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No. of Recommendations: 7
There’s a thoughtful post (#155,719) at the Berkshire forum that merits your attention if you’re looking for ways to get a bit of current yield and are indifferent whether the yield comes from stocks or bonds. As the author has constructed the portfolio of div-paying stocks, $200k is put to work across 23 stocks with weightings ranging from 6.9% of the portfolio to 2.3%. Obviously, weightings could be adjusted, and the money put to work could be scaled down. But the portfolio as constructed and its 4% average current yield would be a good place to begin. The author stresses the fact that that the portfolio is not a short-term project. He writes:

What do I recommend doing with these stocks? If you want dividends, I
think you could buy this slate and pretty much forget about them for a
decade. I would not rebalance the portfolio at all---some of these
firms will grow a lot more than others, so you might as well let those
winners grow to a larger fraction of the portfolio over time. Sure,
they will go though periods that they are overvalued or undervalued in
the short term, but it's best and easiest simply to ignore that.

Lastly, the hidden gem of good news: I would speculate that this slate
of stocks will increase in value and price a lot too. I am (foolishly)
forecasting an annual compound return including dividends of over
10%/year for this portfolio in the next decade or so. (in round
numbers, 3-4% dividends and at least 6-7%/year average price growth
rate). The dividends will be a lot steadier than the share prices,
which can be totally ignored. 10% a year might not sound like so much,
but let's look at the S&P index in ten years and see how high a hurdle it was


Attempts to compare the gains from stock versus bonds always generate as many misunderstandings as useful insights. This one won’t be any different, because I begin with this premise: On a risk-adjusted basis, there will be no difference between the two. If you’re getting more return from one, it is because you’re taking on more risk. But the converse is never true. Just because you take on more risk doesn’t mean you will receive more reward. So the “bottom line” becomes: “Can I manage the risks responsibly?” If not, then it behooves one to find an easier game. Thus, for many investors, bonds offer as much risk as they are willing to assume. They would like the higher returns of stocks, but they suspect they can’t manage their risks. So they settle for bond-like returns, which would be something in the range of 7%, rather then the 10% of stocks. But rather than indulge in idle speculation, let’s go shopping the today’s bond market with the same list of names the author used to put together his stock list and see how well we could do in terms of obtaining some yield. Below is his list of companies:

GE Santander Wells Conoco Sanofi KraftTakeda Eaton Ingersoll Norfolk
Johnson American Express Proctor Royal Bank of Canada Coca Glaxo
Nestle Tesco Colgate Posco Diageo Burlington Toyota.


Not all of those companies have currently-offered bonds. E.g., Nestle’s bonds are unavailable. But I know they issue bonds, because I own some. Ditto Tesco, Royal Bank of Canada, Posco, etc. Right now, they aren’t available in the secondary market. Arbitrarily, let’s use 3% as the lower boundary for YTM and then ask what the yield-curve for each company would be. Let’s begin with Diageo (A3/A-).

Issue Cpn Maturity YTM Price CY
DIAGEO CAP PLC 5.200 01/30/13 3.4 105.850 4.9
DIAGEO FIN BV 5.500 04/01/13 3.5 106.804 5.2
DIAGEO CAP PLC 7.375 01/15/14 3.6 115.772 6.4
DIAGEO FIN BV 5.300 10/28/15 4.1 106.782 5.0
DIAGEO CAP PLC 5.500 09/30/16 4.7 104.632 5.3
DIAGEO CAP PLC 5.750 10/23/17 4.7 106.868 5.4
DIAGEO CAP PLC 5.875 09/30/36 5.2 109.512 5.4

Toyota (Aa1/AA+) has a single, currently-offered issue.
6.050 06/20/31 6.047

Ingersoll (Baa1/BBB+) has two:

Issue Coupon Maturity YTM Price Cur Yld
INGERSOLL-RAND GLOBAL HLDG CO 9.50 4/15/2014 6.3 113.100 8.4
INGERSOLL-RAND CO 4.75 5/15/2015 5.0 98.841 4.8


Wells (various ratings) has lots of maturities to choose from:

Issue Cpn Maturity YTM Price Cur Yld
WELLS FARGO & CO A2 A+ 6.38 08/01/11 3.5 105.724 6.0
WELLS FARGO FINL INC A1 AA- 6.13 04/18/12 3.5 106.896 5.7
WELLS FARGO FINL INC A1 AA- 5.50 08/01/12 3.7 105.123 5.2
WELLS FARGO & CO NEW A2 A+ 5.13 09/01/12 3.6 104.518 4.9
WELLS FARGO & CO NEW A1 AA- 5.25 10/23/12 3.8 104.480 5.0
WELLS FARGO & CO NEW A1 AA- 4.38 01/31/13 3.7 102.064 4.3
WELLS FARGO & CO NEW A2 A+ 4.95 10/16/13 4.7 101.087 4.9
WELLS FARGO & CO NEW A2 A+ 4.63 04/15/14 4.6 100.154 4.6
WELLS FARGO & CO A2 A+ 5.00 11/15/14 4.7 101.165 4.9
WELLS FARGO BK NATL Aa3 AA- 4.75 02/09/15 5.2 97.643 4.9
WELLS FARGO BK NATL Aa3 AA- 5.75 05/16/16 5.8 99.600 5.8
WELLS FARGO & CO NEW A2 A+ 5.13 09/15/16 5.7 96.466 5.3
WELLS FARGO & CO NEW A1 AA- 5.63 12/11/17 5.6 100.227 5.6
WELLS FARGO & CO A1 AA- 5.38 02/07/35 6.1 90.569 5.9
WELLS FARGO BK NATL Aa3 AA- 5.95 08/26/36 6.7 90.536 6.6

