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Subject:  A Very Good Year Date:  1/9/2013  3:27 PM
Author:  globalist2013 Number:  34633 of 35367

It isn’t seven trading days into the New Year, and I’ve already done 2 buys and 2 sells. Also, checking in at Morningstar this morning, I see that I would now be ranked in the top 7% of all fund managers with the same investing objective if I were running a publicly-traded fund. This is the start to very good year indeed. OK, time to stop patting myself on the back and to get serious. In a separate thread, altstrat91 suggested that now might be a good time to prune one’s fixed-income positions. In effect, he proposed a two-fold strategy: (1) Cut likely losers before they become serious losses, and (2) Grab windfall profits while they're available to grab.

His “Cut Losses” advice is a commandment that applies to anyone making bets, whether those bets are done as a ‘gambler’, a ‘trader’, a ‘speculator’, or an ‘investor’. It don’t make no difference. Take small losses before they become bigger ones. In the context of this forum, that means that if you’re long a bond fund that is making long-side bets on the level/direction of interest-rates, you should probably already be on the sidelines. Yeah, the Fed might delay the inevitable a bit longer with its shenanigans. But interest-rates are going to head up due to the fact that deficits and debts can’t be managed by taking on more debt. That’s the fundamentals, and fundamentals always prevail in the end.

His “Take Profits” advice is a bit trickier to implement, and it’s here that we potentially disagree. I’m willing to sacrifice ‘time premium’. He’s not, and that’s the difference between a bond trader and a bond investor. (And you either understand enough options theory to understand that comment, or you don’t. So I’m not going to grind through it.) Instead, I want to address the issue of when?/whether? to take windfall profits from the point of view of a bond investor.
First, some overview. The concept of “asset-class” is almost useless. ‘Risk is risk’, no matter where it is found. Thus, to buy bonds (or, worse, bond funds, because one wants “exposure to that asset class”) is sheer stupidity. The only reason you engage an ‘asset-class’ (through the underlying, or a derivative based on the underlying) is because you know two things. (1) From your own testing (and not from the bullsh*t “research “ of idiots like Bogle, Segal, Bernstein, Sharpe, Moskovitz, Merton), you know can create a game for yourself with a positive-expectancy, and (2) you’d be willing to do the work the game actually requires.

If you’ve figured out that doing bonds as a value-investor can be a viable gig, then --sooner or later-- you’ll come across the following problem. A position you put on at an attractive discount to estimated intrinsic-value has run up in price far beyond what you need to confirm the trade was correct. You could flip and make a killing. OTOH, if you sit tight, you’d still make decent money. "What to do?" Given that I’m a bond investor, not a bond trader, my inclination is to sit tight. The market has confirmed that my entry was correct. Thus, my worries about the position have been reduced. If I sell, I’ve gotta go looking for a new place to park that money, and that’s a lot of work. OTOH, if selling gets me out of a less than advantageous choice, I’m happy to escape, especially if I can do so on the other guy’s nickel.

OK, enough theory. Let’s work through some actual examples.

In this forum (several years ago now), Scott called attention to Hanson’s 6.125’s of ‘16 then trading low 40’s. He and I went back and forth over the pros and cons, and both of us --on our own due-diligence-- put on positions. But I know (from pulling T&S) that no one else in this forum did the trade. In fact, I doubt anyone else even made an effort to dig into the bond. Within a year, the price tagged par, and Scott chose to flip for a compounded return of about a gazillion percent and promptly put the money back to work elsewhere. I chose to sit tight. A CY of about 14% and a YTM of around 21% was “good enough for the girls I go dancing with”, and, besides, I had other fish to fry. So, who was right, and who was wrong? Obviously, both and neither of us, because we have different objectives, and we choose different means to achieve them. Turning money over as fast as is feasible grows an account. Sitting tight on positions the market has confirmed are correct creates account stability. Contrary my friendly running argument with Howard over who is the more risk-adverse investor, I’d claim again that I am, and avoiding negative surprises ranks very high with me. Or to borrow a metaphor from Taleb, a positive Black Swan flew in my window, and I’m choosing to let it live, rather than cook it for dinner. Hanson’s bond is still a part of my portfolio, and it will continue so until maturity.

