Four seasons make up a year, but most people fish (for sport) or farm (for a living) only a couple of them, using the slack times for rest and maintenance, for reviewing the past season and planning the coming one. The same practice might be useful to bond investors, faced as we are with interest rates at 40-year lows. Our cycle isn't an annual one, but it is nonetheless a cycle of planting and harvesting, of highs and lows tied to Fed policy and global political/economic events. Splotto touches on this theme of preparedness in another thread, vowing to jump on bonds when (if?) they ever reach 8% again, and I'd like to sketch in more detail some of the thinking that needs to happen between now and then. (Note: In what follows I ignore munis, preferreds, and converts, which are topics for other posts.)The two major rating systems for corporate bonds are Moody's and S&P's, with the former alleged the more conservative, but, for all practical purposes, the two are interchangeable and S&P's all-caps is easier to read and type, so that's what I'll work with here. Using a system of triple to single letters qualified by pluses and minuses, S&P creates a ranking system we all have seen examples of, but it is instructive to repeat in full:AAA AA+, AA, AA-A+, A, A-BBB+, BBB, BBB-BB+, BB, BB-B+, B, B-CCC+, CCC, CCC-CC+, CC, CC-C+, C, C-D NRNote a couple of things: - Treasuries fall outside (and above) such a rating scheme, for being guaranteed against default. Corporates are merely a promise to pay. (Were Treasuries included in the ranking, they'd be AAAA or similar.)- The top category, AAA, isn't qualified by plus/minus. - Notch differences among bonds of the same issuer indicate subordination of issues to more senior ones. (Yes, this point deserves fuller explanation. Hit the books is my suggestion.)- The top four categories are commonly known as “Investment Grade” ratings, and the emphasis is on estimating the ability of the issuer to make timely payments of principal and interest. - The next five categories are considered “Speculative Grades” and are commonly called “Junk Bonds”. Here defaults are assumed to happen in statistically significant numbers and estimating recovery rates --rather than primarily the issuer's ability to make timely payments of principal and interest-- plays a part in assigning a rating. - “D” means the issuer has stopped making payments of principal and interest, not that the bond has no value. - “NR” means “not rated”, which happens for a lot of reasons, some of which the guide books will mention and all of which need to be investigated. It is not a comment on the issuer's creditworthiness.Now, here's where things get interesting. Given the smorgasbord of categories to choose from, how does one put together a bond portfolio?For a start, let's conflate the full list of 27 some categories given above into a more manageable 5:1) Treasuries and AAA's2) AA and A3) BBB and BB4) B and CCC5) CC/C/DConsider what I've done: I've made the very best corporates equivalent in creditworthiness to Treasuries on the assumption that defaults are going to be so rare as to be negligible. (The historical record suggests the number is virtually nil). If you want only the bluest of the blue chips, this is where you'll confine your buying. If you want a bit more yield in exchange for accepting a bit more risk, you'll buy AA/A as well.I've downgraded BBB bonds to junk, which is where I think they belong. At best, BBB is a transitional category and a would-be buyer suffers under two disadvantages: One, the nominal investment rating of the bond means prices are held at a premium compared to default risk, and, Two, any subsequent downgrade means the institutions – many of whom can't own spec-grade bonds—will dump them and prices will plummet. My thinking is this: If you want investment-grade, then buy it. If you want junk, then buy it, but don't screw around with BBB's, thinking you're getting fat yields as well as safety. (You can't have your cake and eat it, too.) The historical record suggests that the defaults rates over 1-year and 5-year periods for AA and A are ~1/10%, which is tiny compared to the hazards stock investors accept without second thought, and which due diligence --in the form of diversification and proper position sizing-- should offer adequate protection against or make any losses manageable, especially since “default rate” and “recovery rate” are two very different things. But risk is risk and if you want to avoid it, then avoid BBB's. However, it is no biggie if an issue in your portfolio fails as long as you were aware of the risk and managed for it properly. Losses are simply a part of investing, and the average recovery rate --even for junk-- is 40%. I've split junk bonds into three groups: BBB/BB vs. B/CCC vs. CC/C/D on the belief and experience they involve quantitatively different research efforts and investment management efforts (which is a topic for another post: “Easy Junk, Hard Junk, and Special