Smart Investor: a basic guide to asset allocation

Excellent article.. too little thought is given to asset allocation.

Smart Investor

As always you talk 99.9% very good sense but you seem to have a real prejudice re. corporate bonds and it doesn't make sense to me!

You write:

"The holy trinity

My view on asset allocation is pretty straightforward. I only ever hold three asset classes; shares, high-grade government bonds and cash. I do not hold corporate bonds because, in my experience, when a recession hits they often behave in a similar way to shares – their price falls."

Excuse me, but are you inferring that when a recession hits that the other three assets hold do not fall?

1. shares in a recession - most will fall

2. high-grade gilts - these might actually rise in a 'normal' recession as they would be considered far safer than most shares hit by a recession.

3. holding cash - excellent to hold during a recession so that you can pile in when you believe the time is right to buy other assets at perceived bargain prices, but again going down in value in real terms if held too long.

So, what's the difference with corporate bonds?

Shares go down in price, just as corporate bonds do and there appear to be only THREE major differences between the two assets in a recession:

1. If a company goes bankrupt bonds (as a general rule) will be HIGHER up the pecking order than a shareholder - i.e. a shareholder might end with nothing and a bondholder should end up with a lot more!

2. Buying a bond below par in a recession gives the investor the opportunity to lock into very good yields and capital appreciation THAT ARE KNOWN IN ADVANCE and are certain unless the company defaults. A shareholder can have an infinite but unknown capital appreciation (or loss up to 100%) and the dividend is an unknown quantity (and often nothing like the interest yield to market value of a bond).

3. As a general rule the shareholder takes MORE risk than a bondholder as the shareholder takes more risk; i.e. the bondholder's returns are fixed while if the company does well the shareholder should in theory have a better return and vice versa if the company does badly.

I'd appreciate reading your reasons for being so against corporate bonds because you are obviously a smart investor and not a dumb investor and what you have to write is clear and concise and logical and obviously well-respected.

I am relatively inexperienced as far as equities go.

Dumb Investor is a genius with shares compared with me; yet I realise equities provide a very good return over time for the shrewd, sane, sensible long-term investor.

Many shareholders seem to enjoy both growing income and capital........... yet to me investing in equities almost akin to gambling in a casino as the odds are not in my favour due to my lack of experience and knowledge; yet with corporate bonds [assuming a default rate] I can plug in the figures and have a damn good idea what my exact income and gains shall be [if held to maturity].

I look forward to your reply should you be prepared to more fully state your antipathy to what is my 'bread and butter' income stream.

Thank you,

Robert Court

Dear Robert Court

What you have written is very interesting - how do you buy corporate bonds though (other than through a fund) and see what they are worth at any time? Do you buy when they are issued eg National Grid. Thanks, this is a bit of a closed book to me at the moment - my money is in cash, shares and an index tracker but mainly still in cash - I am trying to have a better overall distribution.

Hilary hames

If I were you I'd put a lot more faith in what somebody such as Smart Investor who knows what he is talking about re. asset allocation between a holy trinity of good shares, long-term government gilts and cash.

I respect what Smart Investor has to say but, so far, he has not answered my questions regarding his seemingly deep-seated dislike for corporate bonds.

I have very rarely bought a corporate bond when issued though I am sure there are times when that could be a rational decision but if you buy at par (100) and sell at maturity (100) then your capital gain will be a big zero.

There are some bonds with call dates earlier than the maturity date where the company can exercise an option to buy back the debt early; for this they sometimes pay a premium - e.g. company 'x' issues a bond at 'y'% coupon to mature in 'z' years time but has the option to repay early at 'z - a' years and instead of paying 100 they might pay say 102.5 to compensate the lender for the perceived loss of future interest. Perversely the yield would go up hugely if you bought below par as getting 102.50 for every 100 nominal you bought at say 80 in two years time would be a lot better than waiting for the bond to mature in say the original 8 years time.

There is a complicated formula to work out the yield on any bond to maturity bought whatever price you pay for it; as I am more interested in present income than future capital gains I first look at the annual interest yield I am getting THEN also consider the future capital gain.

Assuming that the company that issued the bond is not going to go bankrupt and default on either or both interest or capital repayments then it makes sense to buy a bond 'below par' - i.e. at less than the 100 issue price. A bond with a coupon of just 5% actually gives you annual interest of 10% if you only pay 50 pence for every pound of the bond bought PLUS your 50 pence turns into £1 on maturity.

Naturally, the lower the price a bond trades for in the market is an indication of a higher perceived risk; however many good bonds in 2009 were 'distressed' as the owners of the bonds had to liquidate their bonds because of other financial liabilities they may have had.

Unless a single bond was part of a much larger fiversified portfolio I'd consider investing in just one corporate bond to be rather risky and to have a good spread of bonds you'd need at least six to eight bonds all with a minimum nominal value of £5,000 each (the maturity value).

