Eddy Elfenbein at Crossing Wall Street has put forth the concept of a “bond bubble” over at his blog.? I support the concept in part, but I need to modify it.? Let’s call it a Treasury Bond Bubble, because other classes of intermediate term debt have significant yield spreads over Treasuries because of the current economic volatility.
Should 2-year Treasury notes yield less than CPI inflation? No, and CPI inflation is not going down.? Scarcity of food and fuel are normal conditions in our growing world.? We can only extract so much out of the planet in the short run.? Why lend to the government at a loss?? Better to invest in a money market fund, or perhaps, the stock of a business that is inflation-sensitive, or TIPS.
Can 2-year yields go lower?? You bet they can.? The Fed is flooding the short end of the yield curve with liquidity for now, until inflaton pressures become intolerable.? In the present political environment, the Fed is incented to loosen, even in the face of rising inflation.? Remember my “pain model” for the Fed.? They move in the direction that avoids the most political pain.? People are screaming over a weak economy now, and no one complains about inflation.? Thus they loosen.? How much at the end of January?? Uh, that is up for grabs.? My view of the Fed is that they want to drag their feet, because they see inflation rising, so even if Fed funds futures indicate a 75 basis point cut, my current view indicates 50 as more likely, again, with language in the statement that indicates even-handed risks.
One final note: the concept of a bond bubble sounds a little like the Austrian school of economics.? The central bank pushes interest rates below the natural rate of interest (i.e., the one that would exist in an free market equilibrium), in order to stimulate the economy.? Bonds would be worth more than their long-term intrinsic value in such a scenario.? That’s true today, with one modification, because of the credit stress, only the highest quality borrowers get those rates.
Bouncing off Adam?s comments on the XLF, the insurers in the index are getting drubbed, and in my opinion, for little good reason. On an earnings basis, many of them are the cheapest I have seen maybe ever, and while some of their earnings prospects will be diminished by the fall in the market, and difficulties in the bond market, in general, the asset side of their balance sheets are in good shape. So, if you are looking for ideas, here are a few I am looking at: MetLife, Hartford, Travelers, Lincoln National, ACE, Chubb, Principal and XL. Hopefully this will do as well as my PartnerRe trade last August.
Position: Long LNC
I would add to that list SFG and DFG. After some thought, I acted:
Lincoln National was a rebalancing buy, Hartford is a new position. Both are quality competitors with good balance sheets. The only possible drawback is in a protracted decline, earnings from variable products could suffer.
Fitch downgrades Ambac to AA from AAA. Stock has a temporary rally. Is this a great country or what? Because of the social dynamic of the rating agencies, and the existence of one downgrade, the dike has been breached, and I would expect more downgrades.
Hey, maybe it?s time for the financing of last resort: Ambac could issue a convertible surplus note. Maybe even sell it privately to Buffett, who could own 30% of the company if things turn around. He won?t delta-hedge common against it. They might even be able to get away with a coupon below 15%. Package it with a reinsurance agreement, and the NY State commissioner smiles on it.
Okay, I went overboard there, but there was no reason for Ambac to have its short-lived rally. That?s probably why it didn?t stick.
Position: none
My last note was half-whimsical and half-serious. Buffett likes convertibles, particularly if they offer attractive optionality at the right price. The question is how big the problems are at Ambac relative to their small capital base.
I should also add that there are reinsurance issues among the financial guarantee companies have reinsurance issues.? I mentioned Channel Re, which mainly provided insurance to MBIA.? MBIA and Ambac, from what I remember, mutually reinsure about 10% of each other’s liabilities.? Beyond that, you have poor RAM Re:?
RAM Re attempts to absorb a quote share of the liabilities of the primary financial guarantors.? I met their management team during their IPO.? They seemed to be good people, and talented managers.? But having a quota share of the seven soon-to-be-formerly-AAA guarantors is a ticket to not being AAA oneself.? They face risks of insolvency of primary writers, which could lead to their own insolvency.
What I am trying to convey here, is that stress at one guarantor could have ripple effects at other guarantors.? The least affected would be Assured Guaranty, FSA (a Dexia subsidiary), and Berky (of course).
As for the recent Barron’s article on MBIA, I would only say that it all depends on structured finance losses.? If losses on CDOs are severe, MBIA could be a sell even at these levels.
These are unusual times, and it pays for investors to avoid for the most part the financial guarantee space (mortgage and title too).? Other insurers (life, health, P&C) are likely better than other financials, and generally cheap; I own a bunch of them.
Full disclosure: long LNC HIG
Tickers mentioned: SCA RAMR AGO ACAH MBI ABK BRK/A BRK/B HIG LNC MET PFG DFG SFG CB TRV MET ACE XL
Hi David,? I really enjoy your blog very much.? Your recent post regarding AAA bonds brings up a question for me and I’ve seen several different answers in the press and on TV.
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I have?about 35% of my portfolio in triple AAA muni bonds–most insured, but not all.? My intention with insured AAA bonds was to not have to worry about them.
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I’m now reading about the potential bankruptcies of the muni insurers–AMBAC, etc.? I heard on the tube today that “we will?see a muni bond crash” if the ratings on these insurers are lowered.? After the close I saw where one was lowered to a AA rating.? This is not what I like to hear and I suspect with further reading that the comment was overblown, possibly irresponsible.?