Situations”). Now, just because I've cut the field down to five groups, that doesn't mean an would-be bond investor has to confine herself to just one of them, nor does it suggest how they might be mixed and matched, nor how they are to be managed. At the risk of over-simplification, I'd like to present the following portfolio scheme, based on “Selections” (from 1-5) and “Investing Styles” ( Buy-and-Hold Investing, Opportunistic Investing [aka, Trading], and Hedged Investing—which is a term I'll need to explain in another post):.........Limited to......create........focus on......focus on ........Invest-Grade..Diversified..Spec-grade...Special Situations B&H.......yes.....yes.....na.....naTrade.....yes.....yes.....yes.....yes Hedge......na.....na.....yes.....yes[“na” doesn't mean that it can't be done, just that it is redundant, not worth the effort, or inappropriate- IMHO. Also, my apologies for this "table". TMF doesn't translate Word docs well.]As an example of how the typology might be interpreted, let's assume the would-be investor describes herself as a Buy-and-Hold sort of person –-which is certainly appropriate to owning individual bonds-- and wants to build a diversified portfolio by selecting from across the credit spectrum, rather than limiting her buying to just investment-grade bonds. How much of Group1? Group2? Etc.?Here's where the ugly topic of MPT (Modern Portfolio Theory) normally steps forward and takes over, but let's set it aside and do things the Fool's way, from the beginning. The first distinction one has to make is between an arithmetic series (e.g., 1, 2, 3, 4, …), a purely geometric one (2, 4, 8, 16, 32,…). and quasi-geometric ones like 1, 2, 3, 5, 8, 13, 21, … (aka, a Fibonacci series, which I'll argue in another post has great utility for bond investors). To keep things simple, let's assume our would-be builder of a diversified bond portfolio isn't going to mess with special situations (eliminating Group5) and she wants to allocate using a simple arithmetic series: 1, 2, 3, 4, or --more fully, and from the top down: 40%, 30%. 20%, 10%, which –-conveniently –- adds to 100%, thusly: 40% Treas & AAA30% AA/A20% BBB/BB10% B/CCC ----100%Such an allocation would create a fairly high-quality portfolio that offers a bit more total return than a purely investment-grade portfolio over the long haul and other weightings invite consideration. How much money would it take? Ah, now, finally, things get interesting. In normal times, investment-grade bonds are priced at par and discounts obtain as credit quality decreases on something like the following schedule:Treas/AAA... 100AA/A ....... 98BBB/B....... 88B/CCC....... 75CC/C/D...... 10-60 Buying a single bond is possible, but 5 or 10 is the more frequent minimum, and buying more than 1 both lowers the cost of average commission paid and also makes the lot more sellable. It is my preference and practice –- which you will need to match to your own investment situation--to limit junk bonds to 5 bonds/issuer and to allow as much as 15 bonds/issuer for the high quality stuff (with no limits on Treasuries.) If that is the scheme followed, then $100,000 divides itself up this way: Treas/AAA @2-4 positions, @ 10-15 bonds each, @ 100 = ~$40,000AA/A @3-5 positions @ 5-15 bonds each, @98 = ~$29,400BBB/BB @4 positions, @5 bonds each, @88 = ~$17,600B/CCC @ 2 positions, @5 bonds each, @75 = ~$7,500 ----------------------------------------------------~$94,500Obviously, each of the variables can be varied to create very different profiles and very different portfolios, but the strategy of using face value rather than cash value is a self-restricting way to limit risk –-you're buying less of the cheapest stuff, which is the riskiest stuff, but also the highest yielding stuff, meaning, the dollars you do commit are -–potentially-- working very hard for you. Summary: there's lots more that needs to be said about how to build a bond portfolio and how to put this stuff into Excel so that portfolio statistics like avg. YTM, avg. CY, avg. cost, avg. rating, etc. can be calculated and benchmarked, but this much at least puts some ideas on the table. Caveat: Money is the easy part about building a bond portfolio. The hard part is time: - The waiting time it takes for the shopping opportunities to happen. - The research time it takes to verify that they are, in fact, opportunities.- And the management time it takes to ensure that the promise of the now-owned opportunity doesn't die from neglect. Charlie
Nice post Charlie--I would suggest however that if you are trying to max your returns as well as create safety via creating a portfolio of bonds you may not need any bonds rated AAA in the portfolio. Why is this?? Because you mitigate your risk as you increase the number of bonds held in the portfolio. If the risk of default is as low as .1% for A rated bonds over a 5 year period then you will do better by simply spreading out your bond purchses amongst many issuers rated A and getting the yield boost.
