Thursday, April 14, 2011

Cohen and Malburg, Surviving the Bond Bear Market

You own bonds because asset allocators say you should. You have some experience in the bond market, but you’re not a bond guru. Since times have been good, you haven’t had to lie awake at night thinking about how to manage your bond portfolio. But what if the market turns ugly? In Surviving the Bond Bear Market: Bondland’s Nuclear Winter (Wiley, 2011) Marilyn Cohen and Chris Malburg present some doomsday scenarios and, more important, action plans that you can follow to insulate your bond portfolio. Along the way we track the progress of the brothers-in-law El Greedo and Neo Fyte.

In anticipation of a bond market crash—and the authors list both warning signs and manifestations of the bond market’s nuclear winter—the bond investor can cushion the shock by rebalancing his portfolio. The recommended allocation is 15% to constant maturing Treasurys and fixed-to-float bonds, 30% to LEAPS and ETFs that are short Treasurys, 30% to a short-duration laddered portfolio, and 25% to cash.

But rebalancing is only the first step, and it assumes an inflationary environment. What would happen if we got hit with deflation instead of inflation? An extended deflationary spiral, the authors believe, is a tail-risk event, but the investor should make contingency plans just in case. “Should the deflationary forces begin to swell, the most profitable bond trade is to buy zero-coupon long-term Treasury STRIPS—but only for those who can take the risk. For those who prefer to avoid such a gamble, buy long-term U.S. Treasury bonds that pay coupons.” (p. 52)

Many of the strategies outlined in this book require significant capital. For instance, in an emergency triage of their bond portfolio El Greedo and Neo Fyte get out of nearly $5 million in problem positions. Small investors can’t make such targeted decisions, especially since most are invested in managed bond funds, which the authors consider particularly vulnerable. So what’s the small investor to do? The authors recommend replacing these funds with specialized funds, such as bond unit investment trusts and floating rate funds. Or, if the bond market starts to tank, allocating some of the portfolio to inverse bond ETFs.

The bond market winter won’t last forever; one day green shoots will begin to appear again. The authors spend about a quarter of the book explaining how to recognize the incipient signs of recovery and how to rebalance into bond market prosperity. So, despite its title, the book pretty well covers an entire cycle in the bond market.

Spreadsheets dot the book, all created in an Excel workbook that is available to purchasers of the book for free download. It “allows you to consolidate all of your bond brokerage accounts in a single analytical spreadsheet system [and] provides a variety of essential bond information presented in easy-to-understand formats, language, and reports.” (p. xiv) The appendix to the book explains how to use it.

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