Tonight’s article is about speculation in the current market environment.  Let’s start with the front page of Wednesday’s Wall Street Journal.  Two medium-large hedge funds at Bear Stearn are likely to be closed down, and the collateral sold by Merrill Lynch, unless an alternative deal can be worked out.

Working out such a deal won’t be easy.  Debt-based hedge funds are frequently long and short credit obligations that are complex, and often unique.  The obligations are difficult to trade, partially because there are few who traffic in the securities, and there is often little trading in the securities to validate the pricing levels that the hedge fund use to calculate their valuations each evening.  Positions are not so much marked-to-market, but marked-to-model.  Illiquid as they are, an auction will test the markets to see how much of a discount is needed to move the securities.  How much slack assets do their competitors have to snap up debt obligations at a bargain?  When the liquidation is done, will there be anything left for the hedge fund investors?  Merrill just wants its money back, will they take their time to get the best price, or will they conclude that the market is decaying, and decide to sell as rapidly as possible?

Now there are a decent number of these investors, and reputedly bright, as this Bloomberg article points out.  There are lots of smart people on Wall Street, perhaps too many, and some always prove to be “too clever by half.”  What is the ratio of vultures to carrion?  So far, more vultures, which is bullish.  The results of any auction will be reflected in the prices, which may overshoot on the downside, if only because when too much liquidity is demanded at once, the prices of what is being sold will suffer.  But if there are a lot of vultures, that will not happen.

Part of this problem is the general willingness to extend credit at low incremental yields.  (Spreads were tight when the worst of the subprime mortgages were originated.) Fundamental bond investors (like me) have been worried for a while, but usually it takes a few years of lending at low spreads before something breaks.  Consider the following articles:

Spreads are too tight, particularly on riskier debt.  More subordinated debt is getting issued.  Covenants are weaker than before.  More CCC-rated debt is getting issued than ever before.  Private equity seeks more and more financing, substituting debt for equity, and making the overall financial system less flexible.  Liquidity is just another way of saying that risky lending takes place at low spreads versus safe debt.

The last two articles cited describe the problem, but also how it might end ugly.  In my opinion, it will take a few entities blowing up before the markets change.  In the fixed income markets there are players who fell that they must deploy cash to justify their existences; they only sell once a crisis is proven, and the client is complaining.  That is why the debt markets react more slowly to a crisis than the forward-looking fundamentals would indicate.  Men have lost their jobs for not grabbing enough yield in the bull phase; this leads others to invest in securities of dubious quality, but possessing stellar YTNJs [YTNJ = Yield To Next Job]. 8D

Part of this mess is a failure of the ratings agencies.  It’s tough to be proactive when most of your revenues come from those you rate.  The ratings agencies have been slow to downgrade through much of the last two years, as subprime creditworthiness deteriorated.  We faced the same problems in corporate credit back in 2001-2002.  The venue changes, but the conflicts of interest don’t.

This will not end well, which is not to say that the sky is falling.  These troubles could take years to unfold.  Tops are a process, not an event, and fundamantally driven investors almost always sell too soon, seeing the crisis well in advance, but not realizing that those in troubles have many ways of delaying the pain.  It is always amazing to see how resourceful some can be during a crisis.  So, be aware of the problems at hand, but don’t give in to imminent panic.  Before the a crisis occurs, the vultures will have to be glutted or scared to death, and we aren’t near that yet.

My posting philosophy when doing commentary on the news is not to do “linkfests,” much as I like them, but to try to give a little more thought behind what has been written, and try to weave them into a greater coherent whole.  My career has been diverse; if I wanted to be mean I would say that I was a dabbler, a patzer, a dilettante.  A jack of all trades and a master of none.  The strength of my varied career is that I have insights into a wide number of areas in the markets, and how they interconnect.  I have always believed that understanding multiple markets helps shed light on each one individually.

So, when I comment on the news, it is my aim to give you a broader perspective on the major factors influencing our investment decisions.  That also means that I might not be commenting on what is breaking news, but on what trends are going on behind the scenes.  Today’s topic is supply and demand factors in the equity market… the true technical analysis. 😉

Let’s start with Jeff Miller at A Dash of Insight. He gives the classic case of why a management would buy back stock.  A management team is able to capture more of the excess returns that the business is earning by substituting cheaper debt for equity in their capital base.  In moderation, this is a decent strategy; it is a strategy increasingly employed because of high profit margins and low interest rates.

Now, as you go through this discussion, you will run into the term “Fed Model.”  The Fed model is a simplified version of a discounted cash flow model, where the earnings of an equity market are discounted using a common interest rate, frequently a long treasury rate, and compared to the current price, to see whether stocks are rich or cheap.  (Note: this calculation does not actually prove whether stocks are absolutely rich or cheap, but only rich or cheap relative to bonds.)  In practice, the calculation can come down to comparing the earnings yield of an index (earnings divided by market capitalization) to the yield on the long Treasury note.

