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The Rules, Part XVII

Saturday, July 31st, 2010

In a panic, only two attributes of a financial instrument get priced — liquidity and quality/survivability.

In a panic, all risky assets become highly positively correlated with each other.

Given that correlations tend to rise in a panic, a reasonable measure of sentiment is to measure the average absolute value of 10-day correlations.

Markets cannot survive for long periods of time at high levels of actual or implied volatility.  They eventually revert to normal.

Panics and booms are different — they may be opposites, but they behave differently.  Panics are events, often multiple events, and booms are processes.  The nature of this is best explained through the credit cycle.  The boom phase of the credit cycle involves rising profits of corporations.  Stocks and bonds behave differently here.

Say the expectation of income moves from negative to a low positive figure.  Stocks will rally; bond may rally more, because the threat of bankruptcy is lifted.

Now suppose that the expectation of income moves from a low positive to a normal positive figure.  Stocks will rally a lot, but bonds will rally a little.  The odds of the bonds being paid rise a minuscule amount.  The stocks estimate of future distributable profits rise a great deal.

Now suppose that the expectation of income moves from a normal positive to a high positive figure.  Stocks will rally some, but bonds will not rally much.  The odds of the bonds being paid don’t change.  The stocks estimate of future distributable profits rise, but with a sense of possible mean reversion.

So in a boom, credit spreads [the difference between the yields of corporate bonds and Treasury bonds] tighten quickly, tighten slowly, and then stop tightening, even though things seem to be going great.  The end of the boom, as far as the credit market is concerned, can last a long time.

The end of the boom comes when a significant amount of companies the overextended their balance sheets during the boom find themselves in a compromised condition, and have a hard time gaining financing.  The suspicion of credit troubles travels fast, and all of the companies where investors waved their hands at problems now get a fresh look with a different set of eyes.

The moment incremental financing seems less likely or more expensive, companies that will need financing get re-evaluated by the market — stock prices move down, bond yields go up.  This is when analysis of the balance sheet and the cash flow statement are worth the most, and the income statement is worth the least.  The bull phase of the cycle is all about income statements, and estimating what future income will be.  The bear phase of the cycle is about estimating  cash flows, and the strength of balance sheets, to identify who might not survive the bear phase well.

During the boom phase of the cycle, the degree of correlation of asset returns is low.  There is noise, and not everything does equally well.  There are multiple risk factors and strategies that are working.  But in the bust phase, the acid test of survival dominates.  One factor gets priced, whether an asset is money good or not. [For bonds, "money good" means the par value of the bond will be repaid at maturity.]

But panics don’t last long — usually two years or so.  As the panic drags on three processes take place:

  • Companies in horrible shape default.
  • Investors examine companies in okay shape, and find weaknesses.  Some will default, and some will clean their acts up.
  • Companies clean up their acts, and it becomes obvious that they will survive.

Toward the end of the bust phase, like a fire running out of fuel, there is a moment of clarity where some realize that things aren’t getting worse.  Most companies have cleaned up, and there will be fewer future defaults.  That sets the scene for the next rally.

Through the bust, equity volatility and credit spreads remain high; they are correlated phenomena, but there is a point of exhaustion.  High yields attract needed financing to companies that are mis-financed, rather than insolvent.  Credit spreads can only get so high before money comes in willing to buy no matter what the future may hold.  Equity volatility can only get so high before players begin writing short straddles, knowing that the odds of winning are tipped in their favor.

It pays to watch both the equities and bonds, and other related securities — it gives a richer picture of what is going on.  In particular, when the bull phase has gone on for two full years, watch for equity volatility and credit spreