Bond Ratings

December 2, 2013

Investment Newsletter for the end of November, 2013

This month I am going to continue discussing bonds.  First, however, the happy score card.  The Dow closed the month at 16,086, up 540 points for the month (a 3.47% increase).  The S&P 500 closed at 1,806, up 49 points (a 2.79% increase).  The Russell 2000 increased to 1,143, up 43 points (up 3.91%).  Everybody made a lot of money.

Bonds are issued either by corporations or by government entities.  The issuer wants to borrow money.  If I buy an original issue bond, I am loaning my money to the issuer.  I want to be paid interest and I want my money to be safe.  I can sell my bond on the market at whatever price exists at that time.  If I buy a bond on the market rather than from the issuer, I am not loaning money to the issuer.  I would be assuming someone else’s loan.  The issuer still owes me money, I still want to be paid interest, and I still want my money to be safe.

I have limited ability to evaluate the issuer’s finances.  There may be different levels of collateral on each bond issue.  There may be complicated financial setups and intercompany arrangements.  There may be a history of paying bond holders no matter what or stiffing them at the first excuse.  The evaluation is highly specific to the corporation or government entity.  To evaluate this issuer, a specialist is needed.

Luckily, when there is a need, someone is willing to sell a solution.  There are five private companies in the United States that rate bonds for financial security.  Only three are big enough to matter.  The three are Moody’s, Standard and Poors, and Fitch.

They issue their ratings with a letter grade.  The ratings range from AAA (called a triple A rating) to a low of D.  D is for issuers already in default.  The exact letter line up varies among the rating agencies.  There are many in between steps.  The above average grades are A (upper medium), AA (high quality), and AAA (best quality).  The B grades are average creditworthiness.

Risk is rewarded by higher profit.  Low risk is punished by lower profit.  Lower bond ratings mean higher risk, which in turn means higher a higher interest rate.  If you buy very low rated bonds, you have bought junk bonds.  You will be rewarded with very sweet interest rates, unless the issuer defaults and you lose everything.

Some issuers, like government entities, must continually issue new bonds.  There is always a new airport expansion, library construction, need for operating capital, etc.  These issuers care deeply about the credit rating.  A drop in credit rating means they have to pay more interest on future issues of bonds.  Because the borrowings are often large, the interest pay outs can often increase by many millions of dollars per year.

The bigger problem for bond holders is what happens when they already hold a bond and then it is down rated.  Since interest rates have to go up, the value of your bond must go down.  The issuer is only changing the payout for future issues.  You are stuck with the same payout.  The bond goes down in price so that the payout divided by the price (i.e. the yield) equals the market rate.


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November 1, 2013

Investment Newsletter for the end of October, 2013

This month continued strong.  The Dow increased from 15,130 to 15,546 (a 2.75% increase), the S&P 500 increased from 1,682 to 1,757 (a 4.46% increase), and the Russell 2000 Value Index increased from 1,074 to 1,100 (a 2.42% increase).  The market is near its all-time high.

This month one of clients asked me to discuss bonds.  I realized then that I had often written about portfolio strategy, the markets, risk, taxes, etc.   However, I have never discussed bonds.  Thank-you Mary.

At its simplest, a bond is a debt.  A company or a government borrows money for some purpose from investors.  The investor can and often will sell these rights to receive future money to another investor.  The key points.

1.  Face Value.  The face value is the original amount borrowed.  It may not be what you paid.  You may have bought the bond from someone else.  That person may have sold the bond to you at a profit or at a loss.  The face value is however exactly what the company or government will repay at maturity.  When that payoff happens, you may have a profit or a loss.

2.  Duration.  How long before the maturity date.  Very short term bonds can mature in only a few more months.  Very long term bonds might be 30 years.  If the bond matures later today as an extreme example, the price this morning will be virtually the same as the face value this afternoon.  There will be no fluctuation in price.  If the bond does not mature for ten years, the price can still bounce around like a teenager’s ideal roller coaster.

