Understanding Total Returns for Bonds

As part of my 2008 Finanical Goal, I plan to evaluate various types of bond investments, post about them and then select one for purchase. First, I want to examine how individual bonds provide returns.

Understanding stock returns is pretty straight forward - market price plus dividend, but Bond returns are a little more complex. In talking with friends and co-workers I realized that very few people are comfortable with how bonds work. In the book, Bogle on Mutual Funds, there is a very good explanation that I bookmarked for future reference. I have summarized Bogle’s description and added a few of my own comments, of course.

Bond returns are comprised of three items:

• Initial yield
• Reinvestment rate
• Impact of Rate change on market price

The primary factor by far is the initial yield – it is the major determinate of the future return on a bond.

One might assume that a bond with an 8% coupon would achieve a return of 8%, if held to maturity. This is not always correct, because of the reinvestment factor. US Govt bonds pay a semiannual interest coupon that is reinvested at the current rate (not the initial rate). If the new rate is less than 8% the return will also be lower and conversely if the reinvestment rate is higher the corresponding total return will also be higher. The following table illustrates the importance of the reinvestment factor for a 20 year Govt bond (8% coupon, $10,000 investment).

The third item, rate change, impacts the bonds market price and is only a factor if the bond is not held to maturity. An increase in rates will reduce the market value of a bond. Many have trouble with this concept. Here’s my explanation. If rates are increasing and you are holding a bond at a lower rate it is no longer as desirable (valuable) because better rates can now be had. You are locked in to your initial rate, but of course the semiannual coupon is being reinvested at this new higher rate. So not all is bad with raising rates – just don’t sell into that environment.

The table is somewhat misleading because rates rarely stay the same for 1 year let alone 20. For a 20 yr bond there will be 40 semiannual reinvestment dates. That will result in a lot of averaging of the overall reinvestment rate. The effect of averaging over a long time period explains why the impact of reinvestment rates is not the primary force in bond returns.

When Taxes exceed living expenses!

My total federal tax bill is frightening. I don’t hear anybody else complaining about their tax bill, anymore. They must have lots of deductions. In fact, the only worry I hear is that they might get hit with AMT! AMT was designed to snag those folks that have lots of deductions. Its kind of mysterious – nobody can tell you what trips the AMT hammer. And none of my co-workers have ever paid AMT or know anyone that has! But, thanks to the media, everyone is talking about it. The fact is only 3% of taxpayers actually fall into the AMT crosshairs.

As I said my tax bill is appalling. Not only is it the single largest expense that I have, it exceeds all of my other living expenses combined.
Think about that…..

How is this Possible?
No 1. I own my own home, so I have no mortgage payments. This reduces my expenses significantly.

No 2. I am definitely frugal – I hate to spend money. Not only do I hate to use money, but I hate to waste things. Things like water, gas, food, you name it - I try to conserve it. I am not suffering. I live in a very comfortable, nice home with a large yard. I have two vehicles and several recreational toys – all are older models and paid off. I could afford much more, but its not necessary and I would not want the associated extra expense and waste that would go along with bigger, fancier places and things.

Calculating my Tax to Expense ratio
Anyway back to the taxes. I pulled up my last 2006 tax return and fired up MS money to get my total expenses for 2006. Dividing my federal tax paid by total expenses equates to a ratio of 1.21. So, my taxes are 121% of my expenses. Just wonderful. It won’t be long before I will be calculating my 2007 tax to expense ratio. From the preliminary data, I expect to set a new personal best (PB) for excess taxation. I can hope and wish for a fair tax or a consumption tax someday, but the reality is none of our politicians have the guts to completely overhaul the tax system. As bad as the tax system is today, I fully expect it to get worse.

