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Moodys and S&P use slightly different procedures, and slightly different coding-systems, to rate bonds, about which Wikipedia does a convenient, easy-to-understand write-up. http://en.wikipedia.org/wiki/Bond_credit_rating But if you count all of the notches of either system (found in the first and third columns of Wikipedia’s chart), or even all of the broader characterizations (found in the right-hand column), you are likely overwhelmed by the granularity. More discriminations (and finer ones) are being made than an average bond-investor can use effectively. To that end (and for my own purposes at least) I’ve proposed a simpler, six-tranche system based on two factors: the level/direction of interest-rates, and the level/direction of credit-worthiness.

E.g., Principal-protected instruments would fall into the top tranche for being nearly, if not completely, a bet about the level/direction of interest-rates. At the other end of the tranche spectrum would be bets made about issuers whose fate is nearly entirely in their own hands, not that they still aren’t impacted by the level/direction of interest-rates. But that’s not the principal bet a bond buyer is making when he/she buys the debt of such issuers, nor will the coupon (aka, the current-yield, no matter how fat) be the principal source of loss or gain from the investment.

The difficulty of getting the direction of interest-rates right can be sidestepped by making an initial bet on their level and then holding to maturity. E.g., if one is comfortable with assuming that inflation won’t average more than 5% over the intended holding-period, nor will one’s combo, marginal tax-rate increase beyond one’s present, 35% level, then any bond that that has a zero probability of defaulting and that offers a total return of at least 7.7% can be held to maturity without suffering a loss of purchasing-power. Yes, if interest-rates fall, then the time-premium created is forfeited if the bond isn’t sold. But the investor can sit tight and be content that the investment is doing what it was intended to do.

For a couple of years now, everybody and his cousin has been saying that interest-rates have nowhere to go up from their present, nearly-zero levels. Meanwhile, money has to be put to work. If interest-rates really are going to go up, then the conventional wisdom is to shorten existing maturities. But doing so excludes from purchase bonds that might prove advantageous to hold if interest-rates don’t go up, or don’t go up as soon as is hoped/feared, or as far up as they have in the past in the face of similar economic circumstances. Also, using bonds to bet on the direction of interest-rates isn’t the most effective tool. (Options or futures offer an easier means to control risk or capture gains.) Nor, as I belatedly realize, are bonds the most effective tool to bet on the direction of credit-worthiness.

In other words, if you intended to be a Tier-One bond investor and to hold only principal-protected debt instruments, you’ve gotten killed in the past several years as you watched your purchasing-power be eroded by negative real interest-rates. If you intended to work the other end of the bond spectrum, Tier-Six, you haven’t yet gotten killed by defaults. In fact, you’ve made very good money. But those defaults are coming, as the economy continues to deleverage. So it’s time to think about other ways to make those sorts of bets. But the middle ground, Tiers Two through Five, do seem to offer fertile ground for directly investing in the underlying.

My apologies if the preceding seems cryptic or coy. That isn't my intention. I fall asleep thinking about bond-investing. I wake up thinking about bond-investing. I'm just trying to work out what direction my research should take for the remaining four months of this year. YTD, I've ton a ton of buying that I don't regret. But I don't like what's happening in markets right know, and I suspect that BofA's troubles are an inflection point, a warning bell, that should be heeded. Also, I've been reading John Lanchester's IOU: Why Everyone Owes Everyone and No One Can Pay which tells roughly the same history of the recent financial crisis as the nearly two dozen other books that have come to market (and a quarter of which I've read). But he does so from a British perspective and with a broader brush and without the optimism that Maudlin offers. In short, as the eminent Yale economist, GBW, noted, "This sucker's going down." I don't think this will be a bad thing, nor intolerable thing. ("Price fluctuate", as Baruch noted.) But I'd prefer to profit from the decline rather than see many of my current holdings migrate to the right-hand column of my balance sheet, which is going to happen if I don't take corrective measures and/or put on some hedges.

Charlie
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