nnn1234,Would that obtaining yield with safety were that simple. I understand the source of your suggestion, which is classic MPT theory, but I also think those guys are full of sh*t, for being rear-view mirror theorists, rather the "average" investors trying to manage retail amounts of money in real time without the admitted benefits of institutionally-sized research departments, institutionally-sized trading desks, plus the willingness to lie their asses off with tricks like end-of-quarter "window dressing" when their theories blow up and they have to make excuses about "relative underperformance" to their share holders. We real-world bond investors can't spend relative performance at the grocery store, and sometimes, maybe most times, the bird-in-the-hand promised by an AAA rating spends a lot better than chasing single A's. Mind you, I'm not saying to avoid single A's -- as I definitely would argue that any investor who wants to focus on investment-grade bonds should avoid triple B's. But I do think an over-weighting of single A's to chase a few basis point of yield is foolishness that will be rewarded by default. Increasing exposure increases risk. I own some truly scary stuff, but I also own some very blue-chip stuff, because they serve different purposes, and anyone who grabbed Treasuries --which are better than AAA-- 2 years ago, and 5 years ago, and 10 years ago is sitting in the cat bird's seat today. Selecting for quality and safety doesn't preclude obtaining the best yields. As an example, let me quote returns from TR Price's most recently quarterly newsletter to their shareholders.The 1/3/5/10 year returns for their SP500 index fund, PREIX, were (-20.64), (-13.09), (-1.88), and 8.65, resp. For their New Income fund, PRCIX, which is one place you'd see the single A's you advocate, the returns were 5.51, 8.17, 6.24, 6.39. Another place you'd see single A's show up is their Spectrum Income fund, RPSIX --normally stabilized by an allocation to equities but hurt in recent years-- with returns of 4.13, 5.00, 4.76, 6.97.By constrast, their bluest of blue-chip bond funds, their U.S. Treasury long-term, PRULX, offered these eye-popping 1/3/5/10 year returns: 12.19, 11.53, 9.20, 8.37. Yes, I'll freely admit those aren't the 20% plus returns equities offered annually '95-99 (which are historical shadows that few investors held on to), nor are they the fat yields single A's can sometimes offer -- from bouncing off bond market lows-- but those returns were steady across their time frames and offered substantive returns vis a vis inflation.Summary: I wasn't advocating anything to anyone in my post, just exploring ideas, thinking aloud about where I find myself in the current interest rate cycle and wondering aloud what my next couple of moves are going to be. What makes sense to anyone else is for them to decide, including --for yourself-- an overweighting of single A's. But you also screw around with tobacco bonds, which I would never touch. So, at best, we are coming to the fixed-income table with very different ideas about risk. When I want "risk", I'll look it in the eye and buy it for what it is: stuff trading at recovery rates from a Ch 11 workout that offers 25-100% total returns if it doesn't fail (such that I can absorb huge losses across a portfolio of such issues and still end up beating the fund managers). But when I want "safe", I'm not going to compromise safety for a couple of basis points by trying to equate the known and proven safety of AAA's (with their nearly immeasurable default rate) with single A's with their miniscule but measurable one. The two aren't the same thing and don't serve the same purpose. Balance. It's all about balance, just like planting a vegetable garden of spinch, radishes, onions, carrots, squash, tomatoes, etc. One year the sowbugs will get your carrots; another year the squirrels, your zuccinni; another year the birds, your corn. But every year you'll harvest enough to make a soup and a salad. The same is true of bond investing. Steinbeck has a memorable short story in which a farmer puts his whole field into sweet peas and the weather gods and the market gods blessed him and he made a killing. But the farmer knew, and the reader knows, that every minute of that summer was a gut-wrenching risk until the crop as harvested and the cash was in his hands. Betting on single A's to the exclusion of the other investment-grades is planting your whole crop in sweet peas. It might work for a while, but it isn't a defensible long term strategy -IMHO. Charlie
my apologies for this "table". TMF doesn't translate Word docs well.The trick is to imbed the HTML tags <PRE> and </PRE> into the text - this preformatting turns on a monospace font and uses the carriage returns you supplied. The table comes out like this: Limited to create focus on focus on Invest-Grade Diversified Spec-grade Special Situations ============ =========== ========== ==================B&H yes yes na naTrade yes yes yes yesHedge na na yes yes