OTOH, a couple years back, I got to worrying about the impact that inflation has on long-dated bonds. When I ran the numbers, I was horrified to discover that positions that looked good in terms of their nominal YTMs were costing me a loss of purchasing-power at steady, predictable rates. So I did what any good trader (or investor, or speculator, or gambler) does when he/she realizes they are causing themselves losses. I sold my losers. The huge irony is that, on nearly everyone of those sales, I made a profit in terms of my entry-price, as well improved my YTM over my holding-period. (I.e., my actually achieved YTM ended up being higher than my originally projected YTM.) By not sticking around and waiting for maturity, I cut what would have been a steady, inexorably, year-after-year loss of purchasing-power, despite the fact the nominal yield was very positive. I don’t remember how many position I sold in all. But it was a lot, maybe 10% to 15% of a portfolio that generally carries 300 to 400 positions. Some of the positions were easy to get out of. I hit the bid on a quote line, and I was out. Others took weeks of patience to get rid out of and the tedium of fussing with the cumbersome, solicit-and-collect-bids system used by brokers who don’t give their clients direct-access. And in some cases, I never was able to get an acceptable bid. So I had given up on trying to sell the position, and one of them was Geico’s 7.350’s of ’23. So let’s look at that bond in more detail.

My entry was April 29, 2009 at 110.750. Yep, in the scary days of 2008 and 2009, when it still wasn’t obvious that stock prices wouldn’t roll over again and resume their fall in 100 and 200 point whacks as they had done throughout the Fall of 2008 and the early part of 2009, I decided that --in addition to nibbling on less than top tier credits -- I also need to “park” some money in things that weren’t likely to blow up on me. In those days, Geico was still rated triple-AAA (if I’m remembering right). So I put on a position, even if it meant paying a premium to par and putting up with a very crappy 4.7% YTM.

To buy a bond at any price in whatever year --but due a long time away-- requires being aware of the fact that the money returned at maturity won’t buy the same basket of good and service it does at the time of purchase. That’s as good a definition of ‘inflation’ as any, and calculating its impact is straight-forward. Future-dollars have a present-day value equivalent to the reciprocal of the inflation-rate raised by the power of the holding-period. Or in plain words, a bond for which you spend $1,100 of 04/29/09 purchasing-power to buy on 04/29/09, and will come due on due 07/15/2023, is going to return you a mere $499.87 cents of 07/15/2023 purchasing-power. In other words, the impact of inflation means you’re “trading elephants for rabbits” *unless* two conditions prevail: (1) The coupon is fat, fat, fat, and/or (2) The discount to par is deep, deep, deep. When you can find bonds with those features, then you can turn a profit after taxes and inflation. In almost all other cases, you’re going to cause yourself losses, as the Dalbar 20-year studies of fixed-income investor behavior so clearly document. In other words, if you’re not pulling more future purchasing-power out of markets (i.e., money on an after-taxes, after-inflation basis) than you bring to them, you’re just a hobbyist who is “paying to play.”

So, finally, I got rid of my Geico position this morning (and I got out on the BID). Also, incredibly enough, I was able to get out of a high-quality, thinly-traded industrial (XXX’s 7.25’s of ’32) on a price-improvement over the current BID that had even worse inflation-impacted numbers and on which I had given up ever getting out of, and on I was able to bump my achieved YTM to 11.0% from a previously projected 6.2%. So this has been a very good day indeed. Again, a big “Thanks” to you, altstrat91, for the heads-up. You’re making me money.

Charlie
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NB "Gambler' is a word that has multiple meanings. "Quants" are 'gamblers' in the best sense of the term, and they use the traditional tools of the trade to create and exploit an edge.

Most 'investors' (as the Dalbar studies so clearly document) mere merely 'gamblers' in the worse sense of that term. They have no idea what their risks are, nor how to manage them. Hence, they lose more money (on an after-taxes, after-inflation basis) than they bring to markets. They're merely "paying to play". This isn't to say they aren't a necessary part of the ecology of markets. But they are the prey species, the mice and rabbits, not the hawks and eagles.
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