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Subject:  To Buy the Common, or the Debt? Date:  3/26/2011  6:10 PM
Author:  charliebonds Number:  32530 of 36853

To be, or not to be: that is the question:
Whether 'tis nobler in the mind to suffer
The slings and arrows of outrageous fortune,
Or to take arms against a sea of troubles,
And by opposing, end them?

Hamlet’s same question could be asked of the asset-allocation choices we all make. Is it better to buy the common, or the debt, in each case suffering risk, but in one less so? “Less risk” is the reason generally offered for buying bonds, But, also, with that lesser risk comes less reward. At least, that is the conventional wisdom, and once upon a time, in the earlier and better days of the Motley Fool, the goal was to challenge the conventional wisdoms and, by doing so, to earn the better profit.

In the Fall of ’07, I bought E*Trade’s 8’s of ’11 at 80.219, for a CY of 10% and YTM of 15.4%. In the Spring of ’09, I picked up some of their 7.875’s of ’15 at 48.000, for a CY 16.4% and a YTM of 23.9%. Obviously, I’ve done well by those trades. So this question has to be asked: “Would I have done better buying the common instead?” Obviously, the future can’t be known, and a lot could happen between now and the maturity-date for those bonds. But some guessing can be done.

On 11/27/07, ETFC closed at $4.91. (My first entry date into their bonds),
On 04/21/09, ETFC closed at $2.43. (My second entry)
On 03/25/11, ETFC closed at $15.80.

For the sake of making easier comparisons, let’s assume that equal money was spent to buy the debt and the common on the same days, that commissions were a buck a bond and a penny a share, and that everything was sold at Friday’s close. The stock gains are simple to figure. The CAGR over the holding-period was a respectable 42.2%. By contrast, the best possible CAGR for the bond (coupons not re-invested) would be around 15%, or a nearly 3x under-performance. Run the same exercise with the next bond-purchase. Now the stock CAGR jumps to 163.8%, but the bond CAGR languishes at a mere 56.0% (coupons not re-invested), or, once again, roughly the same 3x under-performance. Over the years, I’ve run this same pair-wise comparison of stocks versus bonds across dozens of companies. Always, the answer is roughly the same. The stock of a company will offer a return that is roughly 3x as much as its bonds, albeit with greatly volatility and uncertainty. If you want to eat well, buy the common. If you want to sleep well, buy the debt. But which ever you choose, your market-timing had better be good, or you'll end up making money from neither.

There is a tide in the affairs of men,
Which, taken at the flood, leads on to fortune;
Omitted, all the voyage of their life
Is bound in shallows and in miseries.
On such a full sea are we now afloat;
And we must take the current when it serves,
Or lose our ventures.

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