Mortgage-Backed Bonds

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Mortgage-backed bonds got a bad name during the 2008-09 financial crisis.  They were a large part of how bad mortgages made by banks infected the entire financial system, threatening the stability and well being of all of us.  Nevertheless, there is nothing particularly dangerous or devious about these instruments.

Essentially, these bonds are a way for investors large and small to participate in the usually superior interest rate returns available to mortgage lenders.  These bonds are created when banks and other mortgage lenders package the mortgages on their books into securities and sell them to investors in the broad bond marketMost of these bonds are divided into subgroups, called tranches.  Each tranche reflects a level of credit risk for that subset of mortgages in the bundle. Whether their underlying mortgages are risky or secure, these bonds effectively pass the payments made by the borrowers who take out the mortgages through to the holders of these mortgage-backed bonds.

You can buy mortgage-backed bonds directly through brokers or through mutual funds.  Some mutual funds specialize in these bonds, while others include them in a broader selection of offerings.  Although such bonds are similar to those described in this earlier post, they can have a special appeal for three reasons:

  1. Because mortgage borrowers usually pay higher interest rates than corporate borrowers, mortgage-backed bonds tend to pay higher yields than other bonds of comparable maturity and quality.
  2. The pass-through arrangements (mentioned above) pay out monthly, providing a more regular flow of income than conventional bonds, which usually pay semi-annually.
  3. Because mortgages pay down the principal on the loan in stages, bond owners also get part of their principal back with each payment, thus enriching the regular cash flow. (Most conventional bonds pay the principal back only when the bonds reach maturity.)  The drawback with mortgage-backed bonds is that there is no further payment of principal at maturity.

These bonds do have one unique risk.  When interest rates fall, many mortgage borrowers will take advantage and refinance.  Just as with bonds that have “call provisions.” Bondholders get paid in full, but they miss the benefit falling rates have on bond prices.  (For a discussion of call provisions and the price effects on bonds from falling interest rates, see this earlier post.)  But even recognizing this drawback, the other advantages of mortgage-backed bonds give them a distinct appeal to many investors.

If you want to hold mortgaged-backed bonds in your portfolio but remain wary because of memories of the 2008-09 financial crisis, you might consider buying Ginnie Mae bonds.  These mortgage-backed bonds are issued by the Government National Mortgage Association on behalf of the Federal Housing Authority (FHA) and the Veterans Administration (VA).  The US government backs them, making them as safe from default as possible, and they pay a slightly higher yield than Treasury bonds.  You can buy them directly from the US Treasury or through a broker in units of $25,000. Alternatively, you can buy into mutual funds that specialize in Ginnie Maes.


Options and Futures: A Consideration

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These instruments have a mixed reputation –– as something only for the very sophisticated investor, as dangerous, and in some circles as devices that can defy economic and financial laws.  There’s an element of truth in each description except the last.  I will not pretend that options and futures are simple, that they are for everybody or easy to use.  But they do not require a genius mind, and, even if you never use them, it pays to have a notion of how they work.

Basically, options or futures offer you the right to buy or sell a stock, bond, or commodity at a specific price under certain conditions on a specific date or during a specific period of time.  Options and futures are called derivatives because they “derive” their value from the underlying security or commodity they entitle you to buy or sell.


 Futures contracts are possibly the oldest financial instruments in the world. There is evidence that they existed in ancient Mesopotamia, thousands of years before the birth of Christ.  There they dealt with wheat, the ancient staple crop.  Farmers planting their fields would naturally worry they would not get a good price at harvest time. Speculators would contract to pay an agreed-upon price when the wheat was harvested –– regardless of the market price at harvest time.  The speculators effectively took on the risk of a loss should future market prices fall below the price they contracted to pay the farmers.  That risk was worth it, however, because the arrangement gave speculators a potential profit if market prices for wheat rose above the price they paid the farmer. Thus futures allowed speculators to bet on the future price of wheat while allowing farmers to use speculators to hedge the risk of falling prices, happy to exchange the chance of extra profit should wheat prices rise high for the surety of the guaranteed price offered by the speculators.

Futures retain this basic character today, but over time they have come to include minerals, copper, coal, gold, oil, etc., as well as crops and livestock.  There are futures tied to currencies and stock market indices.  In every instance, the principle of the ancient wheat farmer remains the same: One party wants to hedge market risk by securing a price in the future, and the other party is willing to promise that price and take on the risk of loss in the hope of getting a higher price at that future date.

