How did you get started working with bonds?
For me, I started as a cold caller for a bond desk, and the way for me to be successful at that time was to understand what I was trying to sell advisors. I came from a regular investment advisory background as an intern and had no exposure to individual bonds because we only used mutual funds. For me, it was a lot of digging into Bloomberg, looking at bonds and trying to figure out what made one bond cheap and what made another bond not cheap. I had to learn how bonds could be used in any account and why someone would want muni bonds versus corporates or CDs. There’s always value to be found in bonds, and its ultimately just pattern recognition. The question is, where is it and how can you utilize it best for a client? It’s almost like looking for used cars. If you understand the resale value of Toyota Priuses, you can quickly spot one that’s mispriced. What drove me was A) understanding the value of bonds, B) understanding how I could make money for clients using bonds, and C) understanding how I could add value by mixing types and structures of bonds.
Let’s talk about the life cycle of an individual bond. Who interacts with bonds as they move through the market?
The bonds we work with are primarily coming out of an individual investor’s account, so we seek value in finding small bonds versus big bonds. Traditionally, a bond is issued and chopped up into million-dollar blocks, then divvied up from there into individual client accounts. That’s the more retail path, so we find value when that bond comes out of the individual account. It may not have traded for two or three years, but ultimately the little guy takes a haircut. Say John Smith wants to sell ten of the fifty bonds he has, but there’s not a market for that because Morgan Stanley wants to buy a million and be expeditious with it. So, it goes to a “broker’s broker” who get bids on the bond through an auction-style process. Ten to fifteen traders see that bond, they all put a number on it, and if the price is $110 a bond, they think, “I’m going to need to make a cut on it, and the trader is going to need to make a cut on it.” They start bidding at a level they think they can profit at and sell the bond back, which ultimately goes into a client account. Personally, at various points in my career, I’ve been at all different levels. I’ve either been supplying a broker’s broker with retail bonds, I’ve been bidding on the bonds at auction, and now I’m trading for clients.
What’s the difference between buying individual bonds and investing in bond funds?
In terms of returns, it’s more about what you’re trying to do. If you want to buy the Vanguard Total Bond Fund, it’s a one-size-fits-all option as you’re buying whatever Vanguard thinks is the best representation of the bond market. You can have a mix of treasuries, preferred, credit card debt, auto loans, and treasuries because they’re just trying to mimic the total bond market. It’s like going into Walmart and buying a shoe. It’s not necessarily a running shoe or a dress shoe; it’s just a shoe. Different people have different needs, and if you’re a high net worth, tax-sensitive client, you’re going to want to buy things like municipal bonds. Everyone is looking for opportunities to find the shoe that fits best, and we try to get the most bang for your buck as opposed to throwing you in with everybody else. You could buy five million dollars or five hundred million dollars of a bond fund, and your returns are going to be exactly the same, but if you’re a sophisticated investor with specific needs that might not be the best fit.
If you’re a retail investor, how do you make the jump from bond funds to individual bonds?
I wouldn’t do it on my own. Bond math is fairly simple, but it’s sometimes difficult for people to understand. The math is easy addition and subtraction, but you have to understand the potential pitfalls. You can look at a bond and say, “that’s yielding 3%, but the possibility of default could be 50%”, so your expected value could end up being very low. It’s similar to doing your homework in high school where zeros hurt you more, so you need to be very careful of default risk and reinvestment risk. It’s often difficult managing all those different pieces. Once you reach a certain level, if you want to buy individual bonds (which I think is beneficial for everybody), you need to have somebody who knows what they’re doing. Otherwise, you could get charged too much, get terrible yield, or deal with default risk and a number of moving parts that could put you in a worse position than a bond fund would.
How would you compare the bond market to the equity market?
In terms of size, it’s much larger than the equity market. Every single person’s mortgage is in there along with all the debt for corporations, which is often higher than their equity (especially for lower credit quality institutions.) On top of that, every single government that has to build bridges, roads, and stadiums is issuing debt. This variety of options allows you to customize the level of yield and the level of risk that you want with more predictability than equities, based on the types of bonds you buy in a portfolio.
What are your thoughts on the status of the current global bond market?
The worldwide bond market is at an all-time high, which isn’t necessarily a good thing though that may seem counterintuitive. You have to remember, the interest paid on bonds is relative to a par value. If bonds are trading high (or at a premium to par value), the yield relative to your purchase price is lower than the stated yield. You’ve got negative rates in Europe, and you’ve got negative rates in Japan, so the US still has a relative value. For example, five years ago, Greece was on the rocks, they were instituting austerity measures, and everyone thought they were going to go bankrupt. Right now, the Greek 10-year treasury is lower than the U.S.’s, so from a relative value standpoint, the US is still very attractive worldwide. However, bonds at large are as expensive as they’ve ever been.
Are there any bond-specific resources that you recommend for investors?
I really like Howard Marks; he’s a bond guy who works more in distressed debt. He has a book called The Most Important Thing, which is actually twenty important things that are relative to the bond market and the equity market. Things like the importance of price, potential returns, how much distress is built into the price, and if people are over-buying just because they feel good about it as opposed to what the actual fundamentals are. Jim Grant, who is pretty esoteric and typically bearish, is an excellent resource. His stuff is expensive, but his podcast is high-level and interesting even though sometimes I disagree with him. There’s a great book called Adventures in Muniland, which gives you an idea of what it looks like to buy and trade munis. Investinginbonds.com is the government website where they explain yield, fair value, and where you can buy bonds in very simple terms. It’s a bit tougher than reading about the equity market, just because it’s not nearly as sexy, but I would look around as there are plenty of great resources out there.
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