The Lost Art of Bond Investment

There are a couple of bonds and preference shares listed on the Singapore Exchange (SGX). Due to their scarcity, it is rare to find discussions on how these should be selected for investment. Last Christmas, I had the opportunity to reread the Security Analysis, written by Benjamin Graham and David Dodd. In it, there are 2 sections devoted to how bonds and preference shares should be selected for investment. It listed 2 criteria, namely, the minimum average earnings coverage and the minimum current stock value ratio.

The minimum average earnings coverage ensures that earnings are more than adequate to cover the fixed charges from bonds and preference shares for a sufficiently long period of time. The minimum current stock value ratio ensures that there is a sufficiently large pool of shares to cushion the bonds and preference shares in the event of financial distress. The values for the 2 criteria are listed as follows:

	Bonds	Preferred Stocks
Public Utilities	1.75x fixed charges	2x (fixed charges + preferred dividends)
Railroads	2x fixed charges	2.5x (fixed charges + preferred dividends)
Industrials	3x fixed charges	4x (fixed charges + preferred dividends)

Table 1: Minimum Average Earnings Coverage

	Bonds	Preferred Stocks
Public Utilities	$2 bonds to $1 stock	$1.5 (bonds & preferred) to $1 stock
Railroads	$1.5 bonds to $1 stock	$1 (bonds & preferred) to $1 stock
Industrials	$1 bonds to $1 stock	$1 (bonds & preferred) to $1.5 stock

Table 2: Minimum Current Stock Value Ratio

The reason for the more stringent requirements for preference shares compared to bonds is because preference shares have some contractual disadvantages. As an example, it is mandatory to pay bond coupons and principal as and when they fall due, failing which the company might enter into bankruptcy. In contrast, preference dividends are not mandatory and subject to the discretion of the company directors. If the preference dividends are omitted, nothing serious will happen to the company. Hence, to compensate for these shortcomings, the safety margins are higher for preference shares. 

To explain how the earnings coverage and current stock value ratio are computed, we use Hyflux as an example. The table below shows the income statement of Hyflux for the Financial Year (FY) 2012.

Table 3: Hyflux's Income Statement for Financial Year 2012

For FY2012, Hyflux reported a Profit before Tax of $77.0M. Adding back the finance cost of $28.5M and subtracting the share of profits from associates of $4.3M, there is $101.2M available to cover fixed charges. The fixed charges comprise the reported finance cost of $28.5M plus preference dividends of $24.1M, making a total of $52.5M. The earnings coverage is thus computed as $101.2M / $52.5M or 1.93.

On the stock value ratio, Hyflux has 825.2M of ordinary shares and 4.0M of preference shares. The last traded prices are $1.165 and $106.85 respectively. The market values work out to be $961.4M and $427.4M respectively. The stock value ratio is computed as $961.4M / $427.4M or 2.2.

How do the existing bonds and preference shares listed on SGX compare based on the 2 criteria mentioned above? The results based on the latest FY are shown below:

Company	Coupon	Earnings Coverage	Stock Value Ratio	Type
CMA	3.800%	4.01	13.6	Bond
Olam	6.750%	1.92	3.7	Bond
SIA	2.150%	5.37	39.3	Bond
DBS	4.700%	373.22	50.3	Pref
Genting	5.125%	7.33	34.9	Pref
Hyflux	6.000%	1.93	2.2	Pref
OCBC	4.200%	32.05	4.9	Pref
UE	7.500%	6.45	No Info	Pref

On earnings coverage, all the bonds and preference shares passed the criterion for Industrials with the exception of Olam and Hyflux. On stock value ratio, all the bonds and preference shares passed. Hence, all except Olam's bond and Hyflux's preference shares qualify as good fixed income investments.


