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2009 is turning out to be a good year for buying bonds, as the following numbers suggest from my usual, weekend marking-to-market of this year’s buys:

YTD, I have added 36 new positions with an average CY of 9.0%, an average YTM of 13.1%, and a 12.6% current cap gain.

“Current cap-gain” is a mostly meaningless number. You’d like it to be positive, but it’s mostly meaningless if one’s intention is to hold to maturity. Also, simple reports of CY and YTM aren’t very meaningful, either, if they are disconnected from the ratings of the bonds and their maturities. It is the risk context within which gains are achieved that creates meaningfulness. In previous posts, I’ve broken down my returns for this year’s buys by credit rating. So I’m not going to repeat them here. My 2009 returns are good, because prices were cheap, and the buying was easy.

But 2008 wasn’t too shabby a year, either. I’m going to report my current results for 2008 as a way of hammering on the fact that buying ones own bonds can be done, and done with good-enough results. It doesn’t have to be done. But it can be done. That’s my only point. Buying one’s own bonds is possible, and it can be reasonably profitable.

Gross results are the following: In 2008, I bought 46 new positions with an average CY of 5.9%, an average YTM of 8.5%, and a current cap gain of (-19%). Total face-value was $161,000, at a average price of 78, an average maturity of 17 years, and an average credit rating of Baa2/BBB. But “big whoop”, right? Gross numbers don’t tell a meaningful story. So let’s dig into those 46 positions and try to get to some meaningful numbers.

$44,000 (face) of that $161,000 (face) is zeros. That is one reason why my CY for 2008 is so low. Another $13,000 (face) is in Chapter 11. Obviously, they aren’t paying coupons, either. [ROTFL] But the losses from those defaulted bonds do have to be charged against the portfolio when reporting results. Thus, the adjusted numbers become this. 8% of the positions I bought in 2008 (chiefly Lehman’s debt) have defaulted. The other 92% are viable. Of them, 30% are zero-coupon bonds. That large of an allocation to zeros will trash anyone’s current-yield. But zeros are ideal for sticking into IRA accounts, which is where I parked them

To report the portfolio’s current-yield in a meaningful way, the following needs to be done. From gross purchases, subtract the zeros, but not the defaulted bonds, and then ask how much money had to be spent to achieve what kind of a current return? That answer is straight-forward. I spent $87,318 to achieve a CY of 6.3%. Not the best of CY’s, but the number is what it is. But let’s dig a bit further. How does credit-quality play out in the portfolio with respect to CY and YTM even when zeros and defaults are included?


Face CY YTM Mat. Typical Holding

Aaa $6k 0% 7.8% 12 TVA

Aa2 $40k 5.5% 8.6% 19 Toyota

Aa3 $19k 4.9% 8.2% 16 BSC

Baa2 $3k 5.7% 7.0% 11 Anheuser

BBB- $44k 7.6% 9.7% 20 Weyerhaeuser

Baa3 $26k 7.4% 10.3% 18 Sears

Caa1 $7k 9.7% 13.2% 6 Ford

NR $3k 5.4% 7.8% 7 Wrigley

Defaulted $13k 0% 0% na Lehman


The trends are obvious, right? As credit-quality decreases Current Yield and Yield to Maturity increase. That fact offers investment opportunities in at least three directions:

(1) The portfolio can focus on the upper portion of the credit-spectrum. This is how most people choose to invest in bonds. They use the greater risks of stocks to achieve portfolio growth, and they use the less risky portion of the bond market to dampen equity volatility. In other words, they employ a version of the classic 60/40, “balanced” portfolio.

(2) The portfolio can focus on the lower portion of the credit-spectrum (in addition to stocks or without them). Done carefully, the money can be fabulous, and the risks aren’t outrageous. But the risks are high, probably fully comparable to stocks.

(3) The portfolio can attempt to steer a middle course between stability of returns and growth of returns by investing judiciously up and down the credit spectrum. (Because I’ve also chosen to own no stocks at all, I’ve chosen the middle course of balancing bond-quality against bond-yield. What anyone else chooses is for her or him to decide.)

