Thursday, April 30, 2009

how to purchase a bond

step one: be a millionaire.

-sadly, this step is often the most difficult. However, once you finish step one, i promise all the other steps are very easy to accomplish.
- if you can't finish step one, don't worry there are alternatives to engaging in the retail investment grade corporate bond market, which i'll discuss in a bit
- the reality is, if you go to a large financial institution or any investment group, only the high-net worth individuals have the chance to work with the senior advisors. if your investments are at the $200k-500k range, or less than a million bucks, you still likely will get stuck with an inexperienced advisor who will likely not understand how the bond market works and suggest government of canada bonds, bond mutual funds or etfs exclusively and then try to put too much money in equities (this is different depending on your age/pension context)

step two: do a thorough investigation of investment advisors.

- You need to be willing to ask friends, family and colleagues (it can be awkward talking about finance) about their investment advisor or if there is someone experienced they can recommend.
-meet with a variety of investors (at least 4) and ask them about their strategy (never get talked into opening an account right away) and ask them what they think about bonds, what their experience has been buying bonds for clients, and ask them how they interact with the bond desk
- if they tell you that the bond desk can make life difficult for them- walk away. the advisor does not know how to effectively work the retail bond market
- if they tell you that the majority of their activity is with the bond desk and that they have a solid, and ongoing relationship with the bond traders, this is a good sign they know how to consistently get you safe bonds that have an attractive yield (the historical average for investment grade corporate bonds of a 5 or 10 year maturity is 3% ABOVE the government of Canada rate. much higher or lower yield should raise your attention to a risky/bad investment)
-NEVER, NEVER, NEVER trust a young, or inexperienced advisor if you want to invest in bonds. It takes years of experience and relationship building with a Financial Institution's (BMO, TD, CIBC, BNS, RBC, etc) bond desk in order for an investment advisor to be able to effectively structure a large and diversified, laddered bond portfolio
- The reason is also simple: young advisors, and advisors with a small amount of clients need to extract more commissions and fees from that smaller pool of clients than an established advisor with a large book of clients. In order for the established advisor to make his salary, he doesn't need to depend on large commissions of any one client, unlike the advisor who is just starting out and needs to churn his small number of accounts just to make money.
- even if you are lucky enough to get a senior investment advisor, you must still be educated in the corporate bond market in order to work on an even playing field with your advisor, which requires that you complete the final step.

step three: do some studying (you will not need to have any type of expert knowledge, but you will have to become knowledgeable) i.e. build your own fund of investment knowledge.



- study the credit history of the companies you wish to invest your money with (available at DBRS.ca).
- study your personal context and what kind of investments are you comfortable with making (sometimes you only want to be half invested and leave some in GICs or a savings account, sometimes you need dividend income, not interest income, sometimes you want to be fully invested- you need to figure what is the right mix for you)
- i personally believe, and from what i read from people like Niall Ferguson, Nasim Nicholas Taleb, and countless other wise souls, YOU CANNOT PREDICT THE FUTURE. Worse, you will never be able to predict the future and it's actually in your best interest to expect that the worst outcome is the most likely.
-expect and plan for the worst in all circumstance while still being hopeful that things will be rosy.
-this attitude leads me and others (counter to the popular DIY investor strategy)to believe your personal savings should remain in investments that promise to repay your capital and that any investment in equities should not total more that 10%. This way, your claim to future performance is only what you stand to lose (10%) and you have prepared for the worst while leaving hope for the best.
- Every day you need to read the paper and follow the news related to the companies you have invested in. Their respective industries, the state of global trade, finance and output, and the level of debt of nations and corporations are all things you need to at least have a basic understanding of.
If you:

1) read the paper everyday and

2) do a little extra homework on the company you want to buy bonds in (just knowing if they have too much debt, have good assets, steady revenue, etc.) and then

3) know the credit rating of your bonds,

this is all the extra homework you will need.
a good advisor will act as a way to reconfirm what you are already expecting.
In essence, you are paying your advisor to provide you with bonds that meet or exceed your expectations.

- following the news and the credit rating of your company will allow you to determine if it's best for you to keep your bonds in short term lengths to maturity or longer term, or which type to keep long term and which type to keep short term
- a bond portfolio is fully customizable to your particular context, so you need to know where you stand.

....

So, you don't have a million bucks to invest? well, you can still build a rock solid bond portfolio on your own that should have a similar average yield to the millionaire portfolio, just scaled down to your particular heights.

