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Bonds from a Value Perspective

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October 27, 2011 – Comments (0)

Board: Value Hounds

Author: charliebonds

Thanks, guys, for being receptive to including discussions of bond investing on this board if done from a value approach. (The board where such discussions could be taking place has all but died, mainly because of their persistent confusion of cash-management with fixed-income investing. But that’s not a problem that concerns us.)

My bet would have to be that most on this board know a lot more about bond investing that they think they do. But indulge me for a paragraph or two while I lay out what I find attractive about bonds. By and large, for a stock investor to do well, the underlying has to do well. But for a corporate bond investor to do well enough, the underlying merely has to not fail. That’s a lesser standard to meet, and the standard is protected by a put to boot (aka, maturity is promised). OTOH, the price of that put is the lesser returns than might come from buying the debt rather the common. (Anecdotally, it’s about a 3.5x disadvantage.) OTOH, the upside of bonds over stocks is their lesser price-volatility. So for a person who is willing to grind through a company’s financials (rather than just make bets about the level/direction of interest-rates) and who really does want (for the most part) buy-and-forget investments, bonds are a good compromise between risk and reward. But rather than talk theory, let’s work through an example.

Because I generally don't attempt to trade junk bonds, I have to game my odds of failure, and what matters to me is my recovery-rate. As an example of how I buy junk, consider Shopko's bonds, several of whose issues I bought years ago on the basis of seeing mention of the company in one of Oakmark's annual reports that I was reading diligently, because I was a shareholder. They were explaining why they were buying the stock for their funds. They were struck by the fact that the company owned a lot of the real estate on which their stores sat (rather than being the typical retailer who depends totally on leasing), and, consistent with GAAP rules, the true market value of their land was likely higher than book-value which the stock market seemed not to be discounting. (Keep in mind that they were doing their DD and looking at the company as a value stock.)

"But, wait a minute", I thought upon reading their analysis. "Retailers generally offer fairly high recovery-rates from Chapter 11 purely on the basis of inventory. These guys have real estate, as well, that could be claimed by creditors. I don't care if they do fail. I'll likely recover my money if I buy their bonds --instead of their stock-- because of favorable recover-rates and where I stand in the credit line."

So I started digging through their financials and came to the conclusion that I could buy their discounted bonds with zero downside risk, i.e., at less than a likely recovery-rate. (Of course, subsequently, they renegotiated their credit facility, effectively subordinating the credits I was buying, changing the risk/reward relationship.) But on the basis of my initial DD, I scooped up nearly everything I could get a hold of, which were 5 each of the two near-term issues and 3 of the longer-term one, as being all that were available at the time --junk is a very illiquid market-- as well as that many bond made a prudently-sized position relative to my account size. One issue matured soon. The others quickly went to trading above par, and I made an average YTM of 17% on those positions, which is modest. But it sure beats the historical 10% something of stocks over the long haul, which is my bogie: better long-term returns from junk bonds than the long-term returns from the SP500, and with no more risk.

Caveat: I would attribute my success in this instance less to skill than the fact of there being easy pickings at the time. With Shopko, I was fortunate enough to put together a couple of obvious facts in a timely fashion. But I’m still in the bond market on a daily and weekly basis, poking around, looking for discounts to value, and I’m still finding situations that merit the attention of value investors. (Two buys this week so far, and about the same last week after mostly taking off the two prior weeks). In other words, if over a year’s time I do 4-6 buys a month, I’m pretty much on target for the shopping and buying I have to do. That’s not a burdensome research pace, and the constant nibbling pretty ensures that I’m looking at most of what should be looked at in the corporate bond world. Wins and losses on individual positions range can from 200% (rare, but 100% is doable) to minus 100%, and the average across your portfolio can be pretty much what you want it to be depending on your tolerance for risk, meaning, stocks or bonds, it makes no difference on a risk-adjusted basis, as it can't, or else the arbs would step in to correct the inefficiency. But of the two asset-classes, I find bonds to be the easier and more interesting.

Charlie

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