Eaton has a few:

Issue Cpn Maturity YTM Price Cur Yld
EATON CORP A3 A- 5.95 03/20/14 4.4 106.322 5.6
EATON VANCE A3 A- 6.50 10/02/17 4.9 110.798 5.9
EATON CORP A3 A- 5.60 05/15/18 5.4 101.100 5.5
EATON CORP A3 A- 6.95 03/20/19 5.6 110.065 6.3
EATON CORP A3 A- 7.65 11/15/29 6.9 107.841 7.1
EATON CORP A3 A- 5.80 03/15/37 6.9 86.597 6.7

OK, this is as far as I want to take this write up, because the writing is tedious compared with doing the work offline for my own purposes. But the previous data samples clearly suggest that the project is doable. For most dividend-paying stocks, a corresponding bond could be found. The bond will typically offer a higher coupon than the stock dividend, but a lower capital gain. So that becomes the trade-off. If the bond can be bought at a steep discount to par and is sold at its maximally-favorable high price, then serious cap gains can be achieved. But that’s a trading gig, not an investing gig. If an investorly, buy-and-hold attitude is assumed toward the project, then a bunch of decision have to be made.

(1) At what point will the stock be considered to have reached “maturity”?
(2) Will the dividends (from stocks) and/or the coupons (from bonds) be re-invested or spent? (Re-investment skews results to the bond side.)
(3) How far out on the yield-curve is one willing to go?
(4) How far down on the credit-spectrum?
(5) How does one equate stock-risk to bond-risk, so the “risk-adjusted” becomes a meaningful, quantifiable term?

In short, looking at the problem raises a lot of interesting questions, and not just theoretical ones. With her surplus money from her pension, my sister would like to move that cash into the bond market. I’ve suggested that she wait until she has $10k to put to work and then we go shopping. I’m not a financial advisor, and my preference is the make my money in bonds rather than stocks. But the responsible thing for me to do is to review both of the choices she has (div stocks vs. bonds) and to estimate the more favorable path. She has owned div stocks before, as well as CDs, so those choices are familiar to her. It is corporate bonds that she (like most people) has never looked into.

At this point, I don’t know what might be the better path for her. The skills needed for building and managing a div stock portfolio (versus a bond portfolio) are obviously overlapping. But there are some crucial differences. If the next ten years becomes America’s “lost decade”, money now put to work in div stocks is going to suffer huge principal losses. If the US does muddle through, stock gains will clearly outpace bond returns. If her money is to be merely parked money, bonds might be her safer choice. If she wants gains, then div stocks might be her better choice. In either case, I know she wants a “buy 'em and forget about ‘em” program.

So, as always, her choices are a function of her intentions and her tolerance for risk. In other words, her investment plan will be a consequence of her over-all financial plan. But what is possible from the low-level investing side helps to shape what is decided in the high-level planning side. So the two do interact with each other, plus where we are in the market cycle matters hugely. If she had come to me back in March-April with money to put to work, I could have put together a starter bond portfolio offering a reasonably-assured 13% without a problem. Nowadays, getting a risk-equivalent 7% from bonds will take some scrambling, which inclines me to suggest that she explore the equity side rather than the bond side. Although I’m also beginning to wonder if a compromise –-BOTH the debt AND the common of selected, div-paying industrials-- might not be the best solution.

Lots to think about as another summer weekend approaches. http://boards.fool.com/Message.asp?mid=27798752
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Good post. But I like your last sentence best: Although I’m also beginning to wonder if a compromise –-BOTH the debt AND the common of selected, div-paying industrials-- might not be the best solution.

If your sister wants a "park it and forget it portfolio"? Why not look at an all indexed ETF portfolio of stocks and bonds like this one:

50% Fixed Income
20% BND (us bonds)
20% BWX (non-us bonds)
10% PCY (em mkt bonds)

50% Equities
14% VTI (us lg stocks)
07% VBR (us sm value stocks)
14% VEU (non-us lg stocks)
07% VSS (non-us sm stocks)
08% VWO (em mkt lg stocks)

The fixed income port's yield is 3.96% and the equity port's yield is 3.25%. Thus total port's yield is 3.60%

60% of bonds and stocks are in non-US assets and 40% in US assets. 20% of the bonds are in emerging markets. 25% of the stocks are in emerging markets.

