Investing In Corporate Bonds and Debentures Is a Bit Tricky At the Moment

Did you see what happened to Boardwalk Pipelines yesterday? They slashed their divy and the stock went down 40%. I reach for yield also but those MLPs are hard to understand for myself. I'd rather pay a 1% management fee and invest in a bond fund or a closed end fund selling at a discount.

Oh wow. Thanks for letting me know. I was so busy buried in fixed income disclosures yesterday I hadn't paid attention to any of the equity market news. I'm going to have to go do a case study on them and figure out what's driving the numbers.

First glance makes me think my initial valuation on MLP's as a whole was right back when I wrote this. Every way I approached the figures, most of them shouldn't have been attractive unless yields were at least 12% on those levels (there were and are a few exceptions that are decent). I couldn't understand why people were willing to accept such absurd valuations. I'd wager there are a lot of folks that don't know the difference between distribution yield and dividend yield, or the tax consequences of $1 in distributions on an MLP versus $1 in dividends from common stock.

I recently bought a starter position in kinder morgan (kmi); it was down a lot and kinder had bought a bunch of stock. Some times I'll buy a small position then study it more. I remember that article you wrote and then I started reading more about the company. I couldn't get comfortable with the complexities of how kmi is set up so actually sold for a small loss shortly afterwards.

I've been jonesing for a fix; trying to find something to buy in this market that just seems relentless to me. Anyway, after I sold kmi I bought a little coke and berkshire. Then just today decided to buy jm smucker.

I'd suggest studying it thoroughly before initiating any sort of position (even a half position), otherwise you're just paying the brokers with no benefit. $KO and $BRK are great companies for long-term portfolios, are you looking to trade (short term) or invest (long term)?

Joshua,

Most of your wealth comes from owning, or creating private
businesses, not stock ownership (although that too, is quite fun 😉

Passive income, (or economic engine, as you put it), allows
you to pour in that extra jet fuel to solve the red ring problem, as you have
pointed out. However, from what I read about entrepreneurship in general, it
seems there is no clear framework for it – and perhaps you nailed it when you
said that businesses and your work method should be personal.

I don’t know, it’s frustrating when people are going out
there, launching businesses, and here I am, a college student, not knowing
where or how to start – not knowing if this is the right way to do something,
etc. It does not help when there is an overwhelming amount of information with
regards to entrepreneurship (or creating economic engine). I don’t even know
where to get started: 4 Hours Workweek, Maverick Startup, TheFoundation by Dane,
the Startupbros, etc. So many
information out there; how would I know what to do?

Yes, running business is hard, but it is compounded even
further by the fact that I don’t know where to start. And starting without some
sort of conviction, some knowledge base, is extremely dangerous – I think
partly why people sell when prices of stock falls, is because there is no
factual knowledge backing their action. And I can foresee myself panicking
should I try to begin a business without prior knowledge – everything will
screw up when problem comes.

Tl;dr: Could you elaborate more on your process in creating
and owning your private businesses, (in addition to the rather informative
articles you have already written regarding passive income on this blog) – say,
information to look out for, such as how to find your target audience and what
would you be selling. Or if not, are there any books or resources I might look
to, to begin learning how to get that economic engine, like you did?

P.S. I really enjoy your blog – just as much about stocks
and securities, I love it when you write about how you run your life – e.g. how
you think it’s important to create a list of traits you’d like to adopt from
famous people. Or mental model and how it’s applicable to our lives. I don’t
know, that is one of the gems about this blog – how one's life could be richer and
more satisfying for choosing to run it - instead of going with the flow.

But I digress, and anyway, thank you 🙂

Joshua probably doesn't talk about this much because what you need to know and do is extremely unique to each private business. For instance, if you kept tropical fish as a kid (your passion) and wanted to become an importer of tropical fish from South America to supply your local pet shops, all the details of what to do, how to do it, would be so unique to your business that no one could give you any real specifics to get you started. Since it is your passion you probably know more about the topic then most people. And when you figured it out you wouldn't want to tell anyone because someone else could just copy your business plan and put you out of business, so your not going to find out how to do it in some book.

