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Simple Bond Plan How to build a laddered bond portfolio by selecting the correct bonds, the correct qualities, and the correct maturities with competitive yields and reasonable costs. |
| Where you are trying to go Investment Planning: Investor's CalcStation | How you are going to get there Portfolio Management: Investor's WorkStation | How well you have done Modified Dietz Performance Calculator: PerfCalc | What you need to think about, know, do, have, use, forget, and avoid Investing Principles and Perspectives: In My Opinion | Home | Contact Us | Free 30-Day Software Trials | Prices/Order Degrees of investment success have less to do with the performance of the financial markets and more to do with a failure to learn, define, implement, and enforce specific investment selection and management disciplines for each investment sector/category/type. Without investment disciplines for all investments as a foundation for investment analysis, it is troubling to me as to how one can possibly analyze, distinguish, separate, evaluate, and then advise beyond statements such as the investment has done well in the past, has a five star rating, current yield is higher than the present investment, and the analyst said. For example, "A Simple Bond Plan," is my investment selection and management process for bonds. Stockbrokers, investment advisors, and individual investors need the same disciplines, rules, and procedures that determine which investments will be purchased and when and that govern change. My disciplines, rules and procedures for other investment types/classes may be found in the "Almost Perfect Stockbroker" and the "Almost Perfect Investor." Bond Investment Selection & Management Treat bond selection and bond investment management as part of a game theory. "Game Theory" as defined in Webster's Dictionary: "A mathematical theory that deals with strategies for maximizing gains and minimizing losses within prescribed constraints." "A competitive activity involving skill and played according to a set of rules." The bond game is not so much a game of chance, but rather a game of discipline; a game that evolves based on what is known today and what can be done today rather than depending on the correct anticipation of what lies ahead. The investment selection and management discipline process used in the Bond Sector must have a primary goal of preservation and protection of capital, both market value prior to maturity and maturity value, while seeking competitive interest rates/yields. Employ a bond portfolio management strategy that does not depend on the correct anticipation of the direction of interest rates to be successful. Buy individual bonds. Develop a diversified (different bonds) and laddered maturities (different maturities) bond portfolio which is consistent with investor goals, market conditions, bond investment disciplines, and weighted with consideration for capital needs and income requirements. Accept the average yield of the portfolio rather than emphasizing maturity extremes where capital can under perform in the shorter maturities or be exposed to unnecessary market risks in the longer maturities. Recognize changes in the bond markets, understand the need to make changes in a bond portfolio prior to a bond's maturity, and be in a position to take advantage of bond market changes. Implement a simple, straightforward investment selection and management discipline that seeks the "Correct Bond," the "Correct Quality," the "Correct Quantity," the "Correct Maturity," and "Competitive Yield" at a "Reasonable Cost." "Correct" will be determined by the bond investment variables as chosen by the investor/advisor:
And the bond market variables over which the investor/advisor has no control:
The Correct Bond
Invest only in pure debt instruments without enhancements and in bonds in which market value depends on only three investment variables; quality, maturity, and interest rate fluctuations. Invest only in the "conservative" bonds as shown in the illustration. Avoid compromise such as "aggressive" bonds that seem to offer greater yields but mask greater investment risk. Never compromise the discipline to chase yield! Leveraging, borrowing against or margining bonds, and the use of enhancements such as options are absolutely out of the question. The Correct Quality The investor/advisor must select the bond quality ranges that are consistent first with investor risk tolerances and secondly with the investor's need for income. Risk tolerances must have priority over the need for income because it is better to accept a lower income than to lower bond quality to increase income. The increase in income will never offset the investment agony of a more conservative investor who should be in more conservative bonds. Moodys
and Standard & Poors are independent companies that evaluate the investment
quality of bonds. Quality ranges from AAA insured to AA, A, Baa all the way down
to C, D, and non-rated. Typically bonds rated AAA to Baa are considered investment
grade and would generally be considered suitable for conservative investors. Keep in mind that, though it is true the lower the quality the bond the greater the yield, the increase in yield may not justify the added risk. Furthermore, bond rating services are terrible at anticipating bond qualities and their associated ratings. A change in a bond's rating will come only after the fact of a change in the circumstances of a company's or agency's bond and a market adjustment in the price of the bond. The Correct Quantity It is essential that bond investment be broadly diversified. The lower the quality the greater the diversification. As there is always a wide selection of bond investments, there is no justification for concentration of bond investments. If something should go wrong, which is rare, there is no reason to risk the complete loss of capital or the disruption in market value of capital prior to maturity by having capital invested in a few bonds. As a general rule, have no more than 5% of capital invested in a single bond. Insured bonds may be the exception. Remember, preservation and protection of market value and maturity value of bond capital is foremost for most bond investors. Why concentrate bond capital when diversification and the greater protection it offers is just as easy to do. The Correct Maturity Select bonds that have maturities which coincide with the time periods in which the investor will need bond principal and with optimum points on the yield; maximum income and minimum market risk. Competitive Yield Seek after tax yields that are greater than the rate of inflation/cost of living without compromising the need to protect the market value of a bond prior to maturity. Reasonable Cost Bond mutual funds are never needed. There is always a better, smarter way. Bond mutual funds are never at a reasonable cost when compared to the costs that will be incurred by buying individual bonds. $5.00 per bond commission should be the average cost. Furthermore, bond mutual funds, in order to compete for investor capital, will violate responsible bond investment disciplines and use speculative investment strategies in an effort to increase advertised yield. If a fee-based advisor is to be used to build and manage a bond portfolio, ongoing management fees should be very small; less than 1/2%. It is always smarter to build and manage a bond portfolio made up of individual bonds that is very specifically designed to meet the very specific needs of the investor rather than invest capital in a bond mutual fund that will meet some of the general needs of many investors. Follow the bond selection and management discipline to be explained below. It is easy to do, you will have what you need, you will know exactly what you have and why, and you will understand exactly what can and will happen. Building a Bond Portfolio Building a bond portfolio with the "Correct" bond characteristics can best be explained by first drawing a rectangle on a sheet of paper which will be the initial bond portfolio "field of play." As each variable for bond selection and management is added, the bond portfolio "field of play" will be narrowed until the optimum bond portfolio, consistent with investor need and bond market conditions, is created. Assume an investor has a total of $110,000 in principal, of which $10,000 will be needed in 4 years, and the balance of $100,000 of the principal will not be needed for 20 years.