See related blog posts:

• Is Benjamin Graham's Art of Bond Investment Outdated?
• Does FCL's 3.65% Bond Have Sufficient Margin of Safety?
• Does Aspial's 5.25% Bond Have Sufficient Margin of Safety?
• Does Perennial's 4.65% Bond Have Sufficient Margin of Safety?
• Does Oxley's 5% Bond Have Sufficient Margin of Safety?
• Does Aspial's 5.30% Bond Have Sufficient Margin of Safety?
• Do Hyflux's 6% Perps Have Sufficient Margin of Safety?
• Does SIA's 3.03% Bond Have Sufficient Margin of Safety?

Managing My Father's Money Has Become A Full Circle

After reading La Papillion's and Derek's blog posts on how they invested their parents' money, I also wish to share how I invested the money from my father. Because our circumstances are different, our portfolio allocations are also different.

The money did not come from my father, rather, the money came about because we sold a flat and bought a new one. Instead of using the sales proceeds from the old flat to pay for the new flat, we retained the sales proceeds as cash and took out a loan. Strictly speaking, it is my father's money, because he paid for the old flat. However, it could also be viewed as taking out a home equity loan which I am responsible for paying off (there is no change in the flat ownership). The money became a joint investment, and we set up a new joint bank, CDP and stockbroking account for the investment (on hindsight, this is an important step as it allows us to check how the account is doing).

The terms of the account are similar, it is "capital guaranteed" in the sense that I have to pay back the loan at the end of the loan tenure. It's hurdle rate is the loan interest rate of 2.6% (HDB concessionary loan interest rate). However, the investment horizon is much longer, at almost 30 years.

Because both my father and myself are share investors and because of the long time horizon, we invested the money in a portfolio of shares and cash. After reading the 2 gentlemen's blog posts and reviewing my own experience, I think our parents' investing experience and how the money is viewed have a very huge impact on how the money is eventually invested. On the first factor, my father is a share investor, so he is very comfortable with investing the money in the stock market. In contrast, my mother has bad experience with shares and unit trusts, so she is only comfortable with bank preference shares.

On the second factor, if the money is viewed as a stand-alone account with capital guarantee, then very likely I would have invested it mostly in bonds and preference shares. On the other hand, if the money is viewed as a loan for my own portfolio, the money would be invested in shares. There would be almost no change in the risk appetite. In my case, the money was viewed as a joint investment of both my father's and my money. So while the money was still invested in shares, it has a reduced risk appetite since my father's money is involved. Only good shares would be selected, and at the first sign of trouble, the respective shares would be sold out. This has resulted in smaller profits but also less losses compared to my own account.

Thinking back, managing my father's money has become a full circle. I guess a number of us would have the same experience as me. When I was in university, I would recommend to him which stocks to buy (I was not trained in stock analysis then), so in a sense, I was helping to manage his money. When the stocks made money, I would feel very proud of my recommendations. But when the stocks lost money, I would quietly go away hoping it would be forgotten in time. During the days of the Asian Financial Crisis, losses were not in the region of 30-40%, it was almost a complete wipe-out! But my father never blamed me for the losses.

Fast forward to today, we are now officially entrusted with our parents' money. I guess we have all grown to be more sensible and responsible in managing the money, understanding that the money is hard-earned and earmarked for our parents' retirement. Taking smaller risks and making smaller profits is more important than taking larger risks and making larger profits. 

The greatest satisfaction in managing my father's money is not in seeing how much money have made for the account, but in seeing the satisfaction on my father when he views how well the account is doing. This, to me, is priceless.


See related blog posts:

• Fishing for Future Generations
• Building A Lasting Portfolio for Future Generations

One Plus One Equals Two-and-a-Half

If 2 investments both return 5%, can a portfolio made up of these 2 investments return more than 5%? In theory, it should not be possible, but in reality, it is possible to wring out some extra return from these 2 investments. How is this possible? Through portfolio rebalancing.

