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Author: junkman02 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35367  
Subject: Bond Risks: A Folk Taxonomy Date: 3/25/2009 5:06 PM
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The article on taxonomy at Wikipedia will tell you more about the various taxonomic schemes than you're likely want to know, just as reading a typical, mutual-fund prospectus, or the “Management's Discussion” portion of a 10Q or 10K, will tell you more about the various types of risks than you're also likely to want to know unless, of course, you take due diligence seriously. In that case, I'd humbly suggest that any catalog of bond-risks you're likely to encounter will fail in two ways: Incompleteness or Irrelevance.

The Failure of Incompleteness is due to the pervasiveness of the intellectual virus known as Modern Portfolio Theory and its various avatars: EMH, CAPM, etc. This is because MPT can't measure risk in any meaningful way, when risk is defined in the folk sense of “losses due to events that MPT predicts will not happen, but do happen with distressing frequency”. Therefore, if an investor is truly concerned about risk-management, the inadequacies of MPT have to be dealt with. But that is not my concern in this post. (MPT is a garbage theory. So figure out an appropriate workaround for yourself.)

Instead, I want to focus attention on the Failure of Irrelevance that most risk-catalogs exhibit. Such catalogs seem exhaustive. But that's because they are typically written by the lawyers for the defendants (whose sole interest is to disclose potential risks rather than manage them) or by investment theoreticians whose typical concern, once again, is to identify the varieties of risk rather than also suggest a means by which they might be managed. But identification is a good place to begin.

In his books, Marty Whitman argues that it is meaningless to talk about RISK in any generalized sense. Instead, he argues that “risk” only becomes a meaningful term when it is a hyphenated-term such as: default-risk, inflation-risk, reinvestment-risk, call-risk, market price-risk, etc., or the chief of risks for him, investment-risk, which he defines as “the impairment of capital”. For a would-be investor in individual bonds, the risk-management task is to carefully figure out, one alligator at a time, all the ways in which that alligator could bite you in the butt, or less metaphorically, all the ways in which you could lose, not just nominal capital, but also purchasing power. Because that figuring is going to be a personal thing that varies from investor to investor, I'm off the hook for providing anyone with a complete list of “alligators” (aka, a taxonomy of bond-risks). Instead, I'd like to continue that metaphor and suggest that some alligators aren't big enough to worry about and that some others, the really big ones, are the ones you need to be concerned with.

The alligator that everyone thinks is The Big One (TBO) is default-risk, right? But, depending on the swamp in which you're wading, default-risk can range from a temporary inconvenience that eventually restores all capital-put-at-risk to a total loss of that capital. What really matters when a default occurs is the recovery-rate and the time frame. If an issuer whose debt you own (be it through a CD, a money-market fund, a corporate bond, whatever) defaults, what matters to you is the amount of owed-interest and lent-principal that you can recover and the time frame in which you recover it. Thus, I'd argue, the risk of default-risk has to be sized according to the likelihood of the event and the impact of the event. If you're irrationally afraid of default-risk, then you'll attempt to avoid default-risk, even though you are probably underestimating a whole bunch of other risks that you've unknowingly accepted as a consequence of that choice, the most likely one of which is inflation-risk, due in part to the implied-premium you paid to avoid default-risk.

Thus, trying to “be safe” with respect to one specific risk isn't always the safest thing to do with respect to all of your risks. Yes, risk-management has to concern itself with specific risks, but it has to do so within the context of all the hyphenated-risks one identifies, so that one's defenses can be efficiently deployed. In short, worry about the big alligators first, then deal with the little ones, if at all. And what the big ones might be for you will be for you to decide. Thus, each investor, if she or her takes due diligence seriously, will make an effort to create his or her own catalog of risks, a ranked taxonomy of specific risks, against which there will be also created a plan of defenses.

I'm sorry to be so vague, but ranking the hyphenated-risks is my newest idea, and I haven't yet worked out as many of the details as I had hoped. What prompted my inquiry was the belated realization that traditionally-understood diversification was, for me, a poor risk-management tool. Therefore, I had to deal with the alligators directly, not hide from them behind the putative safety of “diversification”. But it was also obvious that I only needed to worry about the big alligators. The little ones wouldn't cause me much damage. Hence, I'm going to have to build myself a ranked taxonomy of risks.

Charlie
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