Tuesday, August 21, 2012

The big question: Risk vs Return, Part 5

In this blog post, I'll discuss the probably very well known "credit risk", of bonds.

It is often the case that many people perceive that credit risk is the only kind of risk they are subject to when they invest in bonds, after all, it pains the most when suddenly your entire loan disappears after the other party's insolvency. But a lot of times, even if you buy the lowest rated bonds, the probability of a default is still relatively small. So although credit risk is certainly a type of risk that is worth paying attention to, you should not be completely bogged down by a loan's credit rating.

So, for those of you who don't already know what a credit risk is, it is the risk that, er, whoever you lend to ends up not having enough money to pay you back. In the worst case, they become Chapter 7 bankrupt.
Usually, there are tools that help you determine the credit risk for a particular bond, things called credit ratings. Ratings for large corporates and sovereigns (governments basically) are usually issued by large rating agencies, such as Fitch and Standard & Poor's. These agencies rate bonds based on whatever public information, usually for a fee, for the bonds issuer. The issuer then puts the bonds on the market branded with some kind of rating, ranging from A to D. The rating agencies actually use different rating schemes and A in Fitch may not necessarily mean A in S&P. But as an individual investor, I don’t actually think they matter that much. 

Unless you have a couple of millions to throw into this investment business, the chances are, you will not buy individual bonds straight from the issue. Reason being that most bond offerings require a purchases worth at least tens of thousand of dollars. Such big numbers greatly reduces the chance for people like you and I to diversify broadly, as we probably only have that much in total to invest. The reduced diversification is vastly detrimental to a successful investment, but the actual rationale for diversification will be the topic of a separate blog post. 

So ordinary folks usually buy bond indirectly from the secondary market in the form of mutual fund or some other kind of aggregate investment vehicle. There are two major advantages of buying a fund of bonds rather than actual bonds. Firstly, you get diversification. Many mutual funds contains a wealth of bonds within, in the order of thousands. For example, Vanguard Total Bond Market Index Fund has 5230 bonds with different maturities, different credit ratings and different sizes encapsulated. Seconds, the minimum investment requirement is a lot less. Take the same example, the Vanguard funds has a requirement of only 3k, that is probably 1/10 of what you need had you chosen to buy bonds from the original issuers. Of course, you have to pay the expense ratio on a mutual fund, so maybe if you had billions, you can achieve the same diversification without paying that annual 0.22%......

Now, back to credit risk. So I said that credit risk is not as bad as it looks. What I mean is, if you bought a mutual fund like the Total Bond Market Index Fund, with more than 7k bonds encapsulated, defaults are then truly just a statistics. And the good thing about statistics is that now things are predictable. Assuming those ratings are accurate (BIG caveat), then A-rated bonds should not default at all, while C-rated probably will default at 3%. If you simply subtract this percentage from the nominal yield, then you’ll have your expected return! That simple!

Junk bonds are perceived to have the worst credit risk, currently default at around 3-4%. They are not really “junk”, they are just “below investment grade”. Their default rate reached about 10% when Lehman Brothers went bust in the 2008 crisis. But junk bonds are especially sensitive to economic fluctuations since in bad times people try to flee from risky investments to safer ones, and one should not take that as a representation of the entire bond market. Most bonds in other ratings, although still suffered, had their default rate going up only slightly in 2008. 

So my take is that credit risk is far easier to control than interest rate risk for bonds with at least investment grade rating (B or higher), and therefore one should pay more attention to the latter rather than being bogged down in choosing between “A”s or “B”s. 

And personally, given both risks, I’d invest in intermediate-term investment grade bond funds. They offer OK yield with little credit risk. The bond market is at its historic highs, and interest rate is at a historical low. Intermediate-term bonds have only 5-10 years until maturity, which puts a limit on how much pain there will be when the interest rate starts to eventually go up. Given the Fed has indicated that the low interest rate environment will probably continue until 2014, my guess is that interest rate probably will go up by then.