Today, futures are sold on organized exchanges for specific “volumes” of a product –– bushels of wheat, tons of copper, and the like –– with set dates when they must settle.  These exchanges have rules on how much money speculators must put up to participate. Futures are bought and sold for a fraction of the amounts due when the time comes to buy or sell the underlying securities or commodities.  Because the ultimate commitment in dollar terms is huge, the average individual investor seldom uses futures directly.  However, many mutual funds participate in them on behalf of their investors.

Sometimes the standardized amounts and dates of expiration used on organized exchanges don’t meet the needs of large players who have in mind both different amounts and dates for settlement.  They have the alternative of tailoring what are called forward contracts.  Forwards work just like futures, but are organized around these different specifics.  They are most heavily used in currencies, typically timed to a point where for business reasons one of the parties to the contract needs to make a payment in a currency other than their own. 


Used mostly with stocks, options are more complex than futures and forwards. They come in two types:

  1. Calls: An investor sells another the right to buy a stock – to “call it” – at a certain price, called the strike price, within a certain period of time.
  2. Puts: An investor, in return for a received fee, gives another investor the right to force humor her to buy a stock at a certain strike price within a certain period of time.  In financial jargon, the first investor sells to the other investor the right to “put” the stock to him.

These options are bought and sold on organized exchanges for standardized periods of time.  They can vary in price, though they usually trade between 3 and 5 percent of the value of the underlying security.  The financial community has worked out many strategies for them to meet specific needs or expectations.  Here are two of the most common:

  • Covered calls: If you own a stock whose price is almost where you want to sell it, you could sell a call, “write” in financial jargon, on that stock at a strike price a little above the current market.  If the stock’s price then rises, you are just as happy to let the option holder call it, because you had already planned to sell at that higher price.  In the meantime, you capture the fee on the call you sold.  And if the price fails to rise, you keep the stock and the fee.
  • Put escape: (This is what I call it.) If you own a stock that might become very volatile, for instance a retailer heavily dependent on holiday spending, you may want to hold it for the upside generated by a good selling season. But because you fear the downside from a bad season, you can buy a put on the stock.  If the stock’s price falls, you have the option to put it to someone else at the strike price.  Rather than sustain a big loss, you lose just the fee you paid for the put option.  If the stock’s price rises, you can then enjoy the upside and forego the use of the put, happy to have paid the small fee on that put for the insurance against a big loss it offered in the interim.

It should be apparent that both futures and options have specific purposes for specific strategies.  For that reason alone, it is mostly professional investors who use them.  Because these instruments also generally involve larger amounts of money than most of us generally invest, they are far from a daily investment concern.  Still, everyone should have a notion of how they work, if only to avoid feeling intimidated when they come up in conversation, and to avoid getting involved when doing so would be unwise.

Real Estate Investment Trusts (REITs)

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Until now, my posts have focused almost exclusively on stocks, bonds, and bank accounts.  This is only reasonable, as most Americans, apart from the value of their homes, keep the bulk of their assets in these financial instruments.  But there are other investment vehicles: options, futures, currencies, and foreign investments of all sorts.  Future posts will look into each; this one focuses on real estate investment trusts (REITs).

REITs, though seemingly exotic, are actually straightforward investment vehicles.  They very much resemble stock and bond mutual funds except that instead of buying stocks or bonds on the investor’s behalf, REITs buy commercial real estate. Before 1960, when Congress passed legislation enabling REITs, the only way to invest in real estate was to buy properties directly, which presented considerable risk because few investors had enough money to diversify their holdings adequately among different sorts of properties and geographic locations.  Now, through the many REITs trading on major stock exchanges, investors have a way to buy into commercial real estate in smaller amounts and with greater diversification.

But diversification remains a critical consideration.  Because most REITs specialize in specific regions of the country, investors often have to consider investing in several to insure geographic diversification.  In addition, many REITs specialize in one type of property, such as shopping centers, commercial buildings, self-storage units, healthcare facilities, office buildings, and the like.  Here, too, you should consider investing in several to assure thorough diversification. Some REITs take on a lot of risk, while others are more cautious.  Before choosing, consider your own objectives and your tolerance for risk.

In addition to offering a way to bring real estate into your portfolio, the other major attraction of REITs is that they pay higher dividends than most common stocks –– often two or three times as much.  This is the outgrowth of the law that excuses REITs from taxes as long as they pay out, in dividends to shareholders, 90 percent of their annual income.  Because this generates a lot of annual income, many investors –– retirees especially –– are attracted to REITs.  Within reason, putting them in your portfolio is probably a good idea.  But investors must take care lest their desire for income seduces them to distort the diversification of their overall portfolio with too large an exposure to real estate.

