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Author: aleax Big gold star, 5000 posts Top Favorite Fools Global Fool Pro Community Winner Motley Fool One Everlasting Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35392  
Subject: Re: How to diversify into bonds Date: 1/11/2014 3:56 PM
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Everybody hates bonds these days -- you've already received responses pointing that out. "The negativity toward bonds is nearly universal", as Barron's puts it in today's `Up and Down Wall Street`.

Historically, being _contrarian_ (selling what everybody loves, to buy what everybody hates) has proven a winning strategy for the long run (while in the short run `momentum`, the reverse idea of buying what's going up right now, works... until it doesn't;-).

You have a very long investment horizon, so you should consider this.

There's nothing mysterious about why being contrarian is useful. The market is a discounting mechanism. At extremes of sentiment, when everybody `knows` asset XYZ will be going up and ABC will be going down -- why, what happens right now of course is that nobody wants any ABC and everybody's bidding XYZ up. So XYZ becomes over-valued, and ABC under-valued, rapidly settling to (respectively) a ceiling and a floor.

In the short run, the market's a voting machine -- tells you what's popular. In the long run, it's a _weighting_ machine -- tending to assets' actual `fair` values (which in theory can be computed as a discounted cash flow, DCF -- the present value of all income that will come from the asset in the future, using an appropriate discount rate).

So, buying the hated, undervalued asset ABC, and selling the beloved, overvalued asset XYZ, in the long run, will give good returns as both valuations eventually revert to `fair` territory (in the short run you're swimming against `the current` of momentum, so things may not look that good for a while, but, just don't panic!-).

This takes patience and fortitude -- as Keynes, who loved to speculate on margin in his private accounts, put it, `the market can stay irrational longer than you can stay solvent` (the solvency issue does not arise if you carefully _avoid_ using margin debt of course, but the observation underscores the need for patience;-).

Sometimes the effects are sharp enough to observe in a shorter span of time. For example, consider TLT, an ETF holding long-term Treasuries (NOT a recommended investment at all -- just an example).

It peaked at 124 on May 1. Then Bernanke spoke the word `taper` -- and TLT in just a few months sank down to 102 in the summer (most of the loss came just in May and June). And there it stayed -- no further loss -- just modest fluctuations for many months now; it's now at 104.

Everybody who thought long-term Treasuries (and thus TLT) would tank obviously sold pretty fast -- so it hit bottom reasonably promptly (in this case I'm _not_ claiming said bottom is undervalued -- rather I think it was overvalued before;-).

My personal reaction to the stock market's strong bull year, and the debentures' panic in late spring, has been contrarian (in the slow, prudent, gradual way I always move -- I'm no fast trader;-). At the start of 2013, as for years before, I was positioned with 75% equities, 25% debentures (`debentures` is a broad term that covers bonds _and_ other investments based on lending money -- bank loans, mortgages, &c; "cash" that one's holding for investment typically is actually in debentures, because money market funds hold e.g commercial paper and T-bills).

And I was that high (25%) in debentures only because I follow Benjamin Graham's sage, immortal advice: _never_ get further than 75/25 to 25/75 in the balance between the two major securities asset classes -- even such extremes are warranted only when you have a strong conviction that one asset class is very under/over valued wrt the other. (If you're not familiar with Graham, he was the founder of security analysis, Buffett's teacher and still-revered mentor, &c; look him up!-).

In 2013 stocks at long last moved to (at least) fairly valued (some claim they're crazy overvalued but I think they're wrong -- other debate, anyway) and debentures to (at best) fairly valued, with clear pockets of under-valuation and extreme negative sentiment.

So, I've re-positioned to 70%/30%, on my way to 65%/35% where I plan to stay for the foreseeable future (Graham thought the ideal balance in normal markets was 50/50; I think 65/35 because that's the ratio of annualized real total returns; as it happens, analyzing Berkshire's portfolio of securities, and counting preferred stocks as debentures the way I personally do, it's pretty close to 65/35 these days...!-).

So, I've trimmed or closed some common-stocks positions, to enhance instead my exposure to bonds, preferred-stocks, loans, &c; and I'll be doing a bit more of that until I'm close enough to my desired 65/35.

Moving _slowly_, prudently, and cautiously, as usual -- and I would recommend you do the same.

Great econometrist Jerry Siegel has traced US securities over 140 years and found that stocks' real (i.e inflation-adjusted) total (dividends plus capital gains) returns, annualized, are 6.5% (pretty steady around that amount); bonds', 3.5% (less steady, actually, in _real_ terms, as bonds are quite vulnerable to inflation); a mixed portfolio, 65% stocks and 35% bonds, and annually re-balanced, has by a little the best returns, 7.0%, with even less variability than an all-stocks one.

That's the real reason to keep a balanced portfolio: the reduction in volatility is only a minor benefit -- the big deal is that, with disciplined rebalancing, you get _higher_ real total returns (rebalancing amounts to `buy low, sell high` -- always a good idea;-).

Now, finally, to your question -- _how_ best to proceed to gradually shift your allocation, from almost 100/0, towards _some_ balance (doesn't have to be my current favorite 65/35 -- but I would recommend not going beyond 75/25, or at a stretch 80/20 if you really insist;-).

