The bond market rules the world . . .

When it comes to earning money through investment, there are really only three broad categories of instrument: those that are based on ownership of an asset (such as stock in a business, or investments that are tied to ownership in real estate), those that are based on lending money to an institution in return for interest payments on the loan (such as bonds issued by corporations and government entities, as well as the interest payments issued by banks in return for the use of your deposits, and a whole host of other debt-based instruments), and those that are based on wealth redistribution (such as lottery tickets, in which a large number of people put in a small amount of money and a few people get a large payout -- other forms of wealth redistribution include taxes, gambling, and to some extent insurance -- these are "zero-sum" schemes since someone gains and someone loses and nothing new is created).

It should be clear to readers of this blog that we believe the foundation of a long-term strategy of wealth preservation and wealth creation should be built upon ownership, and primarily upon the ownership of shares in well-run businesses operating in fertile fields of growth. We also advocate the ownership of real estate as part of the overall capital management strategy for most investors.

However, as we have alluded to before, there are also many situations in which investors should add an income strategy to this main foundation, and strategies requiring steady cash-flow streams often use the second category of debt-based instruments (or "fixed-income" instruments) in order to provide the properties of permanence and definition that are not found in ownership-based investments to the same degree.

In light of the role played by debt-based instruments, it is worthwhile to take a closer look at some of the issues we see from the perspective of long-time professional portfolio managers. A common expression on Wall Street is that "the bond market rules the world," both because of its vast size (about $10.3 trillion larger than the stock market at the end of 2007) and because of the impact that interest rates have on stock prices due to the discount rate that is applied to discount future earnings in order to give a present value on the future cash flows a company is expected to produce.

While the common stereotype of bond investments is that they are "boring" and "safe," the reality is that debt-based instruments are fundamentally composed of an IOU from a borrower, and because of that fact they behave in distress very differently from ownership-based investments such as stocks. The nature of an IOU is very black-and-white: you are receiving payments from the borrower, or (in the event of a failure of the borrower) you are not. In other words, when things go wrong in the world of an IOU, it often takes the form of a sudden transition from "you're getting your payments and everything looks fine" to "you aren't getting your payments, and getting your principal back is now questionable as well."

Note that most of the financial crises of the past thirty years have centered around failures in one part of the bond world or another: the Latin America debt crisis of 1982, the "Asian contagion" of 1997, even the implosion of Long-Term Capital Management's government-bond arbitrage scheme in 1998.

This is not to suggest that debt-based instruments are inherently problematic or that investors should avoid them, but rather to point out the sudden nature of default when it does occur. Statistically, default rates are very low among most categories of bonds that make up the overall bond market, and can be reasonably predicted through proper securities analysis -- most of the problems occur when massive amounts of leverage are added to the equation. It should also be pointed out that leveraged strategies involving fixed-income instruments are far more common and far more extensive than leveraged stock investment strategies. Today's mortgage and credit crisis underscores this, as default rates on the debt in question is at 3% or less, but the leverage involved is enormous, since the amount that can be borrowed against bond positions dwarfs the amount that can be borrowed against stock positions.

Because of the characteristics of debt-based investments described above, we believe that it is very important to diversify sources of income payments inside of a proper income strategy. In addition to owning bonds from different issuers, we also analyze cash-flow sources other than bonds. Again, analysis of the credit quality of the issuer (in other words, the borrower) is very important.

The above two points apply especially to investors who are getting interest payments from banks right now.

First, the credit quality of the bank (its balance sheet) is something investors have tended to ignore since the creation of the FDIC in 1933 (another unfortunate example of implicit or explicit government backing leading to a diminished perception of risk, as we described in an earlier post). It should be clear by now that this is an important consideration.

Second, the diversification of sources of interest is as important with interest you get on cash reserves as it is with any other debt-based income. In other words, these interest payments shouldn't be coming from one big bank CD issued by a single bank. Money market funds, while not insured by FDIC, are by nature pools of literally hundreds of debt-based instruments, giving them much greater diversification of income, which we believe is an important aspect of income strategies.

Along these same lines, it is important to note that the credit history of an insurance company is also a very important consideration for insurance policies with a cash value component (most forms of permanent insurance) and for policies that participate in insurance company dividends. We have touched on important reasons why these policies can work together along with financial market assets and real estate in previous posts such as this one.

Finally, the reality of inflation is critical with the debt-based category of investment instruments. Unlike ownership-based instruments, the debt-based instrument pays back whatever its contract says it will pay back, and nothing more. As long as the borrower doesn't default, it will pay that income stream and return principle at maturity, but as inflation causes the dollars it pays back to purchase less and less, it is effectively paying back a smaller and smaller amount over the years (graphically illustrated here and here).

For all these reasons, it is clear that ownership-based investment should form the foundation of an investor's long-term strategy, and why we say that income strategies can be built on top of that foundation, rather than ever being the foundation itself. The distinction between ownership-based, debt-based, and wealth-redistribution based instruments is important, and investors should understand the very different characteristics of each category.

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For later posts on the same subject, see also:


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