Gyroscopic Investing

Hello all,

After recently coming across this site I have been reading the Bogleheads Thread about the Permanent Portfolio.

In this, it discussed that mid range bonds (10 year) at an allocation of 50% perform very similar to the 25% Cash, 25% 30 year bonds method. This is especially relevant when you are investing in Japan or Australia where the longest term bond is 10 Years.

I was hoping someone could explain this to me. As I understand it, the bonds provide protection against a depression.

So.... If a depression occurs, the yield from the 10 year bonds is good compared to cash/gold/shares, and if you went and sold the bond at say 8 or 9 years, you would not be able to purchase a new 10 year bond at this rate during the depression.

It would seem to me if the maximum bond length was 10 years, then you would be better off creating a 10 year bond ladder (ie 10 bond holdings from 1 year maturity to 10 years) to lock in a decent yield.

Am I missing something here?  Looking forward to your comments on the best approach for the bond holdings when the maximum length bonds that can be purchased are only 10 years.

Hal

Hal wrote:
I was hoping someone could explain this to me. As I understand it, the bonds provide protection against a depression.

It helps to understand this if you actually mentally picture yourself holding the bonds and relying on them for income. 

Say you hold a $1000 30 day bond that pays .05% annually.  Do you really care if the rate goes up or down .02%?  Not really, b/c you know that after a month you can buy a new bond with a better yield.

But now think of a $1000 30 year bond.  If you have one that pays 10% and the rate goes down to 9% or up to 11%, do you care? 

Let's see:


$1000 x  9% is  $90 a year.  x 30 years is $2700
$1000 x 10% is $100 a year.  x 30 years is $3000
$1000 x 11% is $110 a year.  x 30 years is $3300

So yes,  you care b/c it's going to make or cost you $300 (30% of the bonds initial price). 

This makes your bond worth less.  Who would pay $1000 for a bond that pays 10% when you can pay $1000 for a bond that pays 11%?  No one, so the price of you bond drops.  On the other hand, who would pay $1000 for a bond that pays 10% when the new ones issues are only paying 9%?  Anyone, so the price of your bond goes up. 

So bonds with a long time until maturity tend to be much more responsive to changes in interest rates than short term bonds.

For 10 year bonds, you can buy new bonds after 10 years, so you're not as exposed to interest rate risks as you are with 30 year bonds, but more so than with short term bonds. 

The idea behind a 50% 10 year holding is that you give up the extremes at both ends, but make the most of the limited volatility by holding 50%. 

Make sense?

If it doesn't, check out this link:  http://beginnersinvest.about.com/lw/Bus ... ration.htm

or google "bond duration," and do some reading. 

Also, you said that bonds protect you in a depression.  This is true if if it's a deflationary depression.  Bonds will do poorly in the event of an inflationary depression. 

Thanks for the most informative posts!

I should have been more careful with my terminology. I was meaning a deflationary depression in the first post.

Clive, it makes sense now that I realise there is a significant difference between holding to maturity compared to trading LT bonds.

When it comes to rebalancing then, if the total bond value has decreased to 15% then I understand you can either purchase some more ten year bonds or practice "rate tarting" (love that term!).

If the bond value has increased by over 35%, then I would imagine that you sell the bonds closest to maturity? Have I got this right?

And to put something into the forum that might be helpful, this is the link for purchasing Australian bonds directly from the Reserve Bank if you are so inclined.

http://www.rba.gov.au/fin-services/bond-facility/

Hal

Thanks for the extra infromation Clive,

I am finally starting to understand the bond concept, especially the holding to maturity compared to the trading approach.

Just two queries;

1. When you have to rebalance the portfolio, do you simply sell off the bonds that have had the highest increase in value?

2. You also recommend a 5 year ladder rather than say a 10 year ladder. Is that because a 5 year ladder, with bonds held to maturity, perform the similar to Harry's 25% Cash, 25% LT Bond method?

As an aside, while in the process of setting up other portions of the portfolio, I found the Perth Mint Depository Service very helpful for setting up the gold allocation.  Will post about this in the appropriate forum.

Once again, thanks for the help.

Hal

Thanks Clive,

It makes sense now.

If you hold to maturity, the yield is the main factor.
Therefore, if you get similar yields between, say 5 and 10 year bonds, the shorter dated bonds give more flexibility.

And you are ready to take advantage of higher yields on longer dated bonds if the opportunity arises later.

Hal