3.  Interest Rate.  The company or government pays interest to the investor.  The amount depends on the contract interest rate, often called stated yield.  It is paid according to a schedule, often every half year.  I am ignoring here bonds that are originally sold with a deep discount and then do not pay interest.  The interest rate you actually get depends on the payment amount and what you paid for the bond.  If you buy a bond for $1,000 and then receive $100 interest, your actual yield is 10%.  Its stated yield may be 5% (face value of bond is $2,000), 20% (face value of bond is $500), etc.  In general, as market interest rates go up, bond prices go down and vice versa.

4.  Quality.  Bonds can be secured against real estate, revenue from a project, the full faith and credit of the issuer, or unsecured.  The better the security, the safer the bond.  The city of Detroit is in bankruptcy.  Would you rather have an unsecured bond or a bond with a first mortgage on the real estate used for parking lots?  The issuer is also rated by several rating services (Moody’s, S&P, etc) as to their financial health.  These ratings are usually letter based.  Triple A, etc.  Detroit’s rating is very poor.  It is very likely that the unsecured bond holders will lose their money.  Therefore, the bonds are being sold for a tiny fraction of what was originally paid.

Bonds are not safe.  They fluctuate in price based on how long before maturity, quality of the issuer, security, and changes in interest rate.  I use only short term bonds to minimize this fluctuation.  I want the risk to be in the equities not the bonds.  Equity risk has a fatter reward.

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What is the Market

October 1, 2013


Investment Newsletter for the end of September, 2013


What is the market?   The question is important because it what you measure against.

The most widely published number is the “Dow.”  The Dow Jones Industrial Average is 30 big stocks.  Everybody looks at it every day (me included) and says to themselves, “the market is up today” or “down today.”  It is not a very good measure.  It is only 30 big stocks.  Very little of them are in the mutual funds I invest you in.  It is, however, a quick way to look.  The Dow is on every newspaper and internet front page.

The Dow was up this quarter 220 points, about 1.5%.  It also made money in September, bad news and all.  The market is continuing its upswing.

A broader and more accurate index would be the S&P 500.  It is comprised of 500 big stocks.  It is also easily available on every newspaper or internet front page.  With 500 big stocks, it gives a more decent picture of the market than the Dow.  I do not emphasize these big cap stocks in your portfolios but you are exposed.  The S&P 500 index went up 4.7% this quarter.  It also went up in September.

An even better definition would include all the US stocks.  The big and the small.  The Wilshire 5000 Total Market Index is close.  It is a pretty good picture of the US market.   It does not include international stocks.   Unfortunately, it takes some work to find.  It is not on the front page of anything.  This index went up 5.8% this quarter.  It also went up in September.

The Dow up 1.5%.  The S&P 500 up 4.7%.  The Wilshire 5000 up 5.8%.  Very different numbers.  Which is the market?

I focus on the small cap value segment of the market.  You are exposed to the whole market but I put extra weighting on small cap value.  This segment will overtime outperform the market.  The best index for this segment is the Russell 2000 index.  Use the symbol RUT in any internet browser.  This index went up 9.85% this quarter.  It also went up in September.

My message is to be very careful when reading/hearing that the Dow hit a new high, dropped 200 points, reacted to some news, or whatever.  It is not the whole stock market (US and international).  It is not even the whole US portion of the market.  It also has very little to do with your portfolio.

It has been a very good quarter for almost all portfolios I manage.  Profits are continuing nicely.  I cannot predict next quarter, of course.  I have rebalanced this quarter, twice in many cases.  I have sold stock funds and bought bond funds, not because I am predicting a downturn.  I am honoring the risk level agreed to with you.

Thank-you for your trust in me and your business.  Call me with any issues.

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There is No Such Thing as a Free Lunch

September 1, 2013


Investment Newsletter for the end of August, 2013


In economics, there is no such thing as a free lunch.  Every benefit has to come with a cost.  In my world, the price of the great profits of the last few months is greater risk.  The Dow was up 600 points in July.  It was up almost 2400 points July year to date.  That would be 18% profit for 7 months.  I have been warning for months that these numbers were irrational and that a reckoning was coming.  Well, part of the lunch bill came in August.  The Dow was down 690 points.  August year to date was now a profit of 1706 points.  That would still be an extraordinary profit for eight months (13%).