On the Bright side - We are in a Tax Holiday
For now, we should all enjoy our tax holiday, because someday soon we are going to pay for the lack of this governments fiscal management. The country has a budget, just like a household and when expenses exceed income then we either have to cut those expenses or make more income. Pretty simple. The country gets its income from you in taxes. So, since the US has already bought the Iraq war and SS and Medicare are untouchable expenses, its clear we will have to pay for these things with higher federal taxes.

Testing an Asset allocation in Bull and Bear markets

Ever wonder how your portfolio would hold up in a prolonged down or Bear market? How about evaluating the upside during a Bull market? With so many different asset allocations (Couch Potato, Intelligent Asset Allocator, Coffeehouse, Bogleheads, etc ) how do you know if you have the right mix?

One way to better understand your asset plan is to take it back in time to Bull and Bear markets. This can prepare you for what might happen in the future and help you evaluate how much risk you are willing to take. If the returns projected for a Bear market make you uncomfortable then you can use that information to adjust your holdings.

Note that there are many types of bear markets. Some hit the financial sector hard, while others hit technology stocks and so on. But in general, for a market to be considered a true bear market it will weigh down almost all types of stocks, just in different degrees.

Asset Allocation
As part of my personal financial plan, I have set up an asset allocation for my holdings. I call it the CoffeeHouse Portfolio with a Double Espresso Shot. The allocations for each holding are shown in the following table. The dollar amount of the asset is divided by the total dollar amount of the portfolio to arrive at the “weighting” for each fund or stock in the portfolio.

Now for more explanation on the allocations. The Fixed Income asset type is actually a money market account. The 40% allocation to Large CAP stocks has been broken down into three subcategories: Health care fund, defense contractor stocks and technology stocks. So, health care is actually 28% (0.7*40) of my holdings, defense is 10% and technology 2%. I broke these out because their performances vary drastically.

Market Returns
Now that we have the weightings, we need the returns for each market. The return data is based on stock or fund price data with the exception of the Fixed Income (Money Market fund). Because MM funds maintain a constant $1 price, the yield data was averaged across each time span. The stock and fund price data that was used in this table does reflect distributions as the price is adjusted when capital gains and or dividends are distributed. All of the price data was gathered using historical data from Yahoo finance.

For the Bull market example, I used the recent run from January 2006 to December 2006. The Bear market returns are from the couple of years following the irrational exuberance of the 90’s. I used prices beginning on 8/25/2000 and ending 10/7/2002 to calculate the total return during this Bear market. The next step is to multiply the asset weighting times the Bear or Bull returns for each asset class. For instance, the 5% fixed income allocation times the 3.8% bear return equates to a performance weighting of 0.19%. Each performance weighting is calculated and then added up to arrive at the total performance for the portfolio.

Bear and Bull Performance
This is how my portfolio would have performed in a Bull and a Bear market. For the Bear market, the portfolio would have returned 2.01%. It’s a small amount but at least its positive. Most people during this time frame lost a lot of money. For the Bull market, the total return was 21.98%.


If we look a little deeper into the mix, its apparent that Gold and Defense stocks were huge positive factors during both of these runs. Real Estate (REIT) was also a bright spot. One might be tempted to overweight in these sectors, but that could make this portfolio vulnerable to other types of bear markets.

When I first started this exercise, I wasn’t sure what to expect. But, I am pleasantly surprised. From this data, it appears that the portfolio has a good mix of assets that includes sectors that have low correlation to one another. This is a key to any asset allocation. However, I would like more data points. I plan to take this portfolio back in time again to several other Bear markets and post about it within the next month.

Smart Choices made easier with on-line product reviews

One of the best things about on-line shopping is the product reviews. They can be very helpful in narrowing down a large selection of similar items. For instance, how do you choose between the hundreds of different types of bar soap? I would prefer to buy the better quality soap, but how would you know without trying each type or finding a Consumer Report on everything you buy. So I am left with such discriminating factors as: Price, “what mom always bought” and catchy advertisements.

