Practical Bond Portfolio Construction: The 'Rule Of 10'

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Includes: CBND, CORP, CRED-OLD, CSI, CWAI, FCOR, IBD, IGEB, IGIH, LQD, MLQD, QLTA, VTC, WFIG
by: Herding Value

Summary

If you like researching and owning individual stocks, you'll like researching and owning individual bonds.

Bonds provide income, diversification and risk-controlled investment opportunities.

Obey the "Rule of 10:" Own bonds from 10 different companies in 10 different industries with 10 different maturities over 10 years comprising 10% each of your portfolio.

Every investment company on earth - other than those selling gold, silver or collectibles through radio or late-night cable TV commercials - recommends that investors maintain a certain percentage of their portfolio in bonds. The same investment gurus overwhelmingly recommend bond mutual funds as the favored vehicle for exposure to the bond market, and, for most investors, bond mutual funds are an acceptable way to gain exposure to the $38.5 trillion U.S. bond market - or the even larger $100.0 trillion global bond market. For every 100 stocks recommended to retail investors by professional portfolio managers and security analysts on cable networks CNBC, Bloomberg, or Fox Business there were exactly zero individual bonds. On Seeking Alpha, a platform catering to knowledgeable investors, Herding Alpha's off-the-cuff estimate is 1,000,000,000 stock recommendations for each bond recommendation. Individual investors who venture onto the thin ice of microcap bio techs, blockchain boiler-room pump and dump schemes and sketchy business development companies will shy away from buying individual corporate bonds.

Source: Learnbonds.com

Don't be intimidated. Don't be frightened by what seems at first like a complex new world. It is about to be 2018. Put all that aside for the NEW YEAR! For the type of investor who likes to research and own individual stocks owning a portfolio of individual bonds can be fun, interesting and very rewarding.

Why Bonds at All?

Bonds are useful for steady income, asset diversification and risk-controlled investment.

Income

Of these the most familiar is probably income. When bonds are mentioned many investors have a vague notion of some Scrooge-like character "clipping coupons." Coupons were originally attached to bearer bonds like the one below and had to be physically cut from the main bond and sent to a bank or the issuer for redemption to receive interest - hence today's term "coupon rate."

Source: Scripophily.com

Now this is all handled electronically, and bearer bonds, which entitled the bearer - even if they were stolen - to the principal and interest are largely of the past. Income, however, is still the raison d'etre of bonds. Most bonds have a stated coupon or interest rate and provide a stream of cash flows based on that rate times a nominal $1,000 value. A bond with a 6% coupon rate pays $60 a year in income per bond, typically split into two semi-annual payments, in this case of $30 each.

One difference between bonds and dividend paying stocks is that companies issuing bonds are required to make the interest and principal payments per a bond indenture, a binding legal contract between the issuer and bondholders specifying the terms of the bond; maturity date, interest payment dates, coupon rate, call and conversion features, etc. A company's board can decide not to declare a dividend with, in most cases, no legal repercussions, but not paying bond interest or principal when due is a default which allows bondholders to initiate legal proceedings and could jeopardize a company's existence. Even when there is a downturn in a company's business, there are powerful incentives for management to abide by its bond contracts and make those payments.

Asset Diversification

Bonds are also held for diversification; the idea that holding assets that respond differently to various events reduces the risk of an investment portfolio. The traditional view was that bonds, and perhaps bonds alone, were sufficient to diversify an otherwise all stock portfolio; a classic mix suggested to investors was to hold 60% stocks and 40% bonds. Modern portfolio management has added other investments to the diversification mix including real estate, precious metals, timber, etc., but bonds have held their place as a primary means of diversifying a stock portfolio.

Recent research suggests that the correlation between stocks and bonds is dynamic and, depending on a variety of economic and other factors, changes over time. The chart below shows that at times bonds have been both positively and negatively correlated with stocks. Recently the correlation has been negative so that when stocks moved up, bonds have tended to move down.

SOURCE: BlackRock, Inc.

