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Jack writes: I would break it down like this:

A = Above-average-return/low-risk
B = reasonable-return/low-risk, or above-average-return/moderate-risk
C = above-average return/high-risk, or reasonable-return/moderate-risk
(Note: There is no low-return/low-risk; if this is your bond choice, buy a CD and avoid the all the trouble.)

Using the above methodology, we use published ratings as a screening tool and as one analytical metric among many. This means we could find BBB+ companies that are A's on the above scale and AA companies that are B's and A's that are C's.

One disparity that has been constant and that has been mis-pricing; some debt has been too expensive for the quality, some debt has been too cheap for the quality. If we are patient and diligent we can spot these traps and opportunities. It may be easier with all this messiness to spot the good and the bad.


Continuing the previous ideas, I would restate them as follows:

The Four Sources of Credit Ratings Upsides
The Major Rating Agencies free, easily-obtained, authoritative
Bond Boutique Ratings higher quality than the majors
The Bond Market Itself free, easily-obtained, timely, authoritative
Your Own, Traditionally-done CR's free, timely, authoritative


The Four Sources of Credit Ratings Downsides
The Major Rating Agencies often not timely, must be interpreted and/or arbitrated
Bond Boutique Ratings expensive, with limited coverage of issuers
The Bond Market Itself "screen time", spreadsheet skills, intuitive judgment
Your Own, Traditionally-done CR's sustained effort, good financial-statement skills

Thus, a “Catch-22” situation arises. To know whether a bond is being properly priced, you have to know that it is being properly rated. To determine if the bond is being properly rated, you have to know whether it is being properly priced. The two factors are inter-dependent.

An aside: By and large, agency ratings are timely enough and accurate enough for their intended users, which is not retail investors. Once the implications of that phrase sink in, then agency ratings become useful tools, especially when supplemented –as they have to be— with one’s own technically-based and/or fundamentally-based analytic work.

In short, if you would require that agency rating be useful at face value, you probably shouldn’t be buying your own bonds unless you pair your trust of agency ratings with game-theoretic ways to manage the risks you are accepting. What might some of those risk-management techniques be? Ah, grasshopper. That’s a post for another time. But what does emerge is something like the following:

The Projected Reward Relative to its Current Mis-rating/Mis-pricing
Egregiously Higher (and Margin of Safety) Classic, Graham-style Value Investing (long)
Higher of no investment interest
Benchmark (aka, properly proportional) useful only for informational purposes
Lower of no investment interest
Egregiously Lower Classic, Graham-style Value Investing (short)


Incidentally, I executed my 31st bond buy for this year last Friday. The CY for those positions is 9.2%, and their projected YTM is 14.1%. My credit qualities range from AAA to CCC. The coupons range from 0% to 8%. Maturities range from 4 years to 28.

In other words, I build and manage a classic, Graham-style bond portfolio on the basis of the guidelines laid out in his The Intelligent Investor: a Book of Practical Counsel. What Graham advises is what I do, because his low-effort, low-risk methods are as effective with corporate bonds as they are for stocks. It's the same underlying company that is being analyzed, and the same common-sense principles that are being applied to its evaluation.

The method and investing viewpoint that Graham describes is available to anyone who is willing to read his books and to put that viewpoint and method into practice, which academic studies have shown is typically less than 5% of investors. So that's the paradox is value investing. Nothing is more effective, on average and over the long haul, as a means of obtaining reasonable investment returns. But no other method gets more neglect, because value investing requires patience and independent thinking, which are two virtues that most would-be investors lack. So they do whatever the crowd does, because it seems "safer".
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Correction:

When I reported the returns on my YTD bond bonds, I was pulling the numbers from an not-yet-updated spreadsheet.

YTD, I have added 32 new positions (not the previously reported 31). The CY for those positions is 9.1% (not the previously reported 9.2%. The projected YTM is 13.8%, (not the previously 14.4%). The differences are minor, but the corrections needed to be made.

