The spreadsheet shows wonderful long-term increases over very long periods of time. This is, by itself, not amazing. You'll find many stock scenarios that look far better, turning the theoretical 1947 investor into a multimillionaire. So, why isn't America awash in multimillionaires? There are several reasons, but the main one is that the widely published figures are bogus.
I think that stock yields are vastly overstated over time. First, they gloss over management fees, which reduce final results hugely. Almost all actively managed funds consistently under-perform their benchmarks for this reason alone. Second is portfolio churn. "Bad" investments are constantly being sold in favor of "good" new ones. Each time, a layer of transaction costs (buy-sell spreads, broker fees) erodes results. Third, taxes are ignored, even though many investors must pay them. Fourth, the weak, lame, crooked and incompetent are undercounted, as they usually go bankrupt and disappear from the averages. This also applies to fund families. Typically, an investment giant will launch a flock of new funds, and eventually merge the failures into the winners. The former's crummy results are no longer visible in the family's "stellar" long-term results. Factor all this in, and a long term return on a stock portfolio will easily fall to 7% annually, or less.
Now look at the Bodacious Bond Machine again. How does its 7.65% compounded return fare relative to the flaws discuss in the previous paragraph?
Fees: there are none. You run the portfolio; you don't collect a fee from yourself.
Portfolio churn: there is very little. Bonds are bought and held until maturity. Of course, bonds will, after 30 years, be retired and force reinvestment of the funds returned to you. I wouldn't call that churn, though.
Taxes: they are are typically higher on interest than on capital gains or dividends. This is a negative for a bond portfolio, but taxes can be deferred or eliminated through a tax-deferred or post-tax (Roth IRA) plan.
Fallout: this is a real issue for bonds too. Occasionally, a company defaults on its bonds, causing severe losses. However, the plan's focus on investment-grade bonds reduces this risk considerably. For example, since 1981, the average default rate for BBB- bonds (the lowest investment grade) has been .28% (see http://en.wikipedia.org/wiki/Bond_credit_rating). That drops to .16% for BBB+ bonds. In both cases, there are many years when the average rate is 0%, as defaults tend to be cyclical, associated with recessions.
Note, that this default rate would not necessarily be fully realized. Your could, for example, sell a given issue once it is downgraded to junk. For most companies, the road to default is gradual. Companies on the brink (Albertson's, Sears, Lucent, Sprint, Clear Channel, MBIA) have been declining for many years. Selling them as they turn into junk would have caused losses, but a limited portion of the investment. Even if the bond defaulted entirely, there might still be a return of capital once the company is reorganized or liquidated. One clear implication of default rates is that your bond portfolio should be diversified, both over time and company type. The first is accomplished by regular yearly purchases, achieving an automatic ladder of new bonds and ones nearing maturity. The second is your responsibility. Pick carefully, and widely.
Summary:
Can you see why this is so important? Do you now get why the case for bonds is so compelling? If a realistic expectation for a long-term stock investment is really only in the 7-8% realm, and I believe it is, then you'd be nuts to pursue that return with stocks when it is freely available with bonds. Instead of sweating bullets every time the market swoons, you can relax in the sure knowledge that your bonds will recover. Paper losses are irrelevant! A stock that drops 50% in value overnight might come back from the dead, but the bond will make the return journey for certain (barring default, of course).
So, again, why are there so few multimillionaires, either from stock or bond investing? The major reason is psychology. It's rare for anyone to really follow a plan. Psychology swings investors back and forth like a pendulum. They panic when the market has punished them, and swing to exuberance when it's soared. Since you CAN'T predict tops or bottoms, the only way to take advantage of them is to be steady. Over time, a regular investment will capture peaks (typically when bond prices are low), and keep from going overboard when prices are high (and yields low).
So, can YOU follow a plan? Probably not; most people can't. I do think, though, that my plan is far easier to follow than one based on stocks. The main reason is cash. You can see it arrive, on schedule, twice a year, every year. You can then take that cash, reinvest it, and watch even more come in, on schedule, twice a year, every year. This is very comforting. It might be enough to keep you on track, year in, year out.
My next blog will start with specific ways to implement the PLAN. Eventually, I'll also talk about a forbidden topic: bond timing.
Thursday, December 1, 2011
How It Works.