The most important realization is that all profitable businesses are, at their core, nothing more than systems for selling a good or service for more than it costs to produce or source.

When you understand that, it becomes clear that the best place to start is by answering two questions:

1. "Given my current resources, skill set, and passions, what do I sell, license, or rent to others that will allow me to maximize the rewards for my efforts and outlays, both in time, energy, and money?"
2. "How do I structure the production or delivery of this product or service so that it gives me a competitive advantage in pleasing customers, reduces ownership risk so that if something goes wrong I'm not harmed, and allows the system to expand in a scalable way so that a 10x increase in earnings doesn't require a 10x increase in effort on my part?"

That's what I mean when I say that McDonald's sells cheeseburgers, Microsoft licenses software, Disney sells entertainment and emotional experiences, newspapers sell advertising space, AT&T licenses access to its communication infrastructure, or a Holiday Inn rents a place to sleep and shower for a night. Papa John's sells pizza. Starbucks sells coffee. At the heart of every business is something being sold. The entire Colgate-Palmolive empire is built on selling dish soap and toothpaste, yet it produces billions of dollars in surplus wealth for owners every twelve months.

Figuring out 1.) what you sell, and 2.) how you structure the system so the product or service is delivered (determining your cost structure and return on capital to a large degree), is the foundation. Until you've settled those questions, everything else is a distraction. It's the only intelligent place to start as all other decisions should be informed by the answers.

The question of figuring out what to sell is a big one that I could spend weeks discussing. I'll try and keep it in the back of my mind for the future; to write about some of the methods I use going forward whenever I realize I'm using one of them.

Wow, this would be an awesome blog post on its own. Great way of looking at business. Thanks Joshua.

I'll appreciate you writing some of the methods on what to sell, if you do come across those methods. Thank you so much 🙂

Start watching Shark Tank on ABC (including old episodes).

Great response. It all boils down to "better" (iPhone) or "ground-breaking" (automobile). It's all about selling something.

I suggest Stanley starts watching Shark Tank on ABC.

I used to go to Hoagie Haven a lot when I was graduate student at Princeton. I'm often reading your articles to try and absorb random investing knowledge. But this post reminded me of the good old days crunching on academic papers :-).

Your situation sounds very similar to mine (and I'm also a fan of the Startup Bros, their importing articles helped me successfully import products from overseas). I'm eager to hear Joshua's answer, but if you ever want to chat with someone in the same boat, feel free to e-mail me at [email protected]

I appreciate the offer, Odai. Although as of now, I have no information to contribute, and I'd hate for it to be one-sided, but I hope you wouldn't mind if I take up your offer and start bugging you in the future when I am more well-acquainted with the topic 😉

Definitely!

I don't own it because I don't live in Missouri, but look at Nuveen's Missouri Muni Bond Fund, ticker NOM. It's tax free for Missouri and as of today pays a 5.5% annual dividend, payable on a monthly basis. It holds 76 different bonds, so if any one of them goes default (unlikely), it won't hurt as bad.

Thanks for the suggestion. Give me a minute, I'm pulling the regulatory filings. Be right back.

..........

No, I couldn't own it and sleep at night, which means I couldn't live with myself were I to suggest it to someone else (I'm even more conservative with other peoples' money than I am my own, and that's saying something). The yield is an illusion caused by the fact the fund company has leveraged the underlying assets to the point that effectively 39% of the capital structure is leverage. On top of that, the leverage-adjusted duration is 15+ years, which is longer than I think is prudent at the moment.

If nothing goes wrong, it might work out well for people, but I think of bonds as a defensive investment; a sort of quasi-insurance policy against a major economic depression or deflation. Those who owned the highest grade bonds prior to the Great Depression survived just fine, even if their quoted market value fell by 50%. The interest checks kept showing up, and they could use this money to make it through those dark years. For those who didn't need the money, it provided a constantly re-filling source of dry powder to buy blue chip stocks, which were practically being given away for free since people were desperate and had to sell whatever the owned so they could eat.