Caveat: This is a first draft and no doubt full of mistakes. At this point, all I’ve done is take a quick look at how 2008 compares to 2009. Prices weren’t cheap in 2008. But it seems as if reasonable returns could have been achieved had anyone bought their own bonds that year from whatever portion of the credit-spectrum they chose.

2008 was a good year. 2009 is a good year. 2010?


Charlie
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Ops, I've spotted my first mistake already. The composite rating for the row containing Sears should have been Ba3, not the Baa3 that I wrote.
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Charlie,

Any input as to what the minimum size should be in order for a retail investor to run a cost-effective bond portfolio? Bill Gross says it should be $500,000. What expenses do you incur in these trades (I know it is baked in to the ask)?
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<<< Any input as to what the minimum size should be in order for a retail investor to run a cost-effective bond portfolio? Bill Gross says it should be $500,000. What expenses do you incur in these trades (I know it is baked in to the ask)? >>>

What a surprise, Bill Gross says $ 500,000. He is in the business of selling bond funds as investments. One can buy 20 different issues of $ 5,000 each. Cost would probably less than be 1/10 of what he chrages in a year for his funds. You should be able to get pretty good diversification and at only $ 100,000. Except for Vanguard's GNMA fund, I wouldn't consider buying a bond fund. I would much rather own individual bonds. Sorry Mr. Gross.
Norm
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I started bonds with two bonds in an IRA. At that time $2000 was the most one was allowed to contribute to an IRA annually. Yes, it is desirable to be diversified, but you have to start somewhere.

With stocks it is said that the amount of diversification you get with 20 stocks is not that much more than with 10.

You get your second bond in a different industry from the first. To begin now, you will avoid automakers and probably financials.

For a stock picker going into bonds, a method I use is when you find a stock you'd really like, check into whether the company has bonds. You might pick up some bonds in addition to, or instead of the stock shares.

Recently using that approach I got Autozone 5.5% of 2015 at 92 and change; a couple months later others had figured out what I thought, which was that people are going to hang onto cars longer and do more repairs themselves and business would be good for that company. It's trading around 95 5/8 and I'm pleased.

If you are in a higher tax bracket, and buying outside a retirement account, the GO's of your state are a no-brainer. The state won't go away, and the income is tax-free, both state and federal. Those have minimum face of $5000, however, while corporates are $1000 minimum. If you are initially sticking to GO's of your state, diversification to minimize credit risk isn't necessary. I try to spread income more or less evenly over the year, so a bond to pay every month requires a $30000 investment.

Best wishes, Chris
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Any input as to what the minimum size should be in order for a retail investor to run a cost-effective bond portfolio? Bill Gross says it should be $500,000. What expenses do you incur in these trades (I know it is baked in to the ask)?

Longreits,

I love your question. Finally, now, we're getting somewhere.

Gross, on occasion, can be a shrewd observer of the bond market, and he's managing enough money –-he’s an “ax”-- that his actions/opinions matter to other big players. But what he says about bonds is mostly irrelevant to small investors.

So it becomes definition time. If you’re not buying in round lots, you’re a small bond investor. So let that be the distinction between “big” and “small”, the size of your positions. If you size your positions in round lots (or larger), you’re a big player. If you don’t, you aren’t. But within the category of “small”, further distinctions can be made in roughly these sizes: 50, 25, 10, 5, LESS.

Ten bonds is considered to be the standard-sized small position. Anything less is considered to be “unmarketable”. So that becomes a second benchmark and probably what Gross had in mind. What percentage of $500k is $10k? 2%, right? That happens to be the standard, default “risk-size”. In other words, conventional wisdom suggests that you’ll never get yourself into too much trouble if you limit your risks per position (stocks, bonds, whatever) to 2% of working capital.

So, work the numbers backwards. If I have to buy ten bonds at a time (and I’m paying par) and if I want no position to be bigger than 2% of my working capital, then I need $500k. But that’s horse feathers, of course, for a multiplicity of reasons.

#1, Exposure isn’t risk.
#2, An investor can choose to work with larger or smaller risks per position than 2%.
#3 Price isn’t always par. (In fact, it can be a deep discount to par).
#4, A small investor can choose for forego marketability and buy as small a single bond.