Again, here is the link to the spreadsheet:
https://docs.google.com/spreadsheet/pub?key=0AmMlf3bsV3rFdFQ3eDBDeXRCTEU4a2FtOHlpUFMtM0E&output=html
The most difficult task I faced in creating the spreadsheet was how to calculate average returns over time. Simplistic calculations yielded extreme distortions. For example, dividing the net portfolio increase by the total net investment at the end of a long time series greatly understates returns compared to inflation. This is because the cumulative effects of inflation over, say, 40 years are compared to final returns mostly generated far more recently. I finally hit upon a weighting system. This is a factor that combines the BAA interest rate for a given year with the dollar total invested that year. Dividing the sum of those factors by the total amount invested over a period of time yields an average return for that same time period. This average return can then be applied to the final portfolio value to calculate a weighted total investment. This weighted investment is the amount of money that would, compounded by the average interest rate over a time period, yield the final portfolio value.
Typically, a high interest rate will generate a far larger factor than a low one. Also, that high interest rate, toward the end of the series, will create a higher factor than the same interest rate early on (typically less money being invested earlier). The advantage of the factor is that high interest years have greater weight, as do years with high dollar investments. Years with high interest rates AND high dollar investments weigh the most. Note also that investments as long as 30 years in the past are still relevant, as the BAA yield is a 30 year yield. Bonds purchased in 1985, for example, would still be generating interest today.
To put this in other words, the weighted investment calculation converts the many yearly investments into a lump-sum equivalent. This would be a single initial investment that would yield the same long-term results. The advantage of weighted investment is that the cumulative effects of compounded interest and compounded inflation can be seen side by side. The very good news is that inflation's effect diminishes steadily over time. This is, perhaps, counter-intuitive, but actually makes good sense. Inflation compounds at a far lower rate (2.5% or so yearly) than the bonds income does (7.65% or so).
The base spreadsheet assumes a steady injection of inflation-adjusted funds every year. In most time series, the predictable spread of the BAA yield over inflation quickly brings the portfolio into the black. Every single time series has positive results for 10, 20, and 30 year periods. By 20 years, nearly every time series outperforms inflation robustly.
https://docs.google.com/spreadsheet/pub?key=0AmMlf3bsV3rFdFQ3eDBDeXRCTEU4a2FtOHlpUFMtM0E&output=html
The most difficult task I faced in creating the spreadsheet was how to calculate average returns over time. Simplistic calculations yielded extreme distortions. For example, dividing the net portfolio increase by the total net investment at the end of a long time series greatly understates returns compared to inflation. This is because the cumulative effects of inflation over, say, 40 years are compared to final returns mostly generated far more recently. I finally hit upon a weighting system. This is a factor that combines the BAA interest rate for a given year with the dollar total invested that year. Dividing the sum of those factors by the total amount invested over a period of time yields an average return for that same time period. This average return can then be applied to the final portfolio value to calculate a weighted total investment. This weighted investment is the amount of money that would, compounded by the average interest rate over a time period, yield the final portfolio value.
Typically, a high interest rate will generate a far larger factor than a low one. Also, that high interest rate, toward the end of the series, will create a higher factor than the same interest rate early on (typically less money being invested earlier). The advantage of the factor is that high interest years have greater weight, as do years with high dollar investments. Years with high interest rates AND high dollar investments weigh the most. Note also that investments as long as 30 years in the past are still relevant, as the BAA yield is a 30 year yield. Bonds purchased in 1985, for example, would still be generating interest today.
To put this in other words, the weighted investment calculation converts the many yearly investments into a lump-sum equivalent. This would be a single initial investment that would yield the same long-term results. The advantage of weighted investment is that the cumulative effects of compounded interest and compounded inflation can be seen side by side. The very good news is that inflation's effect diminishes steadily over time. This is, perhaps, counter-intuitive, but actually makes good sense. Inflation compounds at a far lower rate (2.5% or so yearly) than the bonds income does (7.65% or so).
The base spreadsheet assumes a steady injection of inflation-adjusted funds every year. In most time series, the predictable spread of the BAA yield over inflation quickly brings the portfolio into the black. Every single time series has positive results for 10, 20, and 30 year periods. By 20 years, nearly every time series outperforms inflation robustly.
Tuesday, November 15, 2011
THE PLAN!
Now, about that spreadsheet!
https://docs.google.com/spreadsheet/pub?key=0AmMlf3bsV3rFdFQ3eDBDeXRCTEU4a2FtOHlpUFMtM0E&output=html
The spreadsheet demonstrates the results of following a bond investing plan. I believe it yields consistent results over time, and avoids most of the huge losses that periodically plague the world of stocks. I think it is fairly simple, yet produces eye-popping results.