Limited to create focus on focus on Invest-Grade Diversified Spec-grade Special Situations ============ =========== ========== ==================B&H yes yes na naTrade yes yes yes yesHedge na na yes yes
On, man. You don't know how much I appreciate that HTML tip. Thank you, William, a million. Tables, here we come. I've got dozens I'd like to post. Yah bah daba doo!Charts? Do you think I can do charts, too? Just tell me how, and I sing your praises until until Tom and Dave cross over the dark side of Technical Analysis. Charlie
Charts? Do you think I can do charts, too?ASCII charts are possible using tables. But I don't know of any way to get real charts into a TMF post. The best approximation I've seen is to put the charts someplace else and include URLs to the charts on TMF. This is easy for those few people that run their own web server. It used to be easier for common folk when Yahoo still had free universal briefcases. Your ISP may have a free web page space that can be adapted to this purpose, although figuring out how to use it may be a daunting task in its own right.If you are going to be posting lots of charts from Excel, you should pick up Radish's macro for this. It takes care of the tedious work of getting the correct spaces in place, etc.http://boards.fool.com/Message.asp?mid=16496985
Willaim,Even an Ascii chart might be fun. Thanks for the Radish tip. It's not a product I know. And if you have any influence with the Gardner Bros, rattle their cage -- yet again--about a spell checker for TMF, plus the ability of the original poster to edit his own posts within a resonable time frame. (E.g., www.elitetrader.com allows 20 minutes, which is generally enough time to distance oneself from one's own words and start seeing them as others do and catch the inevitable oversights and holidays.)Charlie
about a spell checker for TMF, plus the ability of the original poster to edit his own posts within a resonable time frame.I assume you know that the Improve The Fool board is the official collection point for these ideas.
William, Yeah, I was aware of the "Improve the Board" board, but two years ago they solicited ideas, prominent among which was a spell checker, but they didn't deliver, so I gave up. However, I just discovered a workaround, which I'll put up separately. Charlie
Charlie--Clearly we see things a bit differently, but the focus is similar, we are both discussing fixed income- bond investments and how to improve one's investments and returns, at least I think that is what we are both discussing. That is my basic interest at least.If you truely believe as you stated in a previous post that the risk of default of 5 year A rated bonds is 0.1 %, then what is the math behind sacrificing yield to chase higher ratings???? I understand the sleep better part of the equation very well and in fact agree that this is very important and is in fact why I like AAA's and some AA's. But if I were creating a large diversified portfolio to maximize returns and safety I don't think I would weight it as much in the AAA direction as you think is needed. If I did, and in fact I have done so,(my portfolio is heavily weighted AAA) I would readily admit that I am doing it for peace of mind and ability to sleep well, and not really creating the ideal maximum return vs risk bond portfolio.In addition to buying many AAA bonds, I have bought A rated tobacco bonds, but this is due to what I consider a market imbalance creating a unique opportunity for the bond buyer, or in other words, a good deal in this market. This was done with considerable research. I like getting an A rated 9 year bond paying me 50% more than other bonds. Of course it has some unusual features and/or some risk, or why else would it be paying me 50% more yield??? What I especially liked about this particular issue was the relatively short maturity of 9 years. I believe that default risk is minimized with decreasing bond term. This is important if you are considering buying bonds of less than AAA or AA quality, IMHO. At what I would consider short term, or in the 5 to 10 year range, there is much less default risk with the same credit rating vs long term of say 20 to 30 years. I prefer AAA's or strong AA's for long term, and for short term I am willing to consider A's.I am not very keen on your strategy of purchasing real junk. This, IMHO, is best left to the big boys. But I try to keep an open mind and maybe some day I will test the junk bond waters. I think your terminology of "screwing around" with bonds is more appropriate discussing the buying and selling of your junk bonds vs the buying and selling of investment grade bonds.
