The Ultimate Guide to Bond Investing

by Steve McDonald, Investment U Research
Monday, February 20, 2012
Article from Investment U

Corporate and municipal bond investing has one major problem: When interest rates go up, bonds go down.

Actually, bond investing has two major problems. The second is that people are rate pigs. They always go for the highest payout on bonds and bond funds and ignore the problems associated with long maturities.

The result is that when bonds do drop in value, which they will do at some point, the drop is accelerated by “rate pigitis” – really accelerated. Long maturities drop in value a lot more than short ones.

So, a bond investor has to make a choice:

Go with really long maturities, get higher yields and suffer through the sell-off when rates go back up…

Or:

Go for shorter maturities and put up with lower returns, but a much smaller drop in value when the sell-off finally happens…

Of course, there are those who think, “I’ll just wait it out and collect my interest, ignore the big drop in long maturity bonds and collect my principal at maturity.”

Right! And Obama will suddenly develop a sense of business and economics and stop jerking everyone’s chain.

The Real Truth

Here’s the real truth about the average small-bond investor.

The combination of “rate pigitis” and being completely unable to wait out a sell-off in any market – not the just the bond market – have turned one of the safest investments, bonds, into what will be one of the biggest money losers in the history of the markets. Treasuries included.

In the past few years, rates have settled where I have never seen them in my lifetime. Meanwhile, small investors have been standing in line to pour their money into bonds of all kinds in the hope of escaping the stock market volatility and getting some kind of return on their money. I can understand why… It’s been 10 years since we made a dime on stocks.

All of this money is going into bonds at exactly the wrong time, in all the wrong ways and at prices so high, they have to come down.

It will be a blood bath of biblical proportions when almost everyone cuts and runs as prices drop.

The Staggered Approach to Bond Investing

But this is completely avoidable. There’s a way to own bonds now and get around this impending bloodbath, and still beat the stock market.

In fact, if you use a staggered approach to bonds, rather than the usual ladder, you can:

Get very high rates of returns.

Minimize the drop in value when interest rates rise.

Take advantage of higher rates and the bargains they present in a down bond market.

And still sleep at night, too…

I know, too good to be true, right?

But this isn’t a guarantee of any kind, you will have some losses – very few, but some. Based on today’s market averages about one to three out of a 100 trades will be losers.

Sounds good, doesn’t it?

And, you will have to follow all the rules! Yes, rules of the road that cannot be ignored. Any Navy folks out there know what that implies. Standing Orders and all!

Right off the bat, that eliminates about 25% of all investors, big and small. That bottom 25% is doomed by the fact that they don’t know what to believe and are so inexperienced they can’t separate the good information from the garbage.

Another 25% will only play the “swing for the fence” game in the stock market. They will figure it out eventually, but not until they have lost so much they go back to CDs and money markets. At least they aren’t losing anymore.

Another 25% know they have the secret to success and will only buy stocks, because they know the secret, right?

So that leaves you and me and few other survivors who are able to see a real opportunity.

Here it is! It’s called a “staggered bond portfolio.” Your broker will tell you it can’t work, but I have been proving him wrong for a long time.

Forget Everything You Know

First, forget everything you know about corporate bonds, and munis for that matter, especially how to structure a portfolio of them.

Think in terms of very small bond positions, as few as one bond per position, five or more is preferable, but you can do one. I know brokers will tell you it is impossible to buy less than 10 or 20 bonds. Baloney! Get another broker who knows something about bonds!

The Rules of the Road

Buy many bonds of almost all credit qualities, as low as CCC. Right now, I prefer to stay in the BBB to CCC range, but the skittish can go for the higher ratings if you need them to sleep at night. But the BBB to B ratings don’t have that much more risk and the slightly lower-rated bonds are where all the money is.

Buy bonds in many industries. Don’t load up on a few tech names or familiar names. Stay diversified just as in a stock portfolio.

In the current market, shoot for an average maturity of five years or less. That means you can buy a few really good ones at seven years and a few that don’t look as good in the one- to two-year maturity. Then fill in the blanks.

As the market shifts to higher interest rates, this strategy will shift to longer maturities and the higher rates that come with them. But for now, you must stay very short on time. This market requires it.

Never load up on a single bond because you like the return. This is the biggest trap and the biggest money burner in the business. Just ask the folks who bought Lehman Bros. bonds, AAA at the time, because they had a great interest rate and a really good rating.

For the average person, that’s someone who isn’t managing millions, there’s never a good enough reason to buy more than 10 bonds in any one position.

Plan on buying lots of different bonds so when the bad news does hit (and it will eventually), it only affects about one to four bonds out of a 100, and you don’t have your whole life hung out to dry in one position. I’ll bet you can guess which bonds will get you into trouble. Here’s a hint, it won’t be the small positions in your portfolio.