The spreadsheet has four inputs: a starting year, investment amount, lump sum indicator (is this a one-time investment, or a regular investment adjusted yearly for inflation?), and a tax rate. All the scenarios depicted here assume a regular investment amount, with no allowance for taxes. I'll discuss a lump-sum scenario in a later post.
You might be amazed to learn that the plan is simplicity itself: start with a base investment amount, and use it to buy BAA 30-year bonds every year. Each year, increase that base amount by the prior year's inflation rate, to ensure that the same purchasing amount is invested each year. Also, reinvest the prior year's interest. Ignore the ups and downs of the stock market, and ignore periodic panics about inflation, war and pestilence. Repeat every year for MANY years (a minimum of 20, preferably 30 or more). You'll love the results!
Don't take this too literally. "BAA 30-year bond" is a guideline. You might buy bonds with a lower or higher rating (as long as they're investment-grade). You might buy bonds with shorter or longer maturities, depending on what looks favorable when you're ready to buy. Over time, you want a mix of maturities and industries, but buying every year will tend to smooth things out
The spreadsheet demonstrates results for every initial year from 1947 to the present. For each such year, 10, 20, 30 and max (whatever the end year is) results are shown. The benchmark is inflation. To determine how well a time series has done, an inflation "toll" is subtracted from the portfolio's end value. The difference is an after-inflation return. What is striking about the results is that very few years show a negative return relative to inflation. The worst is the earliest start year, 1947. It starts out with nine straight years in which inflation is higher than the bond returns. This is largely due to the fact that inflation 1947 was over 14%, and over 8% in 1948, while BAA yields were slightly over 3%. This anomaly was due to the end of rationing in World War II. However, this same series shows a final portfolio figure of nearly $4.75 million, even after adjusting for inflation! All this from a total investment of $302,000 over 65 years (1000 inflation adjusted dollars every year).
While 1947 shows huge returns, so do more recent time series. 1980 was a terrific time to start (a little over 30 years). A total of $65,000 becomes $463,000 by 2011. But 1990 wasn't bad either. It turns $30,000 into $100,000. And 2000? $14,000 becomes $27,000. In fact, EVERY time series beats inflation by the 10-year mark! By 20 years, every time series outperforms inflation by a large amount.
How could this be? The magic lies in two factors: the power of compounded interest (an amazing thing) and the fact that the BAA yield was higher than inflation in all but 5 of the 65 years covered by the spreadsheet. That excess yield compounds to produce stunning results. Now, is this potential growth unique to bonds? Not at all. Most stock-return charts will show similar, or even better results. The difference is that bonds are far less volatile, far more predictable, and ultimately, far safer than stocks. Given the choice, in my opinion, you should always opt for the safer investment that still meets your investment needs. That is, hands down, the bond option.
Here, again, are a few cautions. The spreadsheet is a back-tested artifact. It takes advantage of hind-sight. The assumptions it makes are not guaranteed to work going forward. Most of its spectacular returns are due to that huge spike in interest rates in the late 1970's and early 1980's. Critically, it presumes that you don't have to pay taxes along the way (or that you pay them from outside the portfolio). Most of the excess return comes from the regular reinvestment of income. Remove some of that for taxes, and the results drop drastically.
The huge advantage of a plan oriented to bonds is that losses can be pretty much ignored. Repeat: your "losses" don't matter! Those terrible drops of 1979-81 were on paper only. They had NO effect on income, which continued unbroken, and increased very nicely in subsequent years due to the giant yields locked in along the way. You don't need to worry because there is a "correct", predictable end price for a bond. It is par. What happens in the meantime is irrelevant, as the price will end, upon maturity, at 100 cents on the dollar. The only thing that can hurt you along the way is a default (very very bad), or a margin call (so don't overuse margin).
The advantage of a "system" is that you have far fewer tough choices to make. Each year, you're going to buy BAA bonds, 30 years out. Yes, you have to decide which bonds, and when to buy during the year. I'll have some more suggestions about these lesser issues in a later blog.
https://docs.google.com/spreadsheet/pub?key=0AmMlf3bsV3rFdFQ3eDBDeXRCTEU4a2FtOHlpUFMtM0E&output=html
The spreadsheet demonstrates the results of following a bond investing plan. I believe it yields consistent results over time, and avoids most of the huge losses that periodically plague the world of stocks. I think it is fairly simple, yet produces eye-popping results.
The spreadsheet has four inputs: a starting year, investment amount, lump sum indicator (is this a one-time investment, or a regular investment adjusted yearly for inflation?), and a tax rate. All the scenarios depicted here assume a regular investment amount, with no allowance for taxes. I'll discuss a lump-sum scenario in a later post.
