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URL:  http://boards.fool.com/running-a-basic-bond-scan-30454610.aspx

Subject:  Running a Basic Bond Scan Date:  12/28/2012  11:53 AM
Author:  globalist2013 Number:  34582 of 35363

With Congress dithering over matters that will affect all investors hugely, and with only two more market days remaining in 2012, I’m not likely to do any buying today. But that doesn’t mean I’m not shopping. I shop every day --meaning, I look for buying opportunities every day-- because that’s what a bond investor does. In a timely and consistent, persistent manner, he/she looks to see what is being offered. The easiest way to get a fast look at where bond prices are is to run a scan. So let’s set up and run a very simple one.

Open up your brokerage account and ask to be shown all bonds of any rating or maturity offering a YTM of 5% of better, and ask that the list be sorted first by issuer and then by maturity. If you’re using a broker who quotes the whole of the corporate market, then you’ll be returned just two pages, or less than 1,000 bonds, which is a reasonable number to look at. Then scroll through the list, top to bottom (or bottom to top). If you ran this same scan yesterday (and the day before and the day before that), you’ll recall seeing many of the same names and similar prices, and pricing anomalies will become easy to spot or, maybe, an issuer or maturity will show up that wasn’t there before. Jot down those names, and then continue scrolling through the list, A to Z (or Z to A, just to break up your routine). Probably you’ll end up with just five or six names, which isn’t an overwhelming number to research further.

But let’s say that you laid off your scanning for a couple of days and that you want review afresh the whole list. The first name that should have caught your attention is AK Steel’s 7-5/8’s of ’20, with its 10.019% yield. Never mind its single-B rating. 10% for a nearby bond is a lot of money in this interest-rate environment. So much so, the YTM is a clear sign that traders/investors are worried about the prospects for AKS, which is A Good Thing. If there’s nothing wrong with a potential investment, then you don’t want it. You don’t get paid for buying what is ‘safe’. You get paid for accepting ‘risk’ (i.e., for buying 'risk' at a sufficient discount to its 'fair market value' to create for yourself a 'margin of safety'). Your job as an investor (in any asset-class) becomes that of figuring out:

(1) whether the traders’ worries are ‘justified’
(2) if the current price of the asset is ‘fair’
(3) whether you could manage the ‘risks’ if you put on a position

In short, your job as an investor is to estimate the odds that the bookies have set the odds correctly and then decide whether or not to fade them.

The fastest way to answer those questions is to work through them backwards. If the minimum-purchase is bigger than would be prudent for your account, and if there’s isn’t a ‘back door’ to a smaller-sized position by paying up in the book, then you can’t do the trade, no matter whether you want to or should. You can’t afford to accept the risks even if you haven’t yet even begun to quantify them. Putting on a position would be beyond your means. That doesn’t mean that tomorrow’s market might not bring a more favorable minimum-purchase (and/or a more favorable price as well). But you can’t do that particular trade today. So move on.

Since it’s a bond we’re considering buying (and not another asset-class), then next step is to pull the whole, currently-offered yield-curve for the issuer, not just the maturity that caught your attention, and here’s where things can get tricky. Many issuers have many name variants, and many issuers have taken over the bonds of other companies, but those bonds still carry their former name. But once you get everything sorted out and you have all of that issuer’s bond in a single list (ranked by maturity), your next step is to look at the shape of its yield-curve. Is it ‘normal’, ‘steep’, ‘flat’, or ‘inverted’? And concerning each of those shapes, you should have a predefined policy in place such as, “I never buy an inverted yield-curve” (because I know/believe that an inverted YC is a highly-reliable, nearly-infallible predictor that the company will soon file Chapter 11).

In other words, just as the ‘min-purchase’ was your first filter (or ‘Go/No-go gauge), the ‘shape of the yield-curve’ becomes a second filter. And the reason for using explicit, mechanical filters --rather than discretionary judgment -- is simple. “That which can be measured can probably be managed, and measurement allows the possibility of future performance improvement.”

OK, this post has already taken more time than I have this morning, and there’s another couple dozen more filters that need to be talked about. But the direction I’m headed is obvious. Investing is process, and it is a highly probabilistic undertaking. You’re making bets with a counter-party about the level/direction of prices, and one of you is wrong. Your job is to ensure that it’s the other fellow. This isn’t to say that you have to be right very often, only that your gains have to be bigger than your losses. Using an explicit, mechanical process to make your investing decisions helps to keep mistakes and losses at tolerable levels. You’re not trying to eliminate all losses, because to do so would also be to eliminate all gains worth pursuing. You’re just trying to chop enough of the left-hand tail of your win/loss distribution that you can hang around long enough to capture the positive-expectancy of your system.

Now here comes the main point of this post. Though you might call yourself an ‘investor’, you’re trading with a ‘system’ that can be quantified and then tested for efficacy. So why not make 2013 the year that you get serious about pulling more money out of markets than you bring to them? As you can see from pulling the numbers for the various investing objectives within the broad field of "fixed-income", there was very decent money to have been made this year in bonds, something in the range of 10%-12%, despite interest-rates being at historic lows. 2013 promises to be another such year. So, if you missed out this year, there's no reason not to grab some of that money next year. All it takes is a sound plan and constant, persistent effort.

Charlie
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"Plan your trades, and trade your plan."
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