Look for bonds whose underlying companies just had some bad news; missed earnings, bad product, lawsuit, etc. It will kill the stock and the bond will slip, too, but here’s where the difference between stocks and corporate bonds really shines.

The only question you need to ask yourself about that bond is, “Will the company be in business when this bond matures?” The answer in almost 99% of cases is, “Yes.”

That’s it! Let the stockholders die on the vine as this thing gets pummeled. You buy the bond while it’s down, collect the interest and capital gains, wait for the bond to go back up in value – which they do in most cases – then sell it or wait for maturity and collect your principal and interest.

Two More Advantages

There are two more advantages to this short staggered portfolio. Take a look at the example below of what a portion of a complete staggered portfolio looks like.

Notice you have several bonds coming due each year. This is key to this strategy. This allows you to buy back into the market at higher rates several times a year. This gives you all kinds of flexibility that laddering doesn’t.

In a traditional laddered portfolio, you have to wait several years for a bond to mature to be able to buy another. That can hurt in a fast changing bond market, which is what I’m expecting in the next few years.

Maybe the most beneficial aspect of the staggered strategy is you can see the horizon. You can see that there’s money coming due, and you know you will get your principal back, and that gives you a psychological advantage over all other types of investments.

Being able to see that horizon – I call it the light at the end of the tunnel – makes it that much easier to sit tight and wait out the worst that any market has to offer.

You have to be there at the end of the race to have any chance of being a winner.

That’s how you avoid the bloodbath that’s coming in the bond market, reduce your risk, avoid the volatility of the stock and make real money in bonds.

Good Investing,

Steve McDonald

Article from Investment U

Shares or bonds - which is a better investment?

Saturday, Feb 18 2012 by Stockopedia Features
Article from Stockopedia

It's sure been a difficult time of late for stocks & shares. Over the last decade, the stock market has returned a feeble 0.6% vs. 3.9% for Gilts (and 1.6% for corporate bonds) and bonds have now matched or bettered stock returns over more than 30 years!

In light of this, there has been a lot of questioning recently about the relative attractiveness of shares versus bonds. Some suggest that investors should allocate entirely to bonds, not just because bonds are safer, but because they believe bonds will outperform shares over the long run. In other words, if bonds can deliver higher returns with less risk, what's the point of messing around with shares?

Citigroup wrote a piece in 2009 arguing that:

"The cult of equities was dead. Long live the cult of the bond".

Their theory: a half-century of bias of pension funds towards shares was reversing, and, given the lack lustre performance of shares, fund managers were instead turning to fixed-income investments for better returns. 

We're mindful of Blaise Pascal's trap that "People almost invariably arrive at their beliefs not on the basis of proof but on the basis of what they find attractive" but, before jumping on the bond band-wagon, we feel that it's worth being cautious for three reasons:

1. Fundamental analysis supports the idea that shares should outperform
2. The long run (and really long run) evidence still clearly indicates (by miles!) the superiority of shares versus bonds.
3. There's grounds for believing that our recent experience with bonds has been highly unusual (even if it has lasted 30 years!)

What's the difference between shares and bonds?

The essential difference between shares (equity) and bonds is that investing in shares is about buying partial ownership in a company, as opposed to bonds which involve making a loan to it.  When an investor buys shares, the value will tend to reflect the earnings experience of the firm — good and bad. In contrast, bonds can never earn more than its face value (plus coupons). shares have (theoretically) an unlimited ability for appreciation but, at the same time, greater downside risk (because they are lower down the capital structure in the event of an bankruptcy). Their returns can be decomposed as:

i) Bond return  = Current yield + Capital gain 

ii) Stock return = Current yield  + Earnings growth +  Price Earning multiple change

Thinking about risk/return, it seems clear that shares "ought" to produce higher returns in order for the capital markets to function, otherwise, stockholders would not be being paid for the additional risk they take (this is known as the "equity risk premium"). 

A Flight to Quality Effect

Despite this, bonds massively outperformed shares in 2011 (15.8% vs. -7.1% according to Barclays). However, there are good reasons to believe that the last few years have been atypical - because of the financial crisis. As Warren Buffett wrote in his 2009 annual shareholder letter:

"When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early  2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary".

