What's the actual rationale for investing in long term bonds?

[ArthurPooh]

I have read both the Permanent Portfolio book by the forum creators and Fail-Safe Investing by Harry Browne. I have also devoured a gazillion threads on PP and GB at several different forums. I sometimes feel that I finally understand how the LTTs are supposed to work, but then I try to explain to my fiancee why we should buy them and pure gibberish comes out of my mouth.

I know that a portfolio is not about the individual assets in isolation, but how they work together. Yet I cannot fail to notice that the other three assets of the PP do have a rationale of their own.

Stocks are correlated to prosperity and productivity and they produce the largest returns in peaceful historical periods. The argument for an all-stock portfolio has been made frequently and exhaustively elsewhere, to the point I can assume everyone will be familiar with it.

Cash provides nominal stability and a predictable return that hopefully compensates for inflation. The vast majority of people who hold any savings at all have an all-cash portfolio.

Gold is more or less a hedge against fiat currencies and trust-based assets in general, and against empire-backed US dollar in particular. What justifies the monetary value of gold is a cyclical view of history which suffers no thousand year Reichs and instead sees all political systems as inherently in flux; they rise, peak, and then they inevitably fall. If you believe the fall of the US-led global order will happen within your lifetime, or have an extremely long investing horizon, an all-gold portfolio makes a lot of sense. I believe Libertarian666 has had nearly such a portfolio.

What is, however, the isolated rationale for LTTs, or indeed for any longer term nominal bonds? High inflation will crush them. Rising interest rates will crush them. In the best case scenario (inflation is low, rates stay low) they will just provide a paltry return. For them to make any real gains interest rates would have to fall into serious negative territory, and in my opinion that would require such serious economic repression (limits on physical cash, capital controls to prevent outflows to other currencies and gold) as to threaten the currency itself (especially the global reserve currency). And if sustained deflation does happen, cash will also benefit from it, no? Is there a single person recommending an all-nominal bond portfolio?

I'm sure there's a sophisticated explanation for all of this. But it just bugs me to no end that I could easily explain the other assets to some homeless alcoholic with an IQ of 91, but the bond part requires breaking out the convexity and yields and Fed policy and other complicated counterintuitive stuff. I'm seriously tempted to just forget about it and invest in a way I can actually understand.

[Hal]

Good Morning ArthurPooh,

Maybe look at the issue from a different perspective. This is how I explained the PP to my late mother.

1. We put your money into 1/2 savings and 1/2 investments.

2. The savings are in 50% Gold, 50% Cash, just in case the AUD loses value

3. The investments are in 50% Shares, 50% Bonds. I don't know if either shares or bonds are overvalued, so we go just 1/2 each.

Since she lived through the Great Depression she was very risk averse. For further evidence I had Benjamins Grahams "Intelligent Investor" book. (although the book was way over her level of understanding) Here are some relevant passages. Perhaps look upon the PP from Grahams "Value" perspective?

[Smith1776]

I see what you mean. For me the big challenge with the canonical PP is the idea of investing in LTTs regardless of what rates are. The lower rates are, the more the risk-reward relationship skews towards risk rather than return (return free risk).

I ended up settling on a global government bond ladder that has an intermediate duration as my perpetual holding. I'm getting exposure to all parts of the yield curve simultaneously, and it removes my own personal trepidations about the long end of the curve, regardless of where rates might go.

[seajay]

Spot the difference between 10 year Treasury and a 50/50 STT/LTT barbell

https://www.portfoliovisualizer.com/bac ... xL88ujgb6z

Near-as ... the same.

As might a ladder of 1, 2, 3 ... 19, 20 year bonds similarly compare.

A conservative 33/67 stock/bond portfolio ... 75% weighted, along with 25% gold as a portfolio hedge, can yield modest/OK rewards, with minimal risk. if you're drawing 4% SWR, and see a relatively consistent 4% real portfolio growth rate, then after 25 years you would both have eaten your cake ... and still have it.

Bear in mind that Harry devised the PP with a alternative to T-Bills type 'security/safety' upmost in mind. Also keep in mind that at times when some said long dated treasury yields couldn't decline (prices rise) even further, is in years when some of the largest price gains occurred. Lower yields and smaller changes in yield drive larger price changes. Attempting to time the yield curve more often proves to have been wrong. That said some do roll the yield curve, buy/rotate into the bond that's near the peak of the steepest part of the yield curve, as all else being unchanged that is the bond that is the more inclined to yield the greatest return. Yet others opt for a broader set of bonds, total bond fund. Others opt to scale up the stock volatility given relatively low exposure, or hold less of more volatile stocks and more bonds. The Larry Portfolio is something like 15% small cap value stock, 15% emerging markets stock (which somewhat includes gold/foreign currency type elements), 70% TIPS. As to which of those alternatives is the better/worse is mostly down to luck, unpredictable, but tend to broadly compare overall.

https://www.portfoliovisualizer.com/bac ... ocJge5YrLL

Personally I dislike bonds and cash deposits, as both are lending to others often for low rates of return, and where the borrower gets to define the rules/conditions. Prefer more in-hand (land (house)/gold) combined with around a third in stocks. Whichever choice is the more comfortable is the one that is less inclined to be rotated out of following a period of relatively poor performance to chase 'better' alternatives - a common buy-high/sell-low investor portfolio management failure.

