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Post 9/11, I bought 2-year and 3-year corps rather than follow Treasury yields down. Most will perform as expected. The bonds will mature, and I'll make the spreads I traded for. Sea Containers is a likely exception. The company is in trouble, and default is a possibility. My entry was an imprudent 101.600. But I paid the premium to obtain the 10 ¾ coupon. Monday, my broker breathlessly called, saying news was bad and asked if I wanted to get out. I did some quick DD, decided he had misread the market, and declined. (The fuller story was told in a prior post). The bonds weren't crashing. But I did have to ask myself, upon reflection, why I was holding them, now only three months from maturity. The traderly thing would be to take a loss on price, but lock in accrued interest, and move on. “Sunk costs” are nonsense and not a reason to hold a position. I saw them trading at 96, so I called him later, asking what price I could get.

He bemoans the fact that I didn't call him two hours earlier when he was putting together his afternoon's order. I asked him what price he got. He doesn't recall, but looks for his ticket, and tells me it was 94x50. Sure enough, I find his trade in the T&S made available at www.investinginbonds.com , now that he's identified it. But he's not doing his clients any favor. He's hitting low bids to get the trade done. (True, that's sometimes what you do. If you need to get out, you take the price you can.) It's now late in the day, and he argues that putting out an offer is a waste of time.

Yesterday, the MM's (the marker makers) opened trading in Sea Containers' bonds late for wanting to guage the news and customers reactions before they made a market. (That's their privilege and why they can trade against you so profitably. They can see the order flow.) Today, trades are happening fairly soon into the session, and I also pull the news. SCR has executed their sale of property, and the market likes it. The stock has jumped 23%, and the bonds are printing at 96.500 on block orders, not the small stuff of yesterday, with the bid advancing, though the ask is a ridiculous 101 (subsequently adjusted to 100 and then 98). My position has become a distraction. So I e-mail him to step in front of the offer and offer me out at 97, accepting nothing less than 96.500. That's where the market is. That's what I want. Shortly, I get an e-mail to call him. The best bid from anyone for my bonds was 95.160. Did I want to accept? He says, “The position is only 5 bonds. That's what happens when you try to sell just 5 bonds, and why I want you to buy ten. You're going to have to take a point or two less for five.”

Now, let's step back and ask what's going on. At IB I could write my own orders and either make a price or take a price without broker intervention. I'm not holding the bonds at IB. So I've got to trade them through Joe. Collusively, all brokers, all desks, hate dealing with “small orders”. E.g., Scottrade requires the order to be ten bonds. E*Trade imposes a commission of $40-45 on less than ten bonds, plus their usual markup. Fido has no set minimum, shows the inside market, and has a $20 minimum commish. (But their inventory is meager.) IB also has no size minimum and has $5 min commish, shows the inside market, plus allows the customer quasi-direct access by facilitating the writing of orders. In other words, you can make prices, and you'll see them posted nationally in real time. True direct-access to exchanges is offered to stock/futures traders. But for bonds, there are no comparable exchanges, nor will there ever be, because the institutionals don't want the riff-raff in their cozy club. Profit margins would decline. They've seen what's happened in the stock market to spreads and commish and don't want the same to happen to them.

So the game they are playing is this: require your customer to trade ten or more bonds, mark the bonds up if they're buying (down if they're selling), and charge as much commish as you can. Total extortion. The technology is there to create an electronic market. But the market makers –-the underlying desks either holding the bonds or trying to obtain the bonds for customers— would be out of business if customers could trade with each other, as they most certainly and most easily can do in the case of stocks and futures. I have no objection to paying a fair commission for the trade. Technology is expensive, as is the back-office support. But if IB processes bond orders profitably –-and by all accounts and their own admission, they are doing handsomely well with their business model--, why can't other brokers match their prices and platform? Obviously they could/can, but, collusively, they decline to do so. No one is willing to break ranks. They're all hoping IB will go away, and are doing everything they can not to facilitate their success.

Interestingly enough, Joe did concede to me that the bid I got of 95.160 was, in his opinion, a good one. “Well, yes, Joe”, I'm saying to myself. “That was 1.6 points better than you got your clients yesterday on a more marketable size. But that's still a sucky bid, because you pirates are gouging investors with your insistence on large-size trades. Let the small guys into the market-making process, and you'll start seeing plenty of small trades happening and done at very tight spreads. Build it, and they will come.”