You might be amazed to learn that the plan is simplicity itself: start with a base investment amount, and use it to buy BAA 30-year bonds every year. Each year, increase that base amount by the prior year's inflation rate, to ensure that the same purchasing amount is invested each year. Also, reinvest the prior year's interest. Ignore the ups and downs of the stock market, and ignore periodic panics about inflation, war and pestilence. Repeat every year for MANY years (a minimum of 20, preferably 30 or more). You'll love the results!
Don't take this too literally. "BAA 30-year bond" is a guideline. You might buy bonds with a lower or higher rating (as long as they're investment-grade). You might buy bonds with shorter or longer maturities, depending on what looks favorable when you're ready to buy. Over time, you want a mix of maturities and industries, but buying every year will tend to smooth things out
The spreadsheet demonstrates results for every initial year from 1947 to the present. For each such year, 10, 20, 30 and max (whatever the end year is) results are shown. The benchmark is inflation. To determine how well a time series has done, an inflation "toll" is subtracted from the portfolio's end value. The difference is an after-inflation return. What is striking about the results is that very few years show a negative return relative to inflation. The worst is the earliest start year, 1947. It starts out with nine straight years in which inflation is higher than the bond returns. This is largely due to the fact that inflation 1947 was over 14%, and over 8% in 1948, while BAA yields were slightly over 3%. This anomaly was due to the end of rationing in World War II. However, this same series shows a final portfolio figure of nearly $4.75 million, even after adjusting for inflation! All this from a total investment of $302,000 over 65 years (1000 inflation adjusted dollars every year).
While 1947 shows huge returns, so do more recent time series. 1980 was a terrific time to start (a little over 30 years). A total of $65,000 becomes $463,000 by 2011. But 1990 wasn't bad either. It turns $30,000 into $100,000. And 2000? $14,000 becomes $27,000. In fact, EVERY time series beats inflation by the 10-year mark! By 20 years, every time series outperforms inflation by a large amount.
How could this be? The magic lies in two factors: the power of compounded interest (an amazing thing) and the fact that the BAA yield was higher than inflation in all but 5 of the 65 years covered by the spreadsheet. That excess yield compounds to produce stunning results. Now, is this potential growth unique to bonds? Not at all. Most stock-return charts will show similar, or even better results. The difference is that bonds are far less volatile, far more predictable, and ultimately, far safer than stocks. Given the choice, in my opinion, you should always opt for the safer investment that still meets your investment needs. That is, hands down, the bond option.
Here, again, are a few cautions. The spreadsheet is a back-tested artifact. It takes advantage of hind-sight. The assumptions it makes are not guaranteed to work going forward. Most of its spectacular returns are due to that huge spike in interest rates in the late 1970's and early 1980's. Critically, it presumes that you don't have to pay taxes along the way (or that you pay them from outside the portfolio). Most of the excess return comes from the regular reinvestment of income. Remove some of that for taxes, and the results drop drastically.
The huge advantage of a plan oriented to bonds is that losses can be pretty much ignored. Repeat: your "losses" don't matter! Those terrible drops of 1979-81 were on paper only. They had NO effect on income, which continued unbroken, and increased very nicely in subsequent years due to the giant yields locked in along the way. You don't need to worry because there is a "correct", predictable end price for a bond. It is par. What happens in the meantime is irrelevant, as the price will end, upon maturity, at 100 cents on the dollar. The only thing that can hurt you along the way is a default (very very bad), or a margin call (so don't overuse margin).
The advantage of a "system" is that you have far fewer tough choices to make. Each year, you're going to buy BAA bonds, 30 years out. Yes, you have to decide which bonds, and when to buy during the year. I'll have some more suggestions about these lesser issues in a later blog.
So take a look at the spreadsheet. Then, you can kick the tires and mock the assumptions.
The Plan: Introduction
I have referred several times to a spreadsheet I built over the last couple of years. It begins with bond yield and inflation data from 1946 to 2010. Bond yield data is taken from the Moody's Seasoned BAA yield series. It represents "average" yields, by year, for corporate bonds of good, but not prime quality. These bonds have a very low default rate, yet yield considerably more than the very top investment groups (AAA, AA and A). Their rates have varied a great deal over the years, going from lows of 3.21% to 16%. A key factor is that these rates are usually higher than the prime rate (the rate charged "prime" customers for short-term borrowing) for any given year, and usually beat inflation. Why are the seasoned BAA rates higher than other bonds? It's very simple: they are long-term rates. As the website says: "Moody's tries to include bonds with remaining maturities as close as possible to 30 years."