The recent popularity of bonds is in part due to concerns about slow economic growth, coupled with a search for investment income amongst a demographically aging population at or near retirement. However, it also reflects four rather unusual (temporary?) factors: 

1. A flight to quality effect: Worries over the macro-economic situation and the fate of the Euro have driven people to buy bonds issued by stronger governments (such as those from the UK, US, Germany and Japan)  due to "a relative scarcity of safe assets". According to the latest Treasury Department data, foreign investors increased their stake in Treasuries to $4.57 trillion in August 2011 from $4.44 trillion at the end of 2010.
2. Consumer deleveraging: Prompted by fears of persistently high unemployment, households have increased savings and cut debt. Bloomberg noted that the U.S. savings rate has tripled to 3.6% since 2005 and has averaged 5.1% since the depth of the financial crisis in December 2008, compared with 3.1% for the previous 10 years, according to government data. 
3. Institutional deveraging: At the same time, banks are trying to rebuild their balance sheets after taking more than $2 trillion in writedowns from the credit crunch. In the US, they have boosted holdings of government-backed securities to $1.68 trillion from $1.62 trillion in December, according to the Fed.
4. Stock Market Volatility: A distrust of stock market volatiity following a decade which saw double-digit losses in four separate years.

Inflation, Interest Rates & the Medium Term

Even over the last few decades, it's undeniable that bonds have had a great run. The Barclays Gilt study shows that gilts have beaten shares over the last 20 years  by 1.8% (5.9% vs. 4.8%). Likewise, in the US, long-term government bonds have gained 11.5% annually over the last 30 years, compared with a 10.8% increase in the S&P 500. However, again, this is arguably because of very special factors that are unlikely to reoccur, especially the remarkable falls in interest rates & inflation experienced in the Western World over the last 30 years from the more inflationary environmen of the 1970s. High inflation does not hurt shares like it does bonds (as it is typically passed through to stock holders via earnings, whereas it reduces the purchasing power of a bond investor’s future interest payments and principal).  This scenario for bonds seems unlikely to repeat itself in the future, given today’s low interest rate environment (discussed below). 

What about the Long Term & the really Long Term?

Looking further back still, there are a number of informative studies, all of which strongly favour equities. Ibbotson Associates' famous analysis of U.S. shares and bonds goes back to 1926. It shows that the S&P 500 compounded to end-2010 at an annual rate of 9.9% vs. 5.5% for long-term  government bonds, an excess return of 4.4%. A $1,000 U.S. stock investment in 1926  would have ballooned to $3 million by December 2010 vs. $92,000 for  an investment in long-term bonds. Investorsfriend has charted this in real terms:

Similarly, a study by Wharton professor Jeremy Siegel, for example, found that after-inflation returns averaged 7.0% over nearly seven decades ending 1870, then 6.6% through 1925 and then 6.9% through 2004. According to work by  Arnott and Bernstein, from 1802–2010, U.S. shares generated a 7.9% annual return vs. 5.1% for long-term government bonds (a 2.8% risk premium). Finally, Barclays' work tracks UK asset returns since 1899 and suggests a 3.6% risk premium (shares have returned 4.9% versus 1.3% for gilts). 

Of course, it's also arguable that all these data-sets are a poor guide to the future too. 19th century data may be irrelevant since the US was effectively an emerging market back then. Also, both the UK and US markets enjoyed the status of global hegemons during different parts of the twentieth century, which may have positively skewed the equity upside for both markets...

Still, bonds look pricey!

The last time bonds beat stock returns for a sustained period of 30 years in the US - like they just have - was apparently prior to the Civil War! As Bill Larkin of Cabot Money Management points, "the first thing [this] tells you is you're probably at the most expensive bond market in our lifetime". To think about relative valuation, it's worth turning to the Fed model. This argues that the bond and stock markets are in a state of equilibrium, and fairly valued, when the one year forward looking earnings yield equals the 10-year Treasury note yield. While there are a number of issues with this model (e.g. not all earnings are paid out as dividends, earnings can grow, the treasury yield is nominal while earnings are real), it has a certain weight to it.  Applying it in the UK context, the FTSE 100’s earnings yield (earnings per share divided by the share price) is 10% versus a 10 year gilt rate of 2.19%, suggesting that the relationship between the two is completely out of kilter. The position in the US is similarly atypical. Indeed, stock dividend yields alone - let alone earnings are increasingly above bond yields, prompting the CEO of Blackrock to argue that investors should be 100% in equities.  

Jeremy Siegel, finance professor at the University of Pennsylvania’s Wharton School in Philadelphia, went so far as to say that:

“the rally in bonds is a once in a millennium event, but it’s absolutely mathematically impossible for bonds to get any kind of returns like this going forward whereas stock returns can repeat themselves".

While his mathematics may be a little off, it seems a fair point that bond yields are close to negative territory - which is kinda impossible, because it implies that investors would be willing to pay to lend their money to a borrower. Nowadays, there’s just not much scope for long-term bond prices to go up, since those values are inverse with interest rates, which are currently nearly as low as they can be. It seems more likely that moves by central governments for the past few years to hold interest rates down will eventually end as inflation starts to creeps up. Back in 1981, long-term Treasury bonds had yields that were greater than the average annual total return on common shares. That made long bonds a good bet then, albeit a brave one due to the high inflation rate (8.9%) of the time. 

Should an investor favour shares or bonds?