Now, with internet shopping those days of shopping blind are gone. If you are willing to try new products based on the reviews of others you may be surprised at how many great products are out there that just don’t have the shiny advertising to bring them to the front.

For example, I learned a valuable lesson about advertising and quality way back in high school chemistry class. I was truly amazed, at the time, that the most prolific, well-known brand of antacid did not perform nearly as well at neutralizing acid in a lab beaker as a much lesser known product. I wondered “How are we to know the best products without testing and reviews?” Now, I know of at least one way.

Just for fun I have listed some other benefits of internet shopping:

• Shopping from home in my PJ’s
• Comparison shopping across hundreds of stores
• Variety, there’s an abundance of similar products to choose from
• Free shipping offers with minimum purchase
• On-line coupons are easy to search for and find
• No taxes applied, if out of state
• No hassle from sales associates
• No waiting in line at the checkout
• Shopping lists are remembered at the on-line site
• Its delivered to my door

Any others?

Value Investing - seldom popular, always prudent

The first PF books that I ever read advocated a form of value investing. For instance, Peter Lynch’s Beating the Street, and the Beardstown Ladies common-sense investment guide expounded on the importance of due diligence. Doing your homework to find undervalued stocks and then buying and holding until everyone else got wise and bid up the price to a more reasonable valuation. Sounds easy. And if you have patience and courage, it is easy. It takes courage to buy a stock that no one else wants. It takes patience to wait for the market to figure out that stock XYZ is undervalued. Since I was new to investing, I thought this was the way everyone did it. LOL.

First Stock Purchase
I followed the advice and did my research. I had some brands that I liked and that I thought had some potential. From there I actually went to the library and checked out the Value Line. The Value Line’s Investment Survey provides an analysis of the company’s annual report giving an assessment of a company’s health and future prospects. Value line provided all of the ratios and financial data that I needed. I looked for such things as industry ranking, debt to asset ratio, price to earnings, management quality, etc. Finally, I had narrowed my stocks down to one – Apple computer. Apple was not in favor in the early 90’s, in fact, it was in distress. The perfect value play. I bought shares and held.

Value in Index Funds
I also looked for value plays in Mutual funds. I wanted low cost, broad based market funds. Since, I abhor fees and “no value added” expenses, I bought Index funds. My first selection was Vanguard’s S&P 500 Index followed by a couple more Small Cap Indexes and a Real Estate Investment Trust index.

The Dot Com Disaster
It was truly amazing. I got pulled in to fast and easy money. Why do all that work (due diligence) and then wait and wait? Instead, buy on momentum, jump on a stock when it's on it's way up, technical analysis is the mantra now. Yes, I made money, lots of money. Those were heady times – everybody was getting great returns – we had become stock picking genius’s and Warren Buffet and value investing was washed up. I was drawn into the crowd that kept saying that this was the “new economy”. All of that previous stock market history was meaningless. The favorite topic at the water cooler was the next hot stock………. And then I gave back a lot of money. For some reason, I am not sure, maybe it was sentimental, or just simple inertia, but I still held my Apple stock. My value play kept on.

Full Circle
The pain still lingers. That’s a good thing. I don’t want to ever forget the lessons from the dot com era. I cleaned out my stock portfolio. I sold off losers to offset capital gains from my Index funds. Then started reading value investment guides again, like The Intelligent Investor and Bogle on Mutual Funds. I have come back, full circle to value investing. I was fortunate, I only dabbled in dot com madness while maintaining my core index funds and of course my favorite value play: Apple. I am aware of a few co-workers and friends that poured everything they had into the skyrocketing market. And when it dropped, many assumed it was just a dip and used options to buy even more with borrowed money. That is a very painful lesson.

It will happen again and again
Don’t be fooled. After the 2000-2002 market dive, most of us were fearful of the market. We didn’t trust it with new investment dollars. So instead of buying into the market when it was cheaper, the crowd looked for a “new” type of investment. And the housing market took off…