The Corporate Bond Investor for Individual Investors
Introducing the Corporate Bond Investor, Kamakura’s Individual Investor Service
Thank you very much for your interest in the Corporate Bond Investor. In this brief note, the Kamakura team provides a 30,000-foot overview of the Corporate Bond Investor and how it works for individual investors. Many Kamakura staff members and employees of Kamakura’s institutional clients subscribe to the Corporate Bond Investor for their personal fixed-income investments.
Objective of the Corporate Bond Investor
To help analytical individual investors outperform all other fixed income investment alternatives on a risk-adjusted basis:
- Outperform U.S. Treasuries and related exchange traded funds by investing in corporate bonds with the highest “reward to risk ratio”.
- Outperform fixed income exchange traded funds by defining the right “benchmark” for each individual: the investor’s future cash needs for retirement, education expenses, medical expenses, and so on.
- Avoid unnecessary taxes and the hidden costs of portfolio “churn” in fixed income exchange traded funds caused by choosing an arbitrary benchmark that needlessly triggers bond trades and incurs tax liabilities. The most notorious sources of churn expenses are benchmarks that do not include bonds with a maturity less than 1 year (or other maturities). That forces bond sales as bonds in the portfolio get closer to maturity. Instead, the obvious strategy should be allowing the bonds to mature, avoiding the expenses and taxes from a sale before maturity
How Does the Corporate Bond Investor Achieve These Objectives?
We use Kamakura Risk Information Services (“KRIS”) default probabilities and bond price histories in the same way that Kamakura’s institutional investors use KRIS to manage their own fixed income portfolios.
What Information Does the Corporate Bond Investor Provide?
Each day (Tuesday through Saturday) the Corporate Bond Investor provides two important spread sheets which analyze all senior fixed-rate bonds which traded at least $1 million in volume for the prior business day:
- Daily Kamakura “Best Trades” Spreadsheet
This Excel spreadsheet ranks all of that day’s bonds from best to worst, both overall and for each annual maturity from 1 to 30 years
- Daily Kamakura “Performance Attribution” Spreadsheet
This Excel spreadsheet explains the reason for each day’s change in bond prices for the universe of bonds covered by the Corporate Bond Investor. Bond prices change because of changes in the “risk-free yield curve” (U.S. Treasuries) and changes due to changes in the issuer’s credit risk, the bond’s liquidity premium, and the bond’s call provisions.
For both spreadsheets, the “My Portfolio” tab allows investors to paste in a list to CUSIPs for the bonds they own or have interest in. The spreadsheet will automatically populate the sheet with the information relevant to the investor’s bonds provided that the bond traded at least $1 million in volume on that day (and the prior day in the case of the performance attribution spreadsheet).
Summarizing the Corporate Bond Investor Approach
The Corporate Bond Investor recommends a two-step process for bond portfolio selection:
1. Forecast your cash needs by year for as far into the future as possible. This is the most important part of investment strategy.
2. Select a bond portfolio that matches cash needs using these key points:
- Diversify. There should be at least 20 and preferably more bonds in your final portfolio
- With each investment, you should try to match cash flows in a different future annual period
- For the period of interest (say 10 to 15 years), sort the best value spreadsheet by maturity.
- Within the maturity range of interest, select the bond with the best (highest) ratio of credit spread to default probability unless you already own a bond by that issuer. In that case, choose the issuer with the second-best ratio.
- Construct the portfolio with trades spread over time, rather than executing all trades at the same time
What Do Subscribers to the Corporate Bond Investor Say About the Service?
Kamakura appreciates the kind comments provided by subscribers in the graphic below:
How Do I Sign Up?
The infrastructure for the Corporate Bond Investor is provided by the very large and successful individual website www.seekingalpha.com. Step 1 is to go to the SeekingAlpha website and establish your free account. The second step is to start a free trial, which is available at this link:
Does the Corporate Bond Investor Provide Advice on How to Execute Trades?
Yes. Here is The Corporate Bond Investor’s guide to smart bond trading, assembled from the suggestions of long-term subscribers.