Why are long-term rates so much higher? They reflect a perception of risk. The farther out a maturity is, the more things can go wrong. Rates can rise, eroding the value of the bonds. Inflation will also do its erosion. Finally, there is credit risk: the possibility that the financial health of the issuing company will deteriorate to the point that the bond defaults. All of these possibilities lead investors to expect, and demand, higher rates of return for long-term bonds. There is also a perceptual problem most investors have with these bonds: thirty years is "too long". Older folks think they'll die first; younger ones dislike thinking about how they'll look in the mirror in thirty years. Either way, that endless prospect discourages investors.
I believe, though, that BAA type bonds represent the absolute sweet spot in the investing world. Sure, if you're old, you may be dead before these bonds mature. But in the meantime, you'll be collecting those fat interest payments. And will your spouse, children, or grandchildren, refuse the money? Furthermore, if you need cash in the meantime, there is a ready resale market for most large-cap bond issues. The price you get on a resale may vary greatly, depending on present interest rates (either up or down), supply and demand, and the ever-present fear factor. All these make it a very good idea to make your initial bond purchases at a discount to par. That shields you on the downside, and builds a predictable upside into the transaction (if you hold the bond to maturity). It will, after all, return the exact same amount as the original buyer paid upon issuance (par).
My ideal scenario, reflected in my spreadsheet, is to build a long-term bond portfolio steadily, year after year. A predictable amount should be added to the portfolio regularly, and interest income should be reinvested steadily. This latter requirement means that the bonds should be held in a tax-deferred vehicle like a traditional IRA, Roth IRA or 401 K plan. Since taxes are paid on the latter two only upon withdrawal, and the Roth is funded with post-tax money, everything compounds tax-free. That's huge, as you will see.
Why not wait for those magic moments when bonds have reached a cyclical peak, and then pounce? Well, there are two problems with that. First, those moments of peak yields are also moments of extreme terror. In 1982, and 2009, people were running AWAY from bonds, not towards them. In 1982 they were panicked about rates (16% and higher) exploding upward. In 2009 they feared the entire financial universe was about to crash. Second, it's hard to recognize a peak until it's past. Once it's past, you regret missing it, and stew instead of acting. The brave souls who grabbed for peak and near-peak yields were richly rewarded, but they spent many sleepless nights until things went their way. I was one of them, because I was following a plan (albeit a newly conceived one).
Psychologically speaking, brave investing is a non-starter for the huge majority of investors. Fear overwhelms greed at the precise wrong moment. It's easy to be intrepid when you've just reached new highs in your portfolio; it's exceptionally difficult to jump in when you've just taken ferocious losses. So, how can you overcome your own inner demons? The only way I know is to have that plan, and stick with it through thick and thin. Put it on autopilot as much as possible.
My next blog will demonstrate the results of following a plan.
Why are long-term rates so much higher? They reflect a perception of risk. The farther out a maturity is, the more things can go wrong. Rates can rise, eroding the value of the bonds. Inflation will also do its erosion. Finally, there is credit risk: the possibility that the financial health of the issuing company will deteriorate to the point that the bond defaults. All of these possibilities lead investors to expect, and demand, higher rates of return for long-term bonds. There is also a perceptual problem most investors have with these bonds: thirty years is "too long". Older folks think they'll die first; younger ones dislike thinking about how they'll look in the mirror in thirty years. Either way, that endless prospect discourages investors.
I believe, though, that BAA type bonds represent the absolute sweet spot in the investing world. Sure, if you're old, you may be dead before these bonds mature. But in the meantime, you'll be collecting those fat interest payments. And will your spouse, children, or grandchildren, refuse the money? Furthermore, if you need cash in the meantime, there is a ready resale market for most large-cap bond issues. The price you get on a resale may vary greatly, depending on present interest rates (either up or down), supply and demand, and the ever-present fear factor. All these make it a very good idea to make your initial bond purchases at a discount to par. That shields you on the downside, and builds a predictable upside into the transaction (if you hold the bond to maturity). It will, after all, return the exact same amount as the original buyer paid upon issuance (par).
My ideal scenario, reflected in my spreadsheet, is to build a long-term bond portfolio steadily, year after year. A predictable amount should be added to the portfolio regularly, and interest income should be reinvested steadily. This latter requirement means that the bonds should be held in a tax-deferred vehicle like a traditional IRA, Roth IRA or 401 K plan. Since taxes are paid on the latter two only upon withdrawal, and the Roth is funded with post-tax money, everything compounds tax-free. That's huge, as you will see.