Modern Portfolio Theory states that if 2 investments are not perfectly correlated, a portfolio made up of these 2 investments should result in lower risk. However, it does not mention that extra returns might be obtained from this portfolio. To prove that this is possible, we consider the returns and standard deviations of 5 indices over the last 25 years since 1988, as follows:

Index	Returns	St Dev
STI	5.0%	22.9%
DJIA	8.5%	14.4%
HSI	9.3%	25.7%
Nikkei	-1.6%	21.5%
FTSE	5.2%	14.6%

Table 1: Risks and Returns of 5 Component Indices

A portfolio of 2 of these indices is constructed, each with 50% weightage (e.g. 50% STI and 50% DJIA). A total of 10 such portfolios are thus constructed. The portfolios are rebalanced whenever the proportion of the indices deviate from the original weightage by 5%. The risks and returns of these 10 portfolios are assessed and compared to their component indices. Of the 10 portfolios, 2 of them actually exhibited higher return while 4 of them exhibited lower risk compared to both their component indices. Please see the tables below for the correlation among the indices, and the returns and risks of the 10 portfolios.

		STI	DJIA	HSI	Nikkei	FTSE
STI			40.3%	54.6%	21.3%	34.0%
DJIA		40.3%		38.2%	22.6%	59.7%
HSI		54.6%	38.2%		16.1%	34.9%
Nikkei		21.3%	22.6%	16.1%		21.0%
FTSE		34.0%	59.7%	34.9%	21.0%

Table 2: Correlation (R-square) Among 5 Indices

		STI	DJIA	HSI	Nikkei	FTSE
	Self	5.0%	8.5%	9.3%	-1.6%	5.2%
STI	5.0%		7.3%	7.6%	2.3%	5.5%
DJIA	8.5%			9.6%	3.9%	7.0%
HSI	9.3%				4.6%	7.7%
Nikkei	-1.6%					2.2%
FTSE	5.2%

Table 3: Return of All Portfolios Made Up of 2 Indices

		STI	DJIA	HSI	Nikkei	FTSE
	Self	22.9%	14.4%	25.7%	21.5%	14.6%
STI	22.9%		17.0%	22.7%	19.0%	16.8%
DJIA	14.4%			18.2%	15.5%	13.7%
HSI	25.7%				19.8%	18.2%
Nikkei	21.5%					15.5%
FTSE	14.6%

Table 4: Risk of All Portfolios Made Up of 2 Indices

From Table 3, a portfolio of 50% STI and 50% FTSE returned an average of 5.5%, higher than STI's 5.0% and FTSE's 5.2%. Similarly, a portfolio of 50% DJIA and 50% HSI returned an average of 9.6%, higher than DJIA's 8.5% and HSI's 9.3%.

From Table 4, a portfolio of 50% STI and 50% HSI has a standard deviation of 22.7%, lower than STI's 22.9% and HSI's 25.7%. Similar observations can be seen from the portfolios of STI-Nikkei, DJIA-FTSE and HSI-Nikkei.

In total, 6 out of 10 portfolios exhibit either higher return or lower risk compared to their component indices. However, none of these portfolios exhibit both higher return AND lower risk.

The reason why a portfolio can beat the returns of its component indices is because when a particular index is performing poorly, the index that is performing better is sold and the proceeds reinvested into the poorer-performing index through portfolio rebalancing. When the poorer-performing index rebounds, the portfolio achieves better return compared to either of its component indices.

Having said the above, the portfolios do not beat both component indices all the time. A plot of the returns of a $10,000 investment in the portfolio and its component indices indicate outperformance only during certain periods of time. See the charts below for the STI-FTSE and DJIA-HSI portfolios.

Figure 1: Performance of Portfolio of 50% STI and 50% FTSE

Figure 2: Performance of Portfolio of 50% DJIA and 50% HSI

Nevertheless, it cannot be denied that portfolio rebalancing provides benefits to investors either in terms of higher return or lower risk in majority of the cases. Portfolio rebalancing should be considered as part of any investor's arsenal of investment tools.


See related blog posts:

• Portfolio Rebalancing - A Fine Balancing Act
• Volatility is Your Friend
• Not All Market Indices Are Equal

The Dogs and Puppies of STI

Many academia and literature says that active investors cannot beat the index. However, if you believe that this is true but still want to beat the index, then it follows that the key to beating the index must lies within the index itself, i.e. the portfolio of stocks that beat the index must come from the index component stocks.