I should think six reasonably safe corporate bonds could be bought with a nominal value of £30,000 for about £24,000 (with bonds rated from as high as A- being bought for as little as 60 to 70 and some BBB+ rated bonds bought for between 80 and 90).

Bonds normally pay out either once a year or twice a year; a minority pay out quarterly; although this might seem good you have to consider if the broker you choose charges you an admin fee for making the interest payments; mine charges me six euro which would be a considerable chunk out of a 100 euro payment but 'peanuts' if the interest payment wasc several thousand euro.

There should be no commission charged to you when a bond matures; however if you sell before the maturity date in the market you'll be charged.

Bonds can go well above as well as below their nominal value; one Mexican bond was recently 190 (i.e. you'd pay $1.90 for every dollar of maturity value).

I'd not normally ever wish to BUY above par but have often sold a bond for more than its 100 face value.

I hope the above is of help. National Grid? I don't think so; way too low a yield for me.

Corporate bonds.

There is the price you pay, the par value you get if you hold to the end, and the interest rate you will get (calculated from previous)

From this, deduct

-The grading is about the risk of the company going bankrupt and your not getting the par value at the end. Itis real and it is supposedly reflected in the ratings agency grade. This risk needs to be spread over the years remaining on the bond, ie annualised, and sbtracted from the return.

-bid / offer spread, which won't matter if you intend to hold to redemption

-storage fees

Comparison

If you work out the net interest rate, you may find that there is no premium for the added risk bewteen government and corporate bonds

In brief

Robert is working it all out o the basis that the bond will be redeemend, 100%. But it ain't certain

Hilary has a good question. Difficult to fd a broker in corporate bonds. And if anyone knows, what about bonds in developing country debt? (ie not dollar sterling euro deominated) Where can you get these? ETFs maybe

Hi Robert

Thanks for your comments above and in one or two other articles.

You make some good points on corporate bonds, which I genuinely respect, and I will devote an article to the topic in the near future. I tend to be a number of articles ahead of the most recently published piece so please bear with me if it does not appear immediately.

Thanks again and thanks to the other readers who commented - I always read all comments.

SI

Smart Investor

Thank you.

I appreciate that you'll take some time to give a considered reply.

Cape Town

1. Depression of 1929 early 1930's - 10% of corporate bonds defaulted yet paid out an average of 40% of their face value.

2. I calculate on 20% of bonds defaulting and only paying out 20%.

3. Default rate in Europe something like 1.28% this year (I read somewhere here)

4. I sometimes feel a company might have trouble repaying their debt in full [interest on a billion USD/EUR/GBP loan must be a lot easier to make than the capital repayment in one large lump on maturity] unless they have managed to roll over their debt by a new bond issue [like many governments do] so I often sell a bond (hopefully at a good profit) a year or more before it is due to mature.

5. Corporate bonds are generally a lower risk than equities and that is why shareholders get a better return if a company does well; a bond holder should generally only do better than a shareholder when a company isn't doing so well (as long as the company doesn't go bankrupt).

Corporate bonds are PERVERSE - everything seems the opposite of what happens with shares (e.g.price goes up = yield goes down and vice versa)

6. All investments carry risk. Some bond investors will only invest in AAA rated bonds; high yield bonds are often known as 'junk bonds' but this is a very negative description - sure, if an unknown company with no rating offers to pay you 25% annual interest when interest rates are very low you'd be very foolish to jump in thinking it's a great deal but when a good company rated A- has a 6% bond that you can buy for 60 pence to the pound then you have to consider it carefully and make a calculated decision whether the risk is acceptable or not.

Cape Town

I have IEMB and they might meet your requirements

Thank you everyone and I will look forward to SI's article presumably a few weeks/months ahead

Robert, you wrote a really good and detailed answer for me and I am very grateful. I am printing all this thread out to keep. I mentioned National Grid just because it was on the radar recently and will be again - it seems easy enough to get the info on new bonds. But existing ones - you did not answer that question? And where is the info for someone learning - not in Citywire, Motley Fool, Investors Chronicle, Money Observer or anything else that I currently pick up.

Hilary hames

Get a good broker; if at first you don't succed keep trying until you do.

There is zero capital gains tax in the UK with most corporate bonds.

The market is not as transparent with corporate bonds as other investments and I've not been able to get the information I want easily via the internet.

It's one thing that makes corporate bonds attractive; they tend to move more slowly [in 'normal' times] than shares and they seem to be traded almost in some kind of 'gentleman's club'.

A good broker should have access to information on corporate bonds that would cost me a lot of money to obtain myself.

I can give you a listing of some corporate bonds, if you like, in USD and GBP and EUR but the information is only indicative and some of the figures are obviously incorrect if you know which questions to ask; there is a weekly bond list published via the internet by my broker but I should first ask my broker if it is ok for me to give the link publicly.