What's not to like about it?
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Charlie,

In all that there's one thing that I didn't come across: inflation. Buffett has always been adamant that quality equities are the safest place to beat long term inflation. The coupons on those corporate bonds never change. In contrast, high quality companies, especially of consumer staples, find a way to pass inflationary costs on to consumers. So, he targets companies with pricing power and simple, primarily essential businesses. If they maintain that pricing power, they'll succeed in building inflation into their profit margins, and thus into their divis, offsetting the erosion you'd experience in a bond. That's what "good management" does. I also think you're assigning too much risk to equities in general. Is P&G common more risky than a C rated bond? No way. There's less long term risk in quality equities than you're acknowledging, when purchased in a diversified port. It's not surprising to me that a BRK junky, after years of listening to Buffett, would prefer this direction. It's WEB's own preference stated time and time again.
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What's not to like about it?

temsike,

You've put together a thoughtfully-constructed portfolio that would meet the needs of some investors. No doubt about it. But bond ETF's aren't bonds and, thus, have no maturity.

Yes, for sure, emerging-market bonds have been on a rip this year, and a fund --an ETF or otherwise-- is the most effective way to access the asset class. But bond funds --ETFs or otherwise-- are merely trading vehicles. They are nothing to own on a buy-and-hold basis. You get in, and you get out.

Bonds, OTOH, can be held to maturity, and if the asset class is easily accessed --e.g., Treasuries and Corporates-- the owner of individual bonds can easily beat the returns of those classes of bond funds with very little effort. Over the long haul, less than 5% of bond fund mangers will beat what even the most average of investors can do with individual bonds. It takes no brains to beat the fundies due to how funds are managed. So suggesting to anyone, much less someone whom I care about, that he or she buy a bond fund if the underlying is easily accessed is dead from the getgo. That's bad advice that I won't give anyone. (Well, almost anyone. There's a few people whom I'd urge to buy bond funds, so I could laugh at their mistake.)

OTOH, a well-constructed stock fund, index or active, is another matter, because stocks have no maturity. So whether it is the underlying being traded, or a derivative of the underlying, doesn't make much difference if the intention is to buy and hold, because something like 85% of the returns will come from the asset class itself. So a stock fund is a macro economic bet, and because the future is unknowable, hedging the future with a long bet isn't a bad idea. In fact, that's the default result of the much-used formula for rotating assets from equities into fixed income. (100 minus one's age is the suggested allocation to bonds. Thus an 80 year-old would still have a 20% toe in the stock markets.)

Given that sis is only 62, she should be hugely into stocks with her investments. But she's not, for having no investments. Like a typical Californian who bought back in the '70's, she's sitting on a half million of easily realizable house equity, has a pension tied to PERS, and is super-sensible about her spending. So if she just lets her accumulating surplus income sit in cash, no great harm will result. If she can invest it prudently, so much the better. But it's small money, and, like most people, she has zero interest in investing as a hobby, much less as a necessity.

Let me guess that she'd want to put $10k to work/year. Under the best of circumstances, how much would her money earn compared to substitute teaching two days per month? That, I suspect, will be the reality for her. If she wants some "mad money" to blow on a trip, she could earn it faster and easier by working than from investing. Where investing makes a lot of sense is when a lot of money is being put to work. Then elaborately constructed and carefully managed plans make sense. But for $10k of what amounts to petty cash, just splitting it between a basket of five bonds and five stocks wouldn't be a bad way to go.

However --and here come more "buts"-- dealing with small accounts is a hassle. Yes, Scottrade changes no minimum account fees, and they would be a good broker to use for buying either stocks or stock funds (ETFs or otherwise). But they suck majorly for bonds (due to their ten bond minimum/ticket and limited inventory). E*Trade wouldn't be as good for stocks/ stock funds as ST due to higher commish. But there is currently no broker who is doing a better job with bonds (although Zions comes close).

ET abuses its customers with minimum account fees, but a $10k balance would solve that problem. So that was my initial thought. When she has $10k to put to work, then we go shopping. If the bond market is hugely over-priced when she's ready to buy, or if div stocks seem preferable to her (as individual holdings or through a fund that focuses on div stocks), then we pursue that route. But launching the project is months away. Now it's summer, and time to play with grand kids, go back-packing, and oversee her house remodeling project. Come the Fall is when she'll want to talk money and investing.

What I was trying to do was to think a few moves ahead of her, so I wouldn't be scrambling for ideas while she's losing patience. I love her dearly, but I know she hates getting bogged down in details. So whatever I pitch will have to be clean and simple. She's smart enough see a recognize a good idea when she sees one, and independent enough to say "No" to those she doesn't like. So making the pitch puts me on the hook for figuring out something that is (1) worth doing and (2) won't blow up on her. I know bond as well as anyone, but prices in the Fall might not justify initiating new positions. So I need a fallback plan, which is kind of why I was poking around in the posts on div stocks. That's an investing format she's familiar with from the example our parents set for us though their own investing and through the stock shares given to us as kids, and, in turn, to her kids by our parents (as presents to their grand kids.)