Sunday, August 12, 2012

The big question: Risk vs Return, Part 4

In this post, we'll discuss the risk involved in bond investment.

Bonds are fascinating! They really are. Different to how most stocks' return comes from appreciation (price increase), bonds often are perceived as "income generating". Psychologically, it feels much less "guilty" for someone to consume their "income" rather than "investment", at least for me.  Think about it, if you bought 10000 shares of Facebook at 20 dollars a couple of days ago, and now it's 21 dollars, you've made 5% gain! But would you sell 500 shares to buy something? Instead, if it were bonds, and the bond somehow magically generated 5% interest in a month, it probably is much easier to transfer the interest to a bank account and use it as your income. Anyway, that's not the only reason they are fascinating :)

So the gains from bonds are actually pretty counter intuitive. This can be demonstrated through a question: Is interest rate increase a good or a bad thing for a bond that you hold? For many people without any investment education, the intuitive answer would be: "of course it's good, because more interest rate means more income per month!" Well, it's not exactly that straight forward, and most of the time, it's the opposite to the straight forward answer.

If you bought a bond from someone with an annual rate of 5%, and later interest rate increases for new bonds purchased from the same person / entity, your bond does not benefit. At all. Most bonds are fixed rate bonds and their interest rates are set when issued. Now what then, does the increase in interest rate mean for the bond your currently hold? It means, its price will drop. In this particular case, a lot, because the 5% hike in interest rate. How does this work?

Let's do the math. Imagine you bought a bond for 10k with 5% interest rate, the bond matures after 10 years (i.e. the principal will be paid off after 10 years). For simplicity's sake, let's assume the principal is paid off at the end of the 10 years. This means that you would have collected 10k * 5% * 10 years + 10k = 15k. This number is the total payment including both principal and interest. Of which, 5k is your return. Now the interest rate has risen to 10%. A different person, interested in these bonds, then has two choices:

  1. buy the bond from the original issuer for 10k, and expect 20k total payment in 20 years (100% return). 
  2. buy the bond from you, with a price such that a return of 100% over 10 years can be secured. Now you'll have to sell your bond at an discount to convince people to buy it from you. In this case, you would have to sell it at 7.5k, which means 100% return in 10 year given your bond's 5% interest rate. 
Through this simple example, you can see how interest rate fluctuations go completely against bonds' prices. And maybe you can also see, that the longer the bond has to wait until maturity, the greater price volatility. But note, that even if a bond's interest rate suddenly surges, usually they still have a much lower volatility than stocks. 5% interest rate change is considered "extreme" for bond, which result in 25% price drop of a 10 year, 5% yield bond, and the price drop is even less pronounced when the original yield is higher. For example, should the original yield in the last example we used be 10%, the price drop would have been 20% instead of 25%. One must also keep in mind that technically, if you give up liquidity, you can still make a profit with that 5% bond you hold in the example, you just need to wait for the entire 10 years, which will enable you to pocket that 50% return.

So this is the so-called interest risk. It's a risk that is present in almost all bonds, regardless of their ratings. Longer-term bonds with lower interest rate are especially tied to this type of risk, whilst short-term bonds are much less sensitive to interest rate changes. So next time when you seek yield, which normally leads you to long-term bonds, make sure that you factor in interest risk.

In the next post, I will touch on the other side of bond risk, the often-mentioned "credit risk". 

Sunday, August 5, 2012

The big question: Risk vs Return, Part 3

Generally, there are two ways of approaching stock selection based on their fundamentals.

  1. Value:
    Value companies are those that have a consistent track record of performance. E.g. Coca-Cola, Procter & Gamble ... These companies consistently generate profit, but they have little space to grow. These are sometimes also known as blue chips or dividend stocks. They typically have relatively low Price to Earning ratio, usually below 15.
  2. Growth
    Growth companies, as their name stands, are companies that are regarded to have a lot of potential in the future. They are typically new companies with limited history and possibly limited earning. Examples of this kind would be LinkedIn, Facebook, Salesforce, etc... Some of those companies don't necessarily have a positive income, (Salesforce), but the Wall Street regards them as future cash cows and is willing ignore their current earning. 
The idea is that value stocks should have less risk, less return, higher dividend payment. It's not necessarily true. The Vanguard U.S. Value fund's last 10 years has actually been a wilder ride than the Vanguard U.S. Growth fund, although the value funds dividend yield was indeed almost 4 times higher than the growth fund. 

