Investing in Bonds

I am an active options trader that likes to invest a portion of my portfolio in safe marginable investments. Recently I have been dabbling in bonds and have been disappointed in the apparent lack of practical information on this subject. Sure there are lot's of tutorials on the basics, but precious little practical information.

So I thought I would start this thread. Here is a starter question:

High quality corporate bonds seem to only pay a few tenths of a percent more interest than treasuries. Given that treasuries are tax exempt at the state level their effective yield is about the same as these high quality corporate bonds.

I am wondering why anyone would buy these high quality bonds when treasuries seem to be the no-brainer choice (at-least in taxable states).

Am I missing something?

Don

 

I think it's a good idea to invest a portion of your profits in bonds. I would recommend to invest in closed-end muni funds like vkl, bfk or high yield funds like hyf, dhf, pty.

 

Closed-end bond funds have their own risks and I am not comfortable of my associated knowledge although I suspect your are correct saying they can be good investments.

In general Bond funds, as opposed to individual bonds, have the disadvantage that you cannot hold them to maturity and be guaranteed to get your money back. So depending on interest rate direction, you could have a loss (or profit). With interest rates trending up bond funds seem to be less desirable at the moment.

OTOH, short term bonds bought in the secondary market are less vulnerable to losses because you can hold them to maturity. Of course when buying bonds instead of funds you become responsible for knowing the associated risks and you do not have an expert fund manager doing that for you.

Seems to me that TIPS are very attractive alternative given that they keep up with inflation and inflation is rising. As I understand it the effective rate of TIPS in the last six months has been around 7%.

Don

 

I am not sure I understand your thinking. Because my knowledge on the subject is also limited from my standpoint holding a portfolio of bonds is more or less equivalent to bying a closed end bond fund in terms of their default rate. Because not all individual bonds in your portfolio would live to their maturity. This is my humble opinion for what it is worth. I don't believe you can outperform by much through random individual bonds the managed closed-end fund if at all.

 

Hi Don...since you are an options trader what are your thoughts on investing in TLT and selling calls? Another fellow on an options chat said he had been doing quite well...the TLT was paying I think close to 5% and collected the add prem on the call...so I've been looking into doing that as well.

 

At a glance I don't see any particular advantage to selling calls on TLT. Basically, the 5% dividend will cheapen the calls so the net benefit should be zero.

Of course, if you think you know where interest rates are headed maybe you can make some good directional plays on TLT.

It's been a while, but the last time I traded TLT options volume was low and therefore fills were not so hot.

Sorry I don't have some more valuable input for you.

Don

 

You might be right about it not being likely to outperform bond funds. I was just trying to give you some feedback on your post.

Let me know if you have any input on my original question.

Don

 

Don - the yield differential is not the only reason driving demand... - look at the explosive growth in all the derivatives, such as credit default swaps etc etc - institutions employ complex risk/asset diversification/allocation/arbitrage strategies which drive demand for individual corporate issues... - furthermore, the tax issues are highly complex at the institutional level, just consider for example tax exempt entities which would not benefit from the tax advantage as you describe in your post - also, consider the sheer huge size of fixed income portfolios, say a few billion portfolio makes what you refer to as only "a few tenths of a percent" worth millions of dollars, i.e. with huge amounts under management, every basis point of yield counts...

i think in general with the growth of derivatives, the market for individual corporate issues is becoming increasingly liquid and hence more "fairly" priced - i.e. if you hold a diversified portfolio of individual corporate issues, the "few tenths of a percent" premium over the treasuries, on average, is fairly priced (the banks et. al. employ tons of smart people to make sure they are not overpaying for risk of say GM vs Uncle Sam )

however, it's a different issue from an individual investor's standpoint - one can have tax benefits, one may not be able to diversify in corporates like an institution and hence, treasures may make more sense - all the best.

 

Don:

Basically, you are right. The yield curve is a dynamic, ever changing, unpredictable measurement. When assessing "equal" credit quality debt securities, the "spread" between that instrument and "risk free" treasuries is important.
That is why some investors get enamored with junk bonds when their spread to treasuries is high. In their opinion (not mine), the additional risk in low quality bonds is worth the reward in interest payment.
The other critical issue is your own tax bracket. Depending on where you fall, munis (again, say high quality) may be much better than treasuries, high quality corporates, or agencies (FNMA, FHLB, etc.)
Lastly, your chosen bond maturity is the other factor in the equation. Depending on where you choose maturities, different instruments will yield better "after tax" returns than other instruments.
Long winded, I'm sorry, but in the end; if using bonds basically for margin as you trade options, I would say stay with best "AFTER TAX" yield between Treasuries, Agencies, and AA or better Munis. Depending on liquidity needs and yield curve, right now you're best to stay with short maturities (less than 5 years).

 

Thanks, fader and craigatelite, your explanations Make sense.

On a related issue, does anyone have experience trading TIPS in the secondary market? Any suggestions?

As I mentioned earlier, I think the TIPS have paid in the neighborhood of 7% in recent periods including the inflation protection component. If inflation continues at say a 3% or better rate their return will be better than treasuries and many high grade corporate bonds.

One disadvantage is than none of my 4 brokers have online TIPS trading data. You are forced to speak to a broker and therefore your information is limited. For example, you cannot peruse all the available offerings. Anybody know a web site that provides this data?

Don