts of your portfolio that are below the 25% allocation band (such as your stocks, cash and gold).

For those thinking their bonds have done great and don’t intend to rebalance, all I can say is be careful. It’s tough to sell a winning asset, but at any time your bond gains could be eroded as interest rates whipsaw upwards. If economist Higgs is right, the inflation we see could be quite bad. Instead of 30-40% profits in your bonds, you could be staring at 30-40% losses or worse. 

By not rebalancing, you may miss out on large gains in your other assets by having too much of your money tied up in your current winners. Imagine missing out on a 20%, 30% or higher gain next year in stocks if the markets recover and things work out. 

YES, I know that sounds impossible right now. But it’s happened before and YES it usually does it after a bad market crash.

Gains like I just mentioned happened after the early 1970′s recession (1975 +37%, 1976 +24%), after the recession in the early 1980′s (1982 +21%, 1983 +22%), after the early 1990′s recession (1991 +31%), after the early 2000′s Internet bust (2003 +29%) and they even happened during the 1930′s Great Depression (1933 +54%, 1935 +47%, 1936 +34%, 1938 +31%).

Virtually nobody during these years was predicting a big bull market would happen right in the middle of those bad economies. Yet, they did. If you find your stocks are up +40% next year that’s great. You’ll be selling off those profits to buy your new losers. That’s the essence of rebalancing. Same for any gains in your gold or even more gains in your bonds. If the markets turn against this year’s winner at least you’ll know you took those profits off the table and put them somewhere more productive before they had a chance to vanish. 

This is not a prediction (I don’t do predictions). Just a reminder that the markets do crazy and unpredictable things so you need to own all of the Permanent Portfolio assets and not try to guess what may happen. Be unemotional about rebalancing out of winners to buy your losers. 

One final note is that taxable investors may want to take the time to do a tax loss harvest on stock funds that are underwater before the end of the year. You can use these losses to offset their taxable gains going forward. If you don’t have any losses to take, it may make sense to wait until 2009 to take the Long Term bond gains to defer the taxes until next year. Talk to your accountant to see what option makes sense. Investors in tax-deferred retirement plans don’t need to worry about this. 

Let’s get to the meat of any investment strategy: How well does it actually work?

In a prior post we talked about the Permanent Portfolio allocation which is:

25% – Stocks (in a broad based stock index fund like the S&P 500)
25% – Long Term Treasury Bonds
25% – Gold Bullion
25% – Cash (in a Treasury Money Market Fund)

This allocation will provide protection when the economy shifts through the cycles of prosperity, inflation, deflation and recession.

Now, some may be thinking that this allocation sounds very different than what they’ve seen elsewhere. For instance, the idea of owning gold is scoffed at by some investment advisors because it has no dividends or interest. Long Term Bonds? Many will tell you that they’re too risky due to rising interest rates. How about Cash? Isn’t holding a bunch of cash missing out on the hot stock market action? And, only 25% in stocks? Well everyone knows that stocks always beat every other investment so surely you want more than 25%, right? Right!?

Not exactly.

The reality is the investment markets are uncertain and unpredictable. What may look good in a theoretical backtest may blow up horribly as economic conditions change. Even worse, portfolio strategies that should work well based history often don’t work in actual application as people abandon them due to volatility and long periods of underperformance. Finally, every reputable study on the subject has shown that relying on your gut instinct, hunches, investment gurus and hot tips to run a portfolio is a road to disaster for performance and safety.

The Permanent Portfolio strategy works because it has very wide and true diversification. You have exposure to assets that can grow your money safely at all times without having to predict the future. You also have protection in the diversification against losing large amounts of money which can cause you to abandon the strategy in bad markets.

A Couple Small Changes

I did make two small changes to the original Permanent Portfolio as investment vehicles have changed in type and availability over the years. Harry Browne recommended using the Treasury Money Market Fund for cash. I personally like using Short Term Treasuries in combination with a Treasury Money Market Fund which provides nearly identical risks but slightly better returns on your cash. Also, instead of using the S&P 500 Index, I’ve chosen to use the Total Stock Market Index(also called the Russell 3000, or Wilshire 5000 index). The Total Stock Market Index provides wider stock diversification (holds 3-7000 stocks) with slightly better results than the S&P 500 (which holds 500 stocks). The slightly better result is because the Total Stock Market also holds small and medium sized company stocks which can sometimes outperform the large company stocks of the S&P 500 alone. The Total Stock Market also has expected higher tax efficiency due to how the index is constructed and managed.

You can use my changes or not. It doesn’t matter much. If you stick to the S&P 500 and Treasury Money Market Fund as originally recommended the results are within about 0.50% (one half percent) annually (favoring short-term bonds and total stock market) through the years.

Historical Returns

Let’s look at the score card and see how the Permanent Portfolio Allocation has done the past 36 years from 1972-2008 (1972 is the furthest we have data for Gold which was taken off the fixed exchange rate in 1971).

The assumption in this table is we rebalance each year to get back to our 25% allocation split among all four asset classes. In the table below I’ve highlighted in Red the asset that did the worst in a particular year and Green for the asset that did the best. Note that “worst” does not mean the asset was necessarily negative, just that it was the lowest performer for that particular year. In the average column I highlighted in Orange any year with a loss for the portfolio.

Data pulled from the Simba Spreadsheet on the Diehards Forum. Gold returns pulled from: http://www.finfacts.ie/Private/curency/goldmarketprice.htm. NOTE: Gold prices were largely fixed before 1971 and tied to the dollar. So the prices of gold did not move according to market fluctuations much before 1971. 2008 values pulled directly from market indicators. LT Treasuries for 2008 reflects owning 25-30 year treasuries directly and not the market index 20 year benchmark (which the portfolio is not designed to use).

