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Author: trader2012 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35400  
Subject: Re: Your Best Pal, Ben? Date: 9/22/2012 2:32 PM
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And if that five-fold partitioning were used, then this is the sort of YTMs I'd expect from each group in today's market:

Benchmark
Returns
for the Current
Bond Market

3% Cash-equivalents (e.g., Treasuries, Agencies, and AAA corporates and munis)

-------------------------------------
5% Defensive (e.g., munis and corporates rated AA to A)
8% Enterprising (e.g., munis and corporates rated BBB to BB)
13% Speculative (e.g., corporates rated B to CCC)
-------------------------------------

34% Lottery Tickets (e.g., tobacco settlement zeros, i.e., low-cost bonds with highly asymmetric payoffs)

In other words, scale out a Fib series and then match it up to each risk tranche with the understanding that only the middle three meet the the definition of investing. The other two really are other things.

Yes, for sure, when prime-debt is used as a proxy for making bets on the level/direction of interest-rates and traded aggressively, serious risks are accepted and serious rewards can be obtained. E.g., trading the long bond in '95 offered 55% gains. Trading it last year offered 35%. But if prime-debt is bought with the intention to hold it to maturity, then that stuff isn't materially different than CDs, which aren't materially different than 'cash'. Due to minimal default-risk, there is little possibility of upside gain. In fact, except in the rarest of circumstances, prime debt will never offer a real rate of return after taxes and inflation, and that isn't its purpose in a properly-constructed portfolio. It's there as ballast, to provide stability.

At the other end of the risk-spectrum are 'lottery tickets' whose occurrence isn't limited to the asset-class of bonds. E.g., most stock IPOs are lottery tickets. IPO buyers might hope to get an opening-day pop. But, on average, they are going to lose money over the next 1 to 5 years, as study after study confirms. Same-same with buying bonds that really are no more than lottery tickets. Occasionally, one might get a big pay-off. But, by an large, buying them provides no more than entertainment.

In his classic intro to value-investing, Graham argues that a self-identified "Defensive" investor is just going to get him or herself into trouble if he/she tries to reach for yield by straying into the 'Enterprising' category. The mind-set needed for success there is different. Also, he is adamant that very little money should be allocated to 'Speculative' ventures, 5%-10% of the portfolio at most, and that's a recommendation I fully accept.

Where confusions might arise is that I'm using the term 'Speculative' as well, but mean something a bit different than he does. What he calls 'Speculative' is what I call 'Lottery tickets'. What he calls 'Enterprising', I break into two categories. Where we do agree is 'Defensive'. But back in his day, 'Defensive bonds' paid much better than they do today, and Cash-management isn't something he talks much about at all. So that's a category I had to back into his trio as well.

But on the essentials, we're both on the same page. We're both trying to buy securities at a steep discount to their estimated, intrinsic value in order to create a margin of safety. The essential difference between 'Defensive' and 'Enterprising' is the amount of work/risk one is willing to undertake and the size of the reward one could reasonably expect from that effort. In today's bond-market, a self-identified 'Defensive' bond-investor will be doing good to make 5%. A competent, 'Enterprising' bond-investor is going to have a hard time making an average 8%, but that will characterize the average YTM of his/her existing portfolio. A junk-bond buyer won't have too much trouble making 13%. And as for lottery tickets, they are available, too.

Charlie
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