“Price discovery is the toughest part of managing bonds,” one of my brokers told me early on.? Right he was.? There may be 7000 or so stocks that trade with some regularity in the US, but there might be one million different bonds.? The last trade on a given bond that you might consider might be weeks or months ago, if you could find it at all.? I was managing pre-TRACE, where reporting got standardized.

I dealt in more illiquid bonds than most managers would.? Part of that was inexperience, another part was knowing that I had a balance sheet behind me that could handle it, and the last part was knowing that my credit analysts were usually right, so if I could find bonds that were off the beaten track and could be held to maturity, we could make some extra money.? Pay us with a good yield, and I will eat the illiquidity risk on behalf of my client.

One of the dirty secrets of bond management is that after adjusting for default risk, the #1 predictor of the return you will get is the yield on the portfolio.? If you do default risk right, that’s almost a tautology — default risks should be lowered after the bust phase of the credit cycle, and raised as the credit cycle gets long in the tooth.? The tighter spreads get, the more you should raise your default loss estimates.

But how to come to the right price/yield/spread?? I had a few trades, but they were dated.? I knew the spreads then, and used the spreads of more liquid similar credits to adjust it to a likely yield spread today.? I put in a fudge factor because illiquid bonds are higher beta, and then studied which of my brokers might have a bead on the bonds in question.? I would ask them their opinion, and if they were in my ballpark, I would back up my bid some, and bid for $1 or $2 million of the bonds.? The response would come back, and I would have a trade, or nothing, but maybe some color on where they would be willing to sell.? If a trade, I would back up my bid a little more, and offer to buy more.? If no trade, I would offer 50-70% of the distance between our bid/offer, and see what they would do.

I never thought I would be good at haggling.? I’m a quiet person for the most part, and I was surprised at how much I enjoyed being on the phone with my brokers most of the day, buying deals, setting up trades, discussing market color, etc.? But I was good at haggling, and I carried tools in my bag that many did not.

I decided to hold auctions and reverse auctions.? On the reverse auctions, I would solicit liquid bonds to be sold to me — maximum spread wins, subject to a reservation spread, or a minimum number of offerers.? On the auctions, I would offer liquid bonds, minimum spread wins, subject to a reservation spread, or a minimum number of offerers.? It worked well, until I read a fiction book that had auction theory as a subtext.? So I designed a new auction.

One of the problems with the auctions was that some investment bank would overbid, and win, and then the salesman would come back to me, confess the error, and say, “Can you show me some love here?”? I was taken aback by it the first time I heard this, but came back with a fairly rational solution, giving back one-third of the difference between the winning bid, and the second-place bid.

But I came up with a better way.? Here is a? Bloomberg post that I made to five of my brokers:

BWIC [Bid wanted in competition] — 1:30PM — 5 dealers only.? I am selling these just to raise cash.? This is a continuation of my experiment so bear with me.? In an effort to reduce buyers remorse (and thus get better bids) I am awarding the bond to the winning bid at the COVER level.? In case of a tie, I will award bonds pro-rata at the tie level.? If you don’t want to play, let me know.? Thanks, David. [Bond list follows]

Everything has meaning here:

• 5 dealers — limit the auction to the dealers who have the most interest, it makes them fell comfortable that they have a shot at getting bonds.? I never used more than 6 dealers in an auction.
• Just raising cash — says that you don’t know anything they don’t know.? Makes them more willing to bid.
• Cover level is the second place bid.
• You can’t come back begging for love here.
• Ties were particularly valuable, because there was no love and both brokers got half of the bonds, and typically lost money on resale, since they were competing against each other.
• If I did not get enough bids on an auction, typically three, I could cancel it.

I reviewed my auction results and found that it erased the advantages of my brokers.? I ended up selling bonds near their ask levels, on average.? What was worse, many thanked me for being innovative in creating an auction method that “showed love” in advance of the auction.? When I explained this gambit to my wife as we were traveling to prayer meeting one evening, she gave me a hard hit on the shoulder, and said to me, “David Merkel, you are horrible!? Not only do you beat Wall Street at its games, but you get them to thank you for it!”? Oh well, guilty as charged.? She doesn’t want me to be proud, and she was right.

There are limits on when to haggle, though.? Occasionally you are invited into deals that you know are good; only a pig would ask for more then.? Those that do ask for more will get dropped from the list.? So be a gentleman; if you are getting an unreasonable deal already, smile, thank them, and move on.? Don’t ask for more.? It is more important to be invited back, than to make a little more today, even if that were possible.