As with any mutual fund, research any REIT you plan to buy.  Examine the prospectus to see how it approaches investing, what kinds of properties it buys, and their geographic distribution.  And look at its historic returns to determine whether the performance is worth the fees.


Should You Have an Active or Passive Portfolio

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Investors have debated seemingly forever the merits of active vs. passive management.  Passive investing aims to duplicate the movements of a major index, like the Dow Jones Industrial Average or, more likely, the S&P 500 stock index or sectors of an index or the European index or a composite of emerging markets indices. Active management attempts to improve on the performance of one or another of these indices. Active approaches can emphasize stock selection, timing market swings, rotating through sectors, or any one of hundreds of other techniques that aim to “outperform the benchmark index,” as the professionals say. A nearby box outlines the pros and cons of the two approaches.

Despite the endless argument, you must decide for yourself which approach best suits your objectives, inclinations, temperament, and tolerance for risk. Many investors mix the two approaches, using one for part of their portfolio and another elsewhere. (Full disclosure: This is the approach I use.)  For instance, you might use an S&P 500 index for the large capitalization U.S. stock holdings in your portfolio but use a more active approach for the small capitalization part, where specialized knowledge might have a bigger payoff than with large, well-known companies. The same sort of tradeoff might appeal in the divide between developed markets, where information is plentiful and widely disseminated, and emerging markets, where information and insights are harder to gather.

Once you decide, the financial community offers a variety of ways to proceed. Here are three primary alternatives:

  • You can buy individual securities and build a portfolio for yourself. Unless you have immense assets, any such effort will by nature have an active component.  Few people have the resources to run a passive portfolio for themselves, which would involve buying every security in an index in proportion to its weight in the index or employing elaborate, computer-based algorithms that can otherwise construct an index-tracking portfolio.
  • You can hire professional help dedicated to you: This route can be very expensive, whether you want a passive or an active approach. You could only justify the expense if you have immense wealth and very particular needs as well.
  • You can use mutual funds and ETFs: Mutual fund companies, both load and no-load varieties (as described in this earlier post) offer a wide array of active and passive portfolio strategies.  Should you want a passive approach, load funds become pointless, since the only justification for the extra fee is superior performance.  Many no-load mutual funds offer a variety of passive portfolios at remarkably low fees.  Since brokers have a hard time buying no-load mutual funds for their clients, you would have to approach these mutual funds directly to channel your portfolio in that direction.  Alternatively, many ETFs offer passive approaches that your broker would happily buy on your behalf.


Passive vs. Active


§  They almost always have lower fees and lower trading costs as well.

§  You always know how well your investments are doing.

§  Most active managers fail to beat the indices.  In the past 15 years, some 90 percent of active managers have actually lost to their benchmarks.  In other time periods more have done better, but seldom do more than 50 percent beat their benchmark.

§  Passive management offers reliability.  They track the index at all times and run none of the risk involved with losing key staff and so suffering performance setbacks.




§  Some active managers do outperform their benchmarks.

§  Active outperformance tends to do best relatively in down markets, which can have a special importance to many investors.

§  Active management, whether you manage for yourself or hire professionals, can offer a greater sense of involvement.

§  Many active managers claim that there really is no such thing as a passive portfolio, since the indices they track are themselves something or an arbitrary assemblage of securities, though the index makers argue that they are representative of the broader market.




Computerized Trading and the Individual Investor


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I’ve been asked about computerized trading.  Sometimes called “program trading,” it was blamed for the market’s extreme movements late last month.  It is not the whole story, as I wrote in my post  at the time, but it was a factor.  My questioners ask if they should account for it in their trading.  The simple answer is: NO.  Here are four reasons:

  1. For all its high-tech associations,computer-based trading is really just a high-tech, algorithm example of herd behavior of the sort that has, in various forms, always typified financial markets. Investing in response to computerized trading only makes the investor one of a herd – never a way to make money in any financial area but especially so in stocks. Trying to anticipate the turn is akin to standing in front of a cattle stampede betting your life that you know when, and which way, it will turn.  You could get lucky, of course, but more likely you’ll be trampled.
  2. Program trading increases market volatility, exaggerating its moves up and down, but in general it has little impact on prices over time. To the fundamental investor seeking to meet the basic objectives described in this post and this one, it is an irritation, but should not be considered anything more.  The market in the closing weeks of 2018 demonstrates this: Computerized trading pushed the downdraft in stock prices much further than it otherwise might have gone, and then exaggerated the upswing the following day.
  3. Individual investors who buy into and out of stocks ahead of such swings are as likely to lose as to win.  Traders buying and selling algorithmically make money because computerized trading enables them to move blindingly fast––faster than most professional investors and certainly faster than any retail investor.  (In fact most of these operations have their computers physically near the exchange, because a profit opportunity can be missed in the time it takes to get an electronic order to the exchange from, say, an office in Connecticut.)  And even at such speed, they can only make money by squeezing pennies or less out of a single transaction; it is only worthwhile for them because they deal in inordinately large volumes of stock.
  4. Computerized trading violates a fundamental rule for the retail stock investor: Even without the added volatility of computerized trading, stocks exhibit considerable volatility. This fundamental aspect should warn investors off stock investing if there is any chance they will need their invested money in a hurry.  If you cannot wait for the ups and downs to cancel each other out and give you the long-term positive gain of stocks, then you should not be in them in the first place.  Go into bonds or savings accounts; look at this post for more detail.