Use of this model is controversial and can produce widely varying results depending on your assumptions.  Take for example, this article over at Trader’s Narrative. It draws the conclusion that the market is “extremely undervalued” at these levels.  This is true, if interest rates and credit spreads stay low, and profit margins stay high.  All three data series tend to mean revert, so how long these factors remain favorable is open to question.  Nonetheless, in the past, comparing treasury and earnings yields was a smart strategy.  Will that continue?

John Hussman ably argues that profit margins are mean-reverting, and that the relationship of earnings yield to bond yields has been spotty at best.  I agree with both of those ideas, but with some caveats:

  • Profit margins could remain high for a longer time than anticipated because of increased globalization, and increased willingness to lever up.
  • The relationship of earnings and bond yields has gone through eras where there has been extreme greed and fear.  That earnings and bond yields do not track perfectly is not a weakness, but a strength of the model.  If they tracked perfectly, there would be nothing to game here.  At extreme differences the yield differential produces signals that will make money, and reduce risk to investors.  (Personally, I like my models to explain half of the variation or so — a good balance between there being a signal, and having significant noise to exploit.)

I expect profit margins to mean-revert, but what if they don’t do so quickly?  As an example, consider the upside surprise delivered in the first quarter.  US corporations don’t just depend on the US economy anymore; they sell outside the US, and buy resources outside of the US, even labor (outsourcing).  With a weak dollar, earnings in dollar terms surprised on the upside.  Buybacks also increased earnings per share.

Ignore Shiller when he does the 10-year average earnings.  10-year averages are less representative of future earnings than the current year’s earnings.  There has been a lot of earnings growth for sustainable reasons.  Could earnings pull back significantly?  Yes, but not to the 10-year average, unless we get a depression.

What of rising interest rates?  Will they derail the equity market?  Some think soSome think not.  My view is that at around 6.50% on the 10-year Treasury, bonds would present serious competition to stocks.  Down here around 5.15%, we will continue to have the substitution of debt for equity through LBOs and buybacks.  Despite the volatility, investment grade credit spreads are still tight, and the collateralized loan obligation market is still active, allowing LBOs to be more easily financed.  Further, there is a yield hunger on the part of buyers that allows corporations to sell debt, even subordinated debt cheaply.  This will eventually change, but we need some genuine failures of investment grade companies to demonstrate the real risks of borrowing too much.

In the short run, that IPOs are being well-received is a plus to the market.  There is demand for stock.  In the long run, buying at low P/Es is also a plus (ask David Dreman).  That’s not true now, except relative to bonds, which are providing little competition to stocks.

So where does that leave me?  My view is more complex than many of the caricatures being trotted out.  Let me give you the main ideas:

  • Comparing earnings yields to bond yields is useful, but must be done with discretion.
  • Profit margins will mean-revert, but given globalization, and its effect in restraining wages, that may be a while in coming.  How much do you want to leave on the table?
  • Demographic trends should keep real interest rates low.  The graying of the global Baby Boomers is one of the factors keeping interest rates low.  Retirees and near-retirees want income, and that is surpressing interest rates.
  • Also suppressing interest rates are those that have to recycle the US current account deficit.  Until we see large currency revaluations in countries that have large surpluses with the US, rates should stay low.
  • Until we get a significant set of defaults in the credit markets, credit spreads should stay low.  At present, there is too much vulture capital lurking, waiting to buy distressed assets.  The distressed investing community needs to be seriously scared; then maybe valuations will head south.

So, reluctantly, in the short run I carry on as a moderate bull.  That said, the valuations in my portfolio are cheap relative to the market, and the balance sheets are stronger than average.  The names are inclined more toward global growth than US growth.  Many companies in my portfolio have buybacks on, but none are doing it to the level where it compromises their credit quality.

Trends have a nasty tendency to persist longer than fundamental investors would anticipate.  So it is with the markets at present.  Honor the momentum, but keep one eye on shifts in interest rates and profit margins.

The most recent closing high in the S&P 500 was on June 4th.  Since then, we have been through a spin cycle where all that mattered were yields on the long end of the Treasury curve.  That’s why I wrote late on Thursday at the RM Columnist Conversation:

David Merkel
Bonds and Stocks Decoupling? They were only Together by Accident.
6/14/2007 4:50 PM EDT

I was somewhat skeptical when I saw bonds and stocks trading in tandem. The relationship between bond and stock earnings yields is a tenuous one operating over the long haul and on average. Using the five-year Treasury as and the S&P 500 my proxies, bond yields have exceeded earnings yields by as much as 8% in the mid-’50s, while earnings yields have exceeded bond yields by more than 4% in 1981, 1984 and 1987. On average earnings yields are 32 basis points over bond yields. If there is mean reversion in the difference between the two yields, the effect is not a strong one. At present, the relationship between earnings and bond yields seems tighter because of the large substitution of debt for equity going on, but that’s not a normal thing in the long run.