Leveraging bonds, or taking on more duration risk than is prudent at a time of record low interest rates, defeats the entire purpose of owning bonds in the first place. At least in my opinion. Sometimes, risk management means you just have to suck it up and accept near-zero returns while you wait for better opportunities. One bad deal can wipe out decades worth of compounding.

I appreciate you mentioning it, though. I always like looking at new things that haven't crossed my radar.

Thanks for the analysis. I agree with you, it's a bond fund on steroids. It's a risky game - can they earn enough on their leveraged bonds before rates possibly rise above the breaking point? In a way, it's a wager against inflation. But I do admire you for not taking that risk with OPM.

Actually, with a 15+ year average duration and the use of leverage it's a bet on prolonged low interest rates. In an inflationary environment fixed income investors would demand higher real rates and this fund's underlying holdings would get hammered. The leverage would only add to the pain.

Yes, I wrote 'a wager against inflation'? I think we agree.

Although, if one wanted to disagree with me, they could argue that when rates rose, the fund would add higher yielding bonds to the portfolio, raising the rate of return. It wouldn't be able to match a rapid rate of inflation, but it wouldn't be stuck in the mud, either.

Feel free to call me an idiot for challenging your logic on this.

When you write: "I managed to get my hands on a nice block of high-grade, non-callable debentures from a major packaged foods company with a 4.3% yield-to-maturity on the remaining decade before maturity, but still have a bit of their dry powder left to spend."

On a risk-adjusted basis, wouldn't you end up with far more income, and far more capital gains, over the next eight, fifteen, and twenty-five years if you had used that money to buy a giant block of Kraft at $53 per share?

Like I said, I could be way off base here, and feel free to call me out on it, but my assumption is that whatever additional safety (by ranking higher in the capital structure) you got from the high-grade, non-callable debentures from a major packaged foods company at 4.3% compared to buying something like Kraft would be quite minimal, especially if you adjust for the foregone wealth (both in terms of dividends and capital gains) by just buying, say, Kraft common stock outright.

I feel like there are some puzzle pieces I'm missing or not processing correctly. Like I said, this misunderstanding is almost assuredly my fault.

When running a business, or even a personal portfolio, the compounding rate is only one of the variables you have to consider. Do you remember Charlie Munger's famous comment at one of the Berkshire Hathaway shareholder meetings; something along the lines of, "If I had a $5,000,000 net worth, I certainly wouldn't want 100% of it sitting in equities in a brokerage account"? There is a reason for that.

Stocks are great, but they can become extremely problematic during times of severe economic catastrophe as investors, who don't want to sell, have to liquidate whatever they can afford in order to avoid starving to death or declaring bankruptcy. Perfectly good companies are sometimes required to take equity infusions, diluting owners. Some fail entirely. If you can hold on, or better yet, buy more during these times, tremendous wealth can be accumulated.

Bonds serve three functions in a portfolio.

The first is to generate sufficient interest to keep pace with inflation and maybe, if you are lucky, provide some real returns. Valuation is critical. I don't think you're going to get any real return at these levels, personally. I think the mathematics don't work from a common sense standpoint, nor is there much historical precedence to suggest otherwise.

The second - and no less important - role is to act as a bulwark against times of severe economic stress. At the top of the hierarchy are Treasury bills, bonds, and notes (e.g,. where Berkshire's famous cash hoard is parked), then you get to gilt-edged AAA corporate securities, all the way down to junk paper issued by highly leveraged enterprises that might default. Even though these securities might lose 30%, 50%+ of their value as forced liquidation commences, they have a maturity date at which you get all of your money back or you get to take the company to court to seize assets. If things get really bad, the bondholders might even get equity in a newly capitalized company as part of a bankruptcy settlement.

