There’s a rule-of-thumb you can use to evaluate when risky, higher-yielding bonds may be worth investing in.

Sadly the hour typically arrives when entering a market looks as suicidal as entering Deathtrap Dungeon in search of fame and fortune.

Apparent probability of death: Near certain!

We saw in part two of our Emerging Market bonds series that this sub-asset class’s historic outperformance has been driven by spikes in credit risk, following market hammerings.

Crisis-charged yields offered a profit opportunity to those who heeded Warren Buffett’s maxim: “Be fearful when others are greedy. Be greedy when others are fearful.”

So I asked hedge fund quant and Monevator reader ZXSpectrum48K if there’s a bond market signal that can help us recognise these decisive moments.

Beware all ye who enter here

Warning: what we’re about to discuss is a very rough rule-of-thumb. It is not an iron law of bonds, and you can have no expectation of profiting from it.

Think of this bond credit risk valuation method as analogous to the cyclically-adjusted P/E ratio (aka CAPE).

Its efficacy is highly debatable. It relies on mean-reversion to a historical ‘average’ that may not apply in the future.

You’ll also need considerable fortitude and spare financial firepower to burn if your judgement proves wrong.

With that said, let’s gird our loins and push into the dungeon’s maze.

Yield and spread

Yield and spread may sound like sweet-nothings whispered on a medieval speed-date but they’re actually the key metrics for ZX’s money.

That’s because his rule-of-thumb enables him to estimate the credit spread of a high-yield fund versus an appropriate benchmark, such as US$ Treasury bonds.

The credit spread compensates you for the default risk inherent in high-yield bonds.

A wide spread may mean the market is over-reacting to recent waves of defaults or anticipated risks. You’ll win if you invest when the credit spread runs ahead of the default rates that actually occur.

By comparing the spread against historic norms, you may get a sense of when to press deeper into the gloom in pursuit of treasure.

I’m going to leave out ZX’s maths and cut to the chase:

Step one: Find the yield-to-maturity (YTM) and duration of the high yield bond fund you’re interested in. These metrics should be published on the fund’s web page or factsheet.

Step two: Subtract the YTM of an equivalent duration US$ Treasury bond fund from your first bond fund’s YTM.

The difference in those yields is a reasonable approximation of the credit spread.

The wider the spread, the riskier your bonds are judged to be by the market.

If Buffett’s adage and market history holds then periods when the credit spread widens could herald an opportunity.

Note, you need to have some sense of historical credit spread fluctuations in your market.

Bond credit risk valuation in practice

Following on from our series on risky Emerging Market bonds, I looked at the iShares Emerging Markets Government Bond Index Fund.

It follows the market-leading index ¹ for EM US$ sovereign bonds, so is a useful proxy for that sub-asset class.

I’ll compare our fund with iShares $ Treasury Bond 7-10yr ETF. This is the closest duration match I can find among the available US Government bond funds.

Here’s the Emerging Market bond fund’s numbers:

Yield-to-Maturity (YTM): 4.09%

(iShares publishes the yield-to-worst for this fund but that’s close enough for our purposes.)

Modified duration: 7.77

Here’s the US$ Treasury fund’s numbers:

Yield-to-Maturity (YTM): 1.4%

Modified duration: 7.96

Approx credit spread = Credit risk bond fund yield minus US Treasury fund yield.

4.09 – 1.4 = 2.69%

How does 2.69% compare to the credit spread history of the EM US$ sovereign bond fund’s index?

This chart shows the index’s spread over US Treasuries:

The spread sank to an all-time low of 1.66% in May 2007. (That’s 166 ‘basis points’ in the chart above.)

2.69% is the tightest spread since January 2018.

What does that tell me, according to our rule of thumb?

It suggests this is probably not an auspicious time to load up on Emerging Market US$ sovereign bonds – at least on this metric.

Better bookmark this four-part series after all, and come back when the rule of thumb is flashing green!

Take it steady,

The Accumulator

1. The JP Morgan Emerging Market Bond Index Global Diversified.[↩]

When it comes to legendary investors, Sir John Templeton was a legend’s legend.

Templeton is immortalised as the man who brought international investing to North Americans. Touring the world in his twenties – still a racy thing to do eight decades ago, at least out of uniform – Templeton was one of the first to see the potential of Japan. He backed its firms to the hilt.

Later he did the same with the tiger economies of South East Asia.

Templeton’s winning career as a fund manager and stock picker in foreign markets is immortalized in names like the Templeton Emerging Markets Investment Trust.

