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junkman
4-25-11, 2:51pm
In another thread, someone writes, "I guess I need to look into some of the safer bonds." To which I say, "Hoorah! Now, finally, that emotions have quieted a bit and reason has stepped forward, the discussion can begin."

In America, unfortunately, “investing” is equated with “stock investing” and all the hoopla that surrounds that financial casino, whereas for Europeans, investing has traditionally meant “bonds”. I’ve got nothing against stock investing, aka, becoming a fractional owner of a variety of companies that one’s analysis suggests should do well, and successful investors like Peter Lynch do an excellent job of trying to teach beginners how they might learn to invest in stocks. But stocks aren’t the only securities one can invest in, nor is the stock market even the biggest market on the basis of capitalization. Bonds are, and they deserve the attention of “risk-adverse” investors because they carry with them structural features that help to make managing their risks a lot easier for financial beginners, namely the fact that they mature, meaning market-price fluctuation can be endured without permanent capital impairment. In other words, bonds are “puts”. On maturity date, the note-holder can 'put' his or her bond to the issuer and can expect to be returned his/her principal and the final interest payment.

Where do most of us begin our investing experience? With passbook accounts and with bank CDs. Some of us, me included, have never really ventured much beyond that initial exposure to accepting financial risk in order to achieve financial gains. We don’t like the risks of stock investing, so we’re stuck in bond land. But some of us decided to explore the territory more thoroughly than others, and we've learned how to buy “across the yield-curve and up and down the credit spectrum”, achieving very decent returns that rival equities on a risk-adjusted basis.

The situation is this. A company can finance its activities by issuing stock or issuing debt. Both of those securities come to be traded in secondary markets, which is where the average investor encounters them. So he/she has a choice and can buy the debt or the common. In my experience, the payoff difference between the two is roughly 3x, favoring equity, albeit with far greater volatility. So if one equates risk with volatility, then he/she will favor buying the bonds of an issuer rather than their stock. Not all issuers issue stock. E.g., the US Treasury Department, most GSEs, and municipalities only issue bonds. Depending on the credit-worthiness of the issuer, their debt becomes a proxy for interest-rates, or, to the extent that their debt is of less than sterling credit-worthiness, their debt takes on the equity-like characteristics of higher yields but with greater uncertainty that interest will be paid and principal returned.

The chief trade-off any bond buyer makes is between default-risk and inflation-risk. Inflation is going to kill you. It is pervasive, pernicious, and persistent. Day by day, week by week, year day year, your purchasing-power is eroded, so that when you do receive your interest payments and when your principal is returned, your money now buys less than it did before. If you opt for the higher yields than come with accepting some credit-risk, your after-tax returns can easily overcome the erosions of inflation, but you also have accepted the risk of capital losses. So a prudent investor does a bit of both, parking some money “safely” and accepting some investment-risk elsewhere, so that the net effect is a real rate of return.

Yeah, I’m very good at what I do. If I were a publicly-trade mutual fund, I would rank in the top 10% of the 200 fund managers with my same investing objective, “multi-sector bonds”. I am also someone who was fortunate to read Your Money or Your Life many years ago and took to heart their message of “Financial Independence” and “Enough”. In the book, Joe pitched bonds as a sensible path toward achieving the two. I’ve found his advice to be sound, though I’ve had to tweak his methods a bit by going beyond just “principal-protected instruments” which is where the self-identified 'risk-adverse' are flocking these days and getting killed, because they don't understand the larger game being played. The Fed/Treasury cartel doesn't give a sh*t about 'savers', and they adopted a Zero Interest Rate Policy, because their intention is to re-capitalize equity markets, which they mistaken assume to be leading indicators of economic health. Meanwhile, those who ever once got burnt in the stock market have been flooding into bonds exactly when rates are lowest and risks are highest. Plus, 'Boomer' demographics are kicking in. Plus, this country does a poor job of financial education at any level.

The net-effect, as study after study has projected, will be massive old-age poverty, which is exactly why I become annoyed with those who want to hide in cash for thinking that is a safe place to be. Well, it isn't. Cash and cash-equivalents are the riskiest choices a would-be investor can make over the long haul, because the losses to taxes and inflation are certain and inexorable, whereas normal investment losses are typically easily managed and easily recouped. Investing, in its essentials, is no different than playing a game of cards. You don't expect to win every hand. But if your strategy is sound, you will win the game, on average and over the long haul.

Lastly, a word of thanks to those of you who remember me from the old forum.

Charlie

bae
4-25-11, 2:55pm
Very well said, thanks!