GRIDLEY

ASSOCIATES INC.

Financial Planning and Investment Management

OCTOBER NEWSLETTER

A Moving Opportunity

The recent drop in the stock markets and coincident fall in treasury bond yields has left many investors wondering what, if any, opportunities exist to make a decent return without taking on unreasonable risks. Corporate bonds can offer what I believe is a good risk/reward balance for many investors.

Before we look at a specific example let’s quickly review some bond basics. Most risks in owning bonds can be broken down into two main categories, Market Risk and Credit Risk. Market Risk is the risk that your fixed rate bond will go down in value as interest rates rise. Market risk is most extreme for lower coupon, longer maturities and least for higher coupon shorter-term maturities. Credit risk, as the name implies, is the risk that the company that issued a bond is unable to pay it back at maturity. The good news here is that bond holders are almost always paid back before stock holders so if you are comfortable with owning a company’s stock you should be comfortable with a comparable dollar investment in their bonds. Also, since it is easier to predict a short-term credit picture, all else being equal, credit risk generally is lower with shorter maturity bonds.

This brings me to my example and the question that should always drive any bond analysis, "am I getting paid to take this risk?" Ford Motor Company is a household name that, like other economically cyclical companies, is not faring well in our current economy. As such, they are considered a higher risk and both Ford stock and bonds are quite a bit lower than in recent history. In the case of the bonds, the perceived Credit Risk is greater than it was a year or two ago. On the other hand, Ford is one of the largest industrial companies in the world with outstanding brands and close to $25 Billion in cash on hand. The potential of Ford or its subsidiary Ford Motor Credit ceasing to be an ongoing business, in my opinion, is exceedingly remote. The likelihood of our government allowing tens of thousands of workers to become unemployed, especially after the precedent of bailing out Chrysler, is small. The problem is that while I believe Ford will survive financially, I’m less certain that they will return to growth anytime soon, especially in an industry facing fundamental oversupply issues. As such I’m disinclined to own the stock but do think the bonds are very enticing. As I write this, Schwab is offering a Ford Motor Credit bond, 7.25% coupon due 10/25/11 at a price of 87.27 which translates to a yield to maturity of 9.29%. In comparison, a ten-year U.S. Treasury currently yields 3.57%. Since the Treasury represents a riskless (from a credit standpoint) return we can calculate that our Ford bond will pay us a risk "premium" or as bond traders refer to it, a spread, of 5.72% (9.29-3.57=5.72). This is a very substantial premium. By comparison, a comparable bond being offered, General Motors Acceptance Corp. 7.25% due 3/02/11 offers a spread of only 4.37%. You will be paid an additional 1.35% to own the Ford bond versus the very similar GMAC bond. This sounds like a generous risk premium to me. Furthermore, the absolute yield on the Ford bond, 9.28%, is close to the long run return on stocks suggesting that while I may not have the upside stocks can offer, I will avoid suffering through a protracted downturn and stagnation in stocks while still hitting my longer term objectives. Also, as long as I am prepared to hold this bond to maturity in October 2011, I have no real market risk since, barring Ford defaulting, I now I will be paid Par at maturity.

Some caveats are in order here. It is foolish to put too much money in one bond, issuer name, or even industry. We cannot predict the future and any company, no matter how big, can potentially default. In addition, bonds produce current income that may create tax problems for some investors unless held in tax-deferred accounts. In the case of Ford or Ford Credit bonds, there are real business issues that could cause these to trade at even lower levels in the future. That said, investing is all about taking intelligent risks, and for the right investor, this risk may be one worth taking, especially for those who have lost their appetite for stocks yet need to reach toward long-term goals.

I will be happy to discuss your particular situation and whether this type of strategy makes sense for you. As always, if you have any questions or concerns about this or any other financial matters, please feel free to give me a call.

Randy Gridley

October, 2002