Great Portfolio Construction: The Case for Bonds

Back in December, I wrote about the 5 Keys to Great Portfolio construction.  I thought that based on the recent positive market performance, a lot of investors would start coming off the sidelines.  As an asset manager and investment consultant, I am always asked questions about the timing of investment and my answer is that “time in the market is more important than market timing”.  With that, I realize investors may be looking for where to put money.  I believe the notion of portfolio construction is worth revisiting based on recent market movements.  Here we go…

As seems to be the case every 7 years or so, bonds can become really cheap.  I probably will receive a lot of flak on that statement depending on what kind of bonds are being bought.  But as most pundits will even admit, the compensation for holding “junk bonds” has gotten as cheap as levels close to 2008-09.  As has been disclaimed in previous writings, my expertise is found mostly in municipal finance, but the ideas I put forth are time-honored for nearly all credits—sovereign, corporate or municipal.  So how do you choose which ones to buy?

 Bond Funds

If you want to play it safe you can always buy a bond fund which will invest in several bonds and fundholders receive the benefit of the aggregate cash flows and any capital gains after fees and expenses [for the fund are taken out].  Arguably the greatest benefit of mutual fund (bond or otherwise) investing is diversification.  This takes the importance out of credit selection and places it onmanager selection.  With longer and mostly positive track records garnering the most attention and money flow.  However, what happens when everyone piles onto the best fund manager investment?  The law of supply and demand takes over and the fund becomes expensive.  As many times is the case, investors may be left with little yield after fund fees and expenses.

 Individual Bonds

On the other hand, you could take a foray into building a bond portfolio of various maturities and payment schedules.  The primary concern usually becomes liquidity (especially for smaller portfolios).  That is to say when you want to buy or sell, could you find a willing partner?  Unlike stocks, bonds are not “exchange-traded” and are primarily traded in an auction-like format.  This is the foundation for my advice to any investor wanting to buy individual bonds:  use a buy and hold strategy.  The time and expense an individual investor would consume as opposed to an investment professional trading individual bonds becomes astronomical in comparison.

 The How

In either case you should be aware of the 3 C’s of credit selection:

  •         Cash flow and ability to pay.  Not enough can be said about cash flow.  Any enterprise worth investing in should be able to demonstrate cash levels appropriate for daily operations.  In the hundreds of credits I’ve researched, this is my primary focus.   Balance sheets and income statements are often idolized when in fact an enterprise’s cash flow statement ties the two together and presents the most accurate picture of true solvency.  It is beyond the scope of this piece, but suffice it to say, becoming intimately knowledgeable of the inter-workings of financial statement interdependence is paramount.
  •         Covenant strength.  When or if things go bad (i.e.  missed interest payments, bankruptcy, etc.) bond holders are protected by bond covenants.  Within the bond covenant lies the legal remedy for bond holders to pursue recourse for violations by the borrower.  However, investors should be aware that the legalese found in most bond documents is byzantine and ironically enough written by bond counsel which represents the issuer of the bonds.
  •         Collateral.  What backs the principal and interest payments?  Real assets are usually pledged in this instance. First and exclusive right to gross revenue is also common.  However, these pledges may often be divided among senior and junior debt holders, the latter having a lesser claim.  When considering real estate as collateral I advise investors to look for recent appraisals for determining value as opposed to relying on book value.

Naturally, investment in either bond funds or individuals involve investors weighing the risk-reward trade off.  But as always, with extra effort you can be handsomely rewarded with a gem of an investment opportunity.

Invest Wisely!