Surveying Bond Management and Overall Financial Market Volatility

A personal note before I begin: My oldest daughter left for college today.  A bright girl who plays the harp beautifully, she is studying harp at the University of Maryland.  She is a true “people person” and an artist, and her good character is known by all of her friends.  She’ll be commuting, so I won’t lose her entirely yet, but we will miss her way with the other children.  She will be a natural mother, unlike her mother and I, who just try hard.

Well, two off to college in a single year.  Good thing I’ve got six left, or I’d be lonely. 😀

It takes two to make a market.  During the panic, some bond managers increased their risk postures as the market sold off.  Here is another example.  I agree with this in principle, but I at this point, I would only have moved my risk posture from “most conservative” to 20% of the way to “most aggressive,” which I actually did get to in November 2001, and October 2002.  There is a lot of leverage to unwind, and so there is a lot of room for further widening.  Take for example, these graphs of lower investment grade, and junk spreads.  We are nowhere near the 2002 wide spreads, though for investment grade, I don’t see how we get there.  Credit metrics are pretty good, though banks are more opaque and questionable.

Bond management is a game where you are paid not to lose, because people are relying on you for safety, and then a modestly good return on their money.  Now, though the last article doesn’t treat Bill Gross well, in this article, he praises simplicity in investing, which I would heartily agree with.  The only thing that gives me a bit of pause there is that PIMCO is a quantitative bond management shop that has historically derived most of its excess returns from quantitative strategies that rely on the equivalent of selling deep out of the money options against their positions, and mean-reversion, and variety of other things.  When the ordinary relationships don’t work, PIMCO could be disproportionately hurt.

Though investment grade looks fine, junk is another thing; it could reach the 2002 wides.  As an example, aside from all of the high yield deals that would like to get done, and all of the LBO debt standing in line waiting to be funded, there are still entities like Calpine that want to emerge from bankruptcy.  Willingness to take risk is not what it was when the banks made their commitments, so they’ll have to take losses to move the loans off of their books.  That will help to back up spreads, as buyers will toss out other paper to buy the Calpine debt, if it comes at an attractive enough concession.

In situation like this, one would expect municipal [muni] bonds to be a haven, and largely, they are, partly because they are one of the few areas not touched by foreign capital.  But I was genuinely surprised when I read this article.  Muni arbitrage?  Okay, it comes from one simple insight muni investors want low volatility, which means short duration bonds, while most municipalities want to lock in long term funding.  After all, most of their projects are long term in nature.  Muni hedge funds (sigh) step in to fill the gap, buying long dated bonds, and selling short bonds against them to muni investors, clipping a yield spread in the process.  Worked fine for a while, but the hedge funds warped the market by their own participation, and played for yield spreads that were too low for the risks involved.  As the market normalized, they got hurt, and some aggressive selling of the long end happened.  Now, long munis are probably a good deal.  For taxable accounts, they make sense, if your time horizon is long enough.

During financial stress, financial journalists may get a little over the top.  Comparing Ken Lewis to JP Morgan is an example.  First, the rescue is not that big, relative to Countrywide’s total liquidity needs.  Second, Countrywide, even if it failed, would not have that big of an impact on the total US financial system; it’s just not that big.  Would it be inconvenient?  Yes.  A bother for the regulators?  Sure.  But it would not appreciably affect the average financial institution, and it would inject some needed caution into those that lend to less secure entities.  Third, in a real rescue, far more capital is hazarded; honestly, the Fed did more by opening the discount window, pitiful as that was… it offered unlimited liquidity to (ahem) “quality” assets at a price.  (Quality has been redefined for now.)

At a time like this, a bevy of survey articles come out to describe what has gone wrong.  Some tell of how aggressive players overplayed their hands as the willingness to take risk dried up.  In this case, they boil it down to bad lending models, whether subprime mortgages, bank debt for LBOs, or internal leverage inside hedge funds.  Other articles point at historical analogies, looking for something that might tell when the crisis will end.  The two years compared, 1987 (dynamic portfolio hedging) and 1998 (LTCM), do offer some help, but are not adequate to deal with an overall mortgage lending problem, and a large external debt, getting larger through the current account deficit.

Is information failure the best way to describe it?  I don’t know; there were a lot of savvy people (myself included) who could see this coming, but could not put a date on it.  Toward the end of almost any bull market, underwriting gets sloppy, and the mess that it leaves usually persists until early in the next bull phase.  That’s the nature of human beings, and the markets they create.

As I have stated before, central bank policy can help marginal entities refinance, but is no good at aiding balance sheets that are truly broken.  As you analyze your own assets, be sure to ask which entities need financing over the next two to three years, and how badly they need the help.  Don’t play with companies that are at the mercy of the capital markets.  Even if in the short run, after a volatility event, stocks tend to do well, there may be more volatility events than just one.  This first one is over financing; there will be defaults later.  Be ready for the volatility that will come from them.

Tickers mentioned: CPNLQ BAC CFC