Don't Understand LT Bond Returns

[EdwardjK]

I understand three out of four components of the POermanent Portfolio.

25% in money market/ST bonds (1-3 years) - some risk with the ST bonds but I get interest on the money market and bond coupons.

25% in equities - market goes up/down.  Got it.

25% in gold - Too much of a hassle of buying the physical gold so I buy into a fund.  Fund value driven by market price of gold less expenses.  Easy.

But I do not understand how I get the reported returns on LT bonds.

If I buy the actual bond at par and hold until maturity, I earn the coupon rate of return.  The change in bond value, driven by a chnage in interest rates, does not impact me since I do not sell it.

So how do I earn the LT bond returns reported elsewhere in this forum? 

It would appear that I would have to buy LT binds through a fund.  But if I do so then I am subjecting myself to the volitlity associated with changing interest rates.  Sure, I could earn more than the underlying coupon rates, but I could lose value as well.

And if I buy the bond itself, my return is limited to the coupon rate, which has been very low over the past many years.

Am I understanding this correctly?

Thanks.

[moda0306]

You don't hold the bond for 30 years.  Long-duration bonds' price on the secondary market are very sensitive to interest rates... so, if you bought a 30 year bond in 2007 at 4.7% or so, and then in December of 2008 the same type of bond was offering 2.8%, you can sell yours on the open market for far higher than what you paid for it, because it's a contract to pay that higher interest rate for a much longer period, and therefore has a larger swing in fair market value when competing bonds offer lower rates.

Does that make sense?

[EdwardjK]

That makes sense assuming I can sell my high interest rate bond at a premium compared to the future interest payments of the lower term bond.  Otherwise I am just trading one cash flow for another of equal value.

But why would I want to sell a bond that has a higher rate of return than what I currently have?

Thanks.

[moda0306]

You wouldn't necessarily sell it.  Like all the assets in the PP, you'd wait until it's up to 35% or more of the portfolio.  At that point, you're basically saying "I've ridden this ride too far, and now I'm going to use my gains to buy into some cheap stocks."

The thing is, you need the sharp movements in LT bond prices (HAS to be treasury bonds... not corporate) to offset some of the worst historical years of the stock market so you CAN rebalance and use bond gains to buy into cheap stocks (and keep your portfolio from having huge drawdowns and letting you sleep at night).

[moda0306]

Somewhere Craig has a graph showing all the other classes of bonds and how they performed during the 2008 panic, and it's amazing to see.  Everything from TIPS, to st corporate bonds to tax-free municipals had ok to horrible performance in 2008.  LT treasuries went through the roof as the US was deemed a "lender of last resort," and they could borrow money for 30 years at 2.7% or so.

This is the action you need to make the PP machine work.  If you look at history, gold & LT treasuries, as a scary couple, have done amazingly in calendar years where the stock market has dropped 10% or more.  This has often resulted in smooth returns and great rebalancing (buy low/sell high) opportunities, and is why the PP has returned about as well as stocks have in the past 38 years.

[Roy]

Somewhere Craig has a graph showing all the other classes of bonds and how they performed during the 2008 panic, and it's amazing to see.  Everything from TIPS, to st corporate bonds to tax-free municipals had ok to horrible performance in 2008.  LT treasuries went through the roof as the US was deemed a "lender of last resort," and they could borrow money for 30 years at 2.7% or so.

ST Treasuries returned well too, given their low risk (VFISX, for example);  that is where flights to quality land (and MM).  Unlike ST Corporates, they don't have puts and calls and default risk.  Sometimes those risks show up, and often when stability is most needed.  TIPS have liquidity risk, and despite a negative correlation to equities, that risk showed up too.  The fact that these securities rebounded well in the great bull market that followed, provides little comfort to those who needed the stability in the downturn—when the holders of Corporates, TBM and TIPS invoked the infamous "Plan B" they never mentioned before. But each Bear is different, and those securities did fine in the prior one.  Still, it is nice to know we can avoid or minimize certain risks.

[moda0306]

This bear hit hard to the point of calling into question the repayment of corporate bonds, which the last bear didn't to as strong a degree.  Stocks are a much better way, though, to capture times of prosperity, than corporate bonds will ever be, and when paired with treasury bonds, make a much better and more diverse pair than stocks/corporate bonds.

Yield chasing outside the normal PP treasury instruments is one of the more dangerous temptations.

Buying corporate bonds instead of treasuries to protect against recession is like buying a slingshot to protect your home because it costs less than a gun.  Buy the right tool for the right job and you'll see how easy it is to continue to both grow and protect your assets.  It worked in the inflation of the 70's by owning gold.  It worked in 2008's deflationary shock by owning LT treasuries, and even cash.  It works because the assets have macro-economic relationships that are almost impossible to break, and the strength of 2 or 3 assets in a given year almost always makes up for the weaknesses of the other 1 or 2.  I haven't seen any other portfolio where it works in such solid ways, and I've seen very little wiggle room with the asset choices in the PP to indicate there's anything better.  Now, you can fiddle with the allocations to take on more risk and reap higher return, but by no means should real-estate or TIPS replace gold or Muni's replace Treasuries or junk bonds replace stocks.

The PP is that band that you hated until one day it just "clicked," and now you wouldn't change 1 thing about it.