Corporate Bonds on the Secondary Market

[Roger_R]

About two years ago I realigned my portfolio and put a significant percentage into short and intermediate bond funds. Needless to say, they have not really performed up to my expectations. I was wondering if it would be possible to improve things by purchasing several quality corporates on the secondary market as somewhat of a bond ladder with maturity dates in the 1 to say 7 year horizon. This is getting into an area that I know very little. Does this idea seem somewhat reasonable? I don't hear or read about many folks doing this and would assume there are some drawbacks I'm not familiar with.

 

[Jarhead*]

About two years ago I realigned my portfolio and put a significant percentage into short and intermediate bond funds.  Needless to say, they have not really performed up to my expectations.  I was wondering if it would be possible to improve things by purchasing several quality corporates on the secondary market as somewhat of a bond ladder with maturity dates in the 1 to say 7 year horizon.  This is getting into an area that I know very little.  Does this idea seem somewhat reasonable?  I don't hear or read about many folks doing this and would assume there are some drawbacks I'm not familiar with.

Roger: Wanted to comment on your use of short-term corps. (I also added a lot of them about two years ago). They are currently yielding about 4.41 last time I looked. The Nav because of interest rate increases in that period has dropped their total return down to about 2%. However, in the long haul, short term corps
will respond pretty well in periods of volitale interest rate changes.

Roger, I don't know your age, or why you made a large commitment to short term corps., but the reason I did was age-related. (I will have to start RMD in about a year). They are part of my game plan when I face manditory draw-down of my IRA.

I plan on using "short-term" Corps as my starting pitcher. Warming up in the Bull-Pen are TIPs, and an ultra-conservative hedge fund.

If I'm fortunate and need a "closer", I have about 30% of the total committed to equities.

I like short-term corps. because I don't expect them to rack up a lot of strike-outs, just to give me about 5 innings or so of not too many surprises.

 

[Howard]

Bond ETF's may be a very good alternative, low MER's and their purchasing power probably gets them cheaper?

I also like to have about 10% High Yield, a.k.a Junk Bonds, to spice up the returns.('08 GMAC's for example, or buy a Fund)

 

[Mr._johngalt]

  The Nav because of interest rate increases in that period has dropped their total return down to about 2%. 

Hello Jarhead. Would you care to explain this? I don't get it.
(And you thought I was not paying attention)

JG

 

[cute fuzzy bunny]

Nobody is more surprised than I am that i'm in agreement with howard...

I wouldnt buy individual issues unless I really knew what was going on, but vanguards high yield corporate pays almost 7%, the credit quality is actually pretty good overall, and they've been improving the credit quality of the portfolio as of late. Its far from a 'sure thing', but I think it was ESRBob who checked into them last year and found they had no defaults at all over the last 5 years.

I've got ~8% of my money there, and thats about 60% of my bond holdings. The regular monthly income is nice. I dont plan to sell shares for at least 5 years so NAV fluctuations dont concern me much. My holdings have suffered a little bit of loss since I bought them, but even factoring those in i'm still seeing well over 6%.

CD's are starting to creep into this territory now, and certainly offer a clean yield with no worry about loss of principal.

Short term bonds certainly were the darlings last year, with the concerns over interest rates. When you can do better with a 1 year CD, its time to rethink the conventional wisdom.

 

[cute fuzzy bunny]

Hello Jarhead. Would you care to explain this? I don't get it.
(And you thought I was not paying attention)

JG

Wow, a 100% bond investor doesnt understand bond nav fluctuations due to increased interest rates?

Let me help. When interest rates go up, new bond issues usually offer higher interest rates. Older bonds with lower interest payouts are worth less on the secondary market, so their nav or sellable value drops.

When the value of the asset gets lower, that detracts from the interest rate to produce a lower rate of return if one is factoring in the value of the bond along with the income from it. Unless of course you keep it until maturity, in which case the original interest rate is intact.

 

[Mr._johngalt]

Wow, a 100% bond investor doesnt understand bond nav fluctuations due to increased interest rates?

Let me help.  When interest rates go up, new bond issues usually offer higher interest rates.  Older bonds with lower interest payouts are worth less on the secondary market, so their nav or sellable value drops.

When the value of the asset gets lower, that detracts from the interest rate to produce a lower rate of return if one is factoring in the value of the bond along with the income from it.  Unless of course you keep it until maturity, in which case the original interest rate is intact.

Well, I am not really a 100% bond investor, but I guess we
were coming at it from a different angle. As you point out,
if you hold to maturity, then you get all your money back and the coupon rate from issuance. When interest rates go up,
your NAV falls, which gives you a HIGHER rate of return because the market value of your original investment is lower
but you are still receiving the same amount of interest as
before. The part that confused me is when you said your NAV fell and that "lowered" your return to 2%. Okay?