One further point need to be made about those returns. The returns are what mostly due to the type of astute buying that characterizes value investing, rather than from the nature of the asset class being bought. In other words, when good quality merchandise goes on sale, the value investor is buying. He buys cheaply, creating a margin of safety for himself. Thus, I do not have to focus my buying on lower-quality credits in order to obtain the kinds of returns that are typically associated with lower-quality credits. Equally so, I do not avoid them either.

Here’s is the break-down of my YTD buys. As you can see, the distribution between invest-grade and spec-grade is roughly 2:1, or a moderate allocation to junk. Thus, reasonable, overall returns can be obtained from accepting a reasonable amount of overall risk. "Reasonable" and "Overall" are the two crucial words.

Average Descriptive Credit Weightings in Portfolio
Rating Quality by Par by Cost by Value
AA/Aa mid-tier 30.00% 25.90% 26.80%
A/A Invest-grade 7.50% 11.20% 10.80%

BBB/Baa lower-tier 27.50% 32.10% 30.80%
invest-grade

Sub-total Invest-grade 65.00% 69.20% 68.40%



BB/Ba upper-tier 17.50% 18.80% 18.70%
spec-grade

B/B lower-tier 17.50% 13.00% 14.20%
CCC/Caa spec-grade 2.50% 1.80% 1.50%


Sub-total Invest-grade 37.50% 33.60% 34.40%


Note: I consider triple-AAA and above to be top-tier. I consider double CC and lower to be highly speculative. I choose to group double-AA and single-A together, just as I choose to group single-B and triple-CCC together. Other people will make different choices. That said, I’ll buy anywhere up and down the credit spectrum, because I’m shopping for value wherever it is found. But my preference is to seek out the best quality I can find for the price, not the highest yield for the price. Safety trumps returns, and I'm in this game for the long haul, not just a few extra bps that soon flees.

How does one attempt to ensure long-term survival in the investing game? by buying what should be bought, at the price it should be bought. The bond game --and it is a game-- is all about value shopping, just the same way that buying one's groceries is all about value. Same-same, and Graham's book tells would-be investors how to shop for stocks and for bonds. You don't need to read anything else. Bond vocab is easy to pick up, and the market itself --if you're willing to pay attention-- will teach you the rest you need to learn.
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A further correction to the previous becomes necessary, because I added another position just now, a lower-tier, invest-grade bond (Baa2/BBB+) with a CY of 7.8% and a YTM of 8.5%. That’s not the best of yields, but I thought the investment needed doing. Apparently, the market thought so too, because I’m being marked-to-marked on the buy in a real-time with a gain of 2.53%. In other words, due to spotting an anomalously low price and immediately executing, I have already recouped the commission I paid, and I’m showing an unrealized capital gains profit on the purchase.

YTD, I have now added 33 new bond positions to my portfolio. The CY on those buys is 9.08%, and the projected YTM is 13.64%. I would argue that those are merely benchmark numbers for a properly-diversified, moderate-risk, corporate bond portfolio such as anyone in this forum could have built for themselves over the same time frame. Anyone. Simply set up an account with a reputable bond broker and start shopping. The bargains have been there for one and all to find. If you can buy CDs, you can buy corporate bonds. This investing stuff ain’t rocket science.

The YTD unrealized cap gains on those 33 positions are 7.56%, which requires a further explanation. On a bond portfolio whose positions are intended to be held to maturity, unrealized cap gains (or cap losses) are just market noise best ignored. The size of the gains (or the losses) reflects daily re-pricing of the bonds, not the value of the bonds at maturity. Obviously, it is better to be showing gains than losses. But the back and forth of unrealized cap gains and losses is just mid-field scrimmaging. It’s what happens in the end zone that matters to the bottom line.