This Is Not The Time to Panic

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Stocks have been having a rough ride.  In the last few weeks, prices have fallen into negative territory for the year. Last week, the media tells us, market indices have had their worst week in a decade.  But before panicking or accepting the media’s parallels to the financial crisis of 2008-09, investors should keep these  considerations in mind:

  1. Unlike 2008, financial markets today function well.  Back then, people were afraid to trade with each other, much less engage in deal-making.  Today, trading in stocks and bonds happens smoothly.  Investment banks continue to underwrite new issues of stocks and bonds, and a variety of financial institutions are lending to individuals and businesses.
  2. The economy is growing. And it’s growing well, in fact, and faster than at any point in the last ten years.  In 2008-09, the economy was entering what came to be known as the “great recession”: unemployment skyrocketed and businesses failed.  There are no signs of a downturn today.  Indeed, the gross domestic product (GDP) for the third quarter (the most recent period for which we have data) grew in real terms at an annual rate of 3.4 percent.  Yes, housing sales and construction have slowed, but nothing like the 2008-09 collapse. On the contrary, the present slowdown reflects a well-ordered and reasonable response to the rising costs of property and mortgage financing.  While it is also true that, with unemployment at new lows and productive capacity utilization in industry on the high side, growth prospects face limits, but no constraints are imminent.

Against this background, the market would seem more likely to rise in the new year than fall.  To see why, consider four factors that have brought it down during these last few weeks:

  1. First is the Federal Reserve (Fed), which has been raising interest rates gradually for years and continued to do so through December. Late last month, policy makers indicated that they were nearly done with this project, but when they raised rates again in December, investors were disappointed. They were further concerned that the Fed indicated further moderate interest rate increases in the new year. Because these recent market losses have already discounted these future rate-hikes, it is unlikely that prices will suffer much, or at all, when the actual rate increases happen.
  2. Fears for the future of the US economy have emerged.  To some extent, they reflect the constraints on productive capacity just mentioned.  But these fears are premature––the effects of capacity restraints will take time before they begin to substantially affect the economy.
  3. Economic fears reflect the prospect of a trade war between the United States and China.  A trade war would indeed be grave and it would threaten markets, but it is unlikely to happen.  China especially needs a trade agreement.  Nor does the Trump administration, despite its bravado, really want a trade war.  The likelihood then is a mutual accommodation within the next few months that will soothe market concerns.
  4. Because prices are down, seasoned investors are harvesting losses in these last few weeks of the year order to write them off against longer-term gains on their taxes.  For the moment, such selling exaggerates the downward pressure on stock prices.  But because these investors will put their money back to work in the market in the new year (called the January effect by financial professionals), markets should see an immediate lift in the opening weeks of the new year or by February at the latest.

Of course, there are risks.  Efforts to avoid an unwanted (by both sides) trade war with China could nonetheless fail. The Fed could change its monetary policy.  Some new fear might emerge among emerging economies — or in Europe, where everything seems to be in flux.  But interpreting today’s picture, investor panic seems ill advised.  Panic selling would lock in losses and make it difficult for these sellers to buy stocks in time to catch the market’s likely future gains.  Even if the rebound fails to develop, little on the horizon suggests a continuation of recent steep declines.


The Stock Part of Your Portfolio

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 This is the last of a three-part posting on portfolio construction.  The first explained general decisions, what financial professionals refer to as asset allocation.  The second in the series focused on bond holdings.  Here I focus on stocks.

Good diversification is the first consideration.  Your portfolio ought to hold stocks from many types of businesses.  In that way, unexpected disruptions in one sector of the economy will not hurt your overall wealth too much, while at the same time, you will gain by having holdings in an industry that experiences unexpected good fortune.  A fully diversified portfolio would hold stocks in industries in proportion to the economy’s overall industrial mix or, more conveniently, the mix of a prominent stock index.  Should you anticipate good or bad news in a particular industry, you might put more or less in that industry, but no matter how convinced you are about such information, you should still retain holdings elsewhere to cope with the inevitable, unexpected developments.

