No. of Recommendations: 2
Jack,

This is too funny. Both parties to this argument can make a valid point. The Never Buy a Bond at a Premium crowd can show, under any circumstances where YTMs are equivalent, that buying the most steeply-discounted bond is the optimal strategy, as the example below suggests. However, the other crowd (Buy What Makes the Best Sense from What’s Actually Available) has the tools to select what is optimal regardless of whether the price is above, below, or at par.

In the example below, I have expressed losses and gains in terms of bond points per year. The inflation-rate is 5%. PP_YTM is "the Purchasing Power Yield to Maturity". The discounting formulas are proprietary, but not undiscoverable for a person proficient with spreadsheets.

Cpn Price Due YTM Hold Prin P/L Inc P/L PP_YTM
6 116.400 04/01/21 4.00% 10.04 -5.491 4.697 -0.794
4 100.000 04/01/21 4.00% 10.04 -3.857 3.131 -0.726
3 91.800 04/01/21 4.00% 10.04 -3.041 2.348 -0.692

Translation: In the above example, assuming a 5% inflation-rate, the most steeply-discounted bond suffers the least erosion of purchasing power. Why? because the fewest present-day dollars are being spent to obtain depreciated, future dollars.

What I would say is this, which is what I've always said. The rule of thumb to "never buy a bond at a premium" is just that, a rule of thumb that can serve its user well, because it forces them to seek value. But if an bond-investor is truly interested in optimal returns, good markets and bad, he/she won't impose price restriction on buying, because he/she can only buy what is actually offered at that time.

Some investors are rich enough, or diversified into other asset-classes enough, that they can wait out a bond-market that is mostly trading at a premium to par (such as it is presently). Others have no choice --or choose to make no choice-- but to put money to work in bonds no matter where prices are. For them, it makes no sense to impose artificial price restrictions. What matters to them is maximal total yield for their dollar. So they are willing to suffer capital losses to achieve income gains.

Obviously, the best of both worlds is a high coupon and a low price. But just as obviously, what is "best" is generally not what is available. So trade-offs have to be made. Some people, as a matter of principal, or reflected experience, choose to never make that trade-off. They never buy a bond at a premium. Others, as a matter of principle, or reflected experience, choose to buy what they should, no matter if the price is above par.

But the choice each makes isn't without consequences, which is why I challenged Kelly to post his portfolio, not to determine the better investor, but to determine the better method when used in actual field conditions. You're an ex-Marine. When is the M16 the better weapon? When is the AK-47? Same-same with this brouhaha over premiums. Use the tool that is appropriate to the battle-field. I can pull better money out the bond market --on either an absolute- returns or risk-adjusted-returns basis-- than most bond-investors, because I'm willing to question my tools and assumptions and to switch between them as might be appropriate.

Charlie
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