The only guide to a winning bond strategy you ll ever need the way smart money preserves wealth today

THE ONLY GUIDE TO A WINNING BOND STRATEGY YOU’LL EVER NEED Also by Larry E Swedroe The Only Guide to a Winning Investment Strategy You’ll Ever Need The Successful Investor Today Rational Investing in Irrational Times What Wall Street Doesn’t Want You to Know THE ONLY GUIDE TO A WINNING BOND STRATEGY YOU’LL EVER NEED The Way Smart Money Preserves Wealth Today LARRY E SWEDROE AND JOSEPH H HEMPEN A TRUMAN TALLEY BOOK ST MARTIN’S PRESS NEW YORK THE ONLY GUIDE TO A WINNING BOND STRATEGY YOU’LL EVER NEED Copyright © 2006 by Larry E Swedroe and Joseph H Hempen All rights reserved Printed in the United States of America No part of this book may be used or reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles or reviews For information, address St Martin’s Press, 175 Fifth Avenue, New York, N.Y 10010 www.stmartins.com Library of Congress Cataloging-in-Publication Data Swedroe, Larry E The only guide to a winning bond strategy you’ll ever need : the way smart money preserves wealth today / Larry E Swedroe and Joseph H Hempen, p cm “A Truman Talley book.” ISBN 0-312-35363-4 EAN 978-0-312-35363-6 Bond Portfolio management Investments I Hempen, Joseph H II Title HG4651.S94 2005 332.63'23—dc22 2005052949 10 To the employees of Buckingham Asset Management, BAM Advisor Services LLC, and the advisors at the more than one hundred independent fee-only Registered Investment Advisor firms with whom we have strategic alliances Each and every one of them works diligently every day to educate their clients on how markets really work and on the benefits of a prudent, long-term investment strategy Contents Introduction One: Bondspeak Two: The Risks of Fixed-Income Investing Three: The Buying and Selling of Individual Bonds Four: How the Fixed-Income Markets Really Work Five: The Securities of the U.S Treasury, Government Agencies, and Government-Sponsored Enterprises Six: The World of Short-Term Fixed-Income Securities Seven: The World of Corporate Fixed-Income Securities Eight: The World of International Fixed-Income Securities Nine: The World of Mortgage-Backed Securities Ten: The World of Municipal Bonds Eleven: How to Design and Construct Your Fixed-Income Portfolio Twelve: Summary Afterword Appendices Notes Glossary Acknowledgments Index The inconvenience of going from rich to poor is greater than most people can tolerate Staying rich requires an entirely different approach from getting rich It might be said that one gets rich by working hard and taking big risks, and that one stays rich by limiting risk and not spending too much —Investment Management, edited by Peter Bernstein and Aswath Damodaran THE ONLY GUIDE TO A WINNING BOND STRATEGY YOU’LL EVER NEED See also retail market Buffett, Warren, 187, 207 buy-and-hold strategy, 64–65, 83–84, 213–14 callable bonds, 14–15, 63, 123 GSE, 101 high-yield (junk bonds), 129 interest rate changes and, 23 municipal, 166 risk and return from, 86, 219–21 callable preferred stocks, 135–37, 139 capital-gains taxes, 205 Cardano, Girolamo, 85 Carhart, Mark M., 61 cashflow,timing and control of, 4, 194, 199, 229 CDs (certificates of deposit), 110–13 certainty-equivalent pretax abnormal return, 204 Chamfort, Nicholas, 58 children, Treasury bond advantages for, 94, 97–98 clawback provision, 129 Clements, Jonathan, 212 CMOs (collateralized mortgage obligations), 156, 162–64 Cohen, Marilyn, 55 commercial paper, 103–6 Consumer Price Index, TIPS bonds and, 89–90 convenience of money-market funds, 109 of mutual funds, 189 conventional wisdom, 57–59, 165 convertible bonds, 140–41 convexity, positive and negative, 157 corporate bonds, 121–41 credit ratings of, 26–28, 121–23 lack of transparency