The month to month fluctuations do not matter much.  They are emotionally driven.  The market is made up of multitudes of buyers and sellers.  They felt good about the market and saw it going up.  Greed comes in and the market goes irrationally high. The market then starts dropping and fear kicks greed out of the chair.  Neither greed nor fear are intelligent motivators when making investment decisions.  But they exist and they move the market in short swings.  I also know that it will swing the other way soon enough.

So how do I make money from others being irrational?  How do I make a profit from most people overreacting?

First, I try to always take a long term view.  As you all know, I do not rush into or out of the market based on what happens in the market.  I do not put much value in monthly results.  I model the allocations and plans for all clients for a ten year investment window.  I presented plans to you using ten years of statistics.

Second, I fight the emotional impulse.  I manage as coldly as I can.  I am, however, aware that the vast majority of investors are usually wrong.  They over react in both directions.  That means, there is money to be made in market crashes.  I have agreed allocations with all clients.  If the market crashes, the allocations demand that I buy more.  If everybody says I am wrong, that is even better.  My world is a bit lonely.  Almost all of you saw that I sold equities in your accounts over the last few months.  I honored the allocations even though everybody was making lots of money.  The result is that everybody else lost more money in August than you did.

At this moment, the Middle East is about to blow up.  Maybe we will bomb Syria.  Maybe Iran will missile attack Israel as a result.  Maybe Iran will shut the gulf.  I know two things.  If these very bad things happen, 1.  The market will have an irrational scare.  1000 or 2000 points down as the fear makes intelligent people run away.  2.  Even if the gulf is shut, the disruption would only be for a few weeks.  1000 or 2000 points down would be an extreme over reaction.  It might take a month to correct back up, maybe it will take half a year.    Sounds like a place to make a profit.  I do not want a war to happen, but if it does I will be buying immediately.  The bargains will be sweet.

Thank-you for your business and support. Call me with anything you need.

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August 2, 2013


Investment Newsletter for the end of July, 2013


The market made fabulous gains this month.  The Dow was up almost 600 points for the month and almost 2400 points year to date.  In percentage terms, 4% per the month and over 18% year to date.

The Dow, however, is an almost meaningless measure for the stock market.  The Dow is an average of 30 big industrial companies.  It is not the entire stock market.  Different parts of the stock market behave in different patterns and with different rates of return.  Historically, large cap companies have worse return than the general market.  Small cap and value will out perform the general market.  It is not a free lunch, however.  If small cap does better, there must be a cost.  The cost, in this case, is higher risk.  When the market goes down, small cap goes down more.

So how did you do?  The engine of most of my portfolios is the DFA Small Cap Value Fund.  It went up 7.34% for the month and 26.17% year to date.  Roughly half again better than the Dow.  Again, there is no free lunch.  This fund can and will go down sharply.  We just do not know when.  A week ago, I engaged in rebalancing the portfolios.  For most of you that meant selling pieces of this small cap value fund and buying more boring short term bond funds.  I am very aware of the risk of downturns and by rebalancing I am trying to control this risk.

Two other funds are worth mentioning in terms of my approach.  DFREX is DFA’s real estate fund.  It invests in various reits; essentially commercial real estate like shopping centers, apartments, etc.  Contrary to what my real estate heavy clients believe, I am not anti real estate.  I do not see wealth management as either real estate or stocks.  I see real estate as a class of investments that goes up and down.  I see real estate as a necessary part of the total portfolio.  But real estate had lousy returns this year.  DFREX went up this month only .87%, year to date up only 5.69%.  Obviously, stocks this year way outperformed real estate.  So that fact means to me that I need to buy more real estate.  In my mind, what is coming is a period where real estate outperforms stocks.  They take turns that way.  You will see my actions in the rebalancing.