To me, the more interesting question isn’t the how big one’s account has to be to be
cost-effective [which is your original question] or risk-effective [which is my expansion of the question] but how small can the account be and still be responsible?

I could provide you with an answer. But I’m going to throw the question back to you. What are the variables? Cost per bond, right? Which can come from three sources: Spread, Markup, Commission. Those costs have to be prorated over the intended holding period. But costs of buying are a bond investor’s least worry. The biggie is default. If costs of buying are free, but the company files Chapter 11 and the eventual workout is $0.18 on the dollar for bonds bought at 95, who cares about buying costs? That’s why I insist that risk be considered when talking about minimum account size.

So it becomes definition time again. Partition the bond market into risk segments, however you choose. If the would-be bond investor is working within the “default-free” segment and a segment that is either highly liquid and/or tightly bid, then responsible, cost-effective bond investing can be done with very little money. E.g., a Treasury bill/note/bond can be bought for $1k. If that’s one’s account size, then one is a bond investor. If one chooses corporates and want to avoid the fees typically associated with small accounts, then use Fido. A account of $2,500 avoids account fees. Fido quotes the inside market. Commish on a single bond would be $8. If the bond is good quality and the holding period is 10 years, then cost/bond/year become $0.80/bond. If the bond was bought near par, then costs/year become 8 basis points, or about as low as any index fund out there.

But let me offer a concrete example. My sister recently retired. Her pension will be bigger than her expenses. So she’ll have surplus capital each month. She was wondering what to do with the money. Knowing my interest in bonds, she asked if she could buy bonds as a way of parking the money. Of course I said yes and immediately recommended Wright’s book. But I also slammed through a quick reread of the book and had to admit that book, the best beginner’s book there is, would overwhelm her. Also, learning the vocab and concepts all so she could buy a single bond would be an exercise in frustration. Also, setting up an account with E*Trade, which is where she should establish her account, would kill her on fees which would be $40/quarter for accounts less than $10k. Even if she snagged bond with an 8% coupon, account fees would mean she had bought a loss from the getgo. Also, without “skin in the game”, Wright’s book wouldn’t be meaningful to her. But without understanding the concepts Wright introduces, she wouldn’t be able to make good choices for herself.

So the compromise I settled on was this. When she got together $10k, then we’d start the bond investing lessons. Basically, I’ll guide her toward an 8-10 bond portfolio of the sort I’ve put together for other people, and then I’d cut her loose to continue on her own. With “skin in the game”, she’s either going to get serious about managing her portfolio and growing it, or she’s going to lose interest. If the latter, the costs of the experiment might be minimal or none.

So that would be my answer. If one wants to put together a cost-effective, risk-effective, investment–grade portfolio, $10k is enough money. If one intends to focus on just spec-grade bonds, then bigger money will be needed, as would be if one want to run a diversified, any-rating portfolio. But if one wants to trade for mere basis points (as does Gross), then $500k isn’t enough money. It’s going to take at least $2 million.

Charlie
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Charlie,

Is the beginner's bond book by Wright that you referenced the book by Sharon Saltzgiver Wright, "Getting Started in Bonds", Second Edition?

Offered at Amazon:
http://www.amazon.com/Getting-Started-Second-Sharon-Saltzgiv...

Thanks,

MKT
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MKT,

Either edition of Wright's book would be just fine. (I have both.) I've skimmed the other beginners book there are (Thau, etc.), but my preference is Wright. Her approach is informal, but shrewdly solid.

Obviously, in a beginner's book, she doesn't cover each segment of the bond market (Treasuries vs. Agencies vs. Munis vs. Corporates vs. Preferreds vs. Etc.) in as great a detail as is really needed. But the book is an excellent beginning that holds up well even after one gains experience. I'll go back from time to time and review basics, and every time I do, I see something in her book I missed on an earlier reading.

I really like both her book and the person who she is that comes across in the book. She's smart. She's funny. She's experienced. She's the bond market versions of Toni Turner whose books on stock investing I like for the same reason. Both authors understand where beginners are coming from their not having forgotten their own experiences as beginners.

