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Author: imdajunkman Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35357  
Subject: For Wendy Date: 7/13/2006 6:45 PM
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Wendy,

In another thread, you asked if I'd describe, in a step-by-step way, how I do bond analysis. I begged off, pleading a variety of genuine but weak excuses, most of which amounted to the fact that #1, I don't have a single (and disciplined) way of buying my bonds, and #2, nobody can play another person's game. But I will describe a recent purchase and let you draw whatever lessons you wish.

I was putting in some screen time this morning, trolling the offering lists, trying to see where the opportunities might be. I prefer not to trade through E*Trade, because of their abusive markups. But they are very aggressive about offering inventory and a good place to begin one's searching. I was running two monitors, instead of my usual three, with E*Trade's “Bond Center” on one screen, IB's market line on another, and “Yahoo Finance” minimized (for when I needed to pull fundamental data). As I found bonds at E*Trade, I'd attempt to price them through IB. But with the 100-year stuff, I was getting nowhere. ET was ready to sell me 20 different issues, but IB would quote only two of them, which was interesting to note and, perhaps, a measure of that market segment's liquidity. But I wasn't yet looking in a sustained fashion, because the Fed isn't done hiking. When rates top out, then I'll go massively long in what may be the final move of my investing career.

Then I switched over to munis, first checking out what was happening my own state, Oregon, and then nationally. Those markets totally sucked. Nervous, yield-hungry investors have driven prices to unacceptable levels. Explanation: Tax-exempt or not, I still expect a real rate of return (after taxes and inflation) on any bond I buy, and I use 5% for my inflation benchmark. Therefore, if I can't get a pre-tax 6.7% or better, I don't fuss with munis, and I don't mess with anything that isn't insured for not being able to do municipal credit analysis. (Where would a person get the needed data?)

I also checked what was happening with Agencies. Federal Home Loan Banks is beginning to look attractive. Because it is one of the Agencies that qualifies for state-tax exemption, its tax-equivalent yields are now over 7%. But it's too early to be buying them, because prices will become further discounted in due time. But I'm watching them and the other qualified agencies, looking for blue light” specials. They will happen. They always do. Taking advantage of them is just a matter of window shopping daily then executing fast when an anomaly happens. Yeah, it would be better to do careful due diligence. But I do allow myself to trade on hunches with a portion of my money. With most of it, I do classic, Peter Lynch-style investigation, an example of which I wrote up a while back for friend but now can't find.

Then I started looking at corporates, seeing what was available with yields greater than 20%, which is very scary stuff and pretty much the same recycled trash that's been available for several years now. That isn't to say that there might not be opportunities there, but pursuing them takes a ton of investigative work, and I was feeling lazy. The next slot I looked at was YTM's of 10-20%. Lots of the same issuers show up, because of the different yields that attach to their near-dated and long-dated issues. Sometimes it's instructive to set a very high threshold for the YTM and then sort the list in descending credit quality and see what shows up. Also, it's useful to note the industry of the bonds with high yields and then look at how their competitors are doing, both with how their bonds and their stocks are being priced/traded. Sometimes a whole industry is under stress, and it's possible to do the classic value thing of selecting the best of the worst (or the worst of the best) and benefiting from the inevitable recovery. Doing that kind of deep-value gig is where a bond investor can become competitive with a stock investor in terms of achieved returns in the range of 20-30% (ann.) and better.

But what I did find this morning amounted to a far-out-of-the-money put.

I had noticed that a fair number of the distressed issues were foreign issues, so I redid the search, limiting it “foreign” and was returned 879 items, which I then sorted in a variety of ways, looking for pricing anomalies, which were easy to find. A bunch of the foreign sovereigns –-to be distinguished from foreign corporates— were trading a puny yields despite their very low ratings, which was surprising to see. I don't know how to interpret that, much less take advantage of it. But I did note it. Eventually, I stumbled on to a zero --actually a busted convert-- whose reported YTM was a puny 5.4% but which had a very attractive put feature of 72 in '13 and the bond was offered near 49. It didn't take a calculator to realize that I was looking at an opportunity with possibly 500% plus gains. The company's nearer-dated 7's of something had a YTM of 8.26%, which seemed a little low for a B3/B-rated issue, but not anomalously so. What was definitely anomalous was the reported 5.4% YTM for the zero. I've reported before in this forum that ET's bond calculator mangles the YTM's for zeros, so I ran my own numbers and came up with 8.39%.

