I’ve read more than my fair share of books on bonds and have always ended up feeling—well, stupid. Somehow I never seemed to grasp the fundamental structure of bonds. I understood the periphery but not the core. I am happy to report that my stupid days are now behind me, at least on the bond front. Jason Brady’s Income Investing: An Intelligent Approach to Profiting from Bonds, Stocks, and Money Markets (McGraw-Hill, 2012) made all the difference. (And not because it has the word “intelligent” in its subtitle.)
I suspect that Brady might be surprised at my eureka moment. He has, after all, written a practical book for investors who are reaching for yield (something that, as he explains, might be a chimera), not a guide for the perplexed. Nevertheless, when he described bonds in terms of options everything fell into place for me. Bingo!
Brady suggests that we “think about investment in fixed income as selling an option.” (p. 102) Bonds have an asymmetric payout profile, so “both in purchasing a bond and in selling an option the investor takes a small risk of a larger loss in order to receive some small payment.” (p. 106) Not exactly the clichéd picking up nickels in front of a steamroller, but certainly more dangerous than many bondholders have been led to believe.
Corporate spreads are, for instance, highly correlated to the VIX. “So when volatility spikes during market stress periods like the Asian Financial Crisis, the Enron/WorldCom debacle, or the Global Financial Crisis of 2008/2009, corporate bonds react in a very nonlinear way. To put it another way, bond investors look at the value of their coupon payments when times are good, but look to the value of the assets that they’re going to receive when times are bad. When the overall value of the asset has a chance to move below the strike price because of volatility spikes, the premium on the covered call suddenly becomes a lot less immediate than the claim on the asset itself.” (pp. 113-14)
One point that Brady hammers home is that yield is a terrible measure of return. There is, however, one place where yield can have value—as a downside cushion. “For most fixed-income instruments, the only protection the investor has against loss is the income return of the bond. There are any number of ways to lose money in bonds and not very many ways to get more than yield. But when prices decline for whatever reason, the total return you receive from bonds can still be reasonable if the yield on the bond is high. … The margin of safety in U.S. Treasuries is low.” (pp. 116-17)
Unlike investors in stocks (well, at least during bull markets) corporate bond investors are a gloomy lot, in part because they have sold the upside to stockholders. Bondholders want a low volatility environment; stockholders want stocks to move ever higher.
One way for the income investor to bridge the gap between bonds and stocks is by owning dividend-paying stocks which, when things go reasonably well, provide both income and capital appreciation. Dividend payers, by the way, have a record of outperformance. From January 1992 to June 2011 the DJ Dividend Select Index had a total return of 12.8% whereas the DJ Total Stock Market Index returned 9.8%. The MSCI World High Dividend Yield Index returned 10.7% as opposed to 2.3% for the MSCI World Index. And the MSCI EAFE High Dividend Yield Index returned 11.8%, the MSCI EAFE Index 7.2%. Somewhat counterintuitively, “the outperformance by dividend-paying stocks is not just due to their income properties, but due to the growth of earnings as well.” (p. 152)
Investing in dividend-paying stocks has been something of a fad of late, but the fad may be waning. For a short-term take on rotation out of these stocks, I suggest Bespoke Investment Group’s piece from August 17, "How Rising Rates Make Dividend Stocks Less Attractive."
Brady describes several income-producing vehicles that investors might want to consider. In whatever way investors structure their portfolios, however, they should always exercise due diligence, diversify their holdings, and stay the course.
I’m pretty sure that I’ll be the only slow learner to thank Brady for looking at bonds through the lens of options. Moreover, I apologize to the author for not giving equal time to some of his other ideas. But eureka moments happen rarely these days, and I am very grateful for them.