Even with all the buybacks and LBOs, it isn’t normal for stocks and bonds to trade in a tight correlated way in the short run, so, take one of your eyes off of bonds, and look at the fundamentals of the companies that you own. You’ll make more money that way, and take less risk.

PS: if the ten-year crosses 5.50%, go ahead and look at bonds again, and maybe allocate some more money to fixed income. Repeat the process each 0.5% up, should we get there. Equilibrium for stocks and bonds on a valuation basis is a 6.50 10-year. We’re not there yet, so I expect the substitution of debt for equity to continue, albeit at a slower pace.

Sometimes I think investors and the media search for an easy target on which to pin their fears or hopes.  In this case, it was the bond market.  Don’t get me wrong, the bond market is important, and usually ignored by investors to their peril.  But using the bond market to make short term equity trading decisions is just plain silly.

Now, when actual volatility rises, my methods usually do well against the broad averages.  One of the things that I have tried to achieve in my adaptive approach to the markets is to create a system does does well in calm markets, but does relatively better in volatile markets.  Volatile markets scare inexperienced investors into making the wrong moves.  My methods are geared toward allowing ordinary investors to benefit from volatility in a rational way.  As I stated in the CC on Friday:

David Merkel
Rebalancing Trades
6/15/2007 11:55 AM EDT

Wow. Nice rally over the last chunk of time, and it’s time to “ring the register” and lighten on a few names that have run nicely. I do this primarily for risk control purposes. Here are the names that I trimmed: Noble Corp (NE), Cemex (CE), Lyondell Chemicals (LYO), and Tsakos Energy Navigation (TNP). They are now back at their target weights in my portfolio. My rebalancing discipline is a way of:

  1. Lowering risk on companies that are more expensive, and thus more risky than when I last bought them.
  2. Raising exposure on names that are cheaper, and thus less risky than when I last bought or sold them.
  3. Capturing swings in sentiment in industries, companies and the market as a whole, without becoming a momentum trader.
  4. Lowering my market impact costs by leaning against the wind (selling into a rise, buying into a fall), and
  5. Forcing a review process at certain price levels
  6. Taking the emotion out of selling and buying
  7. Making an additional 2% to 3% a year on my portfolio.

You can only do this with a high quality portfolio; don’t try this with companies that have a non-zero chance of a severe drop. For more information, review my “Smarter Seller” article series.

Position: long NE LYO TNP CX

Since 6/4, my broad market portfolio has outperformed the S&P 500 by roughly 1%.  My methods are designed to be able to cope with volatility and some back smiling.  Why can I go on business trips or vacation and not worry about the markets?  Why don’t I get scared by many of the negative macroeconomic situations out there?  First, I trust in Jesus; my life is not just the markets.  But beyond that, my eight rules are design to deal with the volatility that the market serves up, and adapt to what is undervalued in the present environment.

My plan for the next three weeks on the blog is to go through another portfolio reshaping.  You’ll get to see how I make choices in my portfolio.  Beyond that, I have one big article on the Fed Model coming, and continuing coverage of the major factors driving the markets.  Have a great weekend.

Full Disclosure: long CX TNP LYO NE

Until you learn to accept it, it is painful for many fundamentally driven investors to accept trends that are short-term rational, but long-term irrational. (And, much as it hurts my fingers to type this, technicians don’t have that problem… they have other problems though.) 😉

Tonight’s topic is private equity. There has been a cascade of bits and bytes splattered across the web on this topic, so I thought I would try to give a well-rounded picture, together with my views on the topic. Let’s start with the bull case:

Who better to start with than my colleague Jim Cramer? Two articles:

  1. Fear Not the Private Equity ‘Bubble’, and
  2. Five Reasons Private-Equity Deals Keep Going.

Let’s take the latter article. What were his five reasons?

Funny; it [DM: the private equity wave] will end. But not before many things happen, including these five:

  1. Interest rates on the long end going to at least 6%-7%. At that point, I believe it will get too risky.
  2. The equity market being closed to the IPOs of the companies that need to be flipped. It’s wide open right now.
  3. Not one, not two, but maybe three or four, or even five deals going bust. Can’t we wait for even one to go belly-up before we get too nervous?
  4. Valuations ramping up more. With the S&P 500 selling for about 17.5 times next year’s earnings, there is plenty of room to keep buying.
  5. Private equity funds running out of money. Very unlikely.