BINGO! I had a winner! 8.39% is a puny yield for a junk bond. (Remember, this is B3/B issue). But if I got stuck with having to hold the bond to maturity, it wouldn't kill me; I'd achieve a real rate of return. I just wouldn't be properly compensated for the risks I was assuming. That yield ought to be closer to 15%, though 12% would be tolerable in today's market. (Sometimes, you got to go with the flow, and, right now, corporate yields are still severally depressed.) But I wasn't buying the bond for its YTM. I was looking to put it and capture that yield. (ET was reporting 536% YTC, but who's counting?) Then I did some quick fundamentals. The Current Ratio was a whopping 5x, meaning the company had a ton of cash, like $2.50/share worth on a $15 stock. That's a margin of safety in two sense: cash means the company has maneuvering room, and a stock price that far above $5 means I have plenty of room to short it if I need to put on a hedge. Also, if you'll remember, it's a foreign corporation so, hopefully, not as tied to the insane gyrations of our own economy and market. Total debt was a worrisome $2B with an adverse Debt/Equity ratio of 2x. But that was consistent with what I know of the industry, and which I should have confirmed. Also, I would have liked to have pulled the SEC filings and worked my way though them, but I was also working against the clock. Only 10 bonds were offered and if the opportunity were as good as it seemed, I didn't want to let it slip away. Priced at 49, I could have bought the whole lot. But I also hadn't done the research that I should have. So I bid for 5 and got a fill.

What are my risks? If the company declares whatever the foreign equivalent of Chapter 11 is, what will be my losses? Likely, I'll recover a few cents on the dollar, maybe as much as 20-30. Since I paid 49, my downside risk is roughly half of my exposure or roughly ¼% of assets under management, making the risk a very traderly one. Explanation: It's a traderly rule of thumb that one's risk on any single position should be no more than 2% of assets under management. Some work with a figure as high as 5%. But the 2% rule means that one can sustain a lot of damage before getting thrown out of the game. But whatever the number one chooses, that becomes the divisor to determine the size of one's portfolio if risks are to be properly managed.

E.g, if the 2% rule is used and a default position is $10k and one makes the very conservative assumption that one's exposure is one's risk, then one needs $500k to implement the investment strategy. And, obviously, if it can be shown that one's risk is a fraction of one's exposure, then, to that extent, the dollars needed to implement the investment strategy can be reduced, which is why, parenthetically, I think the commonly-used figure of needing $50k to buy one's own bonds is total nonsense. What matters is risk and having the means to manage it properly. Under a worst-case scenario in which my exposure was my risk, I'm still well under the 2% rule. In other words, if the position blows up --and one has to assume it will—I'm not going to be hurt. If the trade works out, I capture fat returns that, on average and over the long haul, put me to the plus side of the game. That's what matters: ensuring –-to the extent that one can—that wins are bigger than losses.

If you want to dig into the underlying mathematics of such a strategy, take a look at books such as the following:

Fred Gehm, QUANTITAIVE TRADING & MONEY MANAGEMENT
Perry Kaufman, SMARTER TRADING
Robert W. Ward, OPIONS AND OPTION TRADING: A SIMPLIFIED COURSE THAT TAKES YOU FROM COIN FLIPS TO BLACK SCHOLES

And any of Van Tharp's books, especially the chapters on “positive expectancy” and his “marble game” (which meets Loki's requirements of being understandable by a ten-year old, but is in no way trivial explanation of probability theory as it might be applied to managing investment risks). And for general background reading, you ought to add Nassim Taleb's FOOLED BY RANDOMNESS and Benoit Mandelbrot's THE MISBEHAVIIOR OF MARKETS to your list, both of which are easy, fun reading.

OK, this is an overly long post that does no more than describes a fraction of my thinking about just one trade. My yearly turnover isn't large, maybe a bond trade a week. Sometimes I'm doing more, sometimes less. Investing/trading is like fishing. Sometimes time on the water is productive. Sometimes it's an exercise in frustration. But you don't catch fish unless you have a line in the water, not that fishing is ever just about catching fish. The same is true of bond investing. The bond market for the last couple of years has been tough, and lots of players have either gotten shaken out of the game or have lowered their expectations to absurdly low levels. However the Fed's hiking, Bush's continuing follies, etc. are creating conditions where bonds are becoming interesting again. But how one plays the game –-and which of the infinity of games one chooses-- can only be the most individual of decisions, for each of us being very individual people.

Charlie











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