Based on the chart above from BlackRock (NYSE:BLK), it is obvious that stocks and bonds do not move in lockstep and that there is some benefit from diversification.

Bonds diversify risk in another way: they are senior to stocks in a company's capital stack. Since they are backed by a binding legal contract, the risk of owning the bonds of any individual company is less than the risk of holding that company's stock.

Risk-Controlled Investment

We can control some of the risk in an investment portfolio that is all stocks by adding bonds. We can also control the risk in an individual investment by using bonds. Suppose you want to invest in a risky turnaround situation. The common stock may be wiped out if management cannot perform, but the upside is very attractive. Consider the company's bonds. Yes, your gains are somewhat limited versus the stock, but so are your losses, in fact, in many cases, analysis may show that even if the company declares bankruptcy, the bondholders will not lose principal. If everything works out, you will receive a steady stream of interest plus capital gains on your bonds and your risk will have been limited compared to the company's stock.

Bond Funds

Bond funds have their place. Passive investors are better off just buying a bond index fund or ETF for their bond allocation. On the other hand, if you like to buy your own stocks, why wouldn't you buy your own bonds for the same reasons?

  • Like stock funds, bond funds are actively sold by companies that make money from your purchase. Owning individual bonds has historically been institutional and high net worth investor territory.
  • Actively managed bond funds, according to the most recent S&P Spiva report, do not perform well against their benchmarks for long periods of time: SOURCE: S&P
  • According to the Investment Company Institute, the 60 bps average expense ratio of actively managed bond funds means you are losing 20% of the current 3% average investment grade bond yield to expenses. Bond index funds with average expense ratios of about 10 bps are much better and bond ETFs are even better with some of the larger ones having average expense ratios as low as 5 bps.
  • Bond fund interest payments may vary over time, a negative for an investor who needs a certain amount of steady income.
  • With individual bonds you have the option of holding to maturity and receiving your principal, an advantage in planning for major expenses on a future date.

There is nothing wrong with deciding that owning individual bonds is not for you. Like owning individual stocks, a lot of research and due diligence is required to be successful. Portfolio construction, however, can be simplified.

A Practical Approach: Build Your Own Bond Portfolio

Building a portfolio of corporate bonds is well within the capabilities of the average informed investor. What follows is a practical approach to bond portfolio construction supported by research that will prevent the most egregious issues from developing. There are three main considerations: 1) Selecting bonds to form a diversified portfolio, 2) the maturity of those bonds and, 3) setting a portfolio yield target.

The discussion that follows is limited to corporate bonds whether investment grade or high yield ("junk bonds"), government and municipal bonds have different risk characteristics that require separate treatment.

Bond Picking & Diversification: The Rule of 10

The first bond you buy will be the riskiest. One bond means you are exposed to one company in one industry with one maturity date. Herding Alpha's simple method for bond portfolio construction is the "Rule of 10."

Own bonds from at least 10 different companies in 10 different industries with 10 different maturities over 10 years comprising not more than 10% each of your portfolio.

The "Rule of 10" is a simple way to reduce non-systematic risk, the risk associated with a specific company or industry and a sneaky way to reduce some systematic risk, the type of risk associated with the entire economy, for example, depressions, recessions, panics, etc. that would impact all types of securities.

Buying the bonds of at least 10 different companies in 10 different industries, each comprising no more than 10% of your total bond portfolio is Diversification 101. Academic studies have shown that the proper number of stocks to reduce non-systematic risk to an acceptable level is anywhere from 10 per Evans and Archer (1968) to more than 100 per Kryzanowski and Singh (2010) depending on whether the mutual fund industry was funding the study! Bonds are much less volatile than stocks and owning bonds from 10 different companies in 10 different industries will provide a substantial reduction in non-systematic risk while keeping the number of bonds owned low enough to allow the investor to understand each company and industry - and, if something happens to one company, it impacts at most 10% of your bond portfolio. As St. Warren of Omaha has observed:

Wide diversification is only required when investors do not understand what they are doing.