Thanks for your taking the time to think about the problem and offering a solution that makes sense to you. Sis wouldn't like it, though. Too many parts. She really will want clean, simple, and concrete, which means individual securities, rather than funds. That's an old-world prejudice, but those were our parents' values, and investing is nothing if not mainly an expression of culture and values (wrapped in emotions) most of which are denied (or not even recognized) but very operative when it comes to making choices. So a lot of my success with the "pitch" will depend on saying things that have nothing to do with numbers but whose "heart and feeling " resonates with her.

(ARRGH!. Why anyone would want to be a financial adviser is beyond me.)

Charlie
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How many individual bonds does it take to make a well diversified bond portfolio which includes foreign non-US$ bonds?

That's why for simplicity, I used THREE very low cost indexed ETFs that would give your sister a very low-cost and superbly diversified fixed income portfolio.

I'm trying to keep to the KISS philosophy regarding investing.
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JustMee01,

You ask thoughtful questions. Let me make a quick reply right now, and tomorrow I’ll make others using a different tactics, because answers aren’t easy or obvious.

YTD, I’ve initiated 42 new bond positions, 33 of which were the debt of publicly-traded companies. If I had bought the common the same day, what would have been my results?

Methodology: I froze the holding period as of last Thurdsay’s close. The price data from Yahoo was unadjusted for dividends. I made assumption that divs and coupons would be equal and discarded them. I substituted BRK-B for Geico, and Dow for Union Carbide. And I’m sure my data contain errors.

Question: “How good would I have done as a stock-picker on the basis of just cap gains?”

Rather than present an item-by-item spreadsheet, let me just summarize the results. At an average price of 67.461, I bought $42k face of mainly invest-grade bonds, with an average CY of 8.9%, and average YTM of 12.9%, and an average, current, cap gain of 13.9%.

With the same money I could have bought $28,334 of stock that would have an average, current, cap gain of 9.6%. That’s not shabby. But it sucks compared to my bond picking.

The downside of the bond cap gains is that they would be hard to capture. At best, I might get 90-95% of them. The upside to the stock gains is that I could hit the bid and be out of the positions as fast as I could write the orders. At worst, the gains would be 98-99% realizable.

Now comes the hard part. I need to go back and figure out what the div rate for each stock is and project a price growth rate over a suitable holding period. My suspicion, based on past tests of this sort, is that on a total-gains basis, stocks will outperform the bonds by 3x-4x and be about 3x-4x as volatile (which is a simplistic way to define/measure risk, but it’s a common and workable method.)

Bottom line? In part, I know what I’m doing as a bond picker, and in part, any idiot throwing darts could have made good-enough money in stocks or bonds from January until now. So benchmarking one versus another in this time frame is mostly meaningless. Where the rubber will meet the road is in the coming months. If markets roll over, as they are signaling they’re going to do, I’ll get dinged, but the stockholders will get whacked hard. So that’s the appeal to me of bonds. They are less fragile than stocks, and the money is decent enough.

Yes, inflation is a problem whose overcoming, it is argued, is more easily done with equities than bonds. But I’ve also seen counter-arguments that I’ll have to track down. Also, tomorrow, I dig through the bond offering lists and do some more back-testing. My feeling is that on a risk-to-risk basis, stocks cannot –-on average-- out-perform bonds. The arbs would be all over that one before it could even happen. At the retail level, however, the story is very different. Yes, stocks will “out-perform” bonds because greater volatility is tolerated, and because synthetic contracts aren’t created from the bonds and rolled, so as to provide a fair basis of comparison.

You’re asking thoughtful question I need to deal with for my own investing. Thanks, Charlie
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temsike,

Foreign bonds are available. But I wouldn't mess with them except within the framework of a fund.

Corporates is another matter, as is defining "diversification". For that, Chapter 20 of Barnhill's book offers as good an answer as any I've seen for its critique of attempts to simplistically apply concepts that might be appropriate to stock portfolio to bond portfolio.

If the purpose of "deworsification", as Buffet calls it, is to protect against ignorance, then the better techniques are either proper due diligence and/or proper position sizing. Diversification, however one wants to define it, comes in a poor third and should be a very minor concern compared to buying properly in the first place at a deep enough discount to create a margin of safety.

Yes, the mutual funds tout "instant diversification" as one of their talking points. But grind through their schedules of holdings sometime and run correlation tests. What they preach and what they practice are worlds apart. They make very focused bets whose correlations tend toward 1.0 when their holdings come under stress. Thus, when diversification is most needed, they cannot offer it. That, too, is easy to document. Just pull the historical data and run the tests in Excel. ("Been there, done that" many a time.)

