Bonds or Safe, Reliable Assets

In my posts about Leveraged Barbell Portfolios, I talk about bonds as being the primary holding for investors. Sometimes I mention the term "quality bonds". However, I think it is important to clarify what I precisely mean when discussing bonds in this context.

I tend to use bonds (or "quality bonds") as a proxy term for a safe, reliable asset. There are many opinions on what that means, but I think we can identify some characteristics of a safe, reliable asset.

  1. The asset is not likely to lose value in the short term. (Positive expected nominal returns).
  2. The asset is likely to maintain or increase its purchasing power over longer time periods. (Positive expected real returns).
  3. The asset is liquid. (Active marketplace, low transactions costs, easily divisible.)
  4. The asset is not likely to suffer from expropriation or cancellation (Legal forms of property loss.)
  5. The asset is not likely to be stolen or destroyed. (Illegal forms property loss.)
  6. The asset is durable. (Natural forms of property loss.)

There may be more identifiers of safe, reliable assets, but I think this is a pretty good list to start with.

Quality Bond Characteristics

By these metrics, we should consider the attributes of what I describe as "quality bonds". Quality bonds are high-rated shorter duration government bonds and certain high quality shorter duration corporate bonds.

They almost always have positive nominal returns. In any event, drawdowns in nominal terms are minimal and the coupon can be held until expiry where the face value is paid.

Quality bonds do not always have positive real returns, but they tend to be positive over time. Inflation risk and interest rate risk can be mitigated through building a portfolio of laddered shorter duration bonds. This means interest rates on individual coupons are constantly updated. Most shorter duration bond ETFs provide this service as part of their nature.

These bonds are highly liquid. With face values as low as $100 per coupon, it is easy to sell a small portion of overall bond holdings. In addition, transaction costs are tiny and the trading market is absolutely massive. ETFs can add obvious liquidity benefits for retail investors.

Bonds can suffer from expropriation or cancellation, particularly government bonds from higher risk countries and lower quality corporate bonds via bankruptcy. However, I think this risk can be alleviated quite easily with some basic screening techniques for issuer quality.

Bonds are very unlikely to be stolen or destroyed through criminality. Brokerage accounts, where these instruments are typically held, are insured. If your brokerage is in a country with a good track record for property rights, as most are, the risks are low.

Unlike physical assets that may be subject to deterioration, bonds do not have these properties. They are electronic, ownership is carefully recorded, and they don't physically erode.

Other Real Assets

Other assets that may be typically thought of as safe do not share as many of the same characteristics of safe, reliable assets as quality bonds do. Some of the other assets stated as being safe with stable value include physical gold and silver, productive land, real property improvements, live agricultural assets, and resource extraction rights.

Physical precious metals have a long history and extensive following as being the premier safe asset. In many ways I like precious metals. However, precious metals are not liquid and suffers from illegal property loss risk. The liquidity component may change if we ever move back to a gold standard, but a lot of things would have to change before that happens.

Productive land is in many ways a great asset. However, it is not liquid. There are also risks for durability and legal property loss, but these can be mitigated by choosing a country that respects property rights and a location that is less prone to natural disaster.

Real property improvements (buildings, etc.) are not liquid and not durable. Unlike productive land, buildings and other improvements must be constantly maintained. Eventually, many are simply replaced or removed as the maintenance becomes to burdensome or the characteristics of the area change. Like land, selling real property improvements can be expensive with lots of time and paperwork involved.

Live agriculture assets are interesting. Forests, perennial crops, cattle herds, and farmed or ranched fisheries have many characteristics of safe, reliable assets. They tend to maintain their value over time in real terms and have many liquidity features. However, they can suffer from illegal property loss and may not always be durable (forest fires, disease, etc.). They also require tending and maintenance to ensure long-term value characteristics.

Resource extraction rights, such as mining rights, fishing rights, water rights, agriculture production rights, and so on are essentially legal assets. Though not always, the markets for these assets can be very limited and I believe they carry significant risks. They can suffer from legal property right concerns as they are often politicized due to their monopolistic nature. However, they are often durable and not likely to suffer form illegal property loss with some screening.

Bigger Picture Views

As I've stated on this blog many times before, I believe most investors should have a sizeable allocation to safe, reliable assets. The go-to asset in this context should be quality bonds. While not perfect, they are as close to a safe, reliable asset that an average investor can access on the market today.

However, as an investor's portfolio grows, there may be less reasons to only choose quality bonds as the safe, reliable asset. As the list of alternatives above shows, there are other assets that carry many positive characteristics and returns which are likely to be different from quality bonds, or those growth charging equities.

As well, risks and priorities begin to shift as a portfolio grows. It is reasonably safe to assume that investors will always look for their assets to have positive nominal and real returns over time, that they don't suffer from illegal or legal property loss, and that the asset exhibits some durability or compensate for loss.

The biggest difference may be in the form of liquidity needs. If you have a $500,000 portfolio with $400,000 in safe, reliable assets, it is essential these assets are liquid as you may need to tap into the portfolio and don't want to distort your risk profile too much.

However, if you have a $5 million portfolio with $4 million in safe, reliable assets things are different. The likelihood of needing more than a few hundred thousand for any purpose is very low. At this point, assets like productive land, physical precious metals, real property improvements, and agriculture assets may become very appealing as a component of the overall portfolio despite their lower liquidity characteristics and other management requirements.

