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Author: charliebonds Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35345  
Subject: For Jon: An Answer Date: 5/10/2010 6:37 PM
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You asked how I was managing my bond holdings in my E*Trade account. That’s a fair-enough question, and now that I’m done with my parts- run up to Angler’s Workshop (to build a couple of small-creek, 2-wt rods), I can attempt a reply.

Bond-investing can be done in a lot of ways, for a lot of reasons. What makes sense to me is to invest across the yield-curve and up and done the credit-spectrum, using a classic, Ben Graham-style approach. The essence of that approach is this:

(1) buy what should be bought,
(2) when it should be bought,
(3) at the price it should be bought,
(4) and in the amount it should be bought.

Those four factors determine the risk-reward characteristics of each purchase, and they determine the risk-reward profile of the whole portfolio. For sure, other investors do their bond-investing differently than I do, either because they have different skills and purposes, or because they don’t really understand what they are doing. (The latter becomes obvious when they are asked to provide a copy of their investment plan, and they can’t, because they don’t have one.)

In order for “apples-to-apples” comparisons to be made, each credit-tranche of the portfolio needs to be examined to determine if the price paid (and, therefore, yield to be obtained) is proportional to the risks being assumed. To say that in another way, if a bond is bought that will not provide a real-rate of return after taxes are assessed (at one’s marginal rate) and a reasonable estimate of the forward-rate inflation is subtracted, then the would-be investor isn’t an investor, but a macro-economic gambler. He/she is making several bets, none of which he/she can afford to lose. He/she is betting that credit-risk won’t deteriorate or, if it does, that he/she will be able to manage the situation properly by cutting losses in a timely manner. He/she is also making a macro-economic bet that the forward-rate of inflation won’t be larger than the benign (and unrealistically low) number they hoped for, and, further, that if rising nflation does erode their purchasing-power, they will be able to implement (in a timely and effective manner) an appropriate counter-measure.

What that suggests is that total yields (from coupons and capital gains) in the neighborhood of 6.5%-7% become the minimum-rate of return needed from a bond free of credit-risk, and that something on the order of an additional 500-800 basis points of yield is needed if any credit-risk is assumed. That’s why I think that an unnamed (now on my Ignore list) someone’s purchase of Microsoft’s long-date bonds the 5.2’s of ’30at a price above par was so laughably ignorant. That’s was very amateur mistake, unless one’s intention were to lose money for the sake of entertainment, the same way some people play the slot machines at a casino.

Under what conditions would the purchase of those bonds prove to have been shrewd? Actually, there are several. If interest-rates become lower than they presently are, then price of the bond will rise, and it could be flipped for cap gains. The other scenario that would be favorable to the purchase of that bond would be if the forward-rate of inflation were to fall lower than it presently is. Therefore, in buying Microsoft’s long bond, the individual wasn’t making a bond investment in any conventional sense of the term. He was making a two-fold, macro-economic bet that interest-rates and/or the inflation-rate would fall further than they presently are. If they merely stay the same, he loses a small amount of money. If either of those rates rise significantly, he loses a lot of money. Those are not good odds, nor are they good consequences. Instead, the purchase of those bonds, at the price at which they were purchased, was a wonderfully-instructive example of what not to do, unless your intention is to gamble with bonds for the fun of it (instead of obtaining a positive return from a properly-researched and properly-executed investment).

But as I've said elsewhere, people do a lot of crazy things in their bond-investing for reasons that make sense to them (but not me).

Charlie
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