For an excellent, concise overview of the number of stocks to achieve proper diversification see this Seeking Alpha article by David Krejca.

High yield bonds (those rated less than BBB- by S&P) pose a special case. Many junk bonds are de facto "stock substitutes" having near equity-like risk. As a rule, they should not be mixed into an investment grade bond portfolio governed by the "Rule of 10" as the portfolio size will not provide adequate diversification of this type of risk. An investor would be much better served by creating two separate portfolios: a portfolio of 10 investment grade bonds and a portfolio of 10 high yield bonds. Well-researched junk bonds, however, are ideal for a "Rule of 10" portfolio.

Maturities: Climbing the Medium-Term Ladder

The "Rule of 10" reduces systematic risk by prescribing investment in bonds with 10 different maturities over 10 years comprising not more than 10% each of your portfolio. Maturities out to 10 years from today are short to mid-range maturities. Since it's about to be 2018, we would invest in bonds that mature from 2018 to 2028. Other things being equal, bonds with less time until they mature generally have lower durations, and lower durations mean less sensitivity to interest rates.

Duration is a concept pioneered by Canadian economist Frederick Macaulay and his version is often called Macaulay duration. Duration is the present value of a bond's cash flows, weighted by length of time until each cash flow is received and divided by the bond's current market value. It can be considered the economic life in years of a series of cash flows adjusted for the time value of money.

Source: St. Louis Federal Reserve, Investment Improvement: Adding Duration to the Toolbox, April 1996

Luckily, we don't have to calculate duration as every reputable broker provides this information, along with much more, on their bond trading screens for every bond they offer. Here is a screenshot of the information online broker E*Trade Securities provides on Transocean's (NYSE:RIG) 7.45% Senior Unsecured Note due 4/15/2027:

Note in the far right column data for Yield to Worst, Yield to Maturity, Current Yield, Macaulay Duration and Modified Duration, an adjusted version of Macaulay duration which accounts for changing yield to maturities.

We can use duration to estimate the changes in the price of a bond due to interest rate changes. Let's say rates rise 20 bps. For the Transocean bond above with a Macaulay duration of 6.639 then -6.639 x 0.002 x 100% = -1.33%. We would expect the price of the bond to fall about 1.33% for every 20 bps rise in rates. For modified duration for the same bond -6.354 x 0.002 X 100% = -1.27%. We can calculate the duration for each bond in our portfolio and then calculate a weighted average duration for the entire portfolio.

The "Rule of 10" helps reduce systematic risk by reducing the exposure of the bond portfolio to either rising or falling rates by keeping duration lower through investment in short- to mid-range maturities. In addition, the bond portfolio is "laddered" with no more than 10% of your portfolio allocated to any one maturity across the 10-year investment horizon.

Source: PIMCO

Our laddered bond portfolio is invested 10% in bonds maturing in each year from 2018 to 2028. When the 10% of total bonds invested in 2018 matures, that cash will be invested in bonds maturing in 2029, pushing the ladder forward in time. The laddered approach matches a need for steady cash income, as in retirement, and reduces the systematic risk of having to reinvest a significant portion of bond funds in, for example, a low interest-rate environment resulting from the Fed drastically lowering rates in response to a market crash as in 2008.

The 10-year time horizon is also important since while analysis and due diligence may provide insight into the next 2-3 years of a company and its industry, the crystal ball becomes progressively hazier the further out we try to predict the future. If we intend to hold bonds to maturity, even though we have the option of selling at any time, a shorter time horizon provides a lower probability that any company and/or its industry may suffer adverse change.

Finally, considering human nature and the changes we all experience during our lives, the 10-year period encompasses an intuitively appealing, reasonable amount of time during which most investors' needs for cash flow are relatively predictable.

Am I Getting Paid Enough?

More accurately, are you getting paid enough for the investment risk? How do you know?