The next two books one needs to look at are Crescenzi's The Strategic Bond Investor and Barnhill's High-yield Bonds. If one is an experienced stock investor, my suggestion would be to skip Wright and jump straight to Crescenzi. Alternatively, if one intends to take a game-theoretic and/or "chartist" approach to bond investing, then skip Crescenzi and go with just Wright. However, if one intends to invest in corporates, even just investment-grade corporates, one soon needs the info presented in Barnhill's book as a way to learn how to think about risk-management. The book is expensive. But if one intends to become serious about bond investing, that book will pay for itself in terms of learning how to avoid mistakes. The book is 28 chapters, each of which reads with the suspense and engagement of a detective story. That book, too, lends itself to rereading from time to time.

Beyond that, there is the professional literature that shows up in places like the Journal of Finance. But you've got to be a real nerd to want to deal with it and running seriously-sized money to benefit from it. The better path is lots of screen time. Let the market itself teach you what you need to learn. In these days of good search engines and burgeoning websites that cater to narrow investing niches, an answer to any question that comes up can be easily found. In fact, one could probably even skip books entirely and just depend on web resources to learn bond investing. But I'm old-fashioned enough that I like the stability and portability of having the author's words on paper for me to underline and to write notes about in the margin.

Best wishes, Charlie
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Opps, more mistakes The bolded word was omitted from the previous

So, work the numbers backwards. If I have to buy ten bonds at a time (and I’m paying par) and if I want no position to be no bigger than 2% of my working capital, then I need $500k.
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Charlie,

Thanks for your informative response. So, the conclusion seems to be if one invests in liquid bonds (Gov, investment grade corporate) then transaction costs are low given one uses the right broker (Fido, the example you gave) and whose holding period makes sense in terms of the fees incurred ($8 for a 10 year bond is $0.80 or 8 BPS per year).

You mentioned that anything less than 10 bonds is "unmarketable" and also mentioned the term "round lots". I take "round lots" to mean lots of 100? And, also, that all bonds trade in $1,000 increments?

I also noted the three books you recommend and plan on reading all three - probably sometime over the next six months.

Thanks again. I really appreciate it.
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Longreits,

Stocks: round lot = 100 shares. Bonds: round lot = 100 bonds. Currencies: round lot = $100k. Etc.

"Unmarketable" is an over-statement. "Readily marketable" would be a better term. Typically, a "marketable lot" would be sold at less of a spread than a smaller lot. Yes, at some price, (almost) anything can be sold. But in the bond game, a lot of ten is considered to be (is treated as) the smallest lot in which buy-side brokers are willing to express an interest to the point of being wiling to bid at a price close to the current market for those bonds. For a lot smaller than ten, the price bid is likely to be very unfavorable to the seller.

This works in reverse as well. Often, small lots are offered out at a premium to a larger lot. Odd-lotters can do quite well for themselves.

As for books, given what you've told me of your intentions by PM, Barnhill's book is the only one you need to read. (That one is crucial for you, though not for other people.)

Best wishes, Charlie
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Charlie,

Thank you for the book recommendations. I really appreciate all the time you spend answering newbie questions. Thanks for sharing your knowledge.

MKT
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Thank you for the book recommendations. I really appreciate all the time you spend answering newbie questions. Thanks for sharing your knowledge.

MKT,

The person who deserves the mostest and the bestest credit for answering newbie questions is Jack. His patience knows no limits. I have seen him expend efforts far beyond the call of duty to understand a beginner's question -- in this and other forums-- that humble me and my limited outreaches. What is truly sad is the the beginner typically fails to thank him or to understand him. They bring their preconceived ideas with them and depart the same way. Truly sad, because what he said was solid information and advice.

Another person who deserves a lot of credit for answering questions is Paul. If a person has a question about preferreds, Paul's answer is prompt, through, and authoritative. If the question is about TIPS, then there's several person who do a superior job of that. Etc., etc, etc.

There's a lot of people who make this forum work well, and everyone of them deserves credit (not just board-hogging me who has his own very limited interests).

Charlie
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Thanks Charlie! Crystal clear now. I look forward to your continued posts and the discussion on this board.

Sitting near Lake Michigan now on vacation for a week. Hope to be managing my bond portfolio from this same spot in 20 years!
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