JG

 

[cute fuzzy bunny]

Well actually I didnt say it, but thats alright...

Technically it DOES lower your return if you look at it on an annual basis. You just get a nice extra return when the bonds mature and you return them for your original capital.

 

[Mr._johngalt]

Well actually I didnt say it, but thats alright...

Technically it DOES lower your return if you look at it on an annual basis.  You just get a nice extra return when the bonds mature and you return them for your original capital.

I think we're getting into semantics now.

JG

 

[cute fuzzy bunny]

No, we arent.

If in any given year the value of my assets drops 2% and they produce 2% in income, I have a zero return for that period. In xx years when the bonds mature and I get back my original investment, for that year I recoup the paper losses.

Shoot, I forgot, you're an expert on finances. I must be wrong :

 

[Mr._johngalt]

No, we arent.

If in any given year the value of my assets drops 2% and they produce 2% in income, I have a zero return for that period.  In xx years when the bonds mature and I get back my original investment, for that year I recoup the paper losses.

Shoot, I forgot, you're an expert on finances.  I must be wrong :

Well, you're not necessarily wrong (for once). Just 2 different ways of looking at the same horse.

JG

 

[cute fuzzy bunny]

Then please tell me the other way that one would measure unrealized annual returns on their investments that doesnt include unrealized/paper gains and losses?

Or in GaltLand do they just count the gains and forget about the losses? Just pretend they arent there? That would explain a lot.

Do they wear the mouse ears in GaltLand too?

 

[ats5g]

About two years ago I realigned my portfolio and put a significant percentage into short and intermediate bond funds. Needless to say, they have not really performed up to my expectations. I was wondering if it would be possible to improve things by purchasing several quality corporates on the secondary market as somewhat of a bond ladder with maturity dates in the 1 to say 7 year horizon. This is getting into an area that I know very little. Does this idea seem somewhat reasonable? I don't hear or read about many folks doing this and would assume there are some drawbacks I'm not familiar with.

Hi Roger,

Here is a paper from Vanguard on taxable bond funds vs. taxable ind bonds:

Taxable Bond Investing: Bond Funds or Individual Bonds?

- Alec

 

[Roger_R]

Thanks. I'll have to print out the article to fully digest it, but it does look interesting and helpful. I also looked up what Berstein might have to say about this in the Four Pillars book. He pretty much discourages investing in individual corporates because of default risk and the impact to a portfolio with only a handful of bonds. For corporates, he prefers bond funds.

I guess my thinking is that with such a flat or inverted yield curve that the odds favor rates going up for anything longer than very short term, just because that would result in a yield curve more like things have been historically. So bond funds will continue to take a beating in loss of NAV. I know that I shouldn't try to out guess interest rate moves, but it would not really be changing an asset allocation, but just moving from one flavor of bonds to another. I keep churning over ways to eek out a bit more return from my fixed investments, but don't seem to come up with much. I already have some I-bonds and the vangard TIP fund to help round things out. Sometime I wonder if the best thing to do right now is ride things out in a good money market account or 6 month CD's?

 

[ats5g]

Hi Roger,

If you do have a ladder of corporate bonds, you've just created your own mutual fund. For example, look at the Distribution By Maturity of Vanguard's Short-Term Investment-Grade Fund:

Under 1 Yr..........25.4%
1 - 3 Yrs............45.2%
3 - 5 Yrs............19.5%
5 - 7 Yrs..............4.6%
7 - 10 Yrs............2.1%
Over 10 Yrs..........3.2%
Total................100.0%

That looks quite a lot like a ladder, does it not?

Also remember that the value of those individual bonds you hold will fluctuate just like the bonds in the bond fund.

I took a quick look at corporate bond yields at Vanguard's bond desk and the bond yields look quite close to CD yields [at places like Pen Fed]. CD's seem a lot easier to understand and cheaper to purchase. Annette Thau's The Bond Book has lots of good info on corporates, as does The Bond Market Association.

One problem with riding things out in a good MM account or 6 month CD's is that those have much more reinvestment risk of longer term CDs/bonds. Hence they're not as "safe" for those that want to generate income for periods longer than 1 year, or are trying to match liabilities for periods longer than 1 year. I think it is a better strategy to do the CD ladder thingee, which doesn't require you to make predictions. Hence, you don't have to be right or wrong for it to work out.

- Alec

 

[charlie]

Hi Roger,

The fixed income part of my IRA contains mostly individual
intermediate term corporate bonds maturing in 7-8 years
rated " A" or better. These are "floating rate" bonds that
pay year-over-year CPI + 2% (or better) monthly yield.

