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Subject:  Gibraltar’s 8’s of ‘15 Date:  2/22/2013  9:33 PM
Author:  globalist2013 Number:  34802 of 35343

Gibraltar Industries [Stock ticker: ROCK] is calling their 8’s of ’15. That means it’s time to do another stock versus bond retrospective.

I put on the position 05/19/09 at 64.095, for a projected CY of 12.5%, and a projected YTM of 17.4%, which is decent money for B2/B+ bond position. Due the 03/04/13 call at par, my achieved CY remains the same 12.5%. But my achieved YTM bumps to 22.6%, which, again, is merely decent money for a B2/B+ position that has been bought in a timely manner. How would the buyer of the common have done over the same holding-period?

On 05/19/09, ROCK closed at $7.92 (after opening at $7.83 and tagging $8.15 for the day’s high and $7.771 for the day’s low). It cannot yet be known where ROCK will close on 03/04/13. But let’s project the current trend, and let’s make a guess that $18.17 (or no higher than previous resistance) would be not unreasonable. So, taking a compound root equal to the holding-period in years of the fraction obtaining by dividing the exit price by the entry price suggests an annualized gain of 24.5%, or pretty much a wash with buying the bond from the viewpoint of initial dollars put at risk versus total dollars returned due to each investment alone. However, if the coupons from the bond had been re-invested, the difference between buying the bond and buying the common narrows even further. But that’s not how I score bond gains. Re-invested coupons are “new money” investments, and they have to stand on their own merits. But the fact that the gains from buying the bond, or buying the common, would have been so close does suggest that buying the bond was a good move.

Now, let's spend a few more minutes and think about bond-investing in general terms. Two types of gains are possible from bond-investing, a stream of income from the coupons that will be taxed at ordinary-income rates, and possible capital-gains if the bond were bought at a discount to par and/or redeemed at a premium to whatever the entry- price might have been (as sometimes happens with call or tenders). The cap-gains will be taxed at a more favorable rate. But you can be assured that you will pay taxes on those gains. In the case of Gibraltar’s bond, the ratio of ord-inc to cap-gains turns out to be roughly equal, 46:54, which is very unusual. Generally, the ratio is closer to 3:1 or 4:1, or about the reverse of what a stock jock gets from buying “divvie stocks”. Let’s guess our would-be bond buyer has a marginal, combo, Fed-state tax rate in the neighborhood of 25%-35%. And to make the math simple, let’s say the after-tax gains on a 22% yield would be about 15% net. From that, subtract a realistic rate of inflation of 5%-7%, and the net drops downs to 8%-9% real, or about what a B2/B+ should be offering if the Fed weren't intervening in the credit markets.

Now run the same tax and inflation exercise on a bond that pays a lowly 8% nominal. What do you end up with? A zero net-return, right? Run that same tax and inflation exercise on something that pays 5%, such as the 10-year CDs offered by PenFed, and you’ll see that the investor is losing money on them.

Now, here’s where I part company with nearly everyone who has ever talked about their bond investments on this board. I think it is absolutely reckless, irresponsible, and financially insane to be loading up one’s portfolio with crap paying 5% or less. No matter how safe that stuff might seem from the point of view of default-risk, it is reckless and irresponsible from the point of view of tax-risk and inflation-risk *unless* one’s intention is to lose money.

OTOH, not to buy enough of the stuff that carries little or no default- risk and to go to the other extreme of loading up one’s bond portfolio with high-yield stuff that has little tax-risk or inflation-risk but huge default-risk and recovery-risk is equally, reckless, irresponsible, and financially insane. Unless you are the Bond Market Goddess Herself, you cannot know what’s going to work and what isn’t going to work. Therefore, you’ve gotta hedge yourself six ways from Sunday by buying as widely as possible across the yield-curve and across the credit-spectrum and in sizes small enough that no single position, nor any group of positions, is ever going to cause you more damage than you couldn’t recover from.

That’s why you’ve gotta buy junk bonds --not a lot, but some-- so you can offset the tax-risks and inflation-risk you’re accepting when you buy bonds that carry little default-risk or recovery-risk. Said another way, if you aren’t making a nominal 20%, 30%, 40% on some of your bond holdings, you’re going to end up losing money on a bond portfolio after taxes are paid and inflation is subtracted. Enough of the fat returns have to be there to make up for the skinny ones, so that, on average and over the long haul, you can achieve the investing objective of moving your purchasing-power forward to the future against the time when it might be needed. Achieving a proper balance isn’t an easy thing to do. But it has to be done. Otherwise, you’re just pretending to be a fixed-income investor. You’re just “paying to play” if you can’t show real, after-tax, after-inflation gains from your efforts. OTOH, if you blow yourself up from taking on too much risk, then you were worse than stupid and got exactly what you served.

"Balance, Daniel-san", said Mr. Miyagi. "Balance most important." http://www.youtube.com/watch?v=EfqygporjR0

Charlie
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