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I hold my bonds to maturity with my principle concern of income generation. Is this something one should be worried about?? Anything specifically about the individual bonds that should raise read flags?? As I live in Arkansas, most are Ark. munis although I’ve got some from Puerto Rico.? Thanks for any insight on this.??And keep your great posts coming.
I don’t think you should be very worried.? Municipalities rarely default.? When they do default, it is typically for a little while, and then payment resumes.? So long as a municipal bond has an economic purpose behind it — a necessary city, county, state, or project, defaults are rare.
The financial guarantee is a way of making the bonds thought-proof.? Bond mangers don’t have to do credit analysis; the guarantee is enough.? The guarantors aren’t dumb (at least with respect to municipals), they know what doesn’t deserve a guarantee.
Without knowing exactly what you own, I can’t say it with certainty, but I can say it is likely that you will come out okay if all you hold are munis that have an economic purpose. ? (Be careful on the Puerto Rican issuers, I know little there.)? That said, the market value of your bonds have likely declined a little due to the possible loss of insurance protection.? If you are truly, buying and holding economically necessary issuers, you should end up fine.
In the center of the picture to the left are my friends Bill and Margie Wright. They have been dear friends of our family for eight years. Their kids have played with ours; they have ten, we have eight.
They’re special people. Margie has homeschooled all of their children (so far), and Bill has built a thriving enterprise, Wright Manufacturing, which makes the best commercial lawn mowers in the world. (Full disclosure: I own a little less than one percent of his private firm.)
Wright Manufacturing is unusual because it is a very innovative firm. They manage the business well with a series of principles borrowed from some of the best Japanese manufacturers, but then marry that to the exceptional innovative engineering talent of Bill Wright and his staff. Many of his competitors license his patented technologies.
Oh, the person on the far right of the picture is, yes, President Bush. He came to visit Bill’s factory today, and gave a brief talk on the economy, and the proposed stimulus package. Here’s what he said:
1:55 P.M. EST
THE PRESIDENT: Let me tell you why I’m here. This man started his own business. He’s a manufacturer, he employs over a hundred people, and he represents the backbone of the American economy. And today I talked about our economy, and the fundamentals are strong, but there’s uncertainty. And there’s an opportunity to work with Congress to pass a pro-growth package that will deal with the uncertainty.
Any package has got to remember that jobs are created by small businesses. A good package will have incentives for investment. The package we passed early in my administration helped him. He bought some equipment and made his firm more productive, kept him in business. And that’s the same spirit that needs to be in this next growth package.
The other thing is, is that we got to make sure that we benefit consumers. We want our consumers out there spending, and the best way to do that is broad-based tax relief. Now, this plan ought to be broad-based, it ought to be simple, and it ought to be temporary.
I had a conversation, Congressman, with the leadership on both sides of the aisle yesterday, and I was encouraged by what I heard. And I believe we can come together on a growth package very quickly. We need to. We need to get this deal done and get it out and get money in the hands of our consumers and our small business owners to help this economy.
I’m optimistic, I truly am. One reason I’m optimistic is because I understand we got all kinds of Americans just like this man here, working hard to provide a living for folks and to make a product people want.
And so, while there’s some uncertainty right now, if we act quickly and in a smart way that helps growth, we’re going to be just fine.
Anyway, thanks for letting me come by. I’m proud to be — I love the entrepreneurial class in — I love people who have a dream and work hard to achieve the dream.
And so — a fine-looking machine you got here.
MR. WRIGHT: Thank you. It’s a team effort. We thank you, thank you for all your work, too.
THE PRESIDENT: Do you wonder where they got the name “Wright?” That’s his name. And his wife is the co-founder of the company. And this is — it’s really great to be with you.
And, Congressman [DM — Roscoe Bartlett, another good guy with a big family], thank you for being here. I’m proud to be with your workers. You’ve got some fine workers.
MR. WRIGHT: We’ve got a great team here, don’t we?
THE PRESIDENT: Yes, you do. And if they get a little more money in their pocket as a result of the growth package, it will help make sure this economy continues to grow.
Anyway, thank you all very much.
END 1:59 P.M. EST
Bill, for all of his accomplishments, is a humble guy. He and Margie went through many lean times during the early years, and they bore with it well. The business began as a lawn mowing business, and then broadened out to software for managing lawn mowing businesses, together with grass catching attachments. That started the manufacturing. Bill developed a wide number of innovations, from zero-turning radius mowers, to sulkies, and more.
In my opinion, President Bush could not have picked a better place to visit. It is an example of American manufacturing at its best, and Bill Wright is a great example of American entrepreneurship. I am proud to be a part owner of the firm, and to have been able to help Bill at times on financial issues.
Now, for further coverage of the visit of President Bush:
As far as I am concerned, the stimulus package is hooey; what stimulus occurs now will be funded by debt and a cheaper dollar later. There is nothing wonderful there. There is something wonderful about the Wrights though, and I am happy to be a small part of that.
In the center of the picture to the left are my friends Bill and Margie Wright. They have been dear friends of our family for eight years. Their kids have played with ours; they have ten, we have eight.
MR. WRIGHT: We’ve got a great team here, don’t we?