Results

The Compound Annual Growth Rate (CAGR) is 9.7% for the entire period.

The worse loss for the portfolio in any one year was 1981 which had you down only about 4%. The market problems through the decades were barely registered in the final return each year. This means the portfolio was able to provide these solid and stable returns with very low volatility and risk.

You’re probably wondering how this portfolio compares to other strategies. The Permanent Portfolio was able to rack up the following returns against these competitors if you invested $10,000 back in 1972:

Now, some might be thinking: “Hey, gold was price controlled before 1971 so it’s not fair using 1972 as the start because the price of gold shot up. It made it look better than it really was!” (OK, maybe you weren’t thinking that, but I was because it’s true and we need to consider its impact). We’ll start a couple years out in 1974 then, enough time that the gold market would have settled out:

The Permanent Portfolio allocation is always competitive with the 100% stock allocation and the 50/50 bond allocation. Anything within +-0.50% of each other is essentially market noise that can easily flip back and forth each year.

The most important part is the Permanent Portfolio never had wild gut wrenching swings in value. In 1973-1974 stocks lost 50% in value. In 1987, stocks dropped 25% in one day. During the 2000-2002 Internet bubble crash, stocks dove about 40% over two years and the NASDAQ dove 80%! In 2008 stocks were down about 40% for the year.

Yet given all the above the Permanent Portfolio was able to produce positive returns during these very bad markets. Most recently in 2008 we had the worst single year market crash since 1931 and the portfolio still squeezed out a 2% profit for the year. The Permanent Portfolio allowed you to avoid all those disasters but gave you performance on par with the far riskier 100% stock allocation.

Even better, the Permanent Portfolio was able to provide real after-inflation returns during some times when the stocks and bonds couldn’t (such as the decade of the 1970′s). This means that even though inflation may have been killing your stocks and bond returns (by giving you negative real growth even though they went up in value), the Permanent Portfolio was able to go above and beyond by several percentage points to give real results that weren’t being eroded by a falling dollar.

Take a look at the returns table above and notice how you’ll always have one asset class doing very well and one doing flat or badly. Isn’t that counter-intuitive that you should be able to profit from that type of movement? Nope. It’s diversification in action. The way the Permanent Portfolio uses its assets to diversify according to economic conditions is what makes it work so well.

We’ll talk more about this in the future.

Harry Browne and Terry Coxon formally introduced the Permanent Portfolio in their 1981 book entitled: Inflation Proofing Your Investments. Like most great ideas, the Permanent Portfolio was simple, but was not simplistic.

The Permanent Portfolio investment strategy is the first one I’ve seen that developed an allocation based on economic cycle analysis. The Permanent Portfolio idea separated these economic cycles into four basic categories:

1. Prosperity
2. Inflation
3. Deflation
4. Recession

At any one time the economy will be in one of these phases or transitioning from one phase to another. This is the secret of the strategy and why it works. The strategy does not attempt to predict when these things happen or guess how long they may last. Instead, it holds specifically chosen asset classes that respond well to these cycles no matter when they happen or for how long. 

By 1987, Harry Browne took the more complicated asset allocation presented in his and Coxon’s first book above and refined it to make it easier to implement. This version of the allocation was presented in his book Why The Best Laid Investment Plans Usually Go Wrong (Find a used copy if you can. Like all of Browne’s books, it’s a must read.). The allocation remained the same in all his investing books that followed. Here it is (Preferred investment vehicle in parentheses):

• 25% – Stocks (S&P 500 Stock Index Fund)
• 25% – Long Term Bonds (US Treasury 30 Year Bonds)
• 25% – Gold (Physical Gold Bullion)
• 25% – Cash (Treasury Money Market Fund)

These assets are always present in the portfolio in a balanced way no matter what is going on in the economy. Why were these assets chosen? Because they respond to the four economic cycles listed above:

• Stocks – During prosperity, stock Index funds capture the full market returns available.
• Long Term Bonds – During times of deflation, US Treasury long term bond prices will go up quickly in value. Bonds also do reasonably well during prosperity. 
• Gold – During bad inflation, gold bullion is the only asset that provides strong protection against a falling currency. 
• Cash – During a recession, no particular asset class is going to do well. The cash in a Treasury Money Market Fund acts as a buffer for losses while the markets adjust during these relatively short times of underperformance. It also does well during deflation. 

Remarkably, these four asset classes are all you need to handle good and bad markets. Again, it’s simple but not simplistic. 

Even better, this allocation provides safe growth of your money. This means you won’t have to worry about the crazy swings in the stock market that may cause large losses of your life savings.

In fact, over the 30+ year history of this portfolio strategy the worst loss it ever had was about 4-6% in 1981 with an annual growth of 9-10% since 1972. The portfolio has prospered and protected its money through bear and bull markets alike. 

What this means is the Permanent Portfolio strategy will move along through the years providing stable and secure growth. 

How stable and secure? We’ll talk about that in my next post. But I feel if you combine the Permanent Portfolio with the 16 Golden Rules of Financial Safety you will have a very solid investing foundation that will get you to your ultimate destination in one piece. 

In the meantime, if you haven’t purchased a copy of Fail-Safe Investing you should really consider doing so. This book explains the method to the strategy in a very easy to read and understand form. My postings here will clarify some common questions, provide you with insight into ways to implement the ideas, and delve deeper into the economic mechanisms that make the portfolio work. 

Harry Browne also discussed the Permanent Portfolio Allocation in this radio show link.

Fail-Safe Investing