Why not wait for those magic moments when bonds have reached a cyclical peak, and then pounce? Well, there are two problems with that. First, those moments of peak yields are also moments of extreme terror. In 1982, and 2009, people were running AWAY from bonds, not towards them. In 1982 they were panicked about rates (16% and higher) exploding upward. In 2009 they feared the entire financial universe was about to crash. Second, it's hard to recognize a peak until it's past. Once it's past, you regret missing it, and stew instead of acting. The brave souls who grabbed for peak and near-peak yields were richly rewarded, but they spent many sleepless nights until things went their way. I was one of them, because I was following a plan (albeit a newly conceived one).
Psychologically speaking, brave investing is a non-starter for the huge majority of investors. Fear overwhelms greed at the precise wrong moment. It's easy to be intrepid when you've just reached new highs in your portfolio; it's exceptionally difficult to jump in when you've just taken ferocious losses. So, how can you overcome your own inner demons? The only way I know is to have that plan, and stick with it through thick and thin. Put it on autopilot as much as possible.
My next blog will demonstrate the results of following a plan.
Monday, November 14, 2011
I'm Back
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.
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.
Monday, November 1, 2010
Investing and Cycles
What I'm going to say here is simple, yet utterly essential to bond investing. Bond yields are cyclical. These cycles are different from than stock investing cycles, and easier to identify. Technical analysts in particular love to chart stock movements over various period of time, and from those movements, to deduce grand trends. They give them fancy terms, like "Elliott Wave". They'll argue that a sharp upward movement in stock prices is really a head-fake in a larger "secular" bear market. Some will see deeper meaning in the hourly fluctuations of a specific stock; thus unleashing a storm of day trades.
Bond cycles are much simpler. Bond yields go up for a relatively long time, and then they go down. I have a spreadsheet (mentioned before) which begins with bond yields over a very long time (from 1946 to the present). The key yield for my purposes is the Moody's seasoned Baa yield. This is a benchmark bond yield for a "typical" corporate bond of mid-level investment quality and long-term duration. It's not a blue-blood bond, but it's a good way from junk. These bonds have some investment risk, particularly over time, but that risk is quite small. Diversification in the bonds you buy will largely take care of this risk.
In 1946, the first post-war year and the year of my birth, the Moody's seasoned Baa yield was 3.4%. Not great, considering that inflation that year ran at 14%. Still, the BAA yield stayed in that general range for the next ten years. It then moved into the 4% range, then 5% by 1966. By 1968, the rate had jumped to 8.5%, and finally topped out at 16.1% in 1982. Rates then began a long, slow decline: back to 8% by 1996, and 6.5% by 2007. There was then a tsunami between 2008 and early 2009, which almost disappears in the official statistics for those years (7.44% and 7.29%). In fact, in late 2008 and early 2009, corporate yields of all kind skyrocketed! Many issues topped 20%. Since then, however, the long-term cycle has reasserted itself, with the seasoned yield somewhere under 6% right now.
Notice, over nearly 65 years, a grand swoop up, and a grand swoop down. Lots of business in between, but that's the bottom line. So, being astute cycle experts, what's next? Will the grand down-trend continue back to those 3% levels of the 1940's? Damned if I know. While hindsight is 20/20, the future is almost always murky.
Still, there are a couple of really important things you can learn from this long cycle. 3% is a fairly rotten long-term bond yield, and 16.1% is a really high one. So, it's simple, right? Don't buy bonds with a 3% yield, and load up when they're 16%. Yeah, true enough. But when those bonds were yielding 16%, inflation was running over 20%. Guess what? People deserted bonds in droves in 1982! They were terrified of hyperinflation (Zimbabwe style), and feared bonds like the plague. You couldn't give the darn things away. Back in the fifties, lots of folks were pleased as punch to lock in a 3.5% yield: they were being responsible and avoiding risk.
Clearly, those few brave souls who dove in in 1982 were rewarded extravagantly. The long bonds they bought went up and up and up in price. They were geniuses. So, what happened to the idiots who bought in 1950? Well, THAT DEPENDS. If they made a lump sum investment, and did nothing afterwards, they got slaughtered. Even if they held bonds to maturity, inflation devastated their results. If, however, they kept investing, and particularly, if they reinvested their income as it came in, well, amazingly enough, they did very well too! Why? Because a regular investment program let them buy some high yield bonds too. Almost every scenario I have run confirms the same thing; stay in the bond market long enough to catch the full up and down, and you'll prosper.
