Well, nobody's watching. Too bad, because I know how to make EVERYBODY rich! Yeah, I know, delusions of grandeur. Still, I need to drum up some readers, because my message is actually important. We live in a world where investment advisers almost universally tout the importance of stocks for building wealth and bonds for protecting it. So, when you're young, they tell you to load up on stocks, ride out the ups and downs, and then move into bonds when arthritis claims your joints.
I have another message: bonds can, and should, be a primary vehicle for wealth creation too. You might even consider ditching stocks altogether. Yes, I mean it. What justifies this obsession with boring old bonds? Quite simply, they offer the prospect of stock-like returns over time, along with the demonstrated safety for which they are primarily known. Here is a simple real-life example of explosive potential. In 2009 a Goldman Sachs bond with a coupon of 6.75% maturing in 2036 was offered for sale at a price of 66.5. So, a bond originally issued at $1000, and yielding $67.50 per year, could be bought for $665. It was/is rated at A2/A- by Moody's and Standard & Poors (a solid investment grade rating). The yield on that bond was therefore over 10%, locked in for 25 years! AND the US government had just declared Goldman Sachs to be one of 10 "vital" banks that would not be permitted to fail. AND, that bond, within two years, moved back to par. So, the two-year return on this investment was (on paper) 71%. If you can't get excited about that kind of nearly risk-free return, then you're reading the wrong blog.
Actually, the story is better than that. Because I believed that the opportunity was of the kind that come only once or twice in a lifetime, I bought my bonds on margin. No, not Corzine-type margin (leveraging 5-30 times equity). My use of margin was fairly modest. Here's how.
My broker (Interactive Brokers) will lend you money at rock-bottom rates, presently 1.25%. This is, by the way, the lowest in the business, although professionals can usually borrow for even less. So, let's run that Goldman Sachs bond through the margin machine. On a purchase of 10 bonds at 66.5, I borrowed half of the purchase price, $3325, from IB and paid an equal amount in cash. The 10 bonds yielded $675 per year over that two year span, a total of $1350. The yearly margin expense on the $3325 borrowed from IB was $41.56, or a total of $83.12. So, I netted $1267. Since my cash investment was $3325, the return over two years was 38%. Add in the paper gain to par of $3350, the total gain was $4617, or a two year return of 139%.
Now the warnings. Margin can be frantically dangerous. The greater the leverage, the greater the risk. IB will lend you up to $5 for every 1$ of equity. DON'T EVER DO THAT! The reason is the dreaded margin call. If the value of your bonds (or stocks) declines even a bit, your broker will demand more cash. If you don't supply it immediately (i.e., same day), they'll sell your positions to raise the cash. And, that will, almost surely, lock in a loss. That's why my rule of thumb is 1/1 or less. At that level, even a substantial downward fluctuation in values will not trigger a margin call. But, you'd better hope that the price will recover, as margin will magnify your losses in exactly the same way as it enhances your gains.
What amazes me is how often folks, even brilliant folks, yield to the margin siren. If 1/1 margin can give you a yield of 10 or 12%, they'll leap for the 20-40% you can achieve if you pile on the margin. This is a stupid pet trick and rarely ends well. It is, in fact, the core strategy of those famous hedge funds whose brilliance contributed mightily to the 2008-2009 crash. These guys bought tons of high-yielding long-term stuff with low-cost short-term money. Came the crisis, and the cost of money sky-rocketed. Worse yet, the guys who had lent the money suddenly demanded it back. So, the masters of the universe who had bought my Goldman Sachs bonds at par had to dump them to raise cash. Supply overwhelmed demand, and they sat out there at 66.5. Ironically, the hedgies sold their very best stuff at a loss, because their junk was nearly worthless. You'd think they would have learned by now, but MFS just went belly-up doing the same crazy leverage game.
Note that my investing example above combined two factors to achieve high returns. The first was simply exploiting the cycle. Buy bonds when they're cheap, and ride them back to par. The second was the careful use of borrowed money to enhance returns. Occasionally, you can combine the approaches. That's like riding a big wave off the north shore of Oahu. Sometimes one or the other will work. Ocasionally, neither works. Right now, for example, the approach of buyings bonds cheaply (at a discount to par) is pretty much used up. However, margin rates are still so low that you can achieve very nice yields following the 1/1 rule.
By the way, my Goldman Sachs example describes a theoretical gain of 139%. To get that, though, I would have had to sell the bonds. No way. I have a solid 10% locked in for many years to come. The capital gain (which is taxable) will come in due time (yes, 2036). I may not see the money, but my kids will. And that is a key part of my long-term bond investment strategy. More detail in my next post.
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