He has made the case exceptionally well as to why Private Equity should continue to be a factor in the market in the short-to-intermediate run. Here are two other pieces that make a similar case, which can be summarized like this: if there is a positive spread between the forecast earnings yield of a company, and the interest rate at which we can finance the purchase of the company, then it is rational to take the company private.
It’s at times like this that my inner actuary comes out and says, “Hey, what about a provision for adverse deviation?” That is, how much can go wrong, and still make this deal work? My inner financial analyst asks a slightly different question, “Will you need additional financing later, even if it is selling off the company? What if financing or selling is not available on today’s advantageous terms?”

The private equity folks will say that the high debt levels force success; there is no room for error, so we will work like crazy to make it work. As for financing, there are always windows of opportunity within a reasonable time span. There is no reason to worry.

Now not all deals work out, despite the best efforts of the new private owners. Most are marginal with a few celebrated home runs. During mania times, buyers definitely overpay. As an example, you can see how badly Daimler Benz did in its purchase of Chrysler. Will Cerberus do as well? I am not as bullish as the BW article, but it is clear the Cerberus does not have as much at risk as Daimler. Where I differ is that it will be harder to shed liabilities and reduce costs than the article implies.

At present there aren’t a lot of hot problems in private equity deals. There are financing difficulties, like KKR finding it hard to get additional private equity investors. Institutional investors like to be diversified, which always makes it tough for the biggest players in any asset class to get financing. Aside from that, the risks from doing deals are in the future.

At present, there is a lot of cash to finance private equity for both debt and equity commitments. Today it is rare to find assets that cannot be refinanced. There are more vultures than carrion. There have also been many articles pointing out that amid the flood of financing, the leverage has been going up, and the interest coverage down.

These are not the problems of today, so bulls ignore it and bears get frustrated. These will be problems, just not yet. What if real interest rise? Well, that will affect the ability to re-IPO the company, but it won’t absolutely stop a deal today. What if interest rates rise simply due a bond bear market, whether due to inflation, or global competition for capital? That will affect new deals, making it harder for them to get done, and sale multiples will fall on companies that the private equity folks try to sell.

Perhaps the effects are reversed here. Maybe private equity troubles will be a harbinger of the next junk bond bear market. Could be; after all, one weakness of being private is that tapping the public equity markets is not an easy option, much as that can be valuable when times are about to get tight.

Here’s my verdict. In the short run, almost anything can work. When debts go bad, it typically occurs because the company chokes on paying the interest, not the principal. Private companies that can pay the interest will likely survive to make some money for their private equity sponsors. But many will over-borrow, and in a recession, or in an industry or company downturn, will find that they no longer have enough cash to make the interest payments, and possess limited options for refinancing. Multiple defaults will happen then; think 2009, give or take a year.

But maybe it takes until 2012. If so, perhaps this letter from the future will seem prescient in hindsight. Private equity is not a bubble today; history may judge it to be a mania. To my readers I say be careful, and stick with higher quality bonds and stocks.

Doing estimates of private market value is often difficult. Recently while reading through the annual report of Tsakos Energy Navaigation, the CEO mentioned how much the ships were worth on the open market compared to the value on the books. After running a few calculations, I came to the conclusion that the private market value of Tsakos was around $75/share, a premium to the current quote.

Now, what can go wrong here? A lot:

  1. Protectionism could erupt, and diminish the amount of oil shipped across our oceans.
  2. Too many new boats could be built, eroding the value of existing boats.
  3. I could have done the math wrong.
  4. The CEO may have overstated his case.

I like Tsakos from both a strategic and valuation standpoint, but it is not a risk free investment; like most cyclicals, it relies on the robustness of the global economy, and the willingness of economies to buy oil from overseas. Given the uneven distribution of oil across our world, I would expect that oil shippers will be in a good spot for a while, but one can never tell for sure.
Full disclosure: long TNP

 Note: this note has been edited to remove two material errors.  First, the word “discount” has been changed to “premium” in the first paragraph.  Second, my four points only indicate areas where my analysis could go wrong.  Point four has been clarified, because I meant that you can never tell with any CEO whether everything was stated correctly, not that I thought it was incorrect here.  Rather, I trust their representations.

There’s been a certain amount of chatter lately over some of the comments made by Bill Gross regarding the long end of the market.  Others have discussed that; I’d like to bring up a different point.


Leaving aside the rumors that Bill Gross talks his book in order to create better entry and exit positions (many in the bond market believe it, I’m not so sure), I have criticized his (and PIMCO’s) forecasting abilities in the past.


Fortunately for PIMCO clients, Mr. Gross does not depend on his Macro forecasting to earn returns. Sitting on my desk next to me is a copy of the September/October 2005 Financial Analysts Journal. In it Mr Gross has an article, “Consistent Alpha Generation Through Structure.” That article encapsulates the core of PIMCO’s franchise. Essentially, they write unlevered out-of the money options on a variety of fixed income instruments, go short volatility through residential mortgages, and try to take advantage of the carry trade through the cheap float that their strategies generate.