[boglerdude]

https://www.morningstar.com/etfs/arcx/edv/chart

LTTs are for when stocks crash. Yes, the purchasing power of cash and gold might go up too. LTTs might need a caveat since the PP was invented. You should be prepared to rebalance when rates fall dramatically and might not want to hold them at all when rates are under 2.5%

[barrett]

I decided back in about 2017 not to hold long bonds because they tend to do great for a short period of time and then give up their gains quickly. See the data here:

https://fred.stlouisfed.org/series/DGS30

Plug in an earlier start date so that you can see their performance in late 2008 and early 2009. When the PP book was written, the first part of that short timeframe was highlighted as justification for holding LTTs because for about six weeks they went on a tear that pretty much offset the GFC stock crash. But those gains were all lost in six months or so.

LTTs can't go on a multi-year rally unless we are starting from a very high yield (try plugging in 09-01-1981 as a start date). In that way they are different from stocks and gold that can both carry a portfolio for years.

Harry Browne was a big advocate of holding long bonds no matter what rates were, but one of his 16 rules was to not invest in anything that you don't fully understand.

I see LTTs as great for trading, not as an investment, but one has to have a working crystal ball for that to work out well. In the short term they can definitely smooth out volatility, but knowing when to get out is really tough to call. March of 2020 was another classic case of LTTs coming to the rescue for a short period of time. There was a day in early March (3/6/20 maybe?) when the 30-year rate dipped well below 1%. But that was so short lived that it doesn't even show up in the link I provided above.

Our "bonds" are split between STTs, I-Bonds & TIPS (five-year ladder only) and do comprise almost 50% of our AA. But that's just what I am comfortable with.

Anyway, just my two cents worth.

[ArthurPooh]

Good Morning ArthurPooh,

Maybe look at the issue from a different perspective. This is how I explained the PP to my late mother.

1. We put your money into 1/2 savings and 1/2 investments.

2. The savings are in 50% Gold, 50% Cash, just in case the AUD loses value.

3. The investments are in 50% Shares, 50% Bonds. I don't know if either shares or bonds are overvalued, so we go just 1/2 each.

Good evening Hal,

I find your points 1 and 2 a very good, concise explanation. This "half saving, half investment" concept was what attracted me to the PP in the first place. I struggle with the notion of not knowing if bonds are overvalued. Isn't value in the eye of the beholder? For me, the current yields plus a small chance of them momentarily spiking in price (contingent on rebalancing at exactly right time) are not sufficient compensation for committing to a single currency (even a super-hard one like the Swiss franc) for decades.

I think I should read Mr Grahams book. Based on the passages quoted, a 50% stock, 50% cash and gold portfolio seems perfectly reasonable and also in line with your formula of "1/2 savings, 1/2 investments" (however, unlike you, he seems to place bonds more in the "savings" component). Maybe some Tyler-style tilt in the stock part is advisable if someone is concerned about US stocks and especially the tech white elephants unicorns being overvalued.

And as to gain in principal value, at the current interest rates it seems like more of a gamble than a hedge. Basically one needs to bet on an unlikely and short-lived price increase. Isn't it more like speculation, trading, market timing, and all the other stuff that belong in the VP? I feel I might be buying Bitcoin at this point.

[ArthurPooh]

I see what you mean. For me the big challenge with the canonical PP is the idea of investing in LTTs regardless of what rates are. The lower rates are, the more the risk-reward relationship skews towards risk rather than return (return free risk).

I ended up settling on a global government bond ladder that has an intermediate duration as my perpetual holding. I'm getting exposure to all parts of the yield curve simultaneously, and it removes my own personal trepidations about the long end of the curve, regardless of where rates might go.

There is an argument that the PP's (and GB's) successful performance relies on the decades long trend of falling interest rates. I wonder if HB has ever imagined such a bizarre thing as negative nominal rates.

As an aside: aren't you concerned about the credit risk of the EUR-denominated bonds?

[ArthurPooh]

Also keep in mind that at times when some said long dated treasury yields couldn't decline (prices rise) even further, is in years when some of the largest price gains occurred. Lower yields and smaller changes in yield drive larger price changes. Attempting to time the yield curve more often proves to have been wrong.

