Wednesday, October 2, 2013

My 2 cents on Bonds


I think that conventional thinking and recommendations by most "professionals" tell young investors to keep their bond portion of their portfolio small and go long in equities. As long as they have a long time horizon and they can stomach the volatility, then it'll all work out better in the long run.

But as many people rightly point out, the ability to stomach volatility does not necessarily decrease with age. Even young investors after seeing a huge drawdown may panic and sell off their positions in fear of a complete loss of capital. The lack of experience also does not allow us to draw upon rational past experiences, and we have no idea what is considered normal or strange.


According to my personal investment philosophy, I would definitely say that it makes a lot of sense to slowly build up a simple bond portfolio, and then after forming a strong bond base, to be able to add as cautiously or aggressively to the equity portion of the portfolio.

Q: Bond Ladders or Bond Funds?
A: Bond Fund

My rationale for this is largely shaped by this pdf article by BMO Global Asset Management.

The pros for bond funds suit my case rather well.

  • MUCH less capital requirements
  • diversification (reduced credit risk)
  • ease of liquidity (reduced liquidity risk)
  • higher yields

The cons are simple too

  • early redemption of others forces fund to realizes losses (increased interest rate risk)

Given that as a investor starting out, it is frankly not feasible to create your own bond ladder. After you factor in the time involved in researching the securities and the process, the costs of being a small investor, the lack of diversification, it really does not make it suitable given my circumstances. For much older investors with deeper capitals, a bond ladder could work quite well, but even then, you still will not have as much diversification.

The simple fact that early redemption of bond funds can cause a lot of pain to remaining investors does not bode well with me, which brings me to another important question.

Q: Bond ETFs or Bond Mutual Funds?
A: Bond Mutual Funds

The main reason for this the process of investing and trading in both these vehicles. As ETFs are listed and extremely liquid, they are susceptible to speculative buying, as well as short selling. This causes a high volume of both inflows and outflows very rapidly. ETFs also may not transact at their NAV, though it is usually rather close.

Mutual funds represent investors with a different type of mentality. Generally, these investors are long-only and plan to stay invested in the fund for an extended period, which is further enforced by the initial sales charge. Combining the effect of the initial sales charge and the expense ratio, this forces investors to already be prepared to sit in the red for a while before seeing returns above their original capital investment.

Since you cannot short mutual funds, the process to purchase and redeem does not facilitate speculation, this reduces the amount of realized losses due to redemption, which could possibly be avoided with a good fund manager with foresight. Bond mutual funds are a very good match to suit my needs.

Q: Okay, so bonds don't have large drawdowns?
A: It depends on the type of bond!

So far, this pdf article published by DiMeo Schneider & Associates is my best 15 minute googling effort to find max drawdowns of bonds. Two points to note about this. Interest rates have been falling since 1980, so this is positive interest rate effects on all bonds. Next, before this era of data collection, information for the various types of bond classes never really existed, so although this may be the best proxy of the different asset classes in this post modern era, take it with a pinch of salt. There's also a nice correlation chart.

So for some easy referencing

Max Drawdown (1994 - 2011)
US Bonds -5.2%
Intl Bonds -5.4%
EM Bonds -29.5%
HY Bonds -33.1%
TIPS -12.1%

I do have gripes that it does not have foreign corporates or reveal the underlying benchmarks so that I can check and deconstruct a bit of the data, but this is useful in a nutshell.

Q: Looks horrible for bond investors in the near future doesn't it?
A: Yeah, it kind of does, but I have a few ideas

Firstly, I'll be looking into long-only, actively managed, shorter duration, bond mutual funds.
This will minimize early redemption risk, credit risk and interest rate risk.

Secondly, knowing that the outlook is not good, I am only looking to purchase bonds when its historical, most recent and current drawdowns are relatively close. This will reduce the downside potential as they should already be stretched. I'm thinking anything in it's current drawdown which is 70% or more to it's maximum drawdown.

Lastly, I will solace in the fact that I'll be contrarianly investing, avoiding the winner's of today to pick up the losers, who may very well have good odds to become tomorrow's winners. Reversion to mean and history would both be on my side.

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