The other fund to discuss is the class of inflation adjusted bond funds.  They are not risk free.  They are actually fairly high risk.  Periodically, the funds are adjusted for inflation.  The market is also constantly adjusting them for interest rate changes.  They are generally long term bonds holdings.  The pricing of these holdings can have very large swings with the changes in interest rates.  Interest rates go up and down at different times than inflation.  They are both somewhat manipulated numbers by the Fed.  The result is that these funds will bounce around a lot.  DIPSX is DFA’s version of this fund.  It is down 7.6% this year, because interest rates are creeping up.  The Fed was keeping interest artificially low.  Inflation has not happened much yet.

I appreciate your business and trust.  Please call me with any issues at any time.

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The Tortoise Wins the Investment Race

Investment Newsletter for the end of June, 2013

The following are portions of a speech I will be presenting tonight at Toastmasters.

The Tortoise Wins the Investment Race

Daniel Dollinger Certified Financial Planner

In the famous story as mutilated by me, the tortoise raced the hare to some finish line.  The hare got greedy and self destructed.  The tortoise plodded along without stopping and won the race.  I am talking today about investing your retirement accounts, your precious savings, the safety of your family.  I am giving you today a prescription for success.  But you will not get rich.   Trying to get rich on the stock market is a fool’s dream, a fake mirage in desert.  My central point is that short term investing builds failure and long term investing builds wealth.

The market is risky, duh.  Risk is made up of two components.  A part that can be eliminated with your investment choices by diversifying and a part that can not be.  The part that can be eliminated is the weird things that happen to an individual company.  The BP oil platform blowup for example.  If you owned only that stock, your total changed value as the BP stock price changed.  If instead, you owned a big basket of different stocks, BP would only be a small piece.  The basket would be about the same price.  We will call this basket a mutual fund.  The other part of the risk, the part you can not eliminate, is the general up and down of the market.

The price of a stock is based on many tens of thousands of buyers and sellers constantly bidding against other for a slight advantage.  Many of these participants are experts, with software that reacts to new information to the fraction of a second.  Any company information is released to everyone at the same time.  There is little advantage reading the research reports, watching the TV analysts, etc.  Before the talking head on TV speaks, it is long old news.  Already in the price of the stock.

Buying individual stocks is gambling as to future unknown information.  You are exposed to both market risk and individual company risk.  There is no insight worth having that is not already in the stock price.  You can generate a lot of commissions quickly, however, by listening to your stock broker’s insights.

A broad mutual fund is a bet on the entire economy, not just one company.  Over long periods of time, the stock market returns will match the growth of the economy.  Expansions, recessions, political who knows what – the trend has been up.  Over the last 25 years, the Dow Total Market Index has been up over 10% per year.  Your money would have grown 11 times.  The Russell 2000 value index is up over 11% per year.  Your money would have grown 13.5 times.  Many bad years.  Sick to my stomach with fear, yelled at by my wife, upset clients, minus 30% in one year. Many good years.  Up 30% in one year.   It is not the individual years that matter.  It is the long term trend.

Consistency is the magic weapon of the tortoise in my story.  When our son was born, we set up a custodial account in his name.  We started putting in $100 per month.  Sometimes we had to skip months or even a year.  Then we raised it to $200 per month.  At the very top, we were putting in $300 per month.  Every time, someone gave him a little money for a birthday present, Chanukah present, bar mitzvah present, high school graduation present, it went into that account.  We stopped putting our own money in when he was 15 and the most I ever put in was $300 in a month.  Every penny was invested right away, good market or bad.  Broad mutual funds.  No trying to time when to get in or out.  But did it work?  Did 18 years of small amounts every month add up to anything?  When he entered the university, his account was over $112,000.  Not bad for a tortoise.  And I sure the hare would be jealous.

In summary, investing wealth is built slowly – not by chasing the latest story.  Buy index mutual funds to reduce risk.   Your broker will not be very happy. Consistently add the same amount of money no matter what the market is doing.  Put in the same amount whether you are feeling terrified or greedy. Wait 25 years.  Be one with the tortoise.