of, 124 number of issues of, 217 safety of, compared to municipal bonds, 27–28, 36, 123, 175–77 See also high-yield bonds (junk bonds) coupon interest rate, interest rate changes and, 23 coupon yield, 17 credit ratings of bonds, 26–28, 121–23 of foreign bonds, 146 of municipal bonds, 167–68 of preferred stock, 136–40 credit risk, 25–29, 66–67 of CDs, 113 of commercial paper, 104–5 diversification and, 33–34, 143 of municipal bonds, 167–68, 175–83 reward for, 78–81 cross trades, 196 currency risk, 72, 144–45 CUSIP (Committee on Uniform Security Identification Process), 50 default See credit risk defeasance, 181 deflation, TIPS and, 92, 93 DFA (Dimensional Fund Advisors), 76 discount bonds, 13–14, 166, 172 diversification, 29–34 corporate bonds and need for, 67, 124–25 GSEs and, 102 high-yield bonds (junk bonds) and, 134, 192 international, 142–46 maturity and, 71, 79, 81 municipal bonds and, 67, 168 by mutual funds, 190–91 of portfolio, 190–92 of risk of calls, 86–87 by stable-value investment vehicles, 119 TIPS and, 92 Treasuries and, 88 Duff & Phelps, 25, 113 duration, 23–25 EAFE Index, Treasuries’ maturity correlated with, 71–72 Edison, Thomas, 7, 187 Education Bond Program, I bonds and, 94 education bonds, 177 education savings of EE bonds, 97 Edwards, A G., 27 EE bonds, 96–99 efficient frontier models, 132, 239 Ellis, Charles, 7, 154, 187 emerging-market bond funds, 150–52 Emerging Market Bond Index, 148 emerging-market bonds, 130, 146–52 EMH (efficient market hypothesis), 59–65, 84 equity risk, and type of tax account, 132–33 ETFs (exchange-traded funds), 31–32, 188–92, 203, 214 Eurodollar CDs, 112 Evans, Michael, 64 event risk, 35–36, 122 Fama, Eugene F, 66, 73–75 Fama-French research, 66, 126 Fannie Mae (Federal National Mortgage Association), 99, 101, 121, 155 MBS of, 155, 161, 164 fat tails, 131, 152 FDIC (Federal Deposit Insurance Corporation), 110,112–13 Federal Farm Credit Banks, 99, 101, 107 Federal Home Loan Banks, 99, 101, 107 Federal Reserve system, 21, 137 eligible collateral for, 104 Financial Guarantee Insurance Company, 178 Financial Security Assurance Inc., 178 Fitch (Ratings), 25, 28, 58, 113, 176 fixed-income investing in corporate securities, 121–41 costs of, 40–41, 48, 67, 83, 128, 193 equity investing compared to, 32 GSEs in See GSEs increasing complexity of, 7–8 inflation protection in, 95 international short-term assets in, 72–73 investment policy statement for, 209–11 motivations for, 3–4 prudent strategy for, 4–5, 67, 213–14 to reduce risk of equity portfolio, 72–73, 144, 161 in retirement, 206–7 risk and, 4, 9, 22–39, 66–84 shifting-maturity approach to, 73–77 short-term securities and, 103–20 TIPS strategy for See TIPS withdrawal stage of, 81–82, 206–7 fixed-income specialists, 196 Flow of Funds report, 42 forecasting consensus, 64 of future yield curves, 73–77, 201 of interest rates, 64, 202, 213 of the market, your need to ignore, 212 401(k) and 403(b) plans, 114, 117, 120, 205 Franklin, Benjamin, fraud, 39, 49 Freddie Mac (Federal Home Loan Mortgage), 99, 101, 121 MBS of, 155, 161, 164 French, Kenneth R., 66, 126 funds active vs passive, 61–65, 67, 150–51, 203–4, 214, 235, 244 agency risk of, 38–39 cost of, 5, 67, 80–81, 109, 119, 150 performance of, compared to the market, 61–65 See also mutual funds and other specific types of funds GAN (grant anticipation note), 185 general money-market funds, 107 GICs (guaranteed investment contracts), 115–16, 118 Ginnie Mae (Government National Mortgage Association), 12, 50, 101, 155 MBS of, 155–59, 161, 164 Gonzales, Laurence, 133 GOs (general obligation bonds), 175–76 government bonds, 85–102, 191 corporate bonds compared to, 32–33 See also municipal bonds; Treasuries government money-market funds, 107 GSEs (government-sponsored