The investor/advisor must first choose the range of bond qualities that are suitable for the investor. For this example the lowest acceptable quality is Baa. A horizontal line is drawn at the theoretical constraint of Baa. The gray area between AAA and Baa is the new more narrowly defined bond portfolio "field of play." No bonds will be considered outside of this range. The Correct Maturity The range of bond maturity options will initially depend on when the investor will need a return of capital/principal. For this example of a total of $110,000 in principal, $10,000 will be needed in 4 years and the balance of $100,000 of the principal will not be needed for 20 years, The bond "field of play" is reduced further to bond maturity ranges from 4 years to 20 years.
Bond Quality and Maturity Combined Overlay the Bond Quality and Maturity investment parameters to determine the boundaries of the bond portfolio "field of play" as as revised boundaries for a personalized bond portfolio model. Current holdings outside of these boundaries must be liquidated (quality too low and/or maturities possibly too short and/or too long) and acquisitions must be made within the defined model.
The Yield Curve & Cost of Living/Inflation The bond portfolio "field of play" must be further defined and narrowed by taking into consideration the shape of the yield curve and the cost of living/inflation rate. Treasury Yield Curve
The yield curve graphically illustrates different levels of interest rates for different maturities as shown above by a Treasury Yield Curve.
The cost of living/inflation rate is represented and arbitrarily selected for illustration purposes by the horizontal black line between between 2% and 3%.
Competitive Yield The following illustration combines the yield curve and the cost of living to further define the general boundaries suitable for bond investment based on the two bond market investment variables.
At first glance, the gray area would seem to be the appropriate boundaries for bond investment. The actual area is smaller because bond maturities longer than the intercepts of the theoretical yield curve, the actual yield curve, and the vertical line at that intercept do not offer increased yield; therefore, the correct bond portfolio "field of play" would have minimum maturities where short-term bond yields equal the cost of living/inflation and the longer term bond yields would have maximum maturities at the point where the yield curve "flattens." Staying within these boundaries will insure competitive yield and the correct bond market maturities; capital earning income above the cost of living and taxes and avoiding bond maturities where capital is not compensated for the market risk of extended maturities. Your Bond World The
final step in creating a bond portfolio is to overlay/combine the bond portfolio
"fields of play" as defined by the chosen investor/advisor bond investment
variables of the "Correct Bond," the "Correct Quality," the
"Correct Quantity," and the "Correct (investor selected) Maturity"
with the "Competitive Yield" and "Correct (market defined) Maturity"
realities of the bond market as determined by the bond market investment
variables of the yield curve and the cost of living/inflation.
To ignore the bond investment selection and management boundaries as determined by the investor and as set by the bond market conditions can be fatal:
Buying and Selling Bonds Prior to Bond Maturity For those who wish to play a slightly more advanced bond game, this game can, in some ways, be played like a game of chess in that it must depend on anticipation (thinking several moves ahead) and the probable outcomes and implications of a chosen direction. There are many reasons and opportunities to buy and sell bonds, "swap" bonds, prior to maturity. Rather than go through the standard tax bond swap, the following represents another type of bond swap opportunity. When interest rates change in one time period of the yield curve or should the entire shape of the yield curve change in general, it is possible to take advantage of that change by "managing the yield curve" and by adjusting bond portfolio maturities by moving to new optimum points on the yield curve to ensure the most efficient use of capital (the best average yield) consistent with any interest rate change and to have the opportunity to increase both the number of bonds held and the bond portfolio income with the same initial capital over time. The rule of this bond swap game is that anytime a bond can be sold to increase either the face amount, the number of bonds held and/or increase the income the bond swap should be made. The rule does not mean that a swap can be made simply by lowering bond quality or extending bond maturity to increase face amount and/or income. This aspect of the bond selection and management discipline assumes (correctly) that there are interest rate cycles of highs and lows and that over time the yield curve will always return to a "normal" shape; possible different overall interest rate levels but the longer the maturity the greater the yield. "Buy Hold, & Forget," Not Competitive The purpose of this exercise is to make the investor/advisor aware of bond market changes and how it is possible to capitalize on those changes. The following illustration uses extreme changes in interest
rates that are real, though rare, and were used for illustration purposes only. Be clear that the degree in swings in interest rates for different maturities is not as important the rule that one must always move in from any maturities that rest on the flat portion of the yield curve to the shortest maturity on the flat portion of the yield curve; in the illustration below -10 yr., 5%; be alert, and when it happens, no matter how small, act.
Managing The Yield Curve
We are not always at the extremes of interest rate highs and interest rate lows. Even in the usual gray of day-to-day it is essential that the bond investor be aware of the interest cycles and general financial market cycles to better manage a bond portfolio. Occasional, responsible transactions are consistent with keeping money competitive. |