Portfolio managers use all sorts of industry breakdowns.  Here, with a word or two on each, is the 12-sector breakdown used by the Global Industry Classification Standard (GICS):

  1. Consumer staples: Including food, soap, cosmetics, and similar companies, this sector tends to offer stable businesses whose sales remain relatively steady in good times and bad.
  2. Consumer durables: This sector is dominated by the stocks of companies that make things people tend to use over long periods of time, such as autos, appliances, and furniture.  Such stocks tend to suffer more than others in hard times because it is easier for people to postpone purchases.  They usually recover faster as the economy improves.
  3. Industrials: Companies in this area produce machinery, chemicals, metals, and basically anything used in the production of other things.  For the same reasons as consumer durables, these businesses tend to suffer more than most in hard times and catch up more in recoveries.
  4. Materials: This sector includes stocks of companies that mine, produce lumber, and the like.  Their stocks are even more sensitive to economic swings than industrials, in part because the prices of their products swing in sympathy with gains and losses in sales.
  5. Technology: These stocks are less sensitive to overall economic swings, but they are highly vulnerable to innovation, which can make the stock of a successful innovator soar and that of a competitor crash. Hype and unpredictability are watchwords here.
  6. Utilities: This is possibly the most stable sector. These companies see little variation in their sales except in extreme circumstances and are regulated to give them an acceptable profit.  They have limited growth potentials but usually offer relatively high dividend flows. Because the dividend is so much a part of their appeal, they are said to behave more like bonds than stocks.
  7. Transportation: Including airlines, railroads, trucking, and the like, these stocks — especially airlines — are sensitive to the business cycle and fuel prices.  Their volatility offers considerable potential for gain matched by considerable risk.
  8. Energy: It should come as no surprise that this area rises and falls with the price of oil.  When prices are high, companies that support drilling and exploration thrive along with the oil companies themselves.  High oil prices also place a premium on alternative energy sources like wind and solar. Of course, things work in the opposite direction when oil prices fall.
  9. Finance: Banks, insurers, brokers, investment banks, money managers all have sensitivity to financial conditions and tend to rise when interest rates fall and fall when they rise.  These stocks also move in sympathy to financial markets generally.  These days, stocks in this area have become especially sensitive to legislation and government regulation.
  10. Healthcare: Because it’s a universal need, these stocks combine the stability of utilities (hospitals and medical groups) with the innovation sensitivity of technology (drug companies and medical suppliers).  This industry, too, has become highly sensitive to legislation and government regulation.
  11. Real Estate: Despite the name, these stocks are more related to construction, not location and property.  They are, as a consequence, sensitive to the economic cycle and the impact of financial conditions on mortgage borrowing.
  12. Telecommunications: These stocks are very similar to utilities with the added special sensitivity to innovation so evident in the technology area.

In addition to diversifying your portfolio among industries, it is also important to consider these two additional stock tradeoffs:

  1. Growth vs. Value: Growth stocks, as their name implies, typically grow their earnings faster than others.  When you buy them, you are effectively betting that the relatively rapid growth will continue and the stock’s price will appreciate in tandem.  Because growth companies use their earnings to increase their productive capacities, they typically pay a low or no dividend.  Value stocks, in contrast, are those that may be growing slowly (though not necessarily) and seem to have been overlooked by the market, allowing you to buy them cheaper than a fair assessment — say from the dividend discount equation — would otherwise warrant.  Buying them is effectively a bet that the market will wake up to what it has missed and re-price the stocks up to where they should be.  Because they are priced cheaply, they may well pay a higher dividend as a percent of their price.
  2. Large vs. small:Because larger companies are better established in their segment of the economy, they tend to grow at a slower pace than smaller companies which, for obvious reasons, have more to gain as they establish themselves.  In hard times, larger firms are less volatile, but over time, the stocks of smaller companies tend to outperform those of larger ones.  Because these smaller companies go out of business more often than larger ones, it is especially important that your holdings are thoroughly diversified.