1- register with one of the big financial institution's online discount brokerages (TD and BMO offer the best bond inventory, tools for making a laddered portfolio on your own, current credit ratings, and the best prices). But, to get the discounted fees, you usually need to have at least $100 000. if you don't have that much, you may have to pay some additional costs to keep the account open. Other discount brokers may not have the additional costs, but they are less likely to have the variety, quality and prices of the big boys (TD and BMO).

2- go to the library or book store and get either edition (the 2nd is a little more up to date) of Hank Cunningham's book "In Your Best Interest: The Ultimate Guide to the Canadian Bond Market". Most of what i say is basically repeating his strategy. he also runs a website, where he takes questions directly from people- www.inyourbestinterest.ca
I have no personal connection to this man. It's simply my experience that the only book i would have needed to read (if i had no other experience, information or advice) in order to make safe investments was that one book. And i have read almost all personal investment books currently on the market. Hank is one of the most successful and most recognized 'bondies' in the business in the history of Canada and every single experienced investor and advisor i have ever talked to has talked about the exact same strategy time and again: laddered ten year portfolio of investment grade corporates and provincial bonds. If you want to know the secret of how rich people preserve their wealth and pass it on to the next generation, this is it.

3- follow the same strategy outlined before when it comes to knowing some of the basics of the companies you want to buy a bond from, the basics of your economic needs and the basics of the state of the current global economy. You simply don't need to be an expert. Most experts actually don't know about bonds and if they do, they admit that the average joe is just as capable of making the right choices for their investments if they just did the little bit of extra homework.

4- you will be the one creating your bond portfolio, not an advisor. so it's up to you to spread your money out. the simplest strategy is to put maximum 10% of your investment in each year up to ten years. That way, 10% of your money is freed up every year to reinvest. If inflation is rising, interest rates will also, likely, rise and that returned captial can be invested at the higher rates. the same process is repeated every year. Barring hyperinflation (which is a very remote but real possiblity), you have greatly reduced inflation risk to a fixed-income portfolio.

5- it's important to diversify a bond portfolio because any single issue for a company has some risk of default, or some bonds have a 'call' feature, where the company can decide to give you your money back whenever they want. This isn't a big problem if only say 1-5% of your capital is being returned, but what if you put 30% of your capital into one callable bond because you liked the yield and thought it wouldn't be called, and it's called at a time when interest rates are next to nothing (this is currently happening with some bank bonds).
for each company that i have a bond issue from, i put no more than 1-7% of my capital in that one company, as a way to avoid being overly invested in a single issuer.

6- once you have figured out the right mix of companies and the right amount of money to have invested, take some and put it into the stock market. I say this because once you have built your bond portfolio, that's it. it's finished. you can't tinker with it. the value won't fluctuate if you hold to maturity. in essence, it's a sleep-at-night portfolio. It's a boring way to make money, because it's slow and steady. Imagine the tortoise and the hare. Well, it's wonderful to be the tortoise because he's the hero of the story and he wins the race. But you are a human and you need something to keep you motivated and interested in your investments and not to forget when you have money coming due.
i put no more than 10% of my money in the stock market because i really like it when people promise to pay me back. no one in the stock market ever does that. But i still need some excitement and stock market-induced adrenaline in my life, so I put my money in canadian bank stocks (i know equity people who call these widow and orphan stocks, well these day's their downright speculative) and energy stocks (primarily as a hedge against the type of inflation triggered by rising oil and gas prices). IMO once you have protected the majority of your money, go crazy with the rest. if you want some dividend income, you should have fun on the stock market and see how you can fare. Your probably won't lose it all, but even if you lose over half through stupid investments and trades, you'll have learned the lesson without risking your life savings and you can write-off the capital losses on your tax statements.

2 comments:

  1. Step 1 is what I was afraid of :(

    I'll see if I can find the book you recommended next time I'm at the library.

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  2. No need to be afraid. The online brokerages offer competitive rates and a wide variety of extremely safe bonds.
    And you should know, it is true that even the millionaire has no guarantee of getting an experienced advisor. Many people can be easily misled in the field of personal finance if they lack someone with experience advocating on their behalf.
    the flawed nature of the investment industry creates this terrible conflict of interest where advisors face a constant pressure and reminder that they are selling you products and this ultimately leads inexperienced advisors and investors into highly inappropriate asset classes and allocations.
    trust me on the book. it's no 'get-rich-quick-without-working-for-a-living' mantra. but it's the straight goods on how the fixed income market works from someone who built several large institutional and retail bond desks. This guy is a straight-forward, powerful and experienced mind.
    i also recommend 'The Ascent of Money' and 'The Black Swan'.
    the financial analysis of history and probability examined in these two books explains a great deal about my investing attitude.

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