Is a sentiment of "I'm not going to buy any bonds until they offer a sufficient return" a type of market timing? It's not that I think yields on long bonds are bound to rise in the coming years, or ever (although as I expressed I cannot imagine them going permanently and meaningfully negative without wider economic repercussions). I just don't find them an attractive investment right now.

[ArthurPooh]

barrett, boglerdude - thank you for your contributions, I don't have any further answers right now, but these were thought-provoking.

[Hal]

I think I should read Mr Grahams book. Based on the passages quoted, a 50% stock, 50% cash and gold portfolio seems perfectly reasonable and also in line with your formula of "1/2 savings, 1/2 investments" (However, unlike you, he seems to place bonds more in the "savings" component) Maybe some Tyler-style tilt in the stock part is advisable if someone is concerned about US stocks and especially the tech white elephants unicorns being overvalued.

This should get you started => https://ia801205.us.archive.org/1/items ... vestor.pdf
As he wrote it 50+ years ago, I guess it's out of copyright.

Note that he does allow varying from the 50/50 Shares/Bond ratio "if" you are willing to do a proper analysis. ( I wasn't )
If you are interested in an in-depth investment book, you won't be disappointed.

[Smith1776]

I see what you mean. For me the big challenge with the canonical PP is the idea of investing in LTTs regardless of what rates are. The lower rates are, the more the risk-reward relationship skews towards risk rather than return (return free risk).

I ended up settling on a global government bond ladder that has an intermediate duration as my perpetual holding. I'm getting exposure to all parts of the yield curve simultaneously, and it removes my own personal trepidations about the long end of the curve, regardless of where rates might go.

There is an argument that the PP's (and GB's) successful performance relies on the decades long trend of falling interest rates. I wonder if HB has ever imagined such a bizarre thing as negative nominal rates.

As an aside: aren't you concerned about the credit risk of the EUR-denominated bonds?

For sure, but not enough to lose sleep about it. Just for discussion's sake, this is the geographic breakdown of the government bonds in my chosen bond fund.

bonds.png (110.88 KiB) Viewed 852 times

[dualstow]

Good Morning ArthurPooh,

Maybe look at the issue from a different perspective. This is how I explained the PP to my late mother.

1. We put your money into 1/2 savings and 1/2 investments.

2. The savings are in 50% Gold, 50% Cash, just in case the AUD loses value

3. The investments are in 50% Shares, 50% Bonds. I don't know if either shares or bonds are overvalued, so we go just 1/2 each.
….

I love this, Hal!

[Smith1776]

Who on the forum has actually had the fortitude to stick with the canonical PP's allocation to long-term bonds? Just curious.

[snedgar]

I am cannonical GB.

[425]

Who on the forum has actually had the fortitude to stick with the canonical PP's allocation to long-term bonds? Just curious.

I have stuck to the 25% long term bonds.

At first it appears that having exposure to 10 to 15 year duration US treasuries is a sure way to lose purchasing power in a system where the expectation is that the debasement rate is higher than the yield on these bonds. This is why the longer your time horizon, the more deflation is less probable and hence seemingly not worth the 25% allocation.

In the short term, it seems that despite constant currency debasement, we still go through periods of disinflation/deflation where exposure to US treasuries continue to be useful in a portfolio as a way to reduce short term nominal volatility and drawdowns. It is the inability to reliably time when you need this exposure which is why a constant allocation means you're always prepared.

I would consider the debasement a kind of tax on your total purchasing power while it is also likely that despite paying that tax your standard of living continues to improve since the inflation on consumption is likely low and your wealth in nominal terms is probably growing faster than the cost of consumption.

Personally I choose a liability matching approach where current expenses are covered by 0 - 12 months of cash equivalents, 1 - 5 years of a fixed income ladder, then the bulk portfolio in the PP where the time horizon is 5 - 15 years with an average duration of 10 years and every 5 years the PP will be drawn down equally to purchase a new 5 year fixed income ladder so you can calculate how large your portfolio needs to be.

Any excess capital which has a time horizon beyond 15 years can be allocated to anything you feel in the long run to not be debased. The options are stocks, real estate, bitcoin, gold, long term debt. If we take bitcoin for example, and you believe it can 10x in 15 years and in 15 years your PP also is debased by about 300%, then if you had 30% of your PP portfolio in excess that you can hold BTC long term then you have a strategy for hedging debasement. Traditional methods include a 30 year fixed rate mortgage so you get a levered return on real estate which would be a better debasement hedge than unlevered equities.

In summary, it's been mentioned that hopefully no one invests in the PP to get rich. We all know it's meant to offset some of the debasement of purchasing power. It achieves this by being simple enough and having low enough volatility and drawdown for many to be able to stick to (again easier said than done but I believe easier than most choices). As long as you know that the PP is not the choice to get ahead of debasement then I think it frees up your time and energy to focus on those things that will get you ahead.