As portfolios get even larger, additional risks may be taken on because they are less likely to cause large disruptions in total wealth in their lower probability, large impact risks. For example, resource extraction rights may enter the portfolio. There is the risk of total loss, but there is the advantage of steady, monopolistic investment returns on that asset for a long time.

When I discuss bonds or quality bonds as a core part of the portfolio, it should always be taken in a wider context of the investor's situation. I am generally referring to safe, reliable assets that are suitable for the investor.

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Markets I Trade: March 12, 2019

In my non-registered account, I am developing my trend following strategy continuously. I don’t pretend to have all the answers. I am sharing this ongoing learning journey with you in this series.

I am always exploring new ways of trading, new markets to access, and better control of risk and opportunities. My main goal is to avoid large losses while achieving reasonable returns over time. I try to focus on trades which I believe have good reward-to-risk ratios.

You will see me trade index products, currencies, and commodities primarily with futures contracts and LEAPS options for maximum capital efficiency. I try risk small amounts of capital with each trade targeting high return multiples on that risk.

IWM: LEAPS Options

Source: StockCharts.com

I purchased IWM $160 call options on January 15, 2019 when IWM was trading at approximately $143 per unit. With the recent advance of U.S. Small Cap stocks, my stop has moved past purchase price.

We have seen a pullback in IWM over the past two weeks. This is in line with an overbought reading we saw at the end of February. The reversal appears it may have hit a bottom, so now I am looking for the price to push past the recent high of $159.

EEM: LEAPS Options

Source: StockCharts.com

I purchased EEM $45 call options on January 15, 2019 when EEM was trading at approximately $40.50 per unit. EEM has moved up in price since my purchase and my stop is set at about $40.

EEM had a pullback at the beginning of the month. Looking at the chart, there was a first lower low made on March 8. Although it hasn't hit my stop, I am cautious on this position right now. I should point out that I am quite heavily exposed to emerging markets in general with my positions on EWZ and KWEB.

EWZ: LEAPS Options

Source: StockCharts.com

I purchased EWZ $50 call options on January 25, 2019 when EWZ was trading at approximately $44 per unit. My stop level at a little under $40.

EWZ just about hit my stop level last week. However, I am still quite optimistic about EWZ. This is one of the few positions that I would consider to be in a long-term uptrend. Pullbacks are always expected and healthy, even in uptrends.

GLD: LEAPS Options

I purchased GLD $125 call options on November 19, 2018 when GLD was trading at approximately $115.65 per unit. This has been a very profitable trade for me; my stop is set a little under $122 per unit right now.

The price of GLD fell below my stop level so I sold my call options for a small profit on March 4, 2019.

VXZB: Options

I purchased VXZB $20 put options on January 16, 2019 when EWZ was trading at approximately $20.40 per unit. This is a volatility short trade that I made following the volatility spike we saw in December. So far the trade has nicely moved into profit.

I sold the VXZB options for a small profit on March 7, 2019 when volatility jumped and took an opposing position (more on that below).

KWEB: LEAPS Options

Source: StockCharts.com

I purchased KWEB $50 call options on February 20, 2019 when KWEB was trading at approximately $45.10 per unit. Since my purchase, the price of KWEB moved over $48. My trade is in profit with a current stop set at $42.20.

So far, KWEB has made higher highs and higher lows in a steady pattern since late December 2018. That's always a promising sign and could be indicative of a developing long-term uptrend.

DXJ: LEAPS Options

Source: StockCharts.com

I purchased DXJ $55 call options on February 22, 2019 when DXJ was trading a little under $51 per unit. I'm holding my stop at $47.60 per unit until we see a push over the $51.50 level.

VXXB: Options

Source: StockCharts.com

I purchased in-the-money VXXB $25 call options on March 7, 2019 when VXXB was trading at approximately $32.95 per unit. This is a hedging position betting on volatility increasing in stock markets. After my signal changed on March 11, I exited the position for a small loss.

On March 11, I purchased in-the-money VXXB $50 put options when VXXB was trading at approximately $31.25 per unit.

VXXB provides exposure to increased near-term volatility on the VIX Index.

Silver: Futures Contracts

I purchased Silver futures contracts on December 20, 2018 at approximately $14.83 per ounce. Silver has moved up in price since my purchase and my stop is set at $15.10 per ounce.

Silver fell below the stop price on March 3, 2019 and my position was closed for a profit.

Brazilian Real: Futures Contracts

I purchased Brazilian real futures contracts on January 3, 2019 at approximately US$0.267 per real. As the futures contract came to expiry at the end of February, I exited my position for a very tiny gain.

Since the real has been range-bound since my purchase, I decided not to rollover my position to the next futures contract. Instead, I will re-evaluate my neutral position if the real makes new highs over the $0.275 level.

South African Rand: Futures Contracts

I purchased South African rand futures contracts on January 25, 2019 at approximately US$0.0731 per rand. The rand has weakened a bit against the dollar since my purchase. I have my stop set at US$0.0692 per rand.

The rand fell below my stop price on March 7, 2019 so I exited my position for a small loss.

Summary

As you can see, I have made a few trades since my last market post. For a clearer picture as of March 11, 2019 I hold the following positions in this portfolio:

  • IWM $160 Call Options
  • EEM $45 Call Options
  • EWZ $50 Call Options
  • KWEB $50 Call Options
  • DXJ $55 Call Options
  • VXXB $50 Put Options
  • BSV (for my USD cash holdings)

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.