Part of the reason I have been reporting my purchases of corporate bonds (CBs) is to point out that there are alternatives to buying principal-protected securities (or PPs, of which a conspicuous example is CDs) as a means of moving purchasing power forward to the future. That’s the real game being played. Preserving nominal principal at the cost of losing purchasing power doesn’t make a lick of sense if one’s intentions are patient, long-term investing. Money isn’t a good whose value is itself. The value of money is what it can buy presently, or in the future. The difference between buying now and buying in the far-off future is the measure of purchasing power preservation. Principal-protected instruments never preserve purchasing power over the long term. Never. After taxes are paid and inflation is subtracted, short-term PPs never return the full equivalent of their initial purchasing power, much less appreciate that purchasing power, because that isn’t their intended purpose or best use.

Note: I do NOT dislike CDs. I buy them whenever I can find them being sold at attractive prices and/or when my intentions with the money is the short-term conservation of purchasing power.

When the yield difference between CBs and CDs is minimal, such as less than a couple hundred bps, and investment horizons are short, then CDs are the preferred choice. Why take on principal risk if one isn’t being paid to do so? Ben Graham is adamant about that point in his book, The Intelligent Investor. He says there is no middle ground between “Defensive Investing” and “Enterprising Investing”. The choice is one or the other. He says that for a Defensive Investor to reach for a bit more yield (by going beyond what is both low-effort and low-risk) is foolishness.

But he also says this. When the difference between “defensive” and “enterprising” becomes meaningful, which he defines as a premium of 5% or more, then doing the extra work and taking on the extra risk becomes sensible. So let me ask you this: In today’s interest rate environment, what is the highest yield a CD investor could get with new money? Less than 5%, right? On the other hand, what sorts of yields are investors obtaining from properly diversified portfolios of corporate bonds? What is the difference between the two? Would it seem that CBs investors are being adequately paid for the risks they are accepting?

The real question is whether that present, 9-10% difference between CDs and CBs is likely to persist. Obviously, it won’t. The “blue light specials” are becoming less frequent. The once plentiful bargains are drying up. But 33 new bond positions are now in my portfolio, just as some or all of them could have been in yours. You could have bought any or all of those same bonds. We both had access to the same information and the same market. I chose to buy. Presumably, you didn’t.

Which was the better choice? That’s the unanswerable question, right? because each person’s circumstances are different. But you should be aware that becoming a corporate bond investor (in addition to being a CD buyer) is a choice that you have. The place to begin is with Ben Graham’s book, The Intelligent Investor: a Book of Practical Counsel.
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Welcome back Charlie,

I hope the “fish were jumping”!

I enjoy reading your portfolio numbers, so I will share mine as well. Maybe someone can learn something from mine, just as I have learnt from yours.

The purpose of my bond portfolio is to provide a long term retirement “income stream” to compliment the dividend and growth returns from my equity investments. My thinking is that there will be very little growth in the U.S. economy over the next decade, so I’m investing in Chinese equities for growth and U.S bonds for income. Consequently, I’m looking to accumulate a “high yield (aka junk)” bond portfolio that throws off high rates of income. I’m prepared to take the risks necessary in search of greater rewards.

So far, I have very narrow parameters. I’m searching for bonds that have a minimum Current Yield of 10% and maybe 12% YTM, and have a good chance of SURVIVING the current recession. In general, I’m trying to stay away from C rated securities, but I’m prepared to make some exceptions. My basic “buying lot” is 2 bonds, so that I can add to a given issue if bargains show up in the future. I’d like to average 1 or 2 buys each week. My intention is to hold all positions to maturity (or be called).

What have I learnt so far? Well, I should have been more aggressive at the start. Prices have substantially appreciated over the last 6 weeks. When I look back compared to today’s prices, just about everything was cheap then (but I didn’t know it). I could have bought as much as I wanted. Now, I have to work hard and be patient in order to find good value within my parameters. But there is an advantage to having strict parameters that need constant hunting for purchases. I’m beginning to get to know the companies in my market and I’m getting a feel for what each issue and rating is worth. When a good buy shows up, I’m able to grab it immediately. I find I’m a real “Junkman”. Not only am I buying low quality issues, but I’m picking off the 1 and 2 single lots that other investors consider too small to bother with. I’ll take anything that looks cheap.