enterprises), 11–12,99–102, 121, 191 guaranteed-interest funds See stable-value investment vehicles health care municipal bonds, 28, 176–77 hedge funds, 130 Henning, Fred, 57 high-yield bonds (junk bonds), 125–34 definition of, 79, 121, 242 as hybrid securities, 127 insurers that sold GICs financed by, 115 risk of, 134 skewness and kurtosis of, 130–32 and type of tax account, 132–33 volatility of, 79 Hirsch,Yale, housing bonds, 28, 176–77 hybrid securities, 5, 213 high-yield bonds (junk bonds), 127 preferred stocks, 137 I bonds, 93–95 indentures, definition of, 10–11, 241 industrial development bonds, 28, 176 inflation equities’ slightly negative correlation with, 90 Federal Reserve fight against, 21 MBS and, 159 TIPS and, 89–93, 222–25 inflation risk, 35, 82 initial offerings, 41, 87, 168, 193 liquidity and, 38 insurance companies long-term obligations of, 70 for municipal bonds, 178–80 interdealer market See wholesale market interest-income funds See stable-value investment vehicles interest rate risk (price risk), 23–25, 78 balancing reinvestment risk with, 198–202 diversification of, 202 international diversification and, 143–46 most of returns from, 33, 191 symmetric and asymmetric, 135–36, 158, 160 TIPS and, 90–91 interest rates avoidance of guessing about, 5, 202, 213 bond prices related to rise or fall of, 135, 157 forecasting of, by fund managers, 64 MBS and, 157–59 term structure of, 20 international fixed-term assets, 72–73, 142–53 CDs, 112 investment advisors See RIA; separate account managers investment banks, 41 investment-grade bonds, 26–28, 121–22, 242 investment policy statement (IPS) See IPS IOs (interest-only bonds), IPS (investment policy statement), 207–11, 213–14 IRAs (individual retirement accounts), 114, 117,205–6 James, Bill, 65 Jensen, Michael C, 59–60 JP Morgan, 148 junk bonds See high-yield bonds kurtosis of emerging-market bonds, 147 high-yield bonds and, 130–32 laddering, 32, 198–202 letters of credit as backing of municipal bonds, 180 leveraged buyouts, 36 lines of credit as backing of municipal bonds, 180–81 liquidity and credit enhancements for municipal bonds, 178, 179 of EE bonds, 97 of emerging-market bonds, 148 fixed-income investing and, 2–4, 78, 214 of GSE securities, 100 of high-yield bonds (j un k bonds), 128–29 of municipal vs corporate bonds, 44 of stable-value investment vehicles, 117 liquidity risk, 37–38, 82–84 load funds, 152, 189, 214 loans, bonds contrasted to, 10 long-term bonds See maturity lottery tickets, 131 Macaulay duration, 24 McEwen, Lillian A., 49 MacKay, Charles, 146 market as big insurance company, 22 efficiency of, 59–65, 84 two theories on, 57–58 See also specific markets Markowitz, Harry, 142 markup and markdown, 46–52, 169, 189, 192 Marquis, Don, 59 MARS (municipal auction rate securities), 183–85 matrix pricing, 130 maturity, 11 best strategy for problem of, 213 of commercial paper, 104 credit risk and, 27, 66, 78–81 games brokers play with, 51–54, 193 inflation risk and, 35 laddering of, 199–202 long-term, 70, 213, 229–30 of money-market funds, 106 of preferred stocks, 135, 138 reinvestment risk and, 35 Sharpe ratio and, 68–69 shifting, in fixed-income investing, 73–77 See also yield curves MBIA Insurance Corporation, 178 MBS (mortgage-backed securities), 8, 15, 50, 154–64 equities correlated with, 159–61 interest rate risk and, 23–24 reinvestment risk and, 35, 160 mean-variance analysis, 132 Mencken, H L., 57 Merck, credit downgrading of, 122 mergers, event risk and, 36 modified duration, 24 money-market funds, 106–10 2004 yield of, 113 short-term municipal securities compared to, 183–85 stable-value investment vehicles compared to, 117 Moody’s (Investors Service), 25–27, 58, 104–5, 113 Momingstar, 63, 146 mortgage-backed securities