No. of Recommendations: 3
Brokers calculate the YTM a buyer would receive. Sometimes they include commission in the bond price, thus lowering the YTM compared to what it would be based just on the ASK. Sometimes they don’t make this adjustment. By and large, their calculations can be trusted. But a prudent buyer will always run his own numbers. One thing brokers should do, but don’t, is offer the buyer a chance to see how inflation would impact returns. But that’s a simple macro any buyer can set up for himself. Just dump the result of a bond scan into a spreadsheet and run the procedure. Here is an example.

The scan parameters were this: “Show me all currently-offered triple-AAAs with a YTM of 3% or better.” The names don’t matter. So I present only the relevant other facts, where “Best” is the bond that offers the most yield over the shortest time. In a small data set like this, “Best” can easily be obtained by inspection. But when the output of a scan is 500 bonds (or more), it is more efficient to determine “Best” with an IF-ELSE function, which can easily be implemented in a spreadsheet. Note, also, that “Price” includes a commission of a buck per bond, which is how E*Trade formats its data. That doesn’t cause problems if the intended purchase is ten bonds. If the intended purchase is fewer, then the price needs to be adjusted and, therefore, the yield as well. But for now, for this exercise, I’ll let the data stand as it is.

Cpn Due Price YTM Best
4.500 01/11/2 109.602 3.30 3.30
6.875 02/01/24 133.870 3.50 3.50
6.950 09/01/29 138.621 3.94 3.94
4.950 05/15/33 108.859 4.32 4.32
5.950 08/15/37 126.604 4.25
5.850 07/15/38 124.040 4.33 4.33
5.200 06/01/39 115.247 4.26
4.500 09/01/40 106.590 4.11
4.500 10/01/40 102.026 4.38 4.38
5.300 02/08/41 119.474 4.15
4.850 05/15/41 110.209 4.24
5.250 05/24/41 109.340 4.67 4.67

Currently, the BLS is reporting that YOY inflation is running 3.6%. Therefore, to buy the nearest-dated bonds would be to lose money (aka, purchasing-power). If a more realistic inflation-rate of 5% is used, then no currently-offered triple-AAA bond would return the buyer his investment. (What is done with the coupons as they are received is irrelevant to calculating the yield of the bond, though not, of course, for calculating the total return from the investment. In other words, of two bonds with nominally-equivalent returns, that with the higher coupon is to be preferred.)

Consider, now, just the longest dated bond and its 4.67% YTM. Under the simplest method of understanding the impact of inflation (i.e., subtraction), the loss of purchasing-power to a would-be buyer would be -0.33% per year. Under one of the methods I use to measure the impact of inflation (a discounting method), the loss increases to -0.5% per year. Under the method that I favor (discounting with compounding), the loss increases to -2.7% per year. Which, if any, of these methods (or others) a would-be buyer chooses is a matter of deciding how he wants to manage his portfolio. I prefer to make the most adverse assumptions possible, because I see it as a means of building into my buying a huge margin of safety. But the benefit to a portfolio manager of having what amounts to a simple, go/no-go test for yield is this. One can quickly chew through massive lists of bonds and point to just the very few that merit further investigation.

Charlie
Print the post  

Announcements

What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.