Charlie
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I completely understand your position on bond funds. But please answer my question: how many bonds would YOU need to have a reasonably diversified bond portfolio?
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<1>I also think you're assigning too much risk to equities in general. Is P&G common more risky than a C rated bond?

JustMee01,

Interesting question. Unfortunately, nearly impossible to test for unless two conditions were met. (1) A quantifiable definition of "risky". (2) Some bonds that are rated "C".

By my count, as of July 10, there is exactly one, currently-offered issuer whose bonds are rated single-C. But moving up the scale to include double-CC and triple-CCC, more names show up, some of which would be testable, e.g., Ford and AMD, with regard to how their debt and common preformed relative to each other. Conversely, it should be straight-forward to find bonds whose risk characteristics offered a good test against PG (or similar blue chips).

Thus, to claim that a well-rated stock is less risky than a poorly rated bond only becomes meaningful when the rewards of owning one or the other are factored in. E.g., if owning PG produced 10-15%/year, but owning a junk bond produced 100%/year (and I'd achieved those kinds of returns), which was the better, risk-adjusted investment?

Until the test were run, I have no firm idea of the results. But my suspicions are that on a risk-to-risk basis, there would be little difference. Risk is risk, no matter the asset class. But until back-testing is done, both of us are just guessing.


Issue Rating Max YTM
Advanced Micro CCC+ 12%
AMC Entertainment CCC+ 12%
Berry Plastic CCC+ 37%
Colonial Bank CCC+ 21%
Eastman Kodak CCC+ 18%
Ford CCC+ 11%
Graham Packaging CCC+ 10%
Healthsouth CCC+ 12%
Isle of Capri CCC+ 17%
Marquee Holdings CCC+ 12%
Mueller Wtr CCC+ 11%
NPC Intl CCC+ 20%
Readable Theraputics CCC+ 14%
Sabre Holdings CCC+ 12%
Sealy Nattress CCC+ 15%
Servicemaster CCC+ 13%
Toys R Us CCC+ 13%
United Rentals CCC+ 15%
Yankee Acquistions CCC+ 0%

Atlas Pipeline CCC 28%
Borden Chemical CCC 35%
Freescale Semi CCC 14%
Michaels Store CCC 13%
Pinnacle Foods CCC 16%
Tenneco CCC 16%
TXU CCC 0%

Ames Trutemper CCC- 47%
Brrokstone CCC- 59%
Radio One CCC- 0%

Acuride CC 38%
Blockbuster CC 115%
Clear Channel CC 96%
Ply Gem CC 69%
Reader's Digest CC 31%
Resaurant CC 191%
US Freightways CC 20%
Yellow Roadways CC 0%

NXP C 0%


The preceding list mostly illustrates how over-bought junk bonds have become. Most of the yields are pitifully low compared to prices earlier in the year when the buying should have been done.
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But please answer my question: how many bonds would YOU need to have a reasonably diversified bond portfolio?

Bad question. Very bad question, for its emphasis on quantity rather than quality. The simplistic idea that some magic number like 13 or 20 or 40 creates diversification is laughable. You need to do some very basic reading.

Do I run "a reasonably diversified bond portfolio"? Yes, I do. Thank you for asking.

Could I explain why I make that claim? Yes I could. Thank you for asking.

Will I do so? No. Work out an answer for yourself.

Have a nice day.
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(sorry for barging in, I'm the guy who wrote the post over on the BRK board)

Very nice post!

Just one thing I wanted to point out---my suggested slate was not really
a recommended investment per se, but rather an answer to the unasked
question of "IF you start with the assumption of wanting dividend
paying equities, what's a good way to get a reasonable dividend yield
safely without too much investing savvy", the angle of course simply
stealing most of the picks from Berkshire since it's an above-average crowed of firms.

Truthfully I also didn't consider bonds as an alternative for a few
reasons, notably the usual ones: it's just so darned much harder to do
the research, and difficult and very expensive to purchase the things
when you've done it. But mostly because there can be a lot of "hair"
(complexity) on each one. Personally I'm no corporate bond expert
because of my odd tax situation---only sovereigns make any sense for me.
I pay 30% tax on corporate coupons, 0% on sovereign coupons, and 0%
on cap gains so I almost never even look at corporate bonds.
Otherwise I would probably be a big fan and know a lot more.

As for bonds being a viable alternative to the dividend route, it makes
a lot of sense to me. But I think there might be some even better
deals in the preferred share area at the moment.
My example-du-jour is Wells perpetual preferred series L, which has
an effective yield of 9.8% at the moment ($75 payout on the $1000 face
trading at $765 right now). I like that it's perpetual and effectively
non callable. Sure, dividends might be eliminated for a period, but it
seems like a sweet spot in the capital structure depending on your goals.
I sure wish I'd bought more when they were realy cheap earlier in
the year (I got mine at $359), but ain't that always the case.

Compared to bonds, the preferreds are harder to research because of
the wider range of "usual" unusual conditions, but generally much
cheaper and easier to find and buy when you have done so, so to a first
approximation the pain-in-the-rear factor is probably pretty similar.

