By Paul Scheurer © 2003
Last October,
with the Dow Jones, the Standard & Poor's
500, and the NASDAQ all hitting 5year lows,
I heard the joke, "What's the difference
between the stock market and the lottery?"
"At least you have a chance to win the lottery."
A recent Powerball
had an $86.5 million dollar jackpot  that's
present value, not installments over 20
years  at odds of 1 in 121 million. In
other words, for every dollar gambled, 71
cents was paid back to the bettors. Just
divide the jackpot by the odds.
Of course
the lottery is a game of pure chance. For
a mixture of chance and skill, there is
the racetrack. Only 17 cents of every dollar
is taken away, leaving 83 cents to be divided
by the winners. Using a strategy described
in Ian Fleming's "Diamonds Are Forever",
it is possible to simply play the odds on
horses. Bet on the favorite to place or
show, and you could be a net winner without
knowing anything except the odds. The reason
why this strategy works is that the crowd's
estimate of the probability of a race's
outcome is accurate, as a number of statistical
studies have shown.
Unfortunately,
the racetrack is a closed system of risk
and return. Over time, the average bettor
will lose money because the game is less
than zerosum: the track's 17% takeout
makes it so.
Is there a
game which promises a return of more than
100 cents on the dollar? Yes, it's what
I will call the corporate bond game. Just
as the crowd at the racetrack contains information,
so does the crowd in the bond market. And
in both cases, the information is the odds.
Knowing the
odds is one key to making money with corporate bonds.
The other is holding to maturity: bondholders
have a contract that promises 100 cents
on the dollar at a specified date, and can
thus avoid the risk that higher interest
rates will diminish a bond's value.
But interest
rate risk cannot be avoided in a bond mutual
fund because the fund's manager can sell
when bond prices are depressed, and it is
the bond fund shareholders who suffer the
losses. Furthermore, with annual fees averaging
1%, that's a loss of 14% of the income from
a bond that pays 7%.
Shortly the
SEC is expected to approve an expansion
of the NASD's TRACE reporting system from
500 to approximately 5000 corporate bonds.
At NASDBondInfo.Com,
anyone can set up a bond portfolio tracking
system, free of charge. With 25 bonds in
different industries, a bond holder has
some diversification. And with maturities
of three to five years, a bond holder limits
inflation risk.
Because financial
markets are efficient, I believe that corporate
bonds offer fair odds of getting the promised
return on investment, and more importantly,
the promised return of 100 cents for a dollar.
To quote Mark Twain, who lost large sums
in the stock market of his day, "Investors
should have greater concern about the return
OF capital than the return ON capital."