In my previous post, I mentioned that an equal-weighted portfolio of the Straits Times Index (STI) component stocks can beat the index easily. In this post, we will discuss whether a "Dogs of STI" investment strategy can beat the index and even outperform the equal-weighted portfolio of STI component stocks.

The Dogs of STI replicates the investment strategy of the Dogs of the Dow. In this strategy, the 10 highest yielding Dow Jones Industrial Average (DJIA) component stocks are selected for investment in the following year. This strategy has returned 10.8% per annum over the past 20 years, matching the returns of DJIA and beating the Standard and Poor's 500 index's return of 9.6%.

What is the rationale behind the Dogs of the Dow investment strategy? Proponents of the strategy argue that blue chip companies do not change their dividends regularly to reflect changes in business conditions whereas stock prices regularly fluctuate according to business conditions. Hence, a stock that is higher yield than average would most likely be near the bottom of the business cycle and the stock price is likely to recover more than that of lower-yielding stocks. It suggests that the management of the companies believes their stocks are oversold and are willing to back them up by paying a relatively high dividend. By investing in the Dogs of the Dow, investors gain both by the higher price appreciation and the higher dividend yield.

Besides the Dogs of the Dow, there is a related investment strategy known as the "Small Dogs of the Dow" or "Puppies of the Dow". In this strategy, the same 10 stocks are selected as in the Dogs of the Dow. From this list, the 5 lowest-priced stocks are selected as the Puppies of the Dow. This smaller portfolio outperforms even the Dogs of the Dow, returning 12.5% versus 10.8% for the Dogs of the Dow over a 20-year period. 

So, how would a "Dogs of STI" and "Puppies of STI" portfolio perform? The table below shows the Dogs and Puppies of STI over a 13-year period since 2000 (Please refer to the previous post on Who Says You Can't Beat the Index? for limitations of the stock price data). Stocks highlighted in orange are the Puppies of STI while stocks highlighted in yellow make up the rest of the Dogs of STI.

Dogs and Puppies of STI Selected at End of Year

 

Returns of Dogs and Puppies of STI in Following Year (W/o Dividends)

Returns of Dogs and Puppies of STI in Following Year (With Dividends)

As shown above, the Dogs of STI outperforms the STI and even the equal-weight portfolios of STI and STI without the heavy weights (i.e. DBS, OCBC, Singtel and UOB). The average return including dividends is 19.3%, higher than STI's 6.7%, equal-weighted STI's 14.1% and equal-weighted STI without the heavyweights of 15.4%. The Puppies of STI performed even better than the Dogs of STI, returning 21.0% over the same period.

The outperformance of both the Dogs and Puppies is not due to dividends alone. Without dividends, the price appreciation (12.7% for Dogs and 13.3% for Puppies) already outperformed that of the STI (3.9%), equal-weighted STI (9.7%) and equal-weight STI without the heavyweights (11.0%). The inclusion of dividends further increased the outperformance of the Dogs and Puppies. The table below shows the outperformance relative to the STI, equal-weighted STI and equal-weighted STI without the heavyweights with and without dividends included.

	Dogs of STI		Puppies of STI
	No Dividends	With Dividends	No Dividends	With Dividends
STI	8.8%	12.6%	9.4%	14.3%
Equal-weighted STI	3.0%	5.2%	3.6%	6.9%
Equal-weighted STI w/o Heavyweights	1.7%	3.8%	2.2%	5.5%

On a dollar basis, over a 13-year period ending in Dec 2013, a $10,000 investment in the Dogs of STI with dividends reinvested would become $99,158 while a $10,000 investment in the Puppies of STI would become $119,182. This compares very well with STI ($23,235), equal-weighted STI ($55,554) and equal-weighted STI without the heavyweights ($64,369). So, dogs (and puppies) are Man's best friends apply to investors as well :)


See related blog posts:

• The Dogs and Puppies of STI for 2015
• Who Says You Can't Beat the Index?
• The Bounceback Portfolio of STI