One thing I wanted to mention in passing---it's very fair and true to point out
that the choice between equities and bonds is very much a choice
between risk and reward. But, I wanted to point out that this is
not a universal rule--within the equity world, unknown to most folks,
the nitwits who conflate volatility with risk and who expect higher
volatility correlated with higher reward have it backwards. Higher
volatility stocks have lower average returns than lower volatility
stocks, fairly steadily and by a wide margin decade after decade,
and the EMH/CAPM religion folks keep believing otherwise. Amazing!

Back off where I belong on the equity boards...

Jim
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JustMee01,

I ran a quick test just now using your suggested stock, PG, versus a comparable-quality triple-AAA bond I own and a five-year back-test period using weekly, dividend-and-split adjusted data from Yahoo. The results are laughable. PG’s internal growth rate was 2.05%/year. The bond produced 5.96%.

Admittedly, I need to run more back-tests across larger data samples. But if that’s the best that conservative stock investing can do, I don’t want any part of it. On a risk-to-risk basis, I can beat the stock returns I might achieve with the bond returns I am, in fact, achieving, because I’m capturing “alpha” (for buying shrewdly when the buying should be done.) In other words, I use the same traditional, value-investing techniques for bonds that good investors use for stocks, and our results will be comparable, because risk is risk, no matter the asset class. That’s not how most investor use bonds, but I’m not most investors.

Where the serious money will come from stocks (or from bonds) is from trading, not investing. But I’m lazy, and buy-and-hold produces good-enough returns.

Charlie
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Jim,

Much thanks for providing further background on the scope and intent of your post. You put a lot of thought into it, and it makes me want to dig into stocks a bit further. I can't help but think I'm missing out on opportunities by not exploring both the common and the debt of the companies whose bonds I'm buying.

You say: But I think there might be some even better deals in the preferred share area at the moment. I wholeheartedly agree. PFs aren't my area of interest/expertise. But there's a couple people on this board who know them well and are doing well with them.

Give me some time to reformat the spreadsheet on which I based my stock vs. bond comparisons, and I'll PM you a copy. I think you'll find the numbers interesting (and maybe even urge you to "cross over to the dark side").

Charlie
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Very nice post!

Jim,

It’s your post that was “nice”, because it provokes engagement. (Most of what I write does the opposite. It annoys people for stepping on the toes of their favorite --but unprovable— beliefs, the latest of which is this stocks vs. bonds thingy.)

How to do proper due diligence is no different with bonds than stocks. Two methods suggest themselves: a fundamental approach or a technical approach, and the stock guys lead the way in both. But a bond guy can borrow their methods and do quite well for himself. The “safe-investing” crowd resents such encroachments on what they perceive to be their turf. But what they do isn’t very safe when all risks are considered, instead of just their short-sighted, single one of default-risk. So their protest should be ignored.

You write: One thing I wanted to mention in passing---it's very fair and true to point out that the choice between equities and bonds is very much a choice between risk and reward. But, I wanted to point out that this is not a universal rule--within the equity world, unknown to most folks, the nitwits who conflate volatility with risk and who expect higher volatility correlated with higher reward have it backwards. Higher volatility stocks have lower average returns than lower volatility stocks, fairly steadily and by a wide margin decade after decade, and the EMH/CAPM religion folks keep believing otherwise. Amazing!

The EMH/MPT/CAPM folks show up in the bond world, too, where they fail to understand the implications of the fact that investment returns don’t distribute normally. Due to their epistemological arrogance (aka, their mistaken belief they can project investment returns and inflation rates with minute precisions), they under-estimate they risks they accept. But their likely old-age poverty is their problem, not mine.

Charlie
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Jim,

The problem with most who post on the bond board is that they don’t read the basic investment literature. They believe what Wall Street and the mutual fund industry want them to believe, rather than do their own thinking. Thus, any criticism of their beliefs is regarded as a personal attack, and the board is hugely polarized between those whose do their own bond investing and those whose who never venture beyond the putative shelter of bond funds, CDs, and TIPS. Such is life.

The attached spreadsheet might be cryptic. But the numbers are there. Unfortunately, due to the short time frame and the character of markets during those months, the comparison is nearly meaningless. Dart-throwing would have produced good returns, whether the targets were stocks or bonds.

On a one-to-one basis, any competent bond fund manager (and there are a lot of them) could kick my butt up and down the hall. Ditto any competent stock investor. However, fund managers get sabotaged by stupid shareholders, and “average” stock investor sabotage themselves. (During the years that the broad indexes were averaging 11% something, average investors’ returns were 3.8%.) So beating individual investors or the fundies isn’t hard to do.

What isn’t hard to do, either, is to achieve a real rate of return with bonds, even when “real rate” is defined as returns minus taxes and the real rate of inflation, not the manipulated CPI number.