The trouble is that you could have reviewed most of the same evidence outlined above five years ago and decided to invest in shares - and that would have been a bad decision. It is certainly true - as Jim Bianco has rightly observed - that:

the generation-long outperformance of bonds over stocks has been the biggest investment theme that everyone has just gotten plain wrong”

Still, we would argue that it's dangerous to focus too much on the experience of the the recent past ("the fallacy of representativeness"), especially if there's good reason to suggest that it was unusual. In the words of Hockey legend Wayne Gretzsky:

"I skate to where the puck is going to be, not where it has been”.

Despite ups and downs, stock returns over the last 40 years have been virtually in line with the  long-term historical average. On the other hand, bond returns have been not only much higher than their historical averages, but also higher than their current yields. Apart from the recent "flight to safety" (which may admittedly persist for years!), the high bond return effect looks to have been driven by higher inflation in the 1970s and a subsequent declining interest rate environment. The notion of mean reversion - and the apparent absence of any explanation that suggest that "this time, it's different" - implies that investors hoping bonds will continue to outperform in the coming years will likely be disappointed. But over what time horizon - it's hard to say!

Finally, it's worth stressing that the shares vs. bonds dilemma, although often debated, is something of a false choice. In all likelihood, one should look at both. A disciplined asset allocation strategy will considers return and risk tradeoffs but also take into account the diversification benefits of shares, bonds and other securities. One rule of thumb often used is to have your age in bonds and the rest in equities in percentage terms - there's a lot more to it than that but that's a subject for another day!

Article from Stockopedia

Philippine Stocks Rally to Record on Fund Inflows: Manila Mover

February 17, 2012, 3:56 AM EST
Article from Bloomberg Business Week

By Clarissa Batino and Cecilia Yap

Feb. 17 (Bloomberg) -- Philippine stocks rose to a record, the peso climbed the most in two weeks and the nation’s bonds advanced amid speculation the country’s growth prospects will lure overseas funds.

The Philippine Stock Exchange Index jumped 2.4 percent to 4,880.71 at the close, the biggest gain since Oct. 7. The peso rose 0.5 percent higher at 42.628 per dollar, according to Tullett Prebon Plc. The yield on the 6.375 percent January 2022 peso bonds fell three basis points, or 0.03 percentage point, to 4.87 percent the lowest level since the debt was first sold in July, prices at Tradition Financial Services showed.

The stock index has climbed 12 percent this year as Bangko Sentral ng Pilipinas trimmed overnight rates and signaled further monetary easing this quarter amid a favorable inflation outlook. Net overseas investment in stocks, bonds and deposits rose in January from the previous month, the central bank reported yesterday.

“Rising remittances from our Filipino expatriates and stable inflation will support demand for consumption and corporate profits,” said BDO Unibank Inc. market strategist Jonathan Ravelas from Manila. “Interest rates too have been conducive for business.”

The central bank reduced the overnight borrowing rate to 4.25 percent from 4.5 percent on Jan. 19 after two increases in 2011. The authority still has monetary “policy space” for further easing as the inflation outlook remains favorable, Governor Amando Tetangco said last week. Yields on benchmark Philippine 10-year bonds reached a record low 5.08 percent on Feb. 9 on expectations the bank will trim rates when it meets on March 1.

Funds Flows

The country’s equities have drawn $353.4 million from overseas investors this year through yesterday, almost four times more than a year earlier, according to data compiled by Bloomberg.

The peso “has been stable with an upward bias,” central bank Deputy Governor Diwa Guinigundo told local television station PTV-4 late yesterday, adding that a stronger local currency would benefit the economy.

The Philippine economy is “robust, resilient” and the central bank expects to meet the 3 percent to 5 percent inflation target this year and next, Guinigundo said. The banking system is ’’very sound and stable,’’ he said.

“The peso is among the better performers in the region, supported by portfolio inflows and remittances,” said Radhika Rao, an economist at Forecast Pte in Singapore. “Recent comments by officials signal that authorities will allow the currency to follow the regional bias.”

A rising peso improves the attractiveness of local-currency bonds, supporting a rally in fixed-income assets, Rao said. “Bonds have been rising mostly on expectations of another central bank rate cut in March.”

Currency stories: NI ASIA FRX BN <GO> Bloomberg stories on Philippine bonds: TNI PHIL BON BN <GO> Snapshot of Philippine economy: ECST PH <GO> Currency forecasts: FXFC <GO> Bond yield forecasts: BYFC <GO> World currency ranker: WCRS <GO>

--Editors: Richard Frost, Simon Harvey

To contact the reporters on this story: Clarissa Batino in Manila at cbatino@bloomberg.net; Cecilia Yap in Manila at cyap19@bloomberg.net.

To contact the editor responsible for this story: James Regan at jregan19@bloomberg.net

Article from Bloomberg Business Week