Personally, I think both strategies make intuitive sense for long term investors, because I believe that in the long run, a company's stock price will be mirroring its performance. But I also think just like anything in investment, you need discipline for any of the strategies to work, since one must not get carried away by chasing "best performer"s. 

Another way of categorizing stocks is U.S. vs International.

Generally speaking, U.S. stocks are less risky for people who reside in the U.S. and spend U.S. dollars. This is because even if all else is equal, U.S. stocks lack any currency risks that foreign stocks inherently have, since they are traded not based on U.S. dollar but local currencies. Foreign stocks can offer higher returns in many occasions, so I would not completely shy away from them. This is true even now with the European turmoil. My international stock investment has returned 10 percent since June 1st, while my U.S. stock investment has returned less than 8%. 

My personal strategy towards equity investment is 60/40 U.S. to foreign. I've gone for passive broadly diversified indices rather than growth or value funds, but in the future, when I get more capital to invest, I think I'll keep passive funds as my equity portfolio core and add some actively-managed growth funds for possibly higher returns. 

In the next post, I'll discuss bonds in terms of risk and return. 

P.S. if you have any questions, you can leave them in the comment section. I'll try my best to answer them, but again, everything is just personal opinion, though I do guarantee you that I put my money where my mouth is. 

Friday, August 3, 2012

The big question: Risk vs Return, Part 2

So stocks.

These are high risk investments that involve very high volatility. You can experience gains of 1000% magnitude in a few years, you can also experience losses of close 100% in a couple of years. So how do we approach stocks?

One way, is to pick a few stocks yourself. Generally, the fewer stocks you pick, the higher volatility. Why? Well, unless stocks are at least 100% correlated, when one of the stocks' price changes, other do not follow suit proportionally, and therefore acts as dampening the change. Of course, if you happen to find stocks that are more than 100% correlated, then you can expose yourself to extra volatility by buying more stocks. This approach is heavily dependent on your luck (some call skill).

There are actually two camps on this approach: ones relying completely on technical data, and ones relying completely on fundamentals of a stock. Most people are actually in between. So the technical camp claims that the stock's fundamentals are already "considered" when it comes to stock pricing, and therefore all those nice curves are able to give us all the information we are ever gonna get about the company whose stock we are trading. The fundamentals guys, on the other hand, says that all that matters for a stock is how well the company behind it is performing, and therefore they pay attention to things like Price/Earning ratios (Actually P/E ratio is only a small part). Personally, I think the technical stuff is pure bullshit. Given a reasonable time frame, I am totally convinced that fundamentals guys will always outperform. Think about it, humans are often nuts, therefore those pretty curves mean nothing! They are the product of trading activities performed by some crazy, irrational beings, and how is that going to help me find stocks?

The other way is to broadly diversify, often through some kind of broadly diversified fund. The good thing is that the volatility is vastly lower. It's not uncommon for the price of a single stock to fall by 30 percent in a single day, (Zynga) but it is very rare to see the S&P 500 to fall even 5% in a day, in fact, a 3% percent drop would be termed as "plunge" by the new agents already. On the other hand, broadly diversified funds rarely rise 3% or more in a day either.

Remember, those two approaches do not have to be mutually exclusive. Personally, when it comes to equities investing, I'd like to have a core portfolio consisting of broadly diversified index funds, and then a few individual stocks here and there, acting as supplementary investments. Of course, since I am a complete non-believer of technical analysis, I'd only pick stocks based on their fundamentals. (hmm, FB is looking increasingly attractive at this point)

In the next post, I'll do a high-level discussion on stock picking strategies.