Charlie
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Charlie:
The problem with most who post on the bond board is that they don’t read the basic investment literature. They believe what Wall Street and the mutual fund industry want them to believe, rather than do their own thinking. Thus, any criticism of their beliefs is regarded as a personal attack, and the board is hugely polarized between those whose do their own bond investing and those whose who never venture beyond the putative shelter of bond funds, CDs, and TIPS. Such is life.

True. I'm one of those who is VERY comfortable on the equity side of the portfolio but not so comfortable on the fixed income side of things.

Thus, I now use three indexed bond ETFs to diversify my fixed income portfolio which consists of 40% BND, 40% BWX, and 20% PCY. Before that, I simply used a 5 year CD ladder. And before that, when I was younger, I just used a MMF for fixed income since I only kept 6 months of living expenses in FI.

I've been investing for 26 years--since age 25. I even retired early for 11 years between 1995 to 2006. I'm back at work for the last 3.5 years but I want to early retire again as soon as I can.

Since I'm older (I'll be 52 later this year), I recognize the need for fixed income. So far, I'm very comfortable with 30% of my portfolio in the indexed bond ETFs. But if there's a way to get a better FI return for less risk, AND I can get diversification in non-US bonds, I'm willing to learn.

As stock prices climb and as I age, more and more of my port will be in fixed income---probably in the tune of 40 to 60% of port. So I have plenty of time to get up to speed on the fixed income side.

However, for those of us who are not so knowledegable about FI assets, there is no shame in using laddered CDs or cheap indexed bond funds or ETFs.
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Charlie,

Thought I'd post over here.

1. I like to see two smart guys discuss. Part of MY success has always been that I enjoy listening to people smarter than me and trying to see how their mind works;

2. I know as I near retirement that I need to involve myself more in individual bonds. I very much like what you do, but I've had 40 years of trying to find the best individual companies, and it's a bit harder to buy based upon exploiting the best interest rate among many companies with little examination of the underlying company(that's my simplified explanation of the complex work that you do). I thought in your notice of that Berkshire post you began to look a little at both. I frankly think that I would be interested in examining the bond basis for those companies and doing a comparison of risk and reward. As Jim suggested there is reward in bonds.

3. Interestingly my knowledge has caused me to want to move from bond funds to more individual bonds. At the same time my knowledge and experience have moved me almost exclusively to equity index funds, owning no stocks other than Berkshire (and even that is part emotion). No point, just saying.

Thanks for getting involved in the discussion. I learn from both you and Jim.

Hockeypop
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Hockeypop,

Thanks for the complement. (Flattery will get you everywhere.) But with bond investing –heck, with any investing— it isn’t a matter of “smart”. It’s a matter of simple pragmatics. “Uh, if I do this, what happens?” And just as important: “What do I have to believe about world (and myself) in order for me to act?” Markets are complex enough that any theory will work some of the time, and no theory will work all of the time. So losses are the first fact that has to be accepted. They’re going to happen. Some can be understood retrospectively. Many simply have to accepted as “this is what happened this time”. If gains are adequate, losses become merely a cost of doing business. So, for me, the way to reduce risk is to accept risk and to get paid well for accepting it, because risks can’t be avoided, only managed.

In bond investing, the risk that sends everyone into a panic is default-risk. Behavioral finance offers reasons why. #1, investors give twice as much weight to losses as they do to gains. #2, they give disproportionate weight to near-term losses rather than distant ones. #3, they think concretely, not abstractly. #4, they become ego-invested in the “correctness” of their decisions rather than the effectiveness of those decisions. Etc. The empirically-discovered list of mistakes that investors make is lengthy, and it goes a long ways toward explaining the failure of “average” investors to achieve even average returns and their hostility towards those who do achieve above average ones. (What I call the DeTocqueville phenomenon, that it is un-American to be better than anyone else.)


Thus, they are terrified of default-risk and its near-term concreteness, but mistakenly discount the threat of inflation-risk for its vagueness and non-immediacy. Not everyone will frame the debate that way. But that’s how I see the investing problem. Default-risk is a minor annoyance that is easily managed. Loss of purchasing power is the genuine threat, but even that can be managed as long as gains are multiples of its likely risk. Therefore, from the getgo, one has to push the limits, so as to know where the limits are, both of markets and of oneself. From there, one backs off a notch or two or three, secure in the knowledge that, if need, be one can gear right back up to bleeding-edge performance.

People don’t think about investing that way, but I do. Therefore, one should be constantly pushing, probing, exploring, questioning, learning, expanding, growing, and the low-level stuff becomes increasingly easy and increasingly less important, which is exactly where most investors go wrong. Because they have no high-level testing framework, they can’t do the low-level stuff with grace and ease, because they are trying to walk in someone else’s borrowed shoes, not their own that they crafted over time to fit their feet exactly. (“There are no roads but by walking.”) The investing process is no more complex than taping and mudding dry wall. The actions are simple. But grace and ease only come from practice. But this is America, where instant success is expected and money from financial markets has come to be seen as a “birth right”. My response? Yeah, sure.