So this is an experiment to see how well an individual Junk bond investor can do over the years. I’m not trying to beat anyone other than my 10% CY goal. I think 10% should be enough to keep me ahead of inflation over the next decade or so (we will see).

I will post my current portfolio in a separate post due to formatting problems I’m having (I don’t know how to format spreadsheet data).

Howard
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Ok, here it is so far. (as of 5/26/09)

26 issues in 6 weeks…Caa1/B- to Baa3/BBB ratings
$27,000 face value… $18,912 invested… $20,666 market value… 9.28% unrealized P/L
$2,090 annual income… 11.05% current yield
Don’t know how to calculate portfolio YTM or duration yet.

Hope the formatting works,
Howard

Issue….. Amt Cpn Due. . Inc/Yr. CY YTM CUSIP. . . Moody/S&P Traded. . Price $Invstd CurVal P/L% Mark

Leucadia 6000 8.125 09/15/15 488 9.89 12.218 527288BD5 Ba3/BB+. 04/13/09 82.133 4927.98 5235.00 6.23% 87.25
Liberty Med 3000 8.500 07/15/29 255 15.52 16.112 530715AD3 Ba2/BB+. 04/16/09 54.768 1643.04 1935.00 17.77% 64.50
viacom.. 1000 7.875 07/30/30 79 11.97 12.496 925524AH3 Baa3/BBB 04/21/09 65.800 658.00 795.28 20.86% 79.53
may dept 2000 7.450 09/15/11 149 9.63 19.778 577778BE2 Ba2/BB.. 04/22/09 77.400 1548.00 1918.66 23.94% 95.93
cooper tire 2000 8.000 12/15/19 160 16.00 19.366 216831AE7 Caa1/B.. 04/29/09 50.000 1000.00 1160.00 16.00% 58.00
pep boys 2000 7.500 12/15/14 150 10.34 14.895 713278AQ2 Caa1/B-. 04/30/09 72.500 1450.00 1440.00 -0.69% 72.00
motorola 2000 6.500 09/01/25 130 10.85 12.226 620076AK5 Baa3/BB+ 05/04/09 59.900 1198.00 1389.02 15.94% 69.45
smithfield 2000 7.750 05/15/13 155 10.65 17.463 832248AH1 B3/B. . . . 05/05/09 72.750 1455.00 1520.00 4.47% 76.00
Northwestern 2000 7.750 05/01/30 155 12.03 12.614 668027AT2 Ba1/BBB- 05/08/09 64.400 1288.00 1365.00 5.98% 68.25
nextel.. 2000 6.875 10/31/13 138 8.59 12.928 65332VBH5 Ba2/BB.. 05/15/09 80.000 1600.00 1652.50 3.28% 82.63
westinghouse 2000 7.875 09/01/23 158 10.82 11.877 960402AS4 Baa3/BBB 05/20/09 72.775 1455.50 1561.90 7.31% 78.10
motorola 1000 7.500 05/15/25 75 10.90 11.911 620076AH2 Baa3/BB+. 05/26/09 68.800 688.00 693.38 0.78% 69.34

Total….. 27000 . . . . . . . 2090 11.05 . . . . . . . . . . . . . . . 18912 20666 9.28%
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Correction,

26 issues in 6 weeks…Caa1/B- to Baa3/BBB ratings

sorry, should have read:

12 issues in 6 weeks…Caa1/B- to Baa3/BBB ratings
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Prices have substantially appreciated over the last 6 weeks. When I look back compared to today’s prices, just about everything was cheap.

Howard, Good morning to you, too.