Picking Stocks

 Individual stock selections aim to feed the best possible holdings into the industry diversification and the mix of growth/value, large/small.  Here are four basic ways that stock pickers use to evaluate which stocks are the best possible holdings:

  1. Look for earnings after tax to lie along an uptrend, not simply overall earnings but the earnings for each share of stock, earnings per share in financial jargon. This information is readily available online from various investor services or in each company’s quarterly and annual reports.
  2. Look for increasing dividends. If a company is willing to pay out an increased dividend for each rise in earnings per share, it could indicate that management sees these earnings as secure. A rapidly growing firm, however, might break this rule, having need of the additional earnings to increase its productive capacities.  Company annual reports or broker reports should make this distinction clear.
  3. See that there are enough outstanding shares to ensure that there are always buyers and sellers in the market to accommodate your buying and selling needs, what financial professionals refer to as liquidity. Ten million shares outstanding can serve as a reasonable benchmark.  Less than this number could make a stock difficult to sell quickly.  Some illiquid holdings in your portfolio may have enough other attractions to recommend them, but too many illiquid holdings will create a dangerous inflexibility. Even with attractive names, you should always look for more liquidity.
  4. Seek lower price-earnings (P/E) ratios.  This is a simple division of the stock’s price by the most recent earnings per share. It tells you how much you are paying for those earnings and so is a quick way to determine how expensive one stock is compared to another.  All else equal, the lower the P/E ratio the better.

A Last Word

 There are a number of ways to achieve the diversifications required of a good stock portfolio of which more in later posts.  Even with the most thorough diversification across industries, growth orientation, and size, and so the most stable of stock portfolios, there is no getting away from the inherent volatility of stocks.  They are no place for an investor who will need to draw on the money in less than five years.

The Bond Part of Your Portfolio

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The last post explained general decisions in creating a portfolio, what financial professionals call asset allocation.  This post focuses on the bonds in the portfolio.

Bond decisions focus on two main considerations, maturity risk and credit risk.

Maturity Risk

 This is the tradeoff between yield and the term to maturity of the bonds. Long-maturity bonds tend to pay higher yields than short-maturity bonds, but their prices are also more sensitive to movements in interest rates, falling as they go up and rising as rates fall. (See the box in this post for a more complete discussion.)  Unless you have strong convictions on the future direction of interest rates (always a problematic prospect) you should aim to balance the higher current yield of longer-maturity bonds against the risk of a price decline should rates rise.

Hint:  Be aware that some bonds have a call provision that permits the bond issuer to call the bond back before it runs its full term to maturity.  If interest rates fall below levels that prevailed when the bond was initially sold, the issuer may decide to borrow anew at a lower interest cost and use the money to call back your holding.  You would get your money back and the interest due you to the date of the call, but you would lose the benefit of having a long-maturity bond appreciating in a falling rate environment.

Credit Risk

 As we mentioned in an earlier post, there is always a chance that the bond issuer will go bankrupt and fail to meet its obligations.  The greater this risk, the higher yield the bond pays, but you must decide, based on your life cycle/life style needs, how much of this risk you are willing to assume. Even if there is no bankruptcy, the prices of bonds with a greater risk might suffer on bad economic news.  With this trade-off in mind, we can identify three basic types of bonds:

  1. Treasuries: These are the obligations of the federal government.  They are issued in different maturities and carry the same maturity risk as all bonds, but they never have call provisions.  Because they are considered entirely secure credits, they generally offer lower yields than other bonds.
  2. Investment grade corporate bonds: These are issued by companies with strong finances. All else being equal, they generally pay a higher yield than U.S. treasuries.  There is only a small chance that they might have problems meeting their obligations. Credit rating agencies (of which more in a later post) show this risk on a relative scale.  (See the box at the end of this post.)  Investment-grade bonds have little risk that they will fail to pay the holder all they owe.  But they do have maturity risk, and many have call provisions.
  3. Junk bonds: Despite their colorful name, such bonds can play an important role in a portfolio.  Because they either have low credit ratings or none at all, they are considered more vulnerable to failure than other bonds and accordingly pay higher yields than other bonds of comparable maturity.  As with all bonds, these also carry maturity risk and often have call provisions.

Municipal Bonds

 This is a fourth type of bond that doesn’t fit neatly into any of these categories.  “Municipals” or “munis” are issued by states, cities, and other municipalities.  Their appeal is largely because their interest earnings are exempt from federal income tax as well as from state tax for the state in which they were issued.  Because of that break, they generally pay lower yields than bonds on which interest earnings are subject to tax.

Hint: Except in rare circumstances, the only reason to buy municipal bonds is for the tax break.  If you have a combined tax rate of less than 25-30 percent, you shouldn’t consider them.  The tax break you would enjoy would not compensate you for accepting the lower yield munis pay.