So there’s a free lunch here? Well, not exactly. In a scenario where rates move very rapidly up or down, PIMCO will be hurt. But the move would have to be severe and very rapid. Even then, unlike LTCM, which had many of these same trades on but in a levered fashion, a bad year for PIMCO would ruin their track record, but most of their clients would deem the losses mild in comparison with whatever happened to the rest of the asset markets during a crisis that moved interest rates so severely.


That is the genius of Bill Gross, and I mean that sincerely. As for what he says on the tube, well, that’s just to aid marketing of the funds. He’s an entertaining guy, and on TV, those that invite you don’t care so much that you are right or wrong; they care that you say interesting things that keep the ratings up.


So, ignore Gross and McCulley on macroeconomic predictions, but their funds are generally worthy investments (leave aside for a moment that they are having a tough time this year). That said, if I’m buying an open end bond fund, I go to Vanguard. Low expenses win with bond investing, and it is a more durable advantage than advanced quantitative strategies.

The move in the bond market today was pretty violent. I briefly wondered how notable the move was relative to history, and I found that we have seen much worse moves in the past. Examples:

  1. Early 2004, when the market realized that the FOMC was going to have to tighten.
  2. Summer 2003, when we got a self-sustaining selloff in the market when we realized that fed funds would not be 1% forever, and mortgage hedgers forced an overshoot.
  3. Spring 2003, when the FOMC hinted that it would cut to 1%, and actually did it.
  4. 2002, when the FOMC was aggressively cutting the fed funds rate.
  5. And more… I could go back a lot further, but moves of this level of violence occur about once a year on average. Since the start of the FOMC tightening cycle, things have been calm, and predictable, lulling investors into a false sense of security. That security has just gotten shaken.

Over at RealMoney, except for Tony Crescenzi, there aren’t many who know much about
bonds. A lot of the writers there are paying attention to bonds, but it is basically a black box, or a technical model to them. In this piece, I will try to explain the four factors playing tug of war with the long end of the bond market, and what the prevailing effect is likely to be over the short and intermediate terms.


The largest component of the bond market is residential mortgage backed securities [RMBS]. Residential mortgages shorten when rates fall, because people refinance; when rates rise, fewer people than previously expected refinance, and people take longer to pay off their mortgages. A bunch of similar residential mortgages get gathered into a trust; participations in that RMBS trust are sold to institutional investors.RMBS is a complicated security to manage from an interest rate standpoint. Originators of the mortgages have to hedge them before they sell them off to investment banks who will turn them into RMBS. Many bond managers like to own RMBS for its high credit quality, liquidity, and attractive yields, but the problem is this: when interest rates move, the RMBS does what you don’t want to see happen. When rates fall, the bonds prepay, and you have to reinvest at lower rates. When rates rise the bonds pay slowly; you’d like to have more cash to reinvest at the higher rates, but the RMBS pays slowly.

This effect of shifting cash flows working against the owner of the mortgages or RMBS is called negative convexity. Basically, the owner has written a covered complicated bond call option. Anyone option writer receives a premium (extra yield), but must sell his investment if it goes into the money. If the investment stays out of the money he keeps the premium and the depreciated investment.
The mortgage originators and the RMBS holders want to limit the effect of the options that they have written, so they hedge. They can do that in three ways. I’ll use the example of hedging rising rates:

  1. Sell or short long Treasuries to lower overall exposure to rising rates.
  2. Sell RMBS that is lengthening, and replace it with RMBS that is less sensitive to rising rates.
  3. Enter into a swap where you pay a fixed rate for a number of years, and receive (floating) three month LIBOR over the same period.

Now, when rates rise or fall by a lot, mortgage hedging tends to reinforce the move, making falls and rises sharper. The effect depends on the configuration of the rates that people are paying on mortgages across the US. Negative convexity is highest on mortgages the are near the current mortgage rate for new loans. (At the money) At present, most prime mortgages are now below the current mortgage rate. I estimate that 20% are above and 80% below. What that implies in the current situation, is though mortgage hedging has had a big impact in the move so far, its effect should diminish dramatically from here, and almost disappear if the ten year gets up into the 5.50-6.00% range. Compare this to an era like 1994, where at the start of the move 10% of mortgages were below the current mortgage rate, and 90% above; it’s no wonder that move was so devastating. From the convexity effect, it should not be that bad here.