In general terms, a rational investor would want a bond portfolio to provide a real risk-adjusted return above inflation. In the real world, there is no "right" answer to this question. Some investors, perhaps with a short investment time horizon, might choose to sacrifice a real risk-adjusted return for perceived "safety" of principal. Each investor is free to set his or her own "hurdle rate" for individual bonds or bond portfolios.

We can, however, at least make informed decisions about required returns. Through the pioneering work of Fisher and Lorie (1965, 1968, 1977) and Ibbotson and Sinquefield (1976), we have well-documented research to benchmark our investments. Fisher and Lorie conducted a pioneering study on rates of return on common stocks going back to 1926. Ibbotson and Sinquefield elaborated on this work and introduced the concept of the equity risk premium, essentially that securities returns are composed of a risk-free rate plus a risk premium. For practical purposes, most analysts agree with the Ibbotson Associates long-term return securities returns for 1926-2016 as presented by Morningstar below:

Source: Morningstar, Inc.

The data suggest that when investing in stocks over a long period of time investors have earned 10-12% per year less inflation of 2.9% or 7.1-9.1%. For risk-free government bonds the corresponding figures were 5.5% and 2.6%.

Your bond portfolio should provide a real return. At any point in time analysts will argue that the inflation rate is lower than the long-term rate in the Ibbotson SBBI therefore lower bond yields are justified. What is not said is "right now." Inflation is variable, but persistent. As Addendum # 1 to the "Rule of 10," the weighted average YTM of your corporate bond portfolio should exceed the 2.9% long-term inflation rate.

Closely related to the concept of a real return is that of a risk adjusted return, i.e., a premium over the risk-free rate. Traders price corporate bonds at spreads to the US Treasury yield curve. The table below provides a comparison:

At first glance, it looks like a fair deal for an investor. Buy S&P AAA-rated corporate bonds and earn a 33.5 bps premium to the 10-Year US Treasury. Take a walk on the wild side and earn a 201.3 bps premium with BBB-rated bonds! They're still investment grade. Have you ever wondered why Alan Greenspan, Jeff Gundlach and Bill Gross, among other financial luminaries, are worried about a "bond bubble?"

Source: Businessinsider.com

Take a look at the following table where we compare current 10-year corporate bond yields against the long-term Ibbotson SBBI data:

Source: E*Trade Securities, Ibbotson SBBI

Are we really getting paid enough? A lot of smart folks think we're not being compensated with an adequate premium over long-term inflation and the risk-free return. In the table above, there is no premium other than 8.7 bps for junk bonds. As Addendum #2 to the "Rule of 10," however, an investor's bond portfolio should not only provide a premium over the long-term inflation rate but also over the long term 2.60% risk-free rate as well.

Over the past few years, investors have reacted to their sense of being underpaid for bond investments by increasing the risk of their portfolios; the biggest bond asset class beneficiary has been junk bonds. More risk equals more return; and a prayer of being able to meet the requirements of Addendums #1 and #2, but sometimes more risk just equals more risk.

You can't always get what you want

But if you try sometimes, yeah

You might find you get what you need!

Source: Rolling Stones, Album: Let it Bleed, 1969. Song: "You Can't Always Get What You Want"

In today's economic environment, compromise is required in building any bond portfolio. There is no absolute certainty that from now through the next 10 or 20 years the inflation rate or the risk-free return will approximate the Ibbotson SBBI numbers. What the Ibbotson long-term 5.50% government bond return does provide, however, is a "hurdle rate" that may be adjusted up or down by each investor to fit his or her situation, to use as a benchmark in the creation of a bond portfolio. In a simple, easy to implement way, it serves as a way to determine if you're getting paid enough.

Conclusion

Don't be afraid to buy individual bonds. If you like buying individual stocks, you will like buying individual bonds. Modern brokers have made it easy to research and buy bonds. With the "Rule of 10, Addendums #1 and #2, a modicum of analysis, due diligence and common sense, any investor can build a well-diversified bond portfolio that will provide steady cash flow.

Disclosure: I am/we are long TRANSOCEAN 7.45% NOTE DUE 4/15/2027.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.