If your tax situation warrants buying them, be aware that municipal bonds are otherwise much like other bonds.  They carry more maturity risk at longer maturities and accordingly pay higher yields at longer maturities.  Their credit ratings can vary from good down to junk status, depending on past behavior and the finances of the issuing municipality.  As with other bonds, the less credit-worthy bonds tend to pay higher yields.  Many munis carry call provisions.  Municipal bonds come in three types:

  1. General Obligation Bonds (GOs): These are the safest because the full taxing authority of the issuer backs them.  They finance roads, schools, and other government projects.  They remain exempt from tax as long as no more than 10 percent of the money raised by them goes to finance a private enterprise, not pay for its services.
  2. Revenue Bonds: These pay from the income earned by a specific project or government agency, for instance the tolls from a road or a publically financed operation such as a hospital, a stadium, or convention center.
  3. Industrial Development Bonds: These bonds finance the construction of facilities that are then leased to a private corporation.  Their tax-exempt status follows the same rules as GOs.

A Last Word

 Remembering the necessity of  diversification explained in the last post, the object here is not to settle on one bond or type of bond but to construct the bond portion of your portfolio with a variety of bonds that, when combined, both diversify your bond risk and meet your specific needs.










Bond Ratings


Moody’s   S&P
Aaa Best Possible AAA
Aa1 High Grade AA+
A1 Higher Medium Grade A+
Baa1 Lower Medium Grade BBB+
Ba1 Non-Investment Grade BB+
Ba2 Speculative BB
B1 Highly Speculative B+
Caa1 Significant Risk CCC+
buildingC Near Default CCC-
D In Default D





Tailoring a Portfolio

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This post and the next two are devoted to constructing an investment portfolio.  This first post takes up broad divisions – the mix of cash, stocks, and bonds — what professional investors refer to as asset allocation. The next post will focus on the portfolio’s bond assets and the third will discuss its stock assets.

Typically, a broker’s portfolio report begins with the overall amounts you have in cash, in stocks, and in bonds.  The report then gets into intricate detail, listing all the bonds, who issued each, the original “coupon” rate as a percent of the bond’s face amount, and its maturity date.  (See this earlier post for an explanation of these terms.) The broker’s report will probably also show how much you paid for each bond, its current value, and perhaps the interest payments you earned from it since the last report.  A comparable listing of the stocks in your portfolio will show the name of the issuing corporation, the number of shares you own, what you paid for them, their current value, and possibly dividend payments since the last report.

While these reports are useful to brokers, bankers, and accountants, portfolio managers look at holdings more broadly to consider how they can achieve two key objectives for you:

  1. Good diversification: An effort to avoid having too many eggs, meaning dollars, in one basket, that is too many of one security or type of security. If you could always pick the best, you would not need to diversify.  But perfect foresight is impossible, so spreading your wealth among different types of stocks and bonds will protect the portfolio from setbacks by ensuring that its different parts respond to events in different ways.  Such diversification of exposure allows your portfolio to secure the most gain with the least amount of risk.
  2. Serving the specific goals of the investor: Are your portfolio’s assets meant to provide retirement income?  To buy a vacation home? Or to pay for a newborn child’s college education? These and other long-term objectives will determine what sorts of stocks and bonds your portfolio should hold and how it should mix the types of securities to get the greatest prospective return for the least risk.

So think of the stocks and bonds in the portfolio not necessarily as individual holdings but rather as the best possible representatives of the sort of security that serves these basic aims.

There is no perfect mix.  Your right combination will depend heavily on your particular circumstances and preferences — what many in the investment business term your life-cycle/life-style situation.  Some people cope better than others with risk and occasional loses.  Those more suited to a riskier life style feel comfortable reaching for gains in a more volatile portfolio.  The mix you choose should also reflect where you are in your life cycle.  Young people investing for retirement, for example, will not need the money for years, so they can take more risk to earn greater returns than can older investors who are approaching the end of their working lives and have less opportunity to make up for an investment loss or time to wait for a market rebound after a setback.

Portfolios need to reflect such differences.  Young people, who will not need the money for years, particularly risk-takers, may want few or no bonds in their portfolios. They may want to concentrate on stocks, particularly smaller, less established stocks, because these, though more volatile than other investments, tend over time to gain more than bonds and more conservative stocks.  To be sure, stocks generally and particularly those of less established companies may suffer severe occasional reverses.  But as a group they eventually always come back.  An investor with a long time horizon can count on that recovery.  Someone older, with less opportunity to wait out a temporary setback, may want more bonds and stable, dividend-paying stocks. Retirees, who are already living off investment income, may also prefer bonds and dividend-paying stocks because they also tend to generate more immediate income than less established stocks.

