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URL:  http://boards.fool.com/maximizing-your-bond-returns-30293022.aspx

Subject:  Maximizing Your Bond Returns Date:  10/1/2012  1:35 PM
Author:  trader2012 Number:  34425 of 35400

There’s a really bad video being hosted on Yahoo Finance’s Breakout in which Jeff Macke interviews Larry Swedroe who is supposedly giving viewers “some tips and words for the wise [sic] on how to maximize their bond investments”. http://finance.yahoo.com/blogs/breakout/3-ways-maximize-bond... Swedroe attempts to make three points.

(1) Understand your fees.
(2) Use Mutual funds or ETFs.
(3) Be Conservative.

His first point is merely a very outdated rant against “markups” and worth no further consideration, because anyone who pays an avoidable markup is an idiot who deserves to be fleeced, though I'll freely admit that not all markups are avoidable, such as us odd-lotters constantly must endure for being forced to bid up in the book to obtain our sizes, and I’ll get back to this business of “fees” in a moment.

His second point follows from the first. He argues that ” Rather than going out and buying one bond or another [investors should be] using bond ETFs or mutual funds. The "funds-versus-individual- bonds" argument isn’t an “either-or-thing”. As has already been endlessly discussed in this forum, “it all depends” on the would-be investor’s intentions, skills, and assets. If you have little cash, few skills, but want exposure to the risks and rewards of fixed-income instruments, then buying derivatives (aka, bond funds) is an easy way to do it. The products that Vanguard markets are excellent. The bond ETFs are excellent. The closed-end bond funds are excellent. The open-end bond funds are excellent. Any or all of them, if bought correctly, could make their owners serious money, just as buying individual bonds could make their owners serious money.

Swedroe’s third point is where his (or Macke’s) misunderstandings of bonds really show themselves.

Although less risky than stocks in theory, bonds aren't a surefire way to avoid market volatility. With Treasury rates effectively stuck at zero, investors tend to "stretch for yield" as Swedroe puts it. There is no free lunch on Wall Street. If you want returns you have to take risks. In this environment a junk bond may only have a yield of 7% and contain much of the risk of a common stock. When the risks show up, as they always eventually do, the illusion of safety disappears. These bumps in the road can come as a jolt to conservative bond investors unaccustomed to volatility. Swedroe says this makes bond holders susceptible to giving in to the urge to panic and sell at the lows --an action from which he says you may never be able to recover.

To buy bonds to obtain ‘safety” is to fail to understand what the asset-class can and can’t do, what a would-be investor can and can’t do, as well as the meaning of “safety”. You don’t obtain ‘safety’ by avoiding ‘market volatility’. Volatility (aka, uncertainty) is what makes profits possible, and no one but the truly perverse objects to ‘right-tail’ volatility of the kind that makes them more money than they expected. What would-be investors should worry about instead is ‘left-tail’ volatility in which losses are greater than expected, and the mistake investors make is to assume the two are symmetrically distributed, that safety from left-tail losses can be obtained by lowering right-tail expectations. Well, that kind of attempted bargaining with markets doesn’t work. Prices don’t care about you personally. They go up, and they go down, in total indifference to their impact on your income and balance sheets. If you want to increase “safety” (as Ben Graham describes the process), you have to buy correctly from the getgo. Period.

In markets, nothing is safe, no matter its putative guarantees. If you buy what is touted as “risk-free” namely, US Treasuries, you are accepting tax-risk and inflation-risk. The same goes for the purchases of CDs and “principal-protected, inflation-indexed instruments”. All of them retain tax-risk, as well as inflation-risk, as well as default-risk. (If you think the US won’t default on its debts when it becomes expedient to do so, I’ve got a bridge you might want to buy.)

What bonds do offer (that stocks don’t) is the promise of maturity. Sometimes, that promise can be trusted. Sometimes, it can’t. Markets are constantly re-pricing that promise, and the price isn’t insignificant. This is why an issuer’s debt typically pays a fraction of what an issuer’s common offers when the two are bought at the same time and then disposed of at the same time. In my experience, the common will typically offer about 3.5x the debt, which is to say that stocks, on average, are 3.5x more risky than bonds.

But just as there are ‘junk bonds’ there are 'junk stocks', and just as there are ‘blue-chip’ stocks, there are ‘blue-chip’ bonds. Neither asset-class is monolithic, and an investor generally gets what he pays for. If ‘return’ is desired, then buy ‘risk’, wherever it is found. If ‘low-risk” is desired, then be prepared to accept low returns. In today’s bond market (and generally), there are only two ways to increase bond-yields: extend maturities, or increase credit-risk. The tricks that Swedroe suggests (paying attention to fees, and buying funds rather than bonds) aren’t going to have as much of an impact on enhancing returns as will extending maturities and/or accepting greater credit-risk, not that I’m advising anyone to do either *unless* they fully understand the consequences of their choice(s).

Lastly, a point about fees. Sometime, when you’re truly bored, track down the bond funds with the lowest expense-ratios and then benchmark their returns against some of their more expensive peers. What you find is that ‘low-cost’ isn’t as useful a selection metric as ‘risk-adjusted return’. In other words, are you better off buying a bond fund with 0.22% expense ratio and a 10-year annual return of 5.24%, or a fund that charges more than twice as much (0.58%) but also delivers more than twice as much, i.e., 11.25% annualized?

Charlie
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