The Fed

We finally reached the fifth stage of grieving on the expected FOMC rate cut. The market has accepted that no cut is coming in 2007. This makes me edgy because that had been my view since December, and when the crowd crashes my lonely party, I have to ask, “Okay, now what? When and what is the next FOMC move? What is the crowd missing?”
Honestly, I don’t know, at least not yet. The FOMC is happily balanced between a variety of concerns, and I think it leaves them in a state of noisy inaction. Right now I think they will stand pat for as long as they can justify it. The effect on the bond market been to de-invert the curve, with the long end rising significantly. From here, though, unless the probability significantly increases that the FOMC will tighten, the effect on long rates is done here and now.
Overseas Money Flows

The current account deficit must be matched by a capital account surplus. The books have to balance! The only question is at what price (exchange rate) that the market clearing balancing will occur at. Partially due to the new view of FOMC policy, the dollar has strengthened over the last month, as foreign investors think that US rates will remain high for a while. But the varying currency policies of different countries will have an impact on the overall path of the dollar, and interest rates. Here are some bits of news affecting the question:

  1. South Korea continues to let the won rise, depressing the economy, but limiting local inflation. Also, they don’t have to buy as many US dollar assets.
  2. India has acted similarly with the rupee, which is having an effect on its competitiveness, but is reducing local inflation.
  3. Thailand had to let its currency appreciate against the US dollar because of rampant speculation.
  4. Other countries like Russia and some of the Gulf states are reducing exposure to the US dollar.
  5. Not everyone is reducing exposure to the US dollar, though. Most of the Gulf states still recycle petrodollars at the same rate as before, and China still uses the dollar as its linchpin in its currency system (which is just a dirty crawling peg). Now, this is leading to inflation in China, and a potential crisis, but so far, nothing is imminent, and that should continue to have a depressing effect on US interest rates, and retard the fall of the dollar.
  6. Growth is proceeding better outside of the US, which should put downward pressure on the dollar and upward pressure on rates.
  7. The two main carry trade currencies, the Japanese Yen and the Swiss Franc, are still at low levels, with low but increasing interest rates. There is atill a lot of speculative borrowing going on in both currencies, both locally and abroad, which is depressing the exchange rates. Eventually this will end with the Yen and the Swaissie rallying, but that could take a while.

So long as enough foreign entities are comfortable providing goods and services to the US, which taking back financial promises, there will continue to be downward pressure on rates, and the dollar will muddle. Woe betide us when they tire of giving us such nice treatment.
Yields and Real Yields

Having been a bond manager at a major insurance company I have experienced being a yield buyer. A yield buyer is willing to buy more bonds at higher yields, all other things equal. A real yield buyer is willing to but more bonds as the inflation-adjusted yield rises. Well, we are at levels on the ten year Treasury yield that we have not seen in five years. Yield buyers should become increasingly interested, which should moderate any increase in yields. Similarly, certain types of bond issuance should slow, as some projects will no longer justify paying the higher yield to finance the deal.
Real yields are another matter. As real yields rise, defined benefit pension plans and endowments buy more. But how much is inflation rising? It’s hard to say; our trade with developing nations decreases our inflation rate; some suggest that that might be coming to an end as inflation rises in the developing countries. My suspicion is that inflation is higher than the government says it is, but is not increasing much at present.

My upshot here is that up 0.25-1.0% in yield from here, assuming modest increases in inflation, we would see a lot of incremental buyers for bonds. We would also see fewer issuers.

Of my four effects, convexity is a spent force soon. The FOMC is likely on hold, so that effect is largely over, unless I am wrong. If rates rise, I expect yield and real yield buyers to arrive. The wild card is the foreign investors; if more countries revalue their currencies upward versus the dollar, reducing exports to the US, and reducing the need to buy our debt, then interest rates could easily rise by another percent. I don’t think that will happen, but it is the major risk here.

Absent negative foreign developments, I will get more bullish on the long end around 5.50% on the ten-year Treasury. Until them, I with with my positions, and clip the coupons; I don’t expect the rise to be severe, but will invest more on weakness.

Full disclosure: long TLT, FXF, FXY, and the rest of my bond portfolio is over at

PS — It is not obvious to me that the current correlation between the stock and bond markets will maintain. I expect stocks to do better, relative to bonds, in the short term.

Two years ago in the RealMoney Columnist Conversation, I wrote the following:

Yield curve be nimble, yield curve be quick, yield curve go under limbo stick.Okay, no great allusion in the song there, but I sit watching the long end of the yield curve rally as the short end falls slightly. Is the FOMC back in play that fast after yesterday? I don’t think anything has shifted, but Mr. Market is manic.