There are many ways to combine stocks and bonds to meet portfolio goals. The aim is to learn their characteristics and create a good investment fit for your critical needs.  The next post will explain the role of bonds and the one following will do the same with stocks.


When You Read the Financial Pages

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Many readers have asked me about sources of information — newspapers, TV, radio, and web newsletters, to name some.  These can offer the investor invaluable guidance. They all enable you to keep up with events as well as the buzz in the investment community.  When reading, watching, or listening you should keep four questions in mind:

  • Does this information affect my holdings?
  • How does it affect them?
  • Does the information require action on my part?
  • If so, what action?

You should aim to stay current with the media every day and from as many sources as you can without driving yourself crazy or detracting from your other important obligations.

Some sources are better than others.  Here are ten especially popular sources with my comments on each:

  1. The Wall Street Journal ( appears daily except Sunday, in print and on-line. It offers excellent U.S. coverage, but its international news is less complete than a global investor would want.  The Journal’s writers do a good job of separating news from editorial, and the editorial pages frequently do a fine job of analyzing the news and government as well as corporate policy, but always remember to allow for the paper’s pro-business bias.
  2. The Financial Times ( appears daily except Sunday, in print and on-line. It offers excellent news coverage, though it sacrifices depth on its U.S. reporting for superb global scope.  The FT has a more liberal editorial bias (in the American sense) than the Journal and offers some fine analysis.  It does a good job of separating news from editorial.
  3. The New York Times ( appears daily, seven days a week, in print and on-line. It once rivaled the Journal for U.S. business, economic, and financial coverage but in recent years has slipped in this regard.  The Times makes less effort than either the Journal or the FT to separate news from its editorial bias, which is most definitely liberal.
  4. Reuters ( and Yahoo Finance ( update their content continually on the web and are picked up by many other media outlets. These sources offer thorough, unbiased, and succinct reporting on all developments, domestic and foreign, but provide no analysis.
  5. Barron’s ( appears weekly, in print and on-line. It offers a cursory review of the prior week’s developments, mostly in the U.S., and also highly useful, in-depth analyses of specific subjects of financial interest.
  6. The Economist ( appears weekly, in print and on-line. It offers a comprehensive look at global economic, business, and financial developments, including the U.S.  It also does a good job of analyzing economic policies and their underlying causes.  It editorial bias is strongly free-market.
  7. Bloomberg ( updates continually on the web. It offers good news coverage and a lot of analytical and explanatory material. Its many contributing writers have varied editorial prejudices.
  8. Investopedia ( updates continually on the web. It offers thorough explanations of investment questions as well as analyses of economic and business developments.  It has a North American bias but also offers considerable global coverage.  Like Bloomberg, its many contributing writers have various editorial biases.
  9. Forbes ( appears weekly in print and updates continually on-line. It, like Barron’s, offers a concise review of the previous week’s news and in-depth financial as well as business articles, especially but not exclusively focused on the U.S.  Its strongly free-market editorial bias is evident throughout.
  10. Broadcasts, whether on television, the web, or radio, can help keep you keep up with the news, but because this is a fast-moving medium, they frequently fail to offer the depth necessary to make even simple investment decisions.

A Warning and Some Further Guidance

 Even with the highest quality news sources, the media tends to exaggerate the importance of whatever is happening at the moment, frequently at the expense of useful perspective.  Why? Because all writers want you to read their articles, so they make their subject appear urgent and pivotal.  Also, media are in the business of selling advertising, and by making their subject seem urgent, they keep you reading, ensuring that your eyes are exposed to as many ads as possible.

Here is an illustrative example.  Once a month the Department of Commerce reports on the construction of new housing units. For a number of reasons, these monthly numbers are extremely volatile.  An investor with related holdings might try to discern trends by averaging out the pattern of growth or decline over several months and take each particular month’s leaps and dives as just one piece of the picture.  But journalists have little interest in presenting the latest information in this way. They generally, want to create drama, even if it contributes little to overall understanding.

The investor must then peel away a good deal before safely extracting usable investment insight from an article or broadcast.  This might involve five steps:

  1. Distinguish between the journalist’s tendency to sensationalize and any real-world significance of a particular news item.
  2. Be aware of editorial bias that might slant how the news is reported.
  3. After you have allowed for bias, use what remains to think about how much of the news was expected and therefore already built into asset prices.
  4. If the news contains nothing surprising, then no action is required.  If it contains a significant surprise, you must judge its likely impact on prices.
  5. From that you must determine whether it warrants a buy, sell, or hold decision.

You can now see that hours of following financial news does not often require an immediate phone call to your broker, although you may learn enough to keep your eye on a developing trend.