These bonds are like TIPS in that they pay a guaranteed real
rate above inflation, but unlike TIPS, there is no "phantom"
income. They pay the original par value at maturity.

I bought these as an inflation hedge and for the monthly
income. I figure that if inflation is north of 2.5% I will do
better than most Vanguard bond funds and the ER is zero.

So far so good.

Cheers,

Charlie

 

[Roger_R]

Charlie and ATS, those are examples of exacyly what I'm thinking about, thanks. I do have Thau's bond book and will have to do some further research. I guess mostly I was wondering if this type of idea sounded reasonable and if anyone else was doing something similar. And a big point being that you have control of the bond maturities and can hold onto them to maturity and so have a more predictable and possibly better return.

I suppose the details I'm curious about would be how many bonds you would want to feel like your risk was diversified, would you pay a premium for bonds on the secondary market, and whether places like Fidelity or Vangard are the best types of places to puy things like this?

 

[haha]

I bought these as an inflation hedge and for the monthly
income.  I figure that if inflation is north of 2.5% I will do
better than most Vanguard bond funds and the ER is zero. 

Charlie, what is ER in this context? I am having some wine with my dinner, and I can't figure it out.

Also, could you mention some of the bonds you hold? I need to look at these, since at least theoretically they would yield more than TIPS, and as you say, they will also work well outside of IRAs.

Ha

 

[ERD50]

Re: Another perspective on Bond returns

Then please tell me the other way that one would measure unrealized annual returns on their investments that doesnt include unrealized/paper gains and losses?

I think you can make a case for ignoring bond NAV fluctuations if:

1) You buy bonds with the plan to hold until maturity.
2) You have enough liquidity to be ceretain of #1.
3) You actually do #1 and #2.

In that case, the day-day or year-year fluctuations in NAV never really affect you - so why not ignore them and just look at the dividend % return?

-ERD50

 

[haha]

Jarhead, nice baseball analogy. I tend to think tactically also, rather than theoretically. Too many theories get gunned down as they exit the classroom door.

Right now my fixed income allocation is in 3 and 6 month t- bills. I am certainly not being penalized for holding these, and I don't think I am giving up any positive speculative exposure either

Ha

 

[charlie]

Ha,

If you have access to the Vanguard bond desk on their website
click on the "secondary bond" link then click the "find bonds"
button.  This will bring up a list of all secondary market bonds
being offered with the "floaters" listed first in alphabetical order.
ER = expense ratio.  Also check out "OSM" on the NYSE.  This
is an exchange traded debt security from Sallie Mae paying
CPI + 2% .  You buy and sell it like any stock.

Roger,

My biggest holding is a CD from Std Fed Bank that pays CPI + 2%.
I also hold J. Hancock (CPI + 2%), Principal Life (CPI + 1.8%) bought
at 90,  Household Financial Corp (CPI + 2.38% and Boeing (3 mo T-bill
plus 2.05%).

Cheers,

Charlie

 

[uncledrz]

Jarhead
Pitchers and catchers report this week.
Not a real fan of baseball, but do like that it means spring is on the way
Uncledrz

 

[unclemick]

Good Stuff Charlie

How big is the playing field?

Can't remember where I saw an article that corp bonds were availible with inflation adjustments.

Any thought's on advantages to the issuing company - compared to straight corp bond?

Depending on availibility - ? yet another avenue of protection for the fixed income holder?

Keep us posted as time marches on.

 

[cute fuzzy bunny]

In that case, the day-day or year-year fluctuations in NAV never really affect you - so why not ignore them and just look at the dividend % return?

Because we were talking about annualized/snapshot returns where one looks at the value of ones capital vs the paid yields. Basically you could say the same thing as any investment. I could hold a stock fund with a loss until it bounced back and only sold it then. Would it be reasonable to just forget about current valuations when considering my net worth or investment returns since I didnt plan to sell it until the value was positive?

But that wasnt really the point...

 

[Jarhead*]

Because we were talking about annualized/snapshot returns where one looks at the value of ones capital vs the paid yields.  Basically you could say the same thing as any investment.   I could hold a stock fund with a loss until it bounced back and only sold it then.  Would it be reasonable to just forget about current valuations when considering my net worth or investment returns since I didnt plan to sell it until the value was positive?

But that wasnt really the point...

TH: Yep. By the way thank you for fielding the question from ReWahoo's new neighbor. (JG).
I doubt he still knows who he was responding to, but oh well.......

One of the problems of a forum like this is perspective. (Especially age perspective).

For me personally, total return is the only thing that I am concerned with. (I've never been a live off dividend type). I prefer to take my lumps as I go along.

For JG: To avoid further confusion. TH is a young guy that lives in the valley, and has a pretty young wife and drives a Lexus.
I'm an old phart that lives in the mountains.