It’s times like this that make me want to review the full set of reasons why the long end is rallying:

  1. The supply of long bonds is shrinking, and the Treasury hasn’t decided to reissue the 30-year bond yet.
  2. Pension Reform is happening in Europe, and some Europeans are buying long U.S. debt together with currency swaps.
  3. Pension reform might happen in the U.S. as well.
  4. The PBGC is buying long investment grade debt (it likes to immunize, because it’s risk-averse), particularly Treasuries and Agencies like a madman, and it just got a new slug of cash in with the takeover of the UAL (UALAQ:OTC BB) plans.
  5. Mortgage refinancing tends to depress rates as originators hedge.
  6. Speculators that were previously short longer bonds are now long. (uh oh)
  7. An aging population wants income and increasingly favors bonds.
  8. Neomercantilistic economies buy U.S. bonds because they can’t find anything better to do with their export earnings.
  9. Market players trust the FOMC (however misguidedly) to control inflation in the long run.
  10. There aren’t a lot of other places to get incremental yield, so extending maturities is a temptation for bond investors.
  11. The U.S. economy is anticipated to be growing at a slower rate.
  12. The marginal efficiency of new capital is falling because of the introduction (in principle) of 2 billion laborers to the global capitalist labor pool.

This last point I covered in parts of the articles, “Implications of a Low-Nominal World,” and “The Economy, Seen From Many Angles.” When labor is abundant, more capital isn’t needed to produce a greater output, until labor is scarce again. The returns to the employment of additional capital fall, which leads market players to bid up the prices of fixed claims on the economic system, i.e., bonds, because they can’t find better places to assure a return for the future.

This also explains the increase in buybacks and debt reduction on the part of corporations, relative to increases in plant and equipment. That said, it’s a tough environment, but on the bright side, previously poor areas of the world are developing, and that bodes well for those countries, and the global economy 20 years out, once the labor that is new to the capitalist world is productively deployed.

What a difference two years makes. The above post was meant to justify low rates, and it did a fair job of making the case. Later I added a reason 13, that suggested that there was no other currency that could serve as the world’s reserve currency. Unless we move to a gold or commodity standard, that is probably still true.

So what among the above reasons are still valid? Let’s go through them:

  1. 30-year bonds are being issued now, though not in great abundance.
  2. Still a factor, but small because the initial surge has worn off.
  3. Only 40% complete in the US, but FASB may fix that within a year, which would intensify demand for long bonds as defined benefit plans attempt to match liability cash flows.
  4. The bankruptcy wave is past. Not a factor now.
  5. With rates higher, the mortgage hedging flows favor higher rates.
  6. Kind of a wash. Speculators are long the 10-year and short the 30-year. Not a factor on rates now.
  7. Still a factor. Yield seeking on the part of retirees is big, and Wall Street i catering to that search. (Hold onto your wallets.)
  8. Still true.
  9. Still true.
  10. False; can’t get much incremental yield at all through extension of durations now.
  11. True, but the degree of the slowdown is open to question, and foreign financial flows are a bigger factor.
  12. Still true, though the marginal effect at present is probably smaller.

So where does that leave us on interest rates? Muddled. Most of the big demographic and international effects on rates still favor lower rates. A new factor that was only partially understood by me two years ago has become a bigger factor: rising inflation in countries that fund the US current account deficit. That favors higher rates, both here and abroad. The question is whether foreign countries bite the bullet and allow their currencies to rise against the dollar or not. To the extent that they allow their currencies to rise, so will rates in the US. But if they keep their currencies artificially weak by buying US dollar bonds with their own currencies, it will continue to depress US long interest rates.

Human nature being what it is, I would expect that most countries continue their policies of buying US fixed income until a crisis forces them to change. Those don’t come on schedule, so I will not try to predict timing. I continue to keep a large portion of my fixed income investments in foreign currencies, which has not been a winner in the last month, but has served me well over the last two years.

There was a little stir over at RealMoney over an article printed in Friday’s Wall Street Journal regarding Leveraged Buy-out [LBO] quality. Both Jim Cramer (video) and The Business Press Maven, Marek Fuchs, disagreed with the premises of the article. So who was right? Let’s start with the case made by the Wall Street Journal. It can be summarized in three points:

  1. There are a few LBOs in trouble. This is notable because it is happening early in the tenures of the deals. There are unique things going wrong in the each of the four deals mentioned.
  2. Cash interest coverage ratios are at levels not seen since 1997.
  3. Some of the bonds and loans used to finance the deals are trading below par.

So what do Cramer and Fuchs do with this? They attack the weakest part of the argument, that there are only four deals mentioned to be in trouble out of thousand or more deals. Now, before any credit crisis hits, typically credit metrics have deteriorated, but few deals seem to be in trouble. Why? The companies in question are usually in good shape at the time a LBO takes place, and if not, the financing obtained typically has additional cash to re-liquefy the company.

Typically, it takes 3 years from the time that loans/bonds are sold before defaults start happening. In years 1 and 2, defaults are few, and notable because they look incredibly dumb in hindsight. Point one of the WSJ article does not of itself prove that a crisis is coming. But if they couldn’t point at some bad deals, there would be no article to write.