Yeah, current bond prices suck majorly. Some have doubled, or even tripled, in the past two month. This market is no longer cheap. I was shopping just now, and chart after chart says that the buying time is past. Now comes the waiting time until the next "blue light special" happens.

Thanks for making the effort to post your portfolio and results. There's some overlap in our positions, but not much. What I do find intriguing is that our result aren't that different, even though you are focusing exclusively on junk and I only carry only a one-third allocation.

Where I gained an advantage is that I began my shopping earlier in the year than you. Actually, I shop a couple times each week throughout the year, so the shopping never stops. Whether I buy anything is a different story. And that's an important lesson to would-be bond buyers. You've gotta do your buying when bonds are on sale, and then you've gotta sit on the sidelines when prices are too high. You still window shop, because you have to keep up with prices. But you don't buy what doesn't offer good, risk-adjusted value.

Buying bonds --invest-grade or spec-grade-- is no different than buying bell peppers or broccoli. To everything there is a season.

Charlie
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Yeah, current bond prices suck majorly. Some have doubled, or even tripled, in the past two month. This market is no longer cheap. I was shopping just now, and chart after chart says that the buying time is past. Now comes the waiting time until the next "blue light special" happens.

Charlie,

I’ve been at this 6 weeks and I’m already recalling “those were the good old days”. Man, things move fast when your having fun ;-) Bonds that I then thought were expensive at over 15% YTM, now interest me at less than 13%. I have to watch that I don’t get complacent and lower my standards. Maybe I need to stand back for a while.

If some of the economists that I respect are correct, we may get second chance at the old yields, if and when we get a double-dip recession.

I received my first coupon last week… I hope it’s a long-long time until my first default. (LOL)

Howard
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I received my first coupon last week… I hope it’s a long-long time until my first default. (LOL)

Howard,

Default isn't a problem. Recovery-rate is what matters, and that's why you're buying cheaply, to create --in Ben Graham's words-- a Margin of Safety. The closer you can buy to a Ch 11 workout price, the greater your margin of safety.

I have to watch that I don’t get complacent and lower my standards. Maybe I need to stand back for a while.

It isn't "complacency" that will do you in but "desperation", the urge to put money to work when it really should be parked and sat on until the buying time returns.

On the other hand, markets are crazy and are constantly doing unexpected things. Pull price charts for Pru's bonds. A couple weeks ago, long after the March 9 low, prices did a 2-3 day collapse that offered yield twice what they now do. And just as fast they snapped back to previous levels (and, meanwhile, the stock price didn't even wiggle). But had I been doing my daily shopping as I should have been, one of those bonds would be in my account right now.

Same-same with other fleeting opportunities, especially mis-priced singles and doubles. They aren't always a bargain, but they are always worth looking for. And the only way to find them is to put in "screen time". Not fun to spend hours shopping and have nothing to show for it, but the shopping needs doing.

You're right. On the whole, the bond market is presently very over-bought, and yield-curves are getting very flat, which is probably something I need to investigate. But, meanwhile, I'm spending my time posting, instead of shopping, because I'm so disgusted by prices. :-/

Charlie
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Not only am I buying low quality issues, but I’m picking off the 1 and 2 single lots that other investors consider too small to bother with. I’ll take anything that looks cheap.

Howard,

What you said about “low quality” needs restatement.

Yeah, I know. I’m being picky about language again, but bear with me. As Uncle Ben describes value investing –which is what you are doing, no matter what you call it-- the following paradox emerges. If a putatively “low-quality” asset can be bought cheaply enough, it becomes a high-quality investment decision. I don’t remember the page, but Graham is quite clear about the point that price --relative to intrinsic value— determines the quality of the investing decision. The greater the discount, the higher the quality. Thus, a further paradox emerges. “High-quality” assets for which too much is paid become low-quality investments. So the so-called “flight to quality” that bids up prices actually has the opposite effect for the purchasers. All they done is to increase their risks.