When Great Depressions comes and stocks lose 90% of their value, even small bond positions, depressed as they are, can still be pumping out their contractually guaranteed levels of cash that you can live on, long after the dividend has been cut on the common. You can use that money to survive, or if you are doing fine, buy the stocks that are being given away for free.

The third function is asset / liability matching; a practice that is sacrosanct in the insurance industry as a risk management tool. If you know you are going to have a payment or expected use of cash come up so many years in the future, buying a bond with a similar maturity profile will let you increase the odds of having exactly the right amount of cash when you need it. Someone who is 50 years old, and is retiring in 15 years, might want to have enough money on hand for a downpayment of a new beach house. Even the best stocks in the world fluctuate wildly - Kraft will almost certainly beat these bonds over the long-haul, but who knows what it will be doing on that specific date when retirement is reached. What if it coincides with a period like 2009 when things are falling apart? Or 2001? Or, worse, 1973-1974? Now, here you are at the start of your golden years, and you don't have the money on hand to buy the place you've always wanted because access it means selling for 40¢ on the dollar of intrinsic value. God forbid if its a 1929-1933.

Yet, with those bonds, you could step in and not only have the cash right when you needed it as maturity was reached. If the economy were going off a cliff, you'd suddenly have far more purchasing power. Remember, during deflationary environments, dollars increase in real value, meaning money - and bond coupons - become more valuable to a degree that exceeds stocks. (On the flip side, stocks are better suited to periods of high inflation.) You have a certain peace of mind knowing that come hell or high water, you're going to have the liquid funds on hand at the precise time you need them to buy the house, or pay the insurance claim, or whatever other demands you saw on the horizon.

In this case, my job is to get this portfolio to a 25% bond allocation over the coming decade, even if it means barely keeping pace with inflation on that portion of the money. When normal yields return, those funds will earn a lot more and the interest income will increase as old maturities are rolled into new issues. Right now, this person has only 4% of his or her assets in bonds, and 1% in cash. When you're young that is fine. When you are approaching Social Security age, it's not. You have to have a certain line in the sand that you say, "This is it. I go no further."

We already talked about Charlie Munger, so let's go back to his cohort, Warren Buffett, since I know you are a Berkshire Hathaway stockholder and are familiar with the empire. Warren is one of the greatest equity investors of all time, yet has somewhere between 8 and 9 figures worth of tax-free municipal bonds in his personal portfolio outside of Berkshire Hathaway. It's how he pays his bills and guarantees his family will always stay rich, no matter what happens. It's those bonds that were feeding him money to buy personal stocks during the 2009 crash.

It's funny you mentioned Kraft, though. About 40% of the new deposits I allocated during this lot went to bonds, with the other 60% going to long-term blue chip stocks. Kraft was one of those stocks. The higher dividend yield was perfect for someone approaching retirement where income was more important than growth.

Do you know what year Charlie said that? I'd like to find some notes/transcripts from it. Thanks!

I'm about 85% sure it was during the 2005 shareholder meeting when he was recounting a story about a young acquaintance who had inherited a $5,000,000 portfolio. The college-aged kid wasn't satisfied with the dividend and interest income he could receive passively investing it, or the rental income he could get if he bought properties outright, so he decided he was going to start trading derivatives (futures, options). He lost it all and, at that time, was "waiting tables" - in New York, maybe? - which Munger called a total tragedy.

It was during a time when the real estate bubble was inflating, Wall Street was trading derivatives like crazy, and Charlie kept saying over and over, "This is going to collapse. It's going to end badly." He said if he had a $5,000,000 net worth, he wouldn't want it all in a marginable brokerage account. Part of the subtext in the conversation seemed to be his belief that there would be institutional failures and he didn't want his money tied to any firm that might go down.