But the bond market is what the bond market is, and you either learn to play the game as the game is played, or you find one more to your liking. But that doesn't mean that I don't complain or try to give newbies fair warning. If you're going to buy your own bonds, be prepared for a lot of hassles, but not the kind they warn you about as they try to scare you into funds, which they, conveniently, just happen to market. What's hard about bonds isn't the analysis, which they always claim that most investors could never learn to do. (A claim which is nonsense.) The hassles are in executing. Let anyone have the same ease of execution with bonds that is possible with stocks/futures, and the bond game would be entirely different. But the bond game would no longer be so profitable to the entrenched middlemen. So things aren't going to change very much, or very soon.

They will change some day. Things are much better than they were 20 years ago, 10 years ago, or even 2 years ago. For free, I can pull Time & Sales on bond trades as I could never do before unless I rented an impossibly expensive Bloomberg. I can get historical data for free. Commissions are dropping. Inventory can be searched online 24x7. Etc. Things are definitely better. But when I see how easy the stock guys have it, I do get envious. The stock game is way harder than the bond game. Bonds mature. Bonds come earlier in the credit line. You can't believe what a work-and-worry saver those two features are. They come at a cost of potential returns, but the cost is tolerable.

I love bonds. But sometimes, the game rules can be discouraging.

Charlie
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Just curious... are you saying that you don't invest in stocks at all?
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Just curious... are you saying that you don't invest in stocks at all?

blearynet,

No stocks. None at all.

Well, that's not entirely true, as things never are. I own 68 shares of TRMP that came to me as part of a Chapter 11 workout. The deal was either a combination of cash/new debt/equity for old debt, or cash for old debt, or new debt for old debt, and I chose cash. But E*Trade screwed up with the paperwork, as they did for several hundred accounts on that re-org, and I ended up with the default choice. So, I own some Trump stock. I also own some E*Trade stock, 127 shares that came to me when I did a conversion of three of my E*Trade bonds. I could have taken cash. But the stock was soaring. By converting, I picked up another $100 per bond. I should have immediately flipped. But the stock was very strong, and I decided to let the tiny position ride.

Also, just recently, some warrants have come my way from JL French's re-org, 68 of them that are being priced by E*Trade as worthless. Stocks come my way as part of Chapter 11 workouts. But I get rid of them. Retrospectively, that's not always a good decision. I threw away a small fortune by not hanging on to my KMart stock that I received for my K-Mart bonds. But I'm a bond guy, so I don't mess with stocks. All in, my non-bond holdings are less than 1% of assets under management. But my average, annual returns exceed the average, historical returns for stocks, because I run a multi-spectrum bond portfolio. However, I'm rethinking my entire portfolio, and I'll be moving a portion into equities shortly, not individual stocks, which I do not like and at which I am not a good investor, but to indexes managed as position trades. Given the increasing volatility of markets, I need to be able to respond rapidly and appropriately to changing conditions with a portion of my assets.

The huge advantage bonds have over stocks is that bonds mature and come earlier in the credit line. It's possible, though not always prudent or profitable in specific cases, to be a Buy-and-Hold investor with bonds that way it would scare me silly to do so for stocks. I've been made whole more than once from a Chapter 11 workout, while the equity guys got zilch. Generally, I take a take a haircut from re-orgs. But that's just a cost of doing business. My wins exceed my losses. I'm profitable.

Why can that be so?

Because reward is proportional to risk, all other things being equal. If a bond investor takes on the same risks that a stock investor does, then he earns the same rewards. People mistaken think that bonds are the “safer” vehicle. They aren't. Some bonds are truly safe. Some are toxic trash that are comparable to penny stocks. By running a diversified portfolio, with positions held across the maturity range and down the credit spectrum, I can capture, on average, returns equivalent to a conservatively managed stock portfolio.

But don't take my word for it. Look at mutual funds. Compare the returns of a well-run spectrum bond fund against those of a conservatively-managed stock fund. You'll see the same Alpha's, STDev's, Sharp Ratio's, etc. For the most part, the underlying companies in both portfolios won't be the same. Or, maybe, they will be. A good strategy for a bond investor is the buy the debt of the same companies that the value guys are buying the stocks of. Marty Whitman makes a good living buying either, or both, as the situation warrants. But the thinking behind the two approaches is very overlapping: both are attempts to capture value, and both need to manage risk. I'm doing it almost exclusively from the debt side. Others are doing it almost exclusively from the equity side. And some people take a “balanced” approach, and do a bit of both.