Smart Investor - Those with long memories may remember that in the 1960s and 70s investing in "high-grade government bonds" would have produced a whopping loss. How can we be sure the same is not about to happen now? Bear in mind it is very much in our (and I suspect most other) government's interests to keep gilt returns low, as this means it is borrowing from the gilt-holder at a very attractive rate of interest. With inflation higher than most gilt yields, I can't see the attraction of gilts unless you are going to make a capital gain on selling them.

Robert, thank you for your posting. It would be interesting to see a few of the bonds copied and pasted if not a list - maybe your broker would get some more customers!

Do you do the work yourself from this list or do you pay your broker to make recommendations based on your profile? I have never had dealings with a broker...

Thank you again, this has been a very interesting discussion and there have been some good postings.

Hilary hames

I hassle my broker on an almost daily basis!

I have my own ideas but mostly take into account what my broker thinks - and most of the time he moderates my impulse to do wild and wonderful but potentially financially disastrous things.

For most 'sane' investors under 'normal' conditions they'd do nothing until a bond matured. The broker would then make three, four and maybe even up to six recommendations where to reinvest the capital.

I'm more proactive than that and like to keep a beady eye on what's going on.

Asking the right questions is a great help in getting the right answers; e.g.:

Why has a bond suddenly gone up or down in price?

Also reading something like 'The Economist' gives you a feel for how economies and various sectors are doing.

Ideally I'd like to have a good spread between countries and sectors and the currencies the bonds are traded in, but as I live in the eurozone and spend euros on a daily basis I hate to lose out on currency conversions; however if I had oodles of money and more than I needed I'd spread my investments between currencies in such a way that I believe it'd be almost impossible to lose out - but I'd need a better mathematician than I am to prove or disprove my logic.

I do my own work in that I take note of/ work out three 'core' figures and calculate the one that changes on a daily basis that is the trigger for me to question whether I should buy or sell from a purely Mathematical point of view; at that stage I then need to seek expert advice to confirm whether or not action is worth taking.

It's that simple and that hard - it requires simply noticing when things change and whether the change is beneficial or adverse or fairly neutral and if it is advantageous to do nothing or to sell or to buy.

thank you. I hope you are somewhere hot and sunny and may your investments continue to be successful!

Most useful discussion, especially as I have just lefy my bank manager who is willing to advise and sell me corporate bonds with purcahsing fee of 0.76% and 0.6% annual charges.

This could be the thread where I make some money or at least protect myself from further losses.

What I know so far about bonds is below. Plus, would be worth looking at what is called covered bonds - like bond + CDS, they behave like shaes and like bonds too. Robert?...

PS Robert what part of Eurozone, I'm in Fr and Germany?

http://wallstreetpit.com/27148-the-real-corporate-bond-return-puzzle

You would expect higher returns to carry higher risks as well, but curiously, this is not so – for bonds, there is no extra premium for taking extra risk. This demonstrates that there is no general risk premium.

Conventional wisdom has it that....

• Take U.S. Baa and Aaa bond yields. Baa have only a 4.7 percent 10-year cumulative default rate and the recovery rate is around 50 percent, annualizing to a 0.23 percent loss rate.

• The spread between Baa and Aaa bonds has averaged around 1.2 percent since 1919, generating 0.97 percent annualized excess return compared to the riskless Aaa yield

 creating the puzzle that spreads are too high for the risk incurred

But reality is otherwise…

• management fee (say 0.4%)

• funds transacting costs, in terms of commissions, crossing the bid-ask spread, and price impact, add up to a couple percent per year

• default rate - B rated’s have a 320 point spread over treasuries, an average 6% annual default rate, with 50% recovery, giving 0% premium for the extra risk, but extra expenses for these relatively illiquid assets

 individual investors expect high returns when investing in high risk assets, but this is a mass delusion, the triumph of hope over experience

Risk is made up of chance and alpha

• Chance - we can all understand

• Alpha - those making the product understand and they take it out completely and then it doesn’t work out, so after fees, most alpha is actually negative by the time it gets to the client net returns

 Why is risk factored in at one end and not the other? Conclusion: there is no general risk premium.

only change in the above - my banker notes that corporate bonds have become a lot more liquid recently

Re queries on where to find info. on bonds (e.g. Hilary hanes)

Selftrade are making a decent effort to provide both trading and how-to-invest information, using Stockcube as a sort of subcontractor to give model portfolios, etc. If you are not a client (I am) you may find some stuff is not available, but to the best of my knowledge most of it is available free on the public areas of the website.

Prtobably best for Hilary to buyn Exchange Traded Fund that specialises in corporate bonds initially. That will give low management costs and a good introduction + a good spread of risk.