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No. of Recommendations: 5
In her book, Bonds Now!, Marilyn Cohen works with the assumption that the type of investor who would be interested in building a bond portfolio has a lot of money to work with.

“Putting all of the theories contained in this chapter [“Managing Your Bond Portfolio] into practice, let’s see what a safe bond portfolio looks like. Say an investor has $1 million to invest in his bond portfolio. He lives in a state with a low income tax rate. He wants 5o percent in corporates and 50 percent in tax exempt municipal bonds. The main concern is capital preservation. Here’s what this investor bought to create a safe bond portfolio (see Table 9.2). [pp 123-5]

If you look at her table, you’ll see that she has allotted 2.5% of assets to each position, which I wouldn’t object to on the basis of risk-management (even though “exposure”, which is what that 2.5% really represents, is a very different thing than “risk”). In other words, she is buying 25 bonds per issuer. Doing so probably gets her a favorable price, as opposed to buying in smaller quantities, and buying 25 at a time definitely creates a more marketable position when it comes time to sell. But how many investors have $1 million to work with? At look at the net-worth figures for Americans suggest that very, very few of us have that kind of money.

Net Worth for Americans Based on 2007 Data

All families Average Median
$556,300 $120,300

Net Worth Percentiles Average Median
Less than 25 percent ($2,300) $1,200
25 to 49.9 percent $57,900 $54,200
50 to 74.9 percent $227,000 $219,800
75 to 89.9 percent $586,100 $571,400
90 to 100 percent $3,975,700 $1,890,700

Head of Household Age Average Median
Under 35 years old $106,000 $11,800
35 to 44 years old $325,600 $86,600
45 to 54 years old $661,200 $182,500
55 to 64 years old $935,800 $253,700
65 to 74 years old $1,015,200 $239,400
75 years old and over $638,200 $213,500

Employment Status Average Median
Employee $350,100 $93,200
Self-employed $1,961,300 $388,700
Retired $543,100 $161,300
Other not working $124,100 $5,700

Home Ownership Average Median
Owner $778,200 $234,200
Renter $70,600 $5,100

As I read those tables, 75% of Americans do not have even $220,000 dollars to work with. And if you factor out home-equity, the actual amount of liquid, investible assets is probably far less. In other words, probably only the upper 15% of Americans by median net-worth have at least $250k to work with. Setting aside the shocking, but not surprising, fact that most American investors don’t have much money to work with, let’s ask the more positive question of:

“How much could, in fact, be done with the liquid assets they do have by of building a bond portfolio?”

To buy municipals, the absolute minimum-purchase is nearly universally five bonds. 5 is only 20% of Cohen’s recommended 25. So that would cut the capital needed to replicate her portfolio down to a more manageable (and realistic) $200,000. But corporate bonds are often available as singles and, often enough, at very little price disadvantage. So, possibly, even less capital might be required. Let’s figure out how to do it.

Unless you intend to become an expert in municipal bonds and/or have beaucoup capital to work with (so that risks can be lowered through diversification), it is highly unlikely that you're going to mess with spec-grade munis. Instead, you’re going to be buying fairly top-tier credits with fairly low risks of default. Therefore, I’d argue, your exposure to such issuers could be bumped up to 5% per issuer and that a basket of such issuers as small as 10 to 12 positions would not only not be a bad thing to do, but that you probably couldn’t even find half that many in your own state that would be worth buying, so that the other half of your muni basket would be coming from national munis, or could be bypassed entirely. Doing the latter would chop your capital requirement by half again, making a mere $100k, spread across munis and corporates, a good-enough, starter bond-portfolio and probably within the reach of half of all Americans (by median net-worth).

What kind of return might such a portfolio provide? My guess, if you shop hard, is that you ought to be able to average on your munis (on a tax-adjusted basis) something around 6% and about the same with your corporates (on a pre-tax basis) and a bit more if you make a judicious allocation to spec-grade issues, which you should be doing, because the net-effect would be to lower overall risks, not increase them.

Charlie (a small investor, who elbowed his way into the bond market with money so tiny that I shudder now to think about the risks I accepted in order to build my account.)
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