Charlie
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Charlie, I respect you deeply, but I'm going to have to call you out on one thing.

You said:
The huge advantage bonds have over stocks is that bonds mature and come earlier in the credit line. It's possible, though not always prudent or profitable in specific cases, to be a Buy-and-Hold investor with bonds that way it would scare me silly to do so for stocks. I've been made whole more than once from a Chapter 11 workout, while the equity guys got zilch.

And then:
Because reward is proportional to risk, all other things being equal. If a bond investor takes on the same risks that a stock investor does, then he earns the same rewards. People mistaken think that bonds are the “safer” vehicle. They aren't. Some bonds are truly safe.


But you had just made an argument as to why bonds are safer... higher in the credit chain, etc. All that *does* make bonds less risky.

Now, sure, if you take some of the higher risk bonds compared to some of the safer stocks... overall, you may be able to get similar levels of risk.


By no means do I mean to disparage bond investing, but you just seem to be talking out of both sides of your mouth just a wee bit. Sure, by seeking our riskier opportunities, a bond investor can maybe equal the returns of safest stock invesments, by catching the same risk level. However, that doesn't make bonds safer, as you seemed to be promoting at first.

Meanwhile, for those of us with decades until retirement, there's nothing in the bond universe that can approach the expected returns of moderately risk to the somewhat riskier portions of the stock universe.
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DeltaOne81,

My respect for you is reciprocal. You do good, careful work. If what I said doesn't make sense to you, then it likely doesn't make sense to me, either, or anyone else. Not a problem.

A better restatement might be: Is this particular bond riskier than that particular stock? Answering that question depends on defining "risk". But I'm going to do the cowardly thing of not going there and simply report my own experience. I'm a crap stock investor, but I'm a decent bond investor. In my own life, for my own purposes, bonds provide me with rewards that aren't inferior to what the rearview-looking theorists say I could achieve for myself in stocks, which is why I made the appeal to mutual funds. Call the broad stock market “normal risk”. Back off one notch and call that ”conservative”. Compare conservative to multi-spectrum and what do you see? Equivalent risks and equivalent returns. A 100% bond portfolio is unusual. blearynet asked about it. I attempted a reply. If I misspoke, my apologies.

There is a serous issue here, buried very deep in myths and assumptions, that “bonds are safer than stocks”, and people steer themselves (or get steered) toward one or another on the basis of a whole bunch of factors, some of which serve the interests of financial middlemen (the brokers, advisors, planners, academics, etc.) more than real-life Joe's trying to move a few dollars of savings forward in time for when they do need its undiminished purchasing power. Conventional wisdom suggests that if you want 7% returns, you do bonds, if you want 10% returns, you do stocks. If you want 21% or 34%, or 55%, you're truly delusional, or, if you do achieve them, you're the equivalent of a lucky coin-flipper.

You've heard the standard arguments from Loki and the MPT crowd: theorists like Markovitz, and popularizers like Bernstien and Malkiel. My reply is that the flaws of CAPM are well known. The attempted fixes are plentiful and futile. The theory is garbage for is its assumption that returns are normal. Cut that assumption loose, and what do you end up with? Uncharted territory as to how to build portfolios, but still the need to make financial decisions in the here and now under conditions of uncertainty about things that can't be known. If theory doesn't match with practice, well, then, theory needs to be revised.

The basic situation is this: I'm going to do what I'm going to do, and I'm going to try to understand it. There's going to be contradictions in both actions and explanations. Such is the human condition. Do I trust my own experiences in these matters, or the beliefs of others? Were I running other people's money, I could hand you a tidy prospectus (even if it were based on fictions). My money is my own. So I forge ahead as best I can. It's not that I'm unwilling to discuss this matter, but, in a large part I don't even understand it. I have no “complete theory of investing”. I'm working toward it as fast as I can, because I'd like to se what it would look like, and because it would be a useful tool. So my choices are two: I can either worry about the bush fires of small details and fight them, or I can assume that the forests were meant to burn on 20-30 year cycles and go for the larger picture. I'm not arguing that details don't matter. The whole is, in some sense, merely the sum of its details. Did you ever read “The Bridges of Madison County” or see the movie? There's a scene in which she is talking about her life and sums it up as getting so immersed in the details of daily living that life isn't examined. It is simply “lived”.