What Should I Read First?
We recommend that you read the most recent “Best Value Bond Trades” weekly summary, posted on Friday of each week on SeekingAlpha. The Friday posts go though the Corporate Bond Investor process in more detail. Alongside each post is a set of important links that provide additional information. The Daily Best Value Bond Trades (posted Tuesday, Wednesday, Thursday, and Saturday) is a shorter summary of the day’s highlights with the two spread sheets attached.
What Should I Do If I Have Questions?
It is best if you post your question to the chat room so that the Corporate Bond Investor community can both read the response and contribute to the answer. Please contact Don van Deventer directly via SeekingAlpha messaging or via his Kamakura e-mail address given in the welcome e-mail provided when you start a free trial.
Have fun and be smart!
Technical Summary of the Default Probability Models Used, with Selected Readings
For subscribers with a fairly good background in economics and finance, we’ve attached this summary of advanced background materials.
The Kamakura Risk Information Services version 6.0 Jarrow-Chava reduced form default probability model (abbreviated KDP-jc6) makes default predictions using a sophisticated combination of financial ratios, stock price history, and macro-economic factors. The version 6.0 model was estimated over the period from 1990 to through the “great financial crisis” and beyond. Kamakura default probabilities are based on 2.2 million observations and more than 2,600 defaults. The term structure of default is constructed by using a related series of econometric relationships estimated on this data base. KRIS covers 40,500 firms in 76 countries, updated daily. Free trials are available at Info@Kamakuraco.com. An overview of the full suite of Kamakura default probability models is available here.
General Background on Reduced Form Models
For a general introduction to reduced form credit models, Hilscher, Jarrow and van Deventer (2008) is a good place to begin. Hilscher and Wilson (2013) have shown that reduced form default probabilities are more accurate than legacy credit ratings by a substantial amount. Van Deventer (2012) explains the benefits and the process for replacing legacy credit ratings with reduced form default probabilities in the credit risk management process. The theoretical basis for reduced form credit models was established by Jarrow and Turnbull (1995) and extended by Jarrow (2001). Shumway (2001) was one of the first researchers to employ logistic regression to estimate reduced form default probabilities. Chava and Jarrow (2004) applied logistic regression to a monthly database of public firms. Campbell, Hilscher and Szilagyi (2008) demonstrated that the reduced form approach to default modeling was substantially more accurate than the Merton model of risky debt. Bharath and Shumway (2008), working completely independently, reached the same conclusions. A follow-on paper by Campbell, Hilscher and Szilagyi (2011) confirmed their earlier conclusions in a paper that was awarded the Markowitz Prize for best paper in the Journal of Investment Management by a judging panel that included Prof. Robert Merton.
Background on the Calculations
Assuming the recovery rate in the event of default would be the same on all bond issues, a sophisticated investor who has moved beyond legacy ratings seeks to maximize revenue per basis point of default risk from each incremental investment, subject to risk limits on macro-factor exposure on a fully default-adjusted basis.
Maximizing the ratio of credit spread to matched-maturity default probabilities requires that default probabilities be available at a wide range of maturities. We used the default probabilities supplied by Kamakura Corporation’s KRIS default probability service, interpolated to a matched-maturity basis to the exact day of bond maturity. For maturities longer than ten years, we assume that the ten-year default probability is a good estimate of default risk.
Bond yields are secured from TRACE. The National Association of Securities Dealers launched the TRACE (Trade Reporting and Compliance Engine) system in July 2002 in order to increase price transparency in the U.S. corporate debt market. The system captures information on secondary market transactions in publicly traded securities (investment grade, high yield, and convertible corporate debt) representing all over-the-counter market activity in these bonds.
We used the trade-weighted average yield reported by TRACE for each of the bond issues analyzed. We calculated the credit spread using the matched-maturity yield on U.S. Treasury bonds, interpolated from the Federal Reserve H15 statistical release for the trade date. The source of the information on the H15 release is the U.S. Department of the Treasury.
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