See MBS mortgage pass-through certificates See MBS MSRB (Municipal Securities Rulemaking Board), 45,48–49, 216–17 multifamily housing bonds, 28, 176–77 municipal bond funds, 63, 169, 173–74 municipal bonds, 165–86 credit enhancements for, 177–83 credit risk of, 167–68, 175–83 how an individual should buy, 45 initial offerings of, 41, 168 lack of liquidity and transparency in market for, 43–45, 47, 86, 168–69, 218 lack of volatility of, 170–71 newest vs older issues of, 83–84 number of outstanding issues of, 45, 217 pre-refunded, 181–83 price risk of, 166–67 pricing information on, 216–18 safety of, 27–28, 36, 123, 175–77 short-term, 183–86 size of trade in, 47–48, 168 taxable, 186 taxes and, 36–37, 69, 166, 172–75 two types of, 175 yield curve for, 69–70, 167, 171–72 municipal money-market funds, 107–8 mutual funds, 31–32 convenience of, 88, 189 costs minimized by, 192–93 for corporate bonds, 80–81 diversification and, 34, 190–91 harvesting tax losses in, 193 high-yield bonds (junk bonds) and, 134 “hot money” buying into, 194 for international diversification, 145–46 with loads, 214 MBS and, 160–61 PABs bought by, 173 performance of, 61 SEC yield of, 19–20 See also funds; money-market funds Napoleon, 187 NASD (National Association of Securities Dealers), 217 NAV (net asset value), 32, 106, 110, 116, 161 newest issue vs older issue securities, 37–38, 83–84, 192, 214 noninvestment-grade bonds See high-yield bonds (junk bonds) notes, Treasury, 11, 88 offers, 45–46 opaque market prices, 42, 47, 52 open-end mutual funds, 32 OPIC (Overseas Private Investor Corporation), 99 PABs (private activity bonds), 172–73 passively managed funds, 61–65, 67, 150–51, 203–4, 214, 235, 244 Pasteur, Louis, Paydenfund, 150 PEFCO (Private Export Funding Corporation), 99 pension plans, long-term obligations of, 70 PIMCO fund, 150 portfolio advantages of individual securities in, 193–97 asset location decision for, 202–6 designing and constructing, 187–211 laddering of, 32, 198–202 risk factors of, 66–67 of stable-value investment vehicles, 115–16 POs (principal-only bonds), preferred stocks, 134–40 corporate buyers of, 138–39 reasons for issuance of, 136–38 premium bonds, 12–13, 182 games brokers play with, 52–53 pre-refunded bonds, 181–83 price risk See interest rate risk price spread See bid-offer spread primary market, 41, 83–84 principal-preservation funds See stable-value investment vehicles prospectus, 11 PSA (Public Securities Association) model, 159 puts, 16, 112 RAN (revenue anticipation note), 185 regulatory risk See tax risk reinvestment risk, 34–35, 136, 160, 198–202 REITs, 203–4 retail market, 41–42, 50 See also brokers retirement fixed-income investing in, 206–7 stable-value investment vehicles and, 114–15 revenue bonds, 175–77 Reynolds, Brian, RIA (registered investment advisor), fee-only, 196–97, 214 risk, 215 best taken in equity section of portfolio, 141 of corporate bonds, 122–23, 127 eight types of, 22 of emerging-market bonds, 147–49 of equity portfolio, 72–73 fixed-income investing and, 4, 9, 22–39, 66–84 of high-yield bonds (junk bonds), 134 of MBS, 156–60 of money-market funds, 109–10 return and, 67–70 of stable-value investment vehicles, 116–17 standard deviation as measure of, 131–32 of stocks over Treasury bills, 30 systematic vs unsystematic, 29–32 yield as price of, 17, 26 Ross, Ron, 142 sabermaticians, 65 Samuelson, Paul, 142 savings compared to investing, 103 money-market funds as, 108–9, 183 stable-value investment vehicles for, 114 Schwed, Fred, SEC (Securities and Exchange Commission), 49 commercial paper exempt from regulations of, 104 secondary market, 42–44, 83–84, 168–69, 193 sector funds, 31 SEC yield, 19–20 selling short, 171 separate account managers, 194–97, 214 serial bonds, 11 serial