Who's my hero? Why did he go to the woods? To lead “an examined life”, right? This forum, and years and years of letters (in the old days, e-mails in present times), journal entries, reflections, walks, experiments, are, for me, a financial Walden Pond of the mind with its seasons and its storms, its flora and fauna, and morning spent hoeing beans, afternoons floating on its surface, chasing loons.

Are stocks riskier than bonds? What's a stock? What's a bond? What's risk? Barron's "Dictionary of Finace an Investment Terms" provides seemingly clear descriptions of all of them and five thousand other things. But start thiunking about any one of them in a methodical way and pretty soon you see just how clear they aren't and how mostly useless they are to real investors faced with real markets. Humbly, from the back row, I'll raise my hand and say, "Please, sir. Would you explain that one more time? I still don't understand. That hasn't been my experience."

Charlie
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Delta,

It occurred to me this afternoon, as I did my walk along Portland's streets, salty sweat stinging my eyes, a refrain of “step on a crack, break your mother's back” running through my mind, and your question, too, that my “restatement” needed restating. I pondered that for a while, as I navigated through the heat, seeking out what shade I could find, cutting through parks and under trees. Children were playing “Red Rover, Red Rover” in one of them, a game I hadn't seen in years, and its rules lent themselves to building an investing metaphor. But then I realized that everything does, that everything is linked to everything. The question you ask, the challenge you made, could be explored, and explored productively. But, at bottom, no matter how restated, it's not an interesting question to me. I really don't give a fig whether bonds as a category, however defined, are “riskier” than stocks, however defined. Such questions reek of the oil lamp and of the library. Their answers find their way into publications like the “Journal of Finance”, not the lives of ordinary investors.

What is Jack's rule of thumb when winnowing choices? “Mark with chalk. Cut with an axe.” I love theory for its own sake. But theory is like marzipan. If you have the sense to not take a second piece, you'll enjoy the experience and be none the worse for the indulgence. For all my appeals to theory, investing is a practical art, and I'm looking for the investing equivalent of beer-and-bait fishing, back-of-the-envelope analysis, and kitchen-table financial planning. What I need, what most people need, isn't elegant theory, but the smarts to say of this particular opportunity, dumped into their lap, whether it's a Yea or Nay. That doesn't answer your question. But, right now, it's the best I can do.

Charlie
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jeez you were a pain in the arse in school weren't you.

jack
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Charlie and Delta,

I think this is one place where Warren Buffet offers truly sage advice paraphrased "if you have to crunch the numbers then its too close" Unfortunatly it really is only useful for those experianced with their system.

I rarely crunch numbers to produce a metric that will answer the question "will I invest in stock A or Bond B?" I crunch the numbers in order to know how the beast behaves. The process spits out numbers but it is the journey through the numbers that answer the will I invest question. The numbers spit out help me manage my expectations after the purchase.

jack
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But I'm going to do the cowardly thing of not going there and simply report my own experience. I'm a crap stock investor, but I'm a decent bond investor. In my own life, for my own purposes, bonds provide me with rewards that aren't inferior to what the rearview-looking theorists say I could achieve for myself in stocks, which is why I made the appeal to mutual funds.

Very wise, as always. Very Buffett even. You're talking about circle of competence.

When you do something that you don't know what you're talking about or looking out, mathematical levels of risk are meaningless.

By no means was my comment in any way intended to change anyone's investing behavior. And risk is absolutely is relative - relative to each individual and their skills.


All I was pointing out is that you seemed to say 'bonds are safer because...', and then went out to say about how bonds weren't really safer and could produce equal returns.

The fact is, with your skill set, that probably makes a lot of sense. But I just felt like it was worth pointing out so others may not be unintentionally misled that they should expect equal returns with bonds and stocks.


The question you ask, the challenge you made, could be explored, and explored productively. But, at bottom, no matter how restated, it's not an interesting question to me. I really don't give a fig whether bonds as a category, however defined, are “riskier” than stocks, however defined.

That's another way to put it ;)
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