You’ve chosen to limit your investing universe to triple-BBB and lower. So, yes, you’re digging though what is customarily consider to be “low-quality”. But what you’re buying isn’t necessarily low-quality assets. It’s assets that your research suggests are under-valued/mispriced. If the sellers are right about prices, then you’ve made a bad investment decision for paying a higher price than the asset merited. At some price that asset should have been bought, but not at the price you paid.

On the other hand, if the sellers are wrong about their prices and have set them too low, then they’re the ones who made the bad decision about the quality of those assets, for failing to value them properly.

So, who are the true “junkmen”? Them who throw away good value for not recognizing it, or them who buy good value wherever they find it? That’s why I think the terms “high-quality” and “low-quality” should be applied to the investing decision not to investment assets. Admittedly, it is useful to call certain bonds “junk”, because it scares away the potential competition. But it is more useful to use the term as a measure of one’s thinking. A successful investor in “low-quality" bonds has to be making very high-quality decisions if he expects to survive in this game.
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>> “High-quality” assets for which too much is paid become low-quality investments. <<

This reminds me of what a lot of value-seeking stock investors might say about a well-run blue chip company with a very high valuation: "I love the company, but I hate the stock."

#29
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Charlie,

You’ve chosen to limit your investing universe to triple-BBB and lower. So, yes, you’re digging though what is customarily consider to be “low-quality”. But what you’re buying isn’t necessarily low-quality assets. It’s assets that your research suggests are under-valued/mispriced.

Absolutely… I used “low-quality” to refer to the credit ratings assigned to these securities. The agency ratings are what the market uses to define the quality of an issue, so I use it too. Now it’s possible for some low-quality (low-rated) bonds to be misspriced and undervalued, or it’s possible that certain bonds are incorrectly under-rated. Graham and Dodd teaches us that these types of investments will yield high returns over time. I’ve been a Graham and Dodd disciple for more years than I wish to admit. But you know, It doesn’t always work! That is why Buffett has modified some of Graham’s rules. Also, don’t confuse what we are doing with true value investing. True “value investing” involves tearing the Balance /Income sheets apart. The stuff that Jack does. I used to do that, but it’s a lot of work and doesn’t always work anymore, so I got lazy in my old age.

Graham himself, shortly before his death in 1976, said:

I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham & Dodd" was first published; but the situation has changed...




If the sellers are right about prices, then you’ve made a bad investment decision for paying a higher price than the asset merited. At some price that asset should have been bought, but not at the price you paid.

I don’t necessarily agree with this. If I buy my assets when the market is low, there is enough room for error and I should still do ok. That is why I started buying debt recently. I’m betting that corporate risk premiums were abnormally high and the market was “throwing out the baby with the bath water”.


But of course, I could be wrong… It won’t be the first time…
Investing is just a game of probability. I've learnt, if I play the game long enough, I will do OK.
So, I’m here to play the game.

Howard
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This needs repeating because it is why people buy high and sell low.

The greater the discount, the higher the quality. Thus, a further paradox emerges. “High-quality” assets for which too much is paid become low-quality investments. So the so-called “flight to quality” that bids up prices actually has the opposite effect for the purchasers. All they done is to increase their risks.

Stocks and bonds are rarely like high quality merchandise that deserves a premium price. One of my many non-blood related uncles was a rural route postman. He only bought Mercedes-Benz diesel cars to run his route, everyone thought he was being extravagant in truth he was being practical. He could easily get 250k out of the vehicle without much in the way of maintenance costs and still had resale value come trade in time. When he worked the numbers, buying these "luxury" cars was more cost effective over the service life of the vehicle.

Stocks and Bonds don't work this way. A good set of financial statements is only worth what it is worth, paying a premium to hold a "good" set of statements leads to underperformance. You may have mitigated some volatility but volatility does not = risk nor is it well tied to risk/reward.

Buying $1.00's for $.10's is the name of the investing game; the fewer the $.10's needed the less risk taken and the greater the reward priced in.

jack
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