We're approaching the decade mark here so I could be off a bit, but when I recall it, I remember looking at Warren - who was wearing a grayish-silver-ish sports coat over a pair of navy slacks - and thinking he looked almost like real life version of Mr. Monopoly. Melinda Gates was wearing a short sun dress, which I remember thinking was way too cold for the Omaha weather. Bill Gates was compulsively rocking in his chair. There was a group of college students in front of me discussing the recent spike in copper prices, my father was sitting to my left, and I had a notebook open on my lap, scribbling some general thoughts. Charlie saying that suddenly ripped me back to reality because it was a very direct admonishment from him, when normally he tends to prefer sophistry so people reach their own conclusions. He left no room for debate about how he felt, so I made a point to research why he would insist on something so strongly.

It was 2005. I know it was 2005. It was a tail-end throwaway comment that was part of his sadness of this fool who had obliterated a huge head start in life because of greed and inexperience.

Thanks! It was 2005, I found Tilsons notes. Your description was much more elaborate than his recollection. Looking forward to this years meeting (My third), will be interesting to hear what they say on where we stand on the continuum that is the investing cycle. Reading Tilsons notes it's amazing how precient they are if you allow say 3-5 year intervals of time.

You idiot ♥

I agree that no business is identical to each other. However, I disagree with your statement that " all the details of what to do, how to do it, would be so unique to your business..." While difference will certainly exist, it would be unusual to suggest that the general process itself is unique to the extend that it will mean a steep learning curve everytime I want to start a new company selling new things. I hope I did not interpret you wrongly.

What I'm looking for is the crux of beginning a business - the skeleton, and I think, despite the vast amount of information, most fail to cut through the core to address the underlying issue. They talk about the process, yes, plenty about the process, but not the underlying driver of their action - and this lead to a lot of needless time wasted, obsessing and discussing over secondary details. It's very easy to get lost if you have no anchor to anchor you down.

I think Joshua could decipher what I meant, despite my poor articulation, when he mention the 2 questions - which I think holds the answer to my implicit question. It may seem obvious, but I've learned that what should appear obvious, is not always so obvious.

And in that, several of his articles come to mind. The discussion on ROE, for one. What would I do to increase profit margin - do I look for the cheapest supplier, or somehow structure it to get the lowest price possible? Or do I want to add a premium to what I am selling, by building a brand? Could I build a brand easily, based on my expertise? If not, what else are my options?

I think this is what you mean when you said that the process are "unique to your business..." On the surface, they are, but underneath, these process address the 2 questions in their own, best possible way. The process matter, of course, I'm not discounting the fact that they can be different and yet achieve the same goal - i.e. to generate cash. But there is no denying that understanding the whys is the more superior of approach, so that if circumstances dictate that you change your process (loss of supplier, government regulation, etc) you will not be lost to what needs to be done.

Nonetheless, this means that for every book, or attempts to understand more about entrepreneurship, I must be able to use its content to answer these questions. (I can almost see Joshua, reading, and highlighting passages and phrases from books which he think will adequately answer these two questions.) And like a jigsaw puzzle, piece the answers together to create what becomes my answer to the implicit question of how to get that economic engine.

Goodness knows there could be a more superior way of approaching this open-ended problem. But until I encounter it, I think Joshua's 2 questions is actually a pretty good framework for approaching this problem, and it helps to sift out important information from the non-essentials.

I guess my point was even basic things that are common to all businesses (like determining greatest ROE using the dupont analysis) don't really apply to starting your own business.

That analysis is a great tool if your a CEO moving from company to company. But for starting your own business your passion is really going to decide what choice to make.

For instance, I know a person who started a chain of cheap fast food restaurants and one that started a high end restaurant. Both successful, they didn't go through any analysis to decide what to sell, it was their passions that told them what to sell. If the high end restaurant owner did a Dupont Analysis and the numbers said to start a chain of cheap restaurants, with cheapest suppliers selling at lowest possible prices, and he did that it would of been a disaster because that wasn't in his nature, he is a very obsessive gourmet cook to begin with. He would of hated going to work everyday. For a CEO, though, who just delegates tasks, that is a perfectly acceptable way to run a business.

If your passion in life turns out to be a lousy business plan, you have to honest with yourself and decide that starting your own business is not for you.