So I would urge you simply to jump in. With a background in stock investing, bond investing is a piece of cake. Add a bit of option theory (bonds are a put), a bit of risk-management (proper position sizing), a bit of chart reading, some financial statement analysis, and a whole bunch of screen time (aka, shopping time), and a method of doing things will emerge. There are no two people in this (or any other forum) who do their investing the same way. But as you bum your way around the various forums, you’ll get a glimpse here and there of people who are making a success of it. If asked, most of them say, “Well, I tried a couple things, and then I found something that made sense to me. It seemed to work OK, and I kind of stuck with it.”

Yeah, there are a whole bunch of things a person could learn from me about bond investing just by sitting down besides me at my trading station. But what they’d learn in 2-3 hours isn’t a fraction of what they really need to be shown how to do, which can be summarized in Marty Whitman’s four words: “Buy cheaply. Buy safely.” That’s the essence of any investing. “The rest”, as Rabbi Hillel quipped long ago in a different context, “is merely commentary. Now go and study.”

Charlie

OK, the preceding is deliberately vague, heart-felt, but vague. As I was doing my bike ride today, a research program popped into my head, prompted by your question of what direction I wanted to take this discussion? Its essence is this: Do stock prices lead, lag, or move in synch with corporate bond prices? If an edge can be discovered, the next question becomes: How to exploit it?, which is mainly a matter of settling on a disciplined exit strategy.

My suspicion is that an investor -and, yes, I'm talking "investing", not "trading"-- can move freely between the two asset classes in a variety of ways and make serious money. So the first step is to do the basic research. The next step is to set up a pilot project. The third step --if the preceding go well- is to determine scalability and to look for simplifications. Bingo. Market-indifferent stock and bond investing done with a primary focus on risk-adjusted real returns. Described that way, the idea is nothing new. It's just a typical hedge fund. The only difference is who's running it and into whose pockets the profits are going.
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This one won’t be any different, because I begin with this premise: On a risk-adjusted basis, there will be no difference between the two. If you’re getting more return from one, it is because you’re taking on more risk.

This is a myth, no one has ever shown it to be true in any rigorous study anywhere.

Since this seems like a specious claim, you can find more here:
http://boards.fool.com/Message.asp?mid=25446584&sort=rec...


'Myth #3 – Risk and Return are directly related.

I can see your eyes rolling now:
“Of course they are, they have to be, everyone knows risky assets must generate a higher return and vice versa!'

This is standard CAPM theory, however, Fama and French last year said CAPM had virtually no empirical support, updating a study from 15 years ago. Most economic models assume a positive-variance return related directly to a risk-aversion coefficient. Diversification is a free lunch, and too little exposure is as bad as too much exposure to an asset.

For decades, researches have looked for evidence in the equity markets of a linear relationship of return and risk using market indices and realized returns. Many now accept there is simply no correlation as a practical matter. Whether the academics modeled risk as varying with volatility, cash flows and discount rates, consumption risk, risk and hedge components, CAPM is a failure.

Both Lo and Black were skeptical of the 'size factor' as an effect on risk, due to the lack of any theoretical reason for riskiness. Fama [1993] suggested both size and book/market represent distress risk, which is harder to measure as it has a power-law tendency to jump to zero, and may be linked to difficult-to-measure brainpower at a firm [as firm declines, good employees leave, vicious circle occurs].

Several firms have used models and bond agency ratings to predict defaults to evaluate the equity performance of various 'risk' classes. Generally speaking, they find distressed stocks have abnormally low returns, inconsistent with return/risk assumptions. These firms have higher volatility, betas, and market cap-factors than stocks with a low risk of failure.

Studies have shown that stocks with low risk factors such as lower beta, leverage, higher profits and dividends outperform the market, consistent with the research on distressed firms. O'Shaughnessy shows similar results.

Others have tried to measure 'risk' as uncertainty, and failed. Researches have shown it is not positively related to equity returns, and may even be negatively correlated.

Corporate bonds are no better – recent yields on the High-Yield index were 270bps better than BBB-rated corps, yet the default rate was 3.5% worse according to Moody's, suggesting a negative reward for investing in risky debt. [Falkenstein discusses all the above in more detail]'
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Cryingalot49,

You fail to make a needed distinction between the tactic of between assuming a premise (for the sake of a further point) and asserting a premise (for the sake of itself).

CAPM is irelevant for my bond investing. CAPM isn't a theory within which I choose to work.

But this is relevant. By taking on equity-like risks with fixed-income instruments, one can achieve equity-like returns. I don't give a FF who might or might have "disproved" that working relationship if, in fact, they have done so. The point is irelevent. It's like the old canard about aero-dynamic engineers "proving" the bumble bee shouldn't be able to fly, given the aspect ratio of its wings.

What does become hugely relevant in ordinary investing is the converse of that premise.

Nice try, though.

Charlie
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