Precious metals and fixed income

Precious metals

We started the year with holdings in SLV, an exchange traded commodity fund for silver. In 2008 we bought gold and silver to in a bid to diversify our assets to reduce our portfolio risk. This diversification strategy did not help us as the price of precious metals fell together with stocks and commodities in 2008. I sold off our gold positions in May 2009 when I had a chance to get out at break even but decided to keep our silver position because at that time I was still undecided whether inflation or deflation would be a problem in the next few years. As precious metals are supposed to be the ultimate hedge for inflation, I thought we should still hold small position in this asset class while I continued my research on inflation vs. deflation. The more I understood about this topic, the more convinced I became that there is little risk of inflation in the near future and deflation was the bigger threat so I decided to sell our silver investments in October 2009 at a small loss. The price of gold and silver was still going up at the time as many big investors including some very clever fund managers like John Paulson and George Soros were piling into gold. However, I trusted my own research and once I was convinced of the threat of deflation, I adjusted our asset allocation accordingly.

It looks like the consensus for deflation is growing and in recent weeks there are many headline stories like these in the financial news:

Aug 2, 2010 – Big investors wary of deflation risk
Aug 4, 2010 – Defending yourself against deflation
Aug 4, 2010 – With deflation looming, even the top guys are flummoxed right now

If you are confused about how to invest if there is deflation, you are not alone – even the top investors are flummoxed right now! Most of us who are born after the Great Depression will have no idea what to do to prepare for deflation because inflation is something we have lived with all of our lives. If you want to learn more about deflation, I would highly recommend you learn from deflation experts like Robert Prechter who wrote about it in his best selling book Conquer the Crash which was first published in 2002. This book was republished with updates in 2009 and it gives a very detailed case for deflation and tells you how to protect yourself and maybe even profit from deflation. Do also read Deflation: First Step, Understand It, a recent article published by Elliott Wave International, Prechter’s investment advisory company.

With deflation, cash and cash equivalents are the best investments because cash becomes more valuable when prices of assets fall. Quality bonds are the best types of investments for deflation and US treasury bonds is one of the recommended investments. Investment advisers from the deflation camp like Gary Shilling and Yves Lamoureux have been advising their clients to buy the 30 year treasury bonds. David Rosenberg has been advising his clients to buy quality corporate bonds. Recently, Bill Gross who runs PIMCO’s $US239 billion Total Return Fund increased his allocation to treasuries to about 51 per cent of the portfolio, up from less than 33 per cent at the end of March 2010.

Treasury bonds

With some fear and trepidation, I proceeded to make our first investment in US treasury bonds last year. Even though my research tells me this is the right investment, the thought of buying bonds from a country with trillions of dollars of debt was still a little uncomfortable for me. Based on simple logic, it is hard to imagine why something like bonds that can be freely created from thin air can be more valuable than tangible assets like gold or property, but once you understand what causes deflation, you will understand why they can.

As usual, I looked to get our exposure to bonds through Exchange Traded Funds. In August 2009, I bought some shares in IEF, a US 7-10 year bond ETF together with protective put options, just in case. The bond yield for 10 year bonds was just over 3 percent at the time. The bond market remained pretty flat for a while but when the US stock market started to fall sharply in April 2010, bond ETFs shot up in price as investors rushed into bonds as part of the flight to safety. By June 30, we managed to get an unrealised gain of nearly 7 percent on our IEF position, giving us a total annual return of ten percent. Our bond investments have outperformed our Australian term deposit investments even though the interest rates for the term deposits were a lot higher.