First: taxes matter. IOW, "it's not what you earn, it's what you keep".

_Most_ debentures don't make sense in taxable accounts because coupons are taxed as ordinary income -- substantially higher than stocks' qualified dividends, and long-term capital gains.

Minor exception: some preferred stocks pay _qualified_ dividends, so may make sense to keep in a taxable account (about as much sense as it makes to keep dividend-paying common stocks there). Given that contribution limits constrain the total size of your tax-protected accounts, that can help.

Major exception: municipal bonds' coupons are tax-free (entirely so from Federal taxes; only in the State of issuance, for State taxes; Puerto Rico is a special case, triple-tax-free everywhere, but it's in dire financial straits so its bonds are very risky at this time).

California residents are particularly well placed wrt muni bonds because CA munis are seriously under-valued -- apparently the kind of CA residents who buy munis detest CA's politics and fiscal situation and are firmly convinced we're all going to H*** in a hand-basket. In reality, and despite occasional scary headlines on Stockton or San Bernardino, we're doing better than we have in years; Brown's new budget proposes to start re-paying the State's debts (which will also help the bonds of school districts, counties, &c, since some of the State's debts are to just such local entities!) and accumulating a rainy-day funds.

So CA muni bonds are under-valued (and thus high-yielding) and if the budget passes and the State starts buying some back that can only help their valuation. Plus of course CA's income taxes are among the highest, so the tax-free nature of munis is especially valuable here!

To put a cherry on top, I'm convinced that the best way to own munis is via closed-end funds (CEFs) -- actively managed, please (indexing makes NO sense in debentures). CEFs are still trading to a discount to their net asset value (NAV), so you're getting _that_ vig too, and end up with luscious yields. I personally prefer prudently-leveraged ones and in particular I've picked NKX for my muni-bonds exposure (in my taxable account of course). I bottom-fished it at a cost basis below 12, but even at the slightly more reasonable 12.52 to which it has since recovered, it's still a great buy - its 6.7% _tax free_ coupon is equivalent to a fully taxable yield of 15% or more (depending on your tax bracket of course) which is enough to make my pupils $-shaped!-)

Qualified-dividend preferred stocks need the same due diligence as common stocks do (unfortunately I don't know of any _funds_ doing a good job at collecting preferred stocks -- there may be some, I just don't know about them). So I wouldn't recommend them unless you're happy with the time-consuming process of individual stock-picking.

In tax-protected accounts, you have more latitude (just don't go holding munis there, that would waste their tax-free nature!-). I strongly recommend you go by funds -- actively-managed ones, by all means, indexing makes no sense in debentures: single issues are just not liquid enough for the individual investor, and you'd need far too many (at a minimum $5k a pop) to get properly diversified.

For high-yield (junk) bonds, I heartily recommend actively-managed ETF `HYLD` -- the managers well deserve their expense-ratio. They eschew the really risky stuff (PIK and covenant-lite horrors), do their own credit-solidity studies (who trusts Moody's, S&P's, or Fitch's any more?!), gain flexibility and short duration through the possibility of also buying some floating-rate loans and owning a little equity (which places them well to invest in distressed bonds: a bankruptcy can often turn those into fresh common stock poised for a rally); no leverage.

Past performance is no guarantee of future results, but it's still somewhat indicative. HYLD's coupon is now 7.82% (vs e.g JNK's 6.02%) and in the past year HYLD's +3.43% vs JNK's -0.49% -- all this after expenses of course. Why anybody would choose to own indexed JNK rather than superbly-managed HYLD, I have no idea.

I do think junk deserves some exposure in your portfolio, by the way.

So do non-US corporates; I get that exposure via a mix of GLCB, mostly developed-countries firms, and EMCB, emerging-markets firms. (Yes, emerging markets are also widely hated today, good reason to get into them -- in equities too, but, that's another story).

For investment-grade corporates _and_ dividend-paying blue chips (in a ratio of about 2:1), I've chosen VWIAX, an actively managed Vanguard balanced fund. You probably don't have access to that specific `Admiral` share class (I do only because my 401k's at Vanguard and my employer has negotiated great conditions for us there), but VWINX is OK, too, just with slightly higher expense ratio.

I fill in the corners with SNLN (for floating-rate loans), BIZD (for business-development companies), and BAB (`Build America bonds` -- "taxable munis" with a Federal debt guarantee backing them up). Plus, preferred stock, of course (the non-qualified kind, e.g from REITs, I keep in the 401k's "brokerage window", like all of these ETFs).

I don't own Treasuries (except the tiny amount VWIAX has) and I plan to keep it that way for now. If I'm wrong in my assessment of interest rates' futures, and I see 10y Treasuries yielding 4% while inflation stays low, I'll reconsider. Similarly, I don't own foreign sovereign bonds -- just can't see any bargains justifying the obvious political risks -- but, that might change more easily.

So if I were in your shoes I'd pick a first target, say 80/20, for your asset class balance a year from now, and move towards it slowly in the course of the year, getting debentures via funds mostly in tax-protected accounts except for NKX or the like in a taxable account.
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