But there are plenty of other reminders from John Templeton’s life that can teach us about finding success as an investor.

Templeton did things differently

The most famous of Templeton’s contrarian actions happened in 1939.

On the eve of the Second World War, when Templeton was all of 26-years old, he borrowed a then-massive $10,000. He had decided to buy 100 shares in each of 100 companies whose beaten-up stocks cost less than a $1.

Templeton judged the market was in headless chicken mode due to fears about the upcoming conflict. He wasn’t sure which shares would prosper. But he was convinced they were all trading out of whack.

The profits he banked when the markets recovered initiated a lifetime of running money.

Templeton had learned to read the emotional moods of markets by visiting cattle auctions during the Depression Era with a bargain-hungry older uncle. Perhaps economists would have quicker to get to behavioural economics if they’d spent less time with mathematical models and more time watching farmers yelling at each other!

Even with today’s knowledge though, it takes a rare mindset like Templeton’s to see opportunity on the cusp of a life-or-death conflagration.

Popping the bubble

Fast-forwarding 60 years, and Templeton was actively shorting the Dotcom Bubble. In his 80s! He was no perma-bullish Warren Buffett.

I’ve wondered before about the return sheets of the greatest old investors. Often there’s a presumption that their out-sized success comes courtesy of time and compound interest.

But to be actively betting against your grandkids’ smartest peers on Wall Street by shorting the most popular stocks – and winning – is something else.

What’s more, Templeton chose his targets in a cunning fashion. He studied the Dotcoms that had recently IPO-d, and looked for when the lock-in deals that restricted their freshly-minted founders from selling up would expire. Thus he anticipated who’d first dump their shares on the market. Kerching!

Man of mystery

Passing on little stories about Templeton’s profitable exploits matches how I learned about the man myself.

I’ve never read an investing book about Sir John Templeton, in stark contrast to my other favourite investors. (Templeton passed away at the grand old age of 95 in 2008).

Rather, I found out about Templeton through mentions in unrelated books, word of mouth, and magazines and websites.

That’s how I came across Templeton’s 22 maxims for investing success.

These pointers are most applicable to active investors trying to beat the market.

But there are also nuggets that passive investors should appreciate, too.

Enjoy!

The 22 investing maxims of John Templeton

1. For all long-term investors, there is only one objective: ‘maximum total real return after taxes.’

2. Achieving a good record takes much study and work, and is a lot harder than most people think.

3. It is impossible to produce a superior performance unless you do something different from the majority.

4. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

5. To put ‘Maxim 4’ in somewhat different terms, in the stock market the only way to get a bargain is to buy what most investors are selling.

6.  To buy when others are despondently selling and to sell what others are greedily buying requires the greatest fortitude, even while offering the greatest reward.

7. Bear markets have always been temporary. Share prices turn upward from one to twelve months before the bottom of the business cycle.

8. If a particular industry or type of security becomes popular with investors, that popularity will always prove temporary and, when lost, won’t return for many years.

9. In the long run, the stock market indexes fluctuate around the long-term upward trend of earnings per share.

10. In free-enterprise nations, the earnings on stock market indexes fluctuate around the book value of the shares of the index.

11. If you buy the same securities as other people, you will have the same results as other people.

12. The time to buy a stock is when the short-term owners have finished their selling, and the time to sell a stock is often when the short-term owners have finished their buying.

13. Share prices fluctuate more widely than values. Therefore, index funds will never produce the best total return performance.

14. Too many investors focus on ‘outlook’ and ‘trend’. Therefore, more profit is made by focusing on value.

15. If you search worldwide, you will find more bargains and better bargains than by studying only one nation. Also, you gain the safety of diversification.

16. The fluctuation of share prices is roughly proportional to the square root of the price.

17. The time to sell an asset is when you have found a much better bargain to replace it.

18.  When any method for selecting stocks becomes popular, then switch to unpopular methods. As has been suggested in ‘Maxim 3’, too many investors can spoil any share-selection method or any market-timing formula.

19. Never adopt permanently any type of asset, or any selection method. Try to stay flexible, open-minded, and skeptical. Long-term results are achieved only by changing from popular to unpopular the types of securities you favor and your methods of selection.

20. The skill factor in selection is largest for the common-stock part of your investments.

21. The best performance is produced by a person, not a committee.

22. If you begin with prayer, you can think more clearly and make fewer stupid mistakes.

Want more? Compare Templeton’s maxims to the rules of Walter Schloss.

What caught my eye this week.

