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No. of Recommendations: 6
Buying individual bonds can be made as easy or as complicated as one wants. But from time to time, it’s useful to re-think one’s assumptions right from the very beginning. So let’s run this exercise. Let’s pretend we’ve received a windfall chunk of cash as a bequest from a favorite uncle (whose presence we’d rather have than his money). But $100k has been dumped into our lap, and we’d like to put it to work in the bond-market for having no exposure to that asset-class, or for wanting to increase our current exposure. What I would suggest is this. The first thing one needs to decide is goals. Is the intention to appreciate purchasing-power, to preserve it, or to conserve it? Those are three, very different goals, and they allow different approaches to managing risk. So let’s get a bit more specific. If inflation is running at 5% and if one’s marginal, combo tax-rate is 35%, then any rate of return across the portfolio of less than 7.69% loses purchasing-power. A higher rate appreciates purchasing-power. A lower rate merely conserves it. Each position doesn’t have to offer at least 7.69%. But that’s that rate of return (plus or minus a few basis points) required to preserve purchasing-power.

If that threshold seems aggressive, then pick whatever pair of numbers is appropriate to your own situation. But something like the following is what you’re going to be dealing with where even low tax rates and modest rates of inflation preclude the possibility of preserving purchasing-power unless credit-risk is accepted:

Needed Return to Preserve Purchasing-Power
4.6% 4.8% 5.0% 5.2% 5.4%
25% 6.1% 6.4% 6.7% 6.9% 7.2%
30% 6.6% 6.9% 7.1% 7.4% 7.7%
35% 7.1% 7.4% 7.7% 8.0% 8.3%

So the game becomes this: How much credit-risk can be responsibly accepted if the account is just $100k and the intention is to preserve purchasing-power? How much credit-risk must be accepted if the intention is to preserve purchasing-power?

Let’s divide the bond market into six credit-risk tranches, ranging from “Essentially none” to “Max” that have the following theoretical payoffs: 3%, 5%, 7%, 9%, 11%, and 13%. Let’s arbitrarily break our windfall $100k into four piles of money, prorated 10%, 20%, 30%, and 40%. Let’s impose this further requirement on our shopping. Any of the piles can be used to buy any of the tranches, but no more than one of them. In other words, right from the getgo, we are forcing ourselves to buy more risk than our fears are ordinarily comfortable with and/or less risk than our greed would like to pursue. In other words, from the getgo, we do not allow ourselves to be “totally blue-chip” nor “totally red chip”. Of the 24 possible tranche-and-allocation combos --or how many there are--, four are worth investing in real time using actual offering-lists, two of the seemingly, least-risky profiles and two of the seemingly, most-risky ones. So let’s go shopping.

What’s the best we can do with $40K in the top tier of the current bond-market? With $30k in the next one down, $20k in the next, and $10k in the next? OTOH , what the best we can do in the current bond market with $40k in the bottom tier, $30k in the next one up , $20k in the next, and $10k in the next? In other words, this is our map (or shopping list):

Allocations
Tranche Expected Blue Green Yellow Red
A 3% 40%
B 5% 30% 40% 10%
C 7% 20% 30% 20% 10%
D 9% 10% 20% 30% 20%
E 11% 10% 40% 30%
F 13% 40%

Projected Averages 5% 7% 9% 11%
As-found ? ? ? ?

In a previous post, I discussed what can be found in the top tranche. It doesn’t matter whether you’re shopping for treasures, agencies, munis, or corporates, you aren’t going to get very close to a nominal 5% unless you go very far out on the yield-curve, and once you factor in taxes and inflation --at whatever rates you want to work with-- you’re probably going to be losing purchasing-power. This isn’t a problem if your intention across the portfolio is merely to conserve. So let’s go shopping and look for what currently seems to be the most efficient buys.

But, first, a couple of words about “minimum-purchase requirements” and “diversification”. If you’re buying munis, the nearly-universal, buying minimum is five bonds, and ten is common. (I’ve seen singles offered, but it’s rare.) The supposed purpose of “diversification” is to spread risk. But risk can also be spread through position-sizing. If you limit your exposure to an issuer, you are limiting the size of your risk, though not, of course, the likelihood of the risk. So both factors need to be considered, which results in these basic theorems.
(1) If the likelihood of loss is zero, then you don’t need to diversify.
(2) If the likelihood of loss is high, then the position, as a faction of your account, had better be low.
(3) If a bond has very little default-risk, it has a lot of inflation-risk.

In the top tranche, buying tens and twenties isn’t a reckless thing to do. In the bottom tranche, the only way you can responsibly get away with buying in those sizes is to have an account large enough to bring your “exposure” (which isn’t necessarily your “risk”, due to workouts) down to some reasonable fraction such as 3%- to 5% of the account, and 1% to 2% is a whole lot better . That fact requires the introduction of yet another concept of risk-management, synchronic account-size, versus diachronic account-size. So let’s run a though experiment. Let’s give you a buck, and me ten, and flip for pennies. Likely, at the end of the day, neither of us will walk away a significant winner, nor loser. But if you increase your bet size to two-bits, I’ll break you in as few as four turns and, for sure, within the quarter hour. But if you can add to your bank roll by borrowing , then you could hold your own, if not go on to break me instead.

Same-same with investing. If your account truly is limited to $100k, and if you are charging your risks against that $100k, then you can’t make certain bets. They are too big for you. But if you can charge your risks against your future and, presumably, larger account AND if you don’t increase your bet size, then you can sustain a series of losses that would ordinarily shut you down, and you can go on to capture the average win/loss ratio you are pursuing. In other words, let’s say you’ve allocated 10% to the tranche with the greatest credit-risk (but, also, the greatest potential reward). Let’s say you can get in on singles at an average price of around 83. The 12 separate issuers you could buy is a good step toward diversification. But it’s a far cry from what is needed. According to Fridson (Ch 19 of Barnhill’s book on High Yields) “With just 29 senior-equivalent Single-B issues, thoroughly diversified by industry, the [portfolio] achieves a 95% probability of [sustained profitability]”. If you run a scan for single-Bs at E*Trade, you get around 7,000 hits. Even if you could find 29 of these issuers whose debt is worth buying, your 10% allocation won’t allow you to buy the 29 you need (though a 25% allocation probably would). But your choice isn’t to go “all-in” or to buy nothing if your commitment to that tranche is diachronic. You can buy the best of what you can find for $10k, and then you look elsewhere with the rest of your money, just as in the top tier, if that’s an allocation for you, you buy the best of what you can find and then you look elsewhere with the rest of your money.

Why buy across the yield-curve and up and down the credit-spectrum? Because you need some protection against default-risk (or else you risk blowing up your account), and you need some protection against inflation-risk (or else you risk having a pile of paper that that won’t buy you very much.)

OK, this post is already overly long, and it’s gotten to be past my lunch time. So the shopping and the naming of actual, currently-offered issues I think are the most efficient in each of the six tranches will have to be done another time. But it’s certainly something you can do for yourself. As an investor, you are probably carrying extra cash. As an investor, you cannot know what lies ahead for markets. But at some price, some of what’s currently being offered (in any asset-class) should be bought. Not gobs and gobs of it, but some judicious nibbling should be done, which is as much as an investment plan can require. Take a look at what is being offered and then decide, “Yea or Nay”, and then do it again. “Wash, rinse, and repeat”, as Jack would say. That’s all that investing amounts to, making a series of bets, one after another, in a consistent and disciplined way, so that you achieve your financial goals without getting yourself thrown out of the casino.

Charlie
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