The Education of a Corporate Bond Manager, Part IV

When I started this series, I did not think that it would expand as much as it has.  Part of that is getting great questions, such as:

Hi David,

Great series!

You mention that reputation/size matters. Are there any “poker” aspects of reputation that can be detrimental? For example, if you develop a reputation for consistently making good purchases do brokers catch on and markup prices with the idea that your interest in a bond is evidence of underpricing?

Josh

Mmm… poker; I use gambling analogies freely, but I don’t gamble.  You have a point, Josh.  If you do have skill as a manager, how do you deal with the Street if you think they will use your knowledge against you?

First, it helps if you are honest, keep your word on trades, and never try to weasel out of a trade once you have said “done.”  Your word is your bond, and the Street quickly learns who can’t be trusted.  Second, it also helps if you have a genuinely fair reputation; that you don’t try to pull fast ones on the broker community.  A few things that help in that regard: 1) most trades are “low information” trades — you need to raise some cash, and so you look down your list of bonds that your analysts have tagged as “please sell in the next few months” and select a few bonds on which to solicit bids.  When you talk to the brokers in question, tell them how many brokers you are talking to about this bond, and that you just need to raise some cash.  That sets them at ease, and does not reveal that your analyst has a negative opinion on the bond.

Third, that reputation for fairness should be reinforced by other actions.  a) When an investment bank is quoting a price/spread out of the market context, let them know what you know.  If they insist that they are right, then trade against them. b) If their risk control desk comes to you with a trade because they have to cover a short, and you own the bonds, help them out.  This is an “Androcles and the Lion” situation.  Make them pay up, but don’t “gouge their eyes out,” to use the technical term.  Just make them pay a little more than the ask.  If you do that, they will be grateful, and might offer you the long cross-hedge bond at a very nice price (happened to me twice).

Fourth, in general, have an “openness policy.”  Many bond managers conceal 80% of what they are thinking and reveal 20%.  I would reveal 80% and conceal 20% — the most critical 20%. (Imagine a poker game where you, and only you, get dealt all of your cards face down, and you get to choose which one card remains face down.)  Truth is, most investors and investment banks are not set up to copy everything their bright investors do; it would quickly become an overload.

But there is another reason why if you are a bright investor that you don’t have to worry so much.  Brokers make money off of trades.  They thrive off of differences in information.  They like nothing better than to facilitate the trades of bright investors at the expense of not-so-bright investors, because it gives them a reliable series of trades, where they clip a little for themselves.  They aren’t dumb; they don’t want to kill you on one trade if they know they can have a continued stream of trades.

Fifth, your broker at the investment bank is proud of his best clients.  He does not want to lose you if you are bright, or if you trade a lot, or run a big account.

Sixth, never tell your whole story to any broker.  The intelligent portfolio manager breaks up his business among many brokers, each of which is working on specific deals, with no overlap, unless the brokers have been so informed.

Seventh, it is very good to have a reputation for being bright, or at least, not being a pushover.  It restrains the brokers from taking advantage of you and your client.

So I look at being bright in the bond business another way.  It is an advantage that needs to be manager through proper communications.

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On the Trading Log

My first boss had a trading log, and when he left, I imitated him, and copied down my notes from when I was trading.  In the short-run, it avoided confusion; in the long run it encouraged consistency of thought.

But, it is one thing to keep a log, and another thing to remember prices and spreads.  I did my utmost to forget where I entered trades, and then focused on what was the best thing I could do with any given bond, even of I sold it at a loss; at least I avoided a bigger loss.

It is freeing to avoid thinking about whether any trade will generate a gain or a loss, and rather, as how the portfolio can be improved.  We can’t control market prices, but we can choose the companies in our portfolio.  And though humans might be bad at making choices when there are thousands of options, we can be very good at evaluating whether swapping one asset for another can be bright, dumb, or too close to call.

More on this in future segments.