I suppose it’s because I’ve long worked from home anyway, but I’ve been overlooking a big aspect of ‘back to office’ post-Covid debate.

Hitherto I’ve mostly focused on the productivity angle. How would firms weigh productivity gains from remote work against the loss of culture or development potential, I wondered?

As an active investor, I’ve spent 18 months shifting my money back and forth between work-from-home stocks like Zoom and Atlassian and beaten-up commercial property, reflecting my changing views.

But what I’d forgotten is that people are people. And that some of them are desperate to get back to an office simply to justify their jobs.

I’m someone who has more than once left office life – and killed my career prospects doing so, at least in that dark pre-lockdown era – just to escape the politics, busywork, colleagues I’ve have to carry, and clueless managers.

So it’s pretty dumb of me not to see that those who thrive in such an environment might want it back, pronto, entirely for their own reasons.

Logged out

One class of such people are, more or less, the loafers.

These are the non-working workers celebrated in books like City Slackers, Bonjour Laziness, and Michel Houllebecq’s Whatever.

They need to be in an office because remote work is usually more carefully measured work.

Doing nothing soon adds up.

I haven’t got anything personally against such people. Some of my best friends and so on. Many jobs are rubbish and soulless. Not everyone is cut out to be a cog in a modern machine.

However I don’t want to effectively be paying for them with my output, as the lack of their own drags us all down.

As a freelance I have no choice but to be measured on my own output. At least that way I live or die by my own sword.

How do they manage?

The other type of office denizen who has been drowning for 18 months – while waving all the time – perches at the other end of the org chart.

I’m thinking of high-flying, do-nothing managers.

I’m lucky to have had several great employers in my short on/off work CV. A couple of companies that regularly win/won awards as great places to work.

And largely they were.

Yet their corridors were still patrolled by a few of those passive-aggressive managerial types who climb up the career pole with spiked boots and aren’t concerned with who they gouge in the head on the way.

These are people whose days are packed with meetings where they talk a lot but rarely contribute. People who apparently did something great a few years ago, but always seem to be stealing someone else’s ideas today. People in charge of people that you wouldn’t let look after your dog.

An article from MSN this week brought them flooding back:

Remote work lays bare many brutal inefficiencies and problems that executives don’t want to deal with because they reflect poorly on leaders and those they’ve hired.

Remote work empowers those who produce and disempowers those who have succeeded by being excellent diplomats and poor workers, along with those who have succeeded by always finding someone to blame for their failures.

It removes the ability to seem productive (by sitting at your desk looking stressed or always being on the phone), and also, crucially, may reveal how many bosses and managers simply don’t contribute to the bottom line.

The horror. The horror.

What do you do again?

The CEO of a company I consulted for once admitted to me that he had no idea what a highly-paid mutual acquaintance on his payroll actually did.

This guy was on many projects. Yet looking for his fingerprints in the output was like hunting for the Higgs boson. Younger staff came up with the things that moved the company ahead. Meanwhile our chum was always in a meeting.

The CEO admitted he kept this chancer around almost out of superstition. The company was doing well ever since this chap was hired, even if nobody could say exactly why. The people he managed despaired of him.

I suggested perhaps our mutual contact’s direct reports worked harder under him in order to try to get past him – in the same way you’ll try to overtake a dangerous driver to put him in your rear-view mirror.

The CEO pondered this for a bit. And kept him on.

Poor petals!

Some of these high-flying underachievers do add a sort of social glue that – at least historically – bigger companies have seemed to need to grow.

Others have a brilliant idea every year or two and then fall back into a coma. That might just be enough to justify their salary and position.

But many are simply friction in the system. After a year of sending fifty Bcc-d emails a day or pinging Slack like a teenager on Snap and saying the most on Zoom in meetings but basically saying nothing, they risk being unmasked.

Meanwhile lots of actual workers at the coalface have been working from bed during the pandemic and still turning out great stuff. So it’s not like these unmanageable managers’ fears of the company culture being eroded or destroyed by homeworking are unfounded. Even if it’s actually being replaced by something better.

Often charmers, the best of these people remind me of those flowering epiphytes that thrive high in the rain forest canopy.

Growing on the sides of the trees who do all the proper hard work, they are beautiful and exotic and for hundreds of years scientists have debated whether they are harmless, subtly value-adding, or flat-out parasitic.

If you’re a fancy orchid that bears no fruit, no wonder you’re desperate to get back to the hothouse.

Even as many of the rest of us head for the doors.

Have a great weekend – whoever you are!

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