Of course, in the long run, we're all dead, and few folks have a sixty-five year investment horizon. Can good things come with a shorter time line? Possibly. I'll have more to say about that in awhile.
Bond cycles are much simpler. Bond yields go up for a relatively long time, and then they go down. I have a spreadsheet (mentioned before) which begins with bond yields over a very long time (from 1946 to the present). The key yield for my purposes is the Moody's seasoned Baa yield. This is a benchmark bond yield for a "typical" corporate bond of mid-level investment quality and long-term duration. It's not a blue-blood bond, but it's a good way from junk. These bonds have some investment risk, particularly over time, but that risk is quite small. Diversification in the bonds you buy will largely take care of this risk.
In 1946, the first post-war year and the year of my birth, the Moody's seasoned Baa yield was 3.4%. Not great, considering that inflation that year ran at 14%. Still, the BAA yield stayed in that general range for the next ten years. It then moved into the 4% range, then 5% by 1966. By 1968, the rate had jumped to 8.5%, and finally topped out at 16.1% in 1982. Rates then began a long, slow decline: back to 8% by 1996, and 6.5% by 2007. There was then a tsunami between 2008 and early 2009, which almost disappears in the official statistics for those years (7.44% and 7.29%). In fact, in late 2008 and early 2009, corporate yields of all kind skyrocketed! Many issues topped 20%. Since then, however, the long-term cycle has reasserted itself, with the seasoned yield somewhere under 6% right now.
Notice, over nearly 65 years, a grand swoop up, and a grand swoop down. Lots of business in between, but that's the bottom line. So, being astute cycle experts, what's next? Will the grand down-trend continue back to those 3% levels of the 1940's? Damned if I know. While hindsight is 20/20, the future is almost always murky.
Still, there are a couple of really important things you can learn from this long cycle. 3% is a fairly rotten long-term bond yield, and 16.1% is a really high one. So, it's simple, right? Don't buy bonds with a 3% yield, and load up when they're 16%. Yeah, true enough. But when those bonds were yielding 16%, inflation was running over 20%. Guess what? People deserted bonds in droves in 1982! They were terrified of hyperinflation (Zimbabwe style), and feared bonds like the plague. You couldn't give the darn things away. Back in the fifties, lots of folks were pleased as punch to lock in a 3.5% yield: they were being responsible and avoiding risk.
Clearly, those few brave souls who dove in in 1982 were rewarded extravagantly. The long bonds they bought went up and up and up in price. They were geniuses. So, what happened to the idiots who bought in 1950? Well, THAT DEPENDS. If they made a lump sum investment, and did nothing afterwards, they got slaughtered. Even if they held bonds to maturity, inflation devastated their results. If, however, they kept investing, and particularly, if they reinvested their income as it came in, well, amazingly enough, they did very well too! Why? Because a regular investment program let them buy some high yield bonds too. Almost every scenario I have run confirms the same thing; stay in the bond market long enough to catch the full up and down, and you'll prosper.
Of course, in the long run, we're all dead, and few folks have a sixty-five year investment horizon. Can good things come with a shorter time line? Possibly. I'll have more to say about that in awhile.
Thursday, October 28, 2010
So what's wrong with bonds?
My first three blogs have focused on the things I like about bonds: predictability and durability. Believe me, I'm not alone in liking these qualities. The last couple of years has seen a stampede into bonds. People horrified by the losses they experienced in stocks have sought safety in bonds. In the process, though, they have triggered a wave of sell-side advice. Bonds, particularly bond funds, say many folks, have overreached. Prices have risen so drastically that there is no further upside. Since rising bond prices means lower yields (this is a constant of bonds, and you should run through the logic until you GET it), bond buyers are taking on very large risks for very small gains.
What do I think? Well, I pretty much agree. If you do what most folks are doing, which is to buy into bond funds, you are asking for trouble. I'll talk much more about bond funds in a future blog. For the time being, just know that I don't like them, and would strongly advise against them, now or pretty much ever. Any time that buying a bond fund would be a good idea is a time when buying individual bonds is a far better one. Period. Just an opinion, of course.
So, what's the knock on bonds? It relates to yield. Bonds often don't yield much, particularly in comparison to stocks (remember that squishy 9-10% figure the pundits cite?). Short term Treasuries (3, 6 and 12 month maturities) have ZERO yield, three years out is still only 1/2%. Even ten year maturities are a measly 2.65%. Only the thirty year treasury (3.875%) offers a shred of hope of meeting inflation and taxes. That's pretty bleak. You won't lose your principal, but its buying power will decline over time.