nnn12345,Do you remember the lyrics from the Simon and Garfunkel song, "The Boxer"? ...a man hears what he wants to hear and disregards the rest. I'd accuse you of doing exactly that with my posts (as I likely do with yours and other's). As the Buddhist proverb goes: "A way of seeing is also a way of not seeing". I don't think we share a similar focus at all and will only end up talking past each other. But let me make an attempt to clarify my post. That 40%/30%/20%/10% allocation ratio that you are finding fault with --as you should-- was just a demo, nothing more, merely a way of setting up an example, about which I was careful to point out that the numbers were variables that could be varied to construct different profiles and different portfolios. Portfolios can be built bottom-up, one bond at a time, or they can be built top-down, using allocation schemes such as I was playing with. But the point remains that I was playing, as I almost always am --with words, with ideas-- but playing, because that's what message boards are for - to play. As to that historical default rate for single A's, the number I reported isn't something I believe or not. It's merely a number I found in the professional literature a while back, copied the table summarizing the results of their study, and used it as a guideline. Your mistake is that you believe history is deterministic (i.e., "Past is prologue"). You'll trust those kinds of numbers and build a focused portfolio from them. I'll take a trader's approach and assume that my worst draw-down is yet to come and try to respond to what I'm seeing right in front of me, not what I'm remembering I saw, not what I think I'm seeing, or what others say I should be seeing, but what the market itself is saying, right now. I don't care if the historical default rate for single A's over the last one hundred years has been a steady 0.14%. The only that that matters is which single A's I own, and if I don't own them in sufficient quantities to capture the statistical trends --probably more issuers than the average investor can own, though I'd have to hit the stats books to work out the exact number-- then attempting to apply results derived from statistically valid samples to my admittedly statistically invalid sample is exactly the kind of academic horsesh*t that the MPT boys use to get themselves into trouble with (and so consistently so that they are reliable contrarian indicators). Investing isn't a science, and it isn't even engineering. It's merely an art form with all the vagary, chaos, serendipity, surprises, mistakes that adhere to any art form. Retail investors get themselves into a huge amounts of trouble in trying to apply to their retail-sized portfolios the guide lines that were created for institutionally-sized ones. The concepts don't scale. That's another of your mistakes: using big-money ideas for small-money portfolios. A related point: There is no way in hell that it can be argued responsibly that markets are random, but they are definitely very, very complex and very, very difficult to predict beyond a couple of minutes. Therefore, the agnostic approach of scrupulous diversification becomes the safest approach for the "average investor", which is a category into which I'll put myself most of the time, unless I've put in the time and effort to learn enough about a technique or asset class to set myself apart, as I would argue I've done in the case of junk bonds. That's a place where I know what I'm doing. I've served my apprenticeship, and I'll take on anybody, including the "big boys" whom you hold in awe and reverence, some of whom I've even had the privilege to meet and to swap ideas with, discovering to our mutual delights, --because we both love the game for its own sake-- that we were pursuing similiar paths, selecting the same securites.Lastly, I deliberately used the colloquialism "screw around" with reference to your involvement with tobacco bonds, because I think your approach is financially irresponsible and morally bankrupt. Have a nice day, Charlie
Charlie--Your original post did state:------------------------------------------------------------------------40% Treas & AAA30% AA/A20% BBB/BB10% B/CCC ----100%Such an allocation would create a fairly high-quality portfolio that offers a bit more total return than a purely investment-grade portfolio over the long haul"------------------------------------------------------------------------I personally see quite a bit to take objection to in this type of portfolio, but of course that is simply my opinion. My original point was simply to state out that there may be other and possibly superior ways to create a bond portfolio to get that "bit more total return".Regarding your statement: "But the point remains that I was playing, as I almost always am --with words, with ideas-- but playing, because that's what message boards are for - to play." Are you playing around with your choice of words, "screwing around, financially irresponsible and morally bankrupt"? Its hard to have a discussion with these comments.If you are stating your view of Tobacco bonds, please recall that these are not bonds of the Tobacco Companies, that these are in no way investments in Tobacco Companies, but represent the financial penalty, actually the record legal settlement, which the States of the United States imposed upon these companies and which the States of the United States have issued State Bonds in order to have more up front money for State programs instead of raising general tax revenues. Specifically, and without any misstatement, these bonds are in fact bonds of the States of the United States.I also wonder if you are sincere or are somewhat playing around regarding your discussions about bonds in the C +/-rated category. Surely they are not for everyone but for those who have the knowledge and experience trading such stuff maybe there is real money to be made.I prefer the buy and hold strategy for bonds, not the least of which is due to the high costs of buying and selling individual bonds, whic is one reason I think such horse trading of low rated bonds is best done on a level where the trading costs are minimal, not where I am at I admit. Lastly, I will admit that I am participating on this board not as a game, but as a way to gain knowledge and information and have tried to share some as well.