correlation, 129–30 Sharpe, William, 22, 68 Sharpe ratio, 68–69, 130, 148 Sherden, William, 64 shifting-maturity approach, 73–77, 199–202 short selling, 171 short-term bonds See maturity sinking funds, 15–16 size of company, as risk factor, 66 skewness of emerging-market bonds, 147 high-yield bonds and, 130–32 small-cap stocks, 134, 204 S&P 500 Index, Treasuries’ maturity correlated ith, 71–72 S&P 500 Index funds, 31, 190 stable-value funds See stable-value investment vehicles Stable Value Investment Association, 114–15, 117 stable-value investment vehicles, 113–20 recommendations on, 119–20 Standard & Poor’s, 25–26, 58, 104–5, 113, 176 standard deviation as measure of risk, 131–32 “step-down” feature of some CDs, 111 stock market, risk factor of, 66 STRIPS, 88–89 Swensen, David, 125 syndicates, 41 systematic risk, 29–30, 32–33 T R Price fund, 150 TAN (tax anticipation note), 185 taxable and tax-deferred investing, asset location and, 202–6 taxable money-market funds, 107, 108, 184 tax-deductible interest expense, 175 tax-exempt money-market funds, 107–8 tax losses, harvesting of, 193–96 tax risk, 36–37 Templeton, John, 165 term-to-maturity, and risk, 66–67 TEY (tax equivalent yield), 19, 108 three-factor model, 66, 126 TIAA stable-value funds, 120 TIPS (Treasury Inflation-Protected Securities), 35, 89–93, 222–30 allocation between nominal-return instruments and, 226–28 tracking error, 190 TRAN (tax and revenue anticipation note), 185 tranches of CMOs, 162–63 transparent market prices, 42 transportation bonds, 177 Treasuries, 11–12,85–89 as benchmarks, 87 bills, 11, 88 diversification not needed with, 190–91 EE bonds, 96–99 I bonds, 93–95 inflation-protected, 89–95 initial offerings of, 41, 87 maturity dates of, correlated with indices, 71–72 notes, 11, 88 on-the-run vs off-the run, 37–38, 83–84 positive convexity of, 156–57 risk and returns from, 68, 80 secondary market for, 42, 47 spread between corporate bonds and, 21, 125–26 tax advantages of, 86, 90, 92–94, 96, 193 Web site for, 87 yield curve for, 69–70 zero-coupon bonds, 88–89 See alsoTIPS TreasuryDirect program, 41, 87, 190 Treasury-only funds, 107 TRP (Transaction Reporting Program), 216 TVA (Tennessee Valley Authority), 99, 101 Twain, Mark, 103 two-factor model, 66–67, 82 underwriters, 41 Uniform Prudent Investor Act, 62 unsystematic risk, 29–32 value stocks, 134, 204 Vanguard group, 39–40,76–77, 134, 161, 190, 197 Van Kampen World fund, 150 venture capital, 130 volatility currency risk and, 144–45 of emerging-market bonds, 147 extending maturities and, 78–79 of fixed-income assets, 72, 223 price, 46, 47 of zero-coupon bonds, 89 VRDOs (variable rate demand obligations), 183–85 water and sewer revenue bonds, 177 West, Scott, 40 wholesale market, 42, 46, 50 advisors’ and managers’ access to, 195, 196 withdrawl stage of investment, 81–82, 206–7 wrapped bonds, 115–16, 118–19 Yankee CDs, 112 yield curves, 20–21, 69–70 best estimate of future, 73–77, 201 yield-to-call, 18 yield-to-maturity, 17–18, 52–54 as unknown for MBS, 159 yield-to-worst, 18, 53–54 zero-coupon bonds, 16–17, 35 duration of, 25, 89 Treasuries, 88–89 Zweig, Jason, 212 ... Investing in Irrational Times What Wall Street Doesn’t Want You to Know THE ONLY GUIDE TO A WINNING BOND STRATEGY YOU? ? ?LL EVER NEED The Way Smart Money Preserves Wealth Today LARRY E SWEDROE AND JOSEPH.. .THE ONLY GUIDE TO A WINNING BOND STRATEGY YOU? ? ?LL EVER NEED Also by Larry E Swedroe The Only Guide to a Winning Investment Strategy You? ? ?ll Ever Need The Successful Investor Today Rational Investing... Investors need to also consider measures known as “yield -to- call” and “yield -to- worst.” The yieldto-call is a return calculation that treats the call date as the maturity date An example will illustrate