Corporate bonds are better, but still pretty chintzy over shorter time spans. A Goldman Sachs bond (A rated) will yield under 4% over four years. Not great, but it makes the government bond look sick. Take it out to 2037, and the GS yield is 7.2%. This yield increment over the treasury is the difference between making REAL money and breaking even. So, why not buy a long bond?
Well, the first risk relates to rising interest rates. As demonstrated in my last blog, an increase in rates will trigger a decline in the bond's market price. That's a problem if you need to sell, and a very good reason not to buy a bond if you have a short investment horizon. The second risk is worse: inflation. Right now, we have very low inflation, perhaps even a whiff of deflation. So, the 7.2% you can get by going long is pretty good. You can pay your taxes and still have a nice, real return. Should inflation flare up, though, that real return will decline by the amount of inflation. AND, the bond's price will fall as rates rise. You'll feel bad, and consider selling.
What to do, what to do? If you know the future, it's easy. That foreknowledge in 1980-82 or 2007-2008 would have led you to raise cash, and wait until rates rose to the stratosphere. Then you would have locked them in. In real life, though, nobody knows what's going to happen next. So, I would suggest a method. If you have money to invest, and a long-term bond rate looks attractive in comparison to present inflation, then buy some bonds to snag that yield. Don't bet the farm. If rates rise, don't panic. Buy some more, locking in that higher yield. Keep buying until rates have clearly peaked, then buy a lot, thus locking in near-peak yields. How do you know when rates have peaked? Well, they'll start going down. You'll miss the top, but will probably get in well before the bottom.
This approach presumes that you have money to invest, and will have more in the future. Part of that future money will, of course, come from the bonds you already own. The rest should, one hopes, come from saving part of your income.
Does this work? I'll talk about some analysis I've done of bond investing over various time periods. I think it's extremely interesting, and might put stock investing to shame.
What do I think? Well, I pretty much agree. If you do what most folks are doing, which is to buy into bond funds, you are asking for trouble. I'll talk much more about bond funds in a future blog. For the time being, just know that I don't like them, and would strongly advise against them, now or pretty much ever. Any time that buying a bond fund would be a good idea is a time when buying individual bonds is a far better one. Period. Just an opinion, of course.
So, what's the knock on bonds? It relates to yield. Bonds often don't yield much, particularly in comparison to stocks (remember that squishy 9-10% figure the pundits cite?). Short term Treasuries (3, 6 and 12 month maturities) have ZERO yield, three years out is still only 1/2%. Even ten year maturities are a measly 2.65%. Only the thirty year treasury (3.875%) offers a shred of hope of meeting inflation and taxes. That's pretty bleak. You won't lose your principal, but its buying power will decline over time.
Corporate bonds are better, but still pretty chintzy over shorter time spans. A Goldman Sachs bond (A rated) will yield under 4% over four years. Not great, but it makes the government bond look sick. Take it out to 2037, and the GS yield is 7.2%. This yield increment over the treasury is the difference between making REAL money and breaking even. So, why not buy a long bond?
Well, the first risk relates to rising interest rates. As demonstrated in my last blog, an increase in rates will trigger a decline in the bond's market price. That's a problem if you need to sell, and a very good reason not to buy a bond if you have a short investment horizon. The second risk is worse: inflation. Right now, we have very low inflation, perhaps even a whiff of deflation. So, the 7.2% you can get by going long is pretty good. You can pay your taxes and still have a nice, real return. Should inflation flare up, though, that real return will decline by the amount of inflation. AND, the bond's price will fall as rates rise. You'll feel bad, and consider selling.
What to do, what to do? If you know the future, it's easy. That foreknowledge in 1980-82 or 2007-2008 would have led you to raise cash, and wait until rates rose to the stratosphere. Then you would have locked them in. In real life, though, nobody knows what's going to happen next. So, I would suggest a method. If you have money to invest, and a long-term bond rate looks attractive in comparison to present inflation, then buy some bonds to snag that yield. Don't bet the farm. If rates rise, don't panic. Buy some more, locking in that higher yield. Keep buying until rates have clearly peaked, then buy a lot, thus locking in near-peak yields. How do you know when rates have peaked? Well, they'll start going down. You'll miss the top, but will probably get in well before the bottom.
This approach presumes that you have money to invest, and will have more in the future. Part of that future money will, of course, come from the bonds you already own. The rest should, one hopes, come from saving part of your income.
Does this work? I'll talk about some analysis I've done of bond investing over various time periods. I think it's extremely interesting, and might put stock investing to shame.
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