nnn12345,You are absolutely right about that "morally bankrupt" remark. It was unnecessary, uncalled for, unjustified. My apologies. As to the foolishness of those bonds, however, I'll let stand my original remarks concering it. The issue is over-priced. As to my other points, you're making a concerted effort to misunderstand what I say. The words speak for themselves. TMF offers an "Ignore" button. It really won't hurt my feelings if you use it. Charlie
nnn12345 writes- " I also wonder if you are sincere or are somewhat playing around regarding your discussions about bonds in the C +/-rated category. Surely they are not for everyone but for those who have the knowledge and experience trading such stuff maybe there is real money to be made.I prefer the buy and hold strategy for bonds, not the least of which is due to the high costs of buying and selling individual bonds, whic is one reason I think such horse trading of low rated bonds is best done on a level where the trading costs are minimal, not where Iam at I admit." IMO the Buy and Hold style is for the birds.I am old enough to have been one of the "lucky" ones who bought Treas. yielding double digits in the 70's.Unfortunately I held to maturity(mid 90's) and therefore missed some great entry points for equities.As well as I did in the Gov's I would have done much better taking my profit in the bonds(and paying the damm Tax) and investing more in equities.I also had friends who lost gobs of money by buying and holding bonds in the 50's and 60's-adjusted for inflation:adding insult to injury the govt. imposes taxes on the nominal interest and/or gain. While I agree with your'e statements re the Tobacco Bonds I decided to pass because I could not feel comfortable as to the risks.It is one thing to manage risk by buying Junk where the outsized returns compensatefor risk and another when I am geting 6%.While I have Taken big losses in Junk like Casual Male and Exodus I have more then made up for those losses by Hedging Steps and winners like Level 3 and World Com.While I agree such plays are not for everyone I would think people like Charlie who are willing to invest the TIME as well as the money will do quite well over time. My opion is that now is not the time to buy BBB or higher rated Bonds to hold untill maturity.The only way interest rates can stay at this low level for the next 5 years is if the U.S. economy is in the crapper-which means the default rate will be VERY BAD.Just my opinion.
IMO the Buy and Hold style is for the birdsGreyfox, I'd argue with you over that sweeping generalization and qualify it this way: There are times to Buy and Hold (when the method can't be beat) and there are times when the method is the height of ignorance and foolishness. The trick is in determine which is when, for which tools as simple as a two-MAV crossover system backed up by RELSTR will be good enough for most investors' purposes. But I'd underscore another point you make, namely the importance of TIME AND EFFORT in making one's decisions (aka, DD). That's the make-or-break that distinguishes winners from losers and why so many lazy investors are now whining about their losses. What was an easy game in the go-go years suddenly got hard, as the market turned on a dime --but not without ample foreshadowing--, and they gave back their gains and a whole lot more (as that example luv2earn reports of some idiot turning $800,000 into $250,000, for not having done his homework, nor exercising even a modicum of common sense, nor caution.)Charlie----------------"If you have a minute, I can tell you how to make money in the stock market: Buy low and sell high. Now, if you have 5 or 10 years, I can tell you how to tell when stocks are low and stocks are high."
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