Albert Einstein said “compound interest is the 8th wonder of the world.”  I say consistency is the 9th wonder.  Thank-you very much.

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How to Mislead: Using Wrong Statistics

February 2, 2013

Investment Newsletter for the end of January, 2013

Today is about how to cheat with numbers. The wrong statistical tool, or the right tool used the wrong way, can be misleading. I am not necessarily implying evil intent. You may have just messed up.

I am absolutely certain that the market (The Dow) usually goes down the day before month end and usually goes up the day after month end. My investment management fees are lower as a result. I have been laughing with my wife for five years about the conspiracy to reduce my income.

My son works for me now. I had him prepare a data series for the last 10 years (actually 121 months). It was a huge amount of work and thank goodness I didn’t have to do it. And I am right. The Dow went down 56% of the last days of each month. It only went up 44% of the time. So where is my screw up? I ignored the size of the ups and downs. It turns out the average over the last 121 months was a net GAIN of 29 points. The ups were much bigger than the downs. Behaviorally, humans remember the number of good events and bad events but not the importance of each event.

What about the day after billing, the day after month end? I am absolutely certain that the market goes up. And, I am right. 74 times out of 121 months, 61% of the time, it went up. Am I making the same emotional mistake? It turns out I am not. The market averaged a gain of 79 points.

Lesson number one: The number of up and down periods is meaningless.

But what about that gain? Have I discovered something new? Can I time the market by buying on the last day of each month and selling on the next day? Ten years of statistics says yes. Even after commissions, I wouldn’t burn off 79 points. Now, I know full well that I haven’t discovered anything. I am using the tool incorrectly. Ten years is not a big enough sample. I can not prove that. But I will add another ten years (1992 to 2002) to the data series soon and report back to you. I would be shocked if the gains didn’t disappear with a longer sample.

Lesson number two: Sample size matters. Bigger samples are better than smaller ones. Short time periods are suspicious.

If it was true, the automatic trading programs that many firms use would buy the day before and sell on the first day, just like I am suggesting. The computers can certainly spot the trends. Because of all the buying, the price would go up more on the buy day. All the sales orders on the sell day would force the price down. The net effect would wipe out the 79 points before your alarm even rang in the morning. Remember the stock market is an auction where the price goes up or down because of supply and demand.

Lesson number three: If there was market inefficiency this obvious, it would disappear immediately.

It was excellent month in the market. Thank-you for your continued trust. Please call if you have any problems or questions. I will do everything I can for you. It is also now tax time. Call also with your tax questions.

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Correct Investing is Multi-Year Long Term

Correct investing is multi-year long term. Trading is never about out guessing the market. It is about your risk, about rebalancing, and about cash flow. Trading should be occasional at most. Commissions should be discount. Commissions destroy portfolios. The research is all available on the internet for free and it is old and of thus of little value before it is ever published. Concerning market pricing, information becomes obsolete in at most one day. Correct investing is following the plan and turning off the white noise.

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An Excuse for Every Day

Day by day, the swings recently were dramatic (or melodramatic) as everyone’s fear and greed alternated in power. So far in November, there have been a horrible day (the Greek Crisis), and two great days (the Greek Crisis). Over the last several months, I have heard Greece used as an excuse dozens of times. I sometimes wonder if the market watchers make up the reasons after the swing. If the market goes way up tomorrow, somewhere there is a good economic report to blame. There will also be bad economic reports for the other kind of market. There are almost always bad and good economic reports every day. The reason, however, is irrelevant. Fear and greed are the cause of the daily fluctuations. And irrational behavior cannot be predicted.

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TV Overblows Investment News

The market swings cannot be predicted. The TV and internet stock reports exist by amplifying the excitement of the day. Ask yourself what would be the ratings of a Market Watch type TV program that announced “nothing relevant happened today. There was lots of talk overseas about an economy you have almost no exposure to. Daily fluctuations are meaningless white noise anyway.” Would you watch this boring program?

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