The more serious issues are loan pricing and interest coverage.WSJ Interest Coverage Interest coverage of 1.7 times cash flow is very low, and akin to what one gets on CCC-rated debt, except that the loans are typically secured by the assets of the company, which lessens the severity level of defaults. Further, for loans to trade below par when there is hot demand for loan collateral from Collateralized Loan Obligations, implies that something is amiss. Now, what do Cramer and Fuchs do with these issues? Not much. Cramer doesn’t deal with it, and Fuchs says:

For an article that implies a turn in the pace and fate of LBOs (did I mention the graph titled “Less Breathing Room”?) there needs to be more and better evidence. To make a point in journalism, you do not need the rigors of a scientific sample. Daily journalism simply has to move faster than that.


In short, he dismisses it without any significant comment.Now, I generally appreciate most of what Cramer and Fuchs write, but in this case, they didn’t seem to get the most significant points of the article (2 and 3 as I number them). That said, the WSJ emphasized point 1 the hardest, probably because they didn’t want to bore their audience, so perhaps they both can be excused.

Credit metrics deteriorate before defaults happen, and it takes three years afteer the peak of issuance to see how bad it will be. We are seeing record loan issuance combined with deteriorating fundamentals at present. It may be as late as 2010 before we see the bad results of this in full, but I would not cavalierly dismiss the problem simply because there are few distressed situations now. Within three years, we will have more than enough distress to overwhelm the sizable resources of vulture investors.

Some housekeeping before I start. My post yesterday was meant to be a “when the credit/liquidity cycle turns” post, not a “the sky is falling” post. Picking up on point number 4 from what could go wrong, I would refer you to today’s Wall Street Journal for two articles on LBOs that are not going so well, and the sustainability of private equity in the current changing environment. Please put on your peril-sensitive sunglasses before reviewing the credit metrics.

In the early 90s, as 401(k)s came onto the scene, savings options were the hot sellers to an unsophisticated marketplace. Because of the accounting rules, insurance contracts could be valued at book, not market, and so Guaranteed Investment Contracts [GICs] were sold to 401(k) and other DC plans.

The difficulty came when companies that issued contracts failed, like Executive Life, Mutual Benefit, Confederation, and The Equitable (well, almost). A market that treated all contracts equally was now exposed to the concept that there is such a thing as credit risk, and that the highest yielding contract is not necessarily the one that should be bought.

In the mid-90s, that was my first example of market maturation, and it was painful for me. I was running the Guaranteed Investment Contract desk at Provident Mutual, and making good money for the firm. We survived as other insurance companies went under or exited the business, but as more companies failed, the credit quality bar kept getting raised higher, until we were marginal to the market. Confederation’s failure was the last nail in my coffin. I asked my bosses whether I could synthetically enhance my GICs by giving a priority interest to the GIC-holders in an insolvency, but they turned me down, and I closed down an otherwise profitable line of business.
Failure brings maturity to markets, and market mechanisms. When a concept is new, the riskiness of it is not apparent until a series of defaults occurs, showing a difference between more risky and less risk ways of doing business. Let me give some more examples:

Stock Market Leverage: How much margin debt is too much, that it helps create systemic risk? In the 20s leverage could be 10x, and the volatility that that policy induced helped magnify the boom in the 20s, and the bust 1929-1932. Today the ability to lever up 2x (with some exceptions) is deemed reasonable. If it is not reasonable, another failure will teach us.

Dynamic Hedging: In the mid-80s, shorting stock futures to dynamically hedge stock portfolios was the rage. After all, wasn’t it a free way to replicate a costly put option?

When it was first thought up, it probably was cheap, but as it became more common the trading costs became visible. For small price changes, it worked well. Who could predict the magnitude of price changes it would be forced to try and unsuccessfully hedge? After Black Monday, the cost of a put option as an insurance policy was better appreciated.

Lending to Hedge Funds: I’m not convinced that this lesson has been learned, but if it has been learned, the crisis from LTCM started that process. After LTCM failed, counterparties insisted more closely on understanding the creditworthiness of those that they expected future payments from.

Negative Convexity: Through late 1993, structurers of residential mortgage securities were very creative, making tranches in mortgage securitizations that bore a disproportionate amount of risk, particularly compared to the yield received. In 1994 to early 1995, that illusion was destroyed as the bond market was dragged to higher yields by the Fed plus mortgage bond managers who tried to limit their interest rate risks individually, leading to a more general crisis. That created the worst bond market since 1926.
There are other examples, and if I had more time, I would list them all. What I want to finish with are a few areas today that have not experienced failure yet:

  1. the credit default swap market.
  2. the synthetic CDO market (related to #1, I know)
  3. nonprime commercial paper
  4. covenant-lite commercial loans, particularly to LBOs.

There is nothing new under the sun. Human behavior, including fear and greed, do not change. In order to stay safe in one’s investments, one must understand where undue risk is being taken, and avoid those investments. You will make more money in the long run avoiding foolish risks, than through cleverness in taking obscure risks ordinarily. Risk control triumphs over cleverness in the long run.