Introduction:

There is a presumption of homogeneity in a typical bond index. In the indexed approach, the limit of one’s expectation as to selectivity might be “intermediate-term investment grade corporate bonds.” One is unlikely to be offered an undifferentiated yield from such a generic population, particularly in a stable market. With today’s ultra-low interest rates and the great demand for fund-based yield vehicles, the likelihood of a truly remunerative and adequate return is even lower.

Where can one find the possibility of a differentiated return? From a security NOT in the indexation sphere of interest. For instance:

  • A bond that might be excluded from an index, just as for equities, because of limited trading liquidity, as for a small issue or one that has been subject to repurchase by the issuer.
  • Or, a bond might be expelled from an intermediate-term index if, with the passage of time, it has become shorter term, since the index must maintain a certain target maturity.
  • Or, a bond that has suffered a credit downgrade which makes it ineligible for its original index. Paradoxically, one of the safest (in terms of asset coverage and actively enforceable rights) and highest return bonds one can buy are those of companies arranging for (or in the midst of) a pre-packaged bankruptcy reorganization. Yet both index funds and major institutional investors such as pension funds may be prohibited from holding such securities.

These and any other factors that cause a security to fall outside the strict indexation rule-sets, irrespective of fundamental valuation attractiveness, remove them from a normal supply/demand environment and set up the opportunity for mispricing. One wants a security not in demand, a security whose price has not been driven by indexation algorithms. Below are some examples that, because they fell outside of the indexation flow of funds, offered a higher prospective yield, appreciation, optionality or other advantageous features. None of them are ‘normally’ available, they only become available for a period of time.

Examples of Security Selection:

Coupon Income

Brookfield Residential Properties Inc., a small affiliate of a large enterprise, at the right time, with a non-standard issue, offered a very attractive bond return. Read More >

Discounted Bond Price

Freeport-McMoRan Inc., a large and diversified natural resources company’s bonds had few natural buyers during a period of uncertainty – an opportunity to invest in its shortest-maturity notes at an unusually-high discount resulted. Read More >

Convertible Securities

Royal Gold, Inc.’s “busted” convertible bonds dropped in price, not due to credit concerns, but simply because the common shares fell sharply from the all-time highs they reached when the bonds were originally sold. These converts offered the margin of safety the prudent investor values, with a degree of optionality not usually available. Read More >

Alternative Income Securities

Beyond the situations above, the opportunistic income investor seeks opportunities to harvest income in other mispriced investment instruments such as closed-end funds, non-traditional REITs, and select equities that offer a substantial dividend. Read More >