In haggling, I would bid/offer fewer bonds than was wanted by the seller/buyer at the level, and ask for better terms at their size.? That would make them more willing to deal.

I had more tricks in my arsenal, but one was always paying my brokers.? If at the end of a trade, my broker said to me, “Well, your prices match so I will cross the bonds to you,” I would say, “No, I am raising my price (by 1/64th on $100) so that you can be paid.? My broker must always earn something on my trades.”? This made my brokers more loyal to me.? They knew that I cared for them, which meant something, particularly with the regional brokers.

In one sense, trading was just an amplified version of character.? Could you be trusted?? Do you play fair?? I tried to be fair everywhere I could while making money for my client.? That had a lot of payoffs for my client, even though if they were watching over my shoulder on individual trades they might have said, “Why are you not pursuing the maximum here?”

I have a saying that playing for the last nickel might cost ninety-five cents in the long run.? Intelligent managers do not look like pigs, or their opportunities get shut off.

I would simply say that you should play for long run advantage.? Better to make modest gains in many opportunities, than to make a killing once, and be shut out from opportunity thereafter.

I have more tales on this topic, but they will have to wait until a later episode… I have four left at maximum I think.

Credit analysts are a corporate bond manager’s best friends.? No portfolio manager can be entirely aware of the extent of credit risks in a broad portfolio.? They provide a necessary check on the ability of the portfolio manager to play “cowboy” (or “cowgirl”), and to mix the metaphors, be a yield hog.

The native tendency of almost all bond portfolio managers, unless they have discipline, is to seek extra yield, for two reasons:

• In the short run, on average, a portfolio with more yield earns more.
• Many managers will conclude that a higher yielding credit will rally, due to mean-reversion.

The second observation is true about half the time in my opinion, but the rewards are asymmetric.? Gains are small, and losses are large.? It does not pay to be a yield hog.

I listened closely to my analysts.? After all, if you have talented analysts, why shouldn’t you listen to them aside from a misbegotten pride?? I always did what my analysts told me to do, but I did it on my timing, and I explained that to them: “I will sell this bond, but right now, the market is running hot, and marginal bonds like this one are in hot demand.? If I wait a week or two, I will get a better price.”

Communication is the key, as it is in any relationship.? More communication make the analyst feel valued.? Letting them know why you like or don’t like an idea of theirs is useful to them.? Giving them pricing data helps them grasp what you are up to, and can lead them to provide real help, once they grasp the problem.

But ignoring them, except to blame them when they make bad calls, leads to a poisonous relationship, and does not lead to stellar performance.? Don’t get me wrong, I think portfolio managers should lead, and credit analysts guide them, but if there isn’t respect for the analysts, you may as well give up.? They are professionals as well as you.

Now, the intelligent portfolio manager underwrites his analysts.? All analysts have biases.? Some will say “Yes” to almost everything, some will say “No” to almost everything, and some are balanced.? There are ways to break them out of their biases, though.? Giving them a list of spreads for the companies that they cover, and asking them to rank the credits in their sector is a good start.

For Mr. Yes, ask him about risk factors.? Ask him how it would rank relative to major competitors.? For Ms. No, ask her what are the best names she would invest in.? Where is there opportunity?? Ask her to rank the company versus major competitors.? It’s a challenge, but if your analysts are bright people, you can retrain them to think past their biases, and give you good information that you can apply to making buy and sell decisions.

If I may, this is another area where being polite, reasonable, and (dare I say) loving, pays off.? Showing care for you colleagues pays large dividends.? I am not saying be a pushover, but the more you cultivate your colleagues, the better results become.

Monoculture

Every investment shop tends to create? a sort of monoculture, modeled off the guy at the top.? Now, if the boss has succeeded for a long time, it is because his unique views have punch.? All the same, situations will come up where the firm is long a name to nearly the maximum level, and the credit analyst is certain of his opinion, though the price keeps falling.

What to do?? Here are the steps:

• Have other analysts analyze it.? It may not be their sector, but they are professionals, and will bring a fresh set of eyes to the problem.? If that fails, then…
• Have the portfolio managers take the name home and analyze it.? Let them poke holes in the thesis.? But if no one can find a hole…
• Look at Street research, to find the bears… circulate the opinion to all on the team.? If the opinion makes sense at present pricing, sell out.? If it makes no sense, waive the credit limits and buy more.? Look for reasons as to why others might be forced sellers.

The idea is to challenge the internal credit culture of the firm, and analyze the market dynamics that might be creating a lower price in the short run than might exist in the long run.

That’s all for now, more to come in part eight.? Wait, how many parts will there be in this series?? The present target is twelve.