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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 35400  
Subject: Re: PenFed’s CD Offer, Again Date: 9/21/2010 3:36 PM
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Jack,

Thoughtful post, and, “No”, you aren’t rambling. Since I’ve got to turn my daughter’s rod 180 degrees every five to ten minutes while the final coat of epoxy on the thread-wraps cures enough not to sag, I’ve got time to hammer out a reply. (If I were a serious rod-builder, I’d own a drying motor or borrow back the one I helped my neighbor build. But, actually, I don’t mind having to wait around while the epoxy cures. So I’ve got time to post).

For nearly a year, since summer of 2009, I’ve been saying that bonds are over-priced compared to the bargains that were available in spring of ’09. But every time I’d go shopping, I’d keep finding things to buy. I added 75 new positions in 2009, typically sized at a single bond. And YTD, I’ve added another 80, some of which were fives (i.e., the munis). So I’ve put a lot of cash to work, far more than my schedule requires. In other words, I try to work on a ten-year cycle. Between maturities, Chapter 11 workouts, coupons received, and savings accumulated (due to my expenses being less than my income), I can generally count on having to put back to work an amount of cash equal to approximately 10% of my portfolio. If I spread the purchases over a year’s time, that means I have to make no more than one purchase per week, and some years, as few as two a month. That isn’t a burdensome research schedule. A couple mornings a week, I run some scans. If something shows up, I look into it. If nothing shows up, I’m done for the day with a clean conscience. I did my looking, and I can move onto other things.

Right now, my “gross cash” (as a percentage of total assets) is 8.49%, and my “deployable cash” (as a percentage of total assets) is 1.40%. (Gross cash minus an emergency fund equals deployable cash.) Neither of those figures is worrisome. What is worrisome is that my average-return on that cash is a measly 1.79%, which is far from being a real–rate of return. In fact, it is a predictable –4% loss of purchasing-power. That loss has to be made up elsewhere in the portfolio if the overall portfolio is to offer a real-rate of return.

As you shrewdly point out, the fabulous gains I am able to report for this year are phantom profits. I bought cheaply, and I benefited from some immediate cap gains. To cite an egregious example of this discrepancy, the average YTD cap-gain on my top 100 positions is a whopping 38.5%. But my average YTM on those same positions is a mere 9.9%. Across the whole portfolio, the numbers converge more realistically. My average YTM is a believable 8.9%, and my average P/L is a lowly 11.4%. But both of those numbers are also bogus, because they included positions that are viable, but are so illiquid that they have no current, MTM value; positions still in Chapter 11 for which no YTM can be calculated, etc.

In other words, though my investment-objective is clear (“buy across the yield-curve and up and down the credit-spectrum to obtain a real-rate of return after taxes and inflation”) and though I seem to be achieving that, the portfolio could easily be blown up by a systemic failure of the US economy. In fact, this is something I’ve discussed before. If a normal bear market is a 20% retracement, then a double-bear is 40%, and a triple-bear is 80%. A normal bear would be an annoyance, as would a double-bear. A triple-bear, or an 80% loss of my investment assets would be survivable in the sense that I’d still be able to put food on the table and cover all expenses, but I wouldn’t be very happy about it. But the portfolio is robust enough that it is very likely that I could salvage at least 20%, and 20% would provide enough of an income-stream to get by on. But if I over-weight portions of the portfolio, so that I can chase yield (when I shouldn’t be doing so), then even a double-bear is likely to take the value of my portfolio to zero.

Hence, I need downside-protection more than I need upside-gains. Hence, I have to invest conservatively rather than “put the petal to the metal”. Hence, if the margin of safety offered by discounts from intrinsic-value has all but disappeared in the current market, I have to stop buying, and I have to start “herding”. That, essentially, is what my purchase of PenFed’s CD is. It’s a herding move, as have been some of my other recent purchases. That’s how I’m trying to deal with the problem of there being “no value”. If there’s no value, then I had better start buying some protection, and, right now, there’s two books on my shelves on options that I need to dig into, as well as other things I should be doing in case the bad things do begin to happen.

What I’m not considering doing is “going to cash”. I really am a LTBH investor. My average maturity is 15 years, and I rarely sell anything so I can capture short-term cap-gains, nor do I trail stops (no matter how good an idea it is). I “let things ride”, even if that means going into Ch 11 with the position. What I do put a lot of effort into is buying as cheaply and as widely as I can in order to create holdings that are ”robust” to a wide variety of adverse conditions. If I abandon that discipline and start buying over-priced credits, I’m going to get myself into trouble, because I will have decreased my margins of safety, and I will have increased my dependence on luck to bail me out. Not smart. So I hunker down and “wait ‘em out”.

Now back to more important things. Mixing epoxy in a 50:50 ratio, so that it cures properly, can be tricky. But I seem to have gotten it right this time (again), and I’m seeing no sagging, and I can stop rotating the blank. “I love it when a plan comes together.”

Charlie

PS A recent exception to my not selling was my acceptance of Morton International's tender offer and its 45 (forty-five!) point premium over par. It was just a single bond, but I took the gains so I could reduce my exposure, just as I also was happy to see CHC Helicopter call their outstanding bond, given that for a couple of years it had been so illiquid it wasn't being marked to market. Getting those two positions out of my portfolio edged my average credit-quality upward, which is the right direction to be moving these days, provided the price is tolerable.
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