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Bond Investing

A Dirty Little Secret About Bond Funds

In a way, in becoming The Oxford Club’s Bond Strategist I feel like a prosecutor who’s decided to switch sides and become a defense attorney.

As I mentioned in my last piece, I managed a $160 million (assets under management) taxable bond fund for a bank early in my career.

It was my first job out of the Navy. I joined a bank in Cincinnati, Ohio, which at the time was known for its ability to churn out spectacular earnings growth – and by extension, stock price growth.

The bank hired veterans in large part because it demanded a lot from its employees – much more than other trust banks.

The cost of its success – as you’ll occasionally see in district attorney’s offices on Matlock or Perry Mason – was a big-picture investing strategy that was less focused on individual investments and the account holder’s financial goals.

I started out as a generalist in three areas: researching, managing portfolios on a large number of small accounts and bringing in new accounts.

I took well to all three areas – likely because I also had a degree in math and bond fund management is very mathematical.

But you don’t need to be a numbers person to understand how it works…

How to Think Like a Bond Fund Manager

In general, funds can be managed using a bottom-up or top-down approach.

In the bottom-up approach, securities are selected for the fund without any forward-looking view of how the market might evolve.

Our team took a top-down approach, where a forward-looking view of how the market might evolve is factored into the process. We discussed where we saw interest rates heading and how to manage our funds’ durations relative to competitive benchmarks.

My fund consisted of Treasurys, investment-grade corporate bonds, mortgage-backed securities and asset-backed securities.

(Mortgage-backed securities are used to invest in a collection of residential or commercial mortgage loans. Asset-backed securities represent collections of other kinds of nonmortgage debt, like credit card debt and leases.)

This was a time – and there have been a few in the intervening years – when exotic mortgage-backed securities were “in vogue” with fund managers and bond salespeople.

I managed the fund for three years, and the one- and three-year performance numbers were in the top half of my comparative industry peer group.

But I soon realized something…

The “Dirty Secret” That Prompted Me to Switch Sides

There’s danger in being a generalist: If you buy into a bond fund and rates rise, you will more than likely get back less money than you put in.

As a result, you can net dramatic profits more securely outside of a managed fund.

If you buy a portfolio of solid corporate bonds and hold them to maturity, you’ll get all of your principal back, plus interest along the way.

This is exactly why I’m taking more of a defense attorney approach. I want to take income generation on a case-by-case basis and focus on individual bonds.

And for good reason…

The Fed has cut rates three times – and it has said it would pause before determining the next move – but I think when that happens it will be predisposed to cut.

Treasury rates move in tandem with interest rates. In contrast, corporate bond rates perform based on the underlying fundamentals of the company that issues them. And presently, Treasurys are very expensive compared with corporate bonds.

As a result, I shy away from Treasurys and opt for blue chip bonds.

And now that I’m “for the defense” of your hard-earned savings, I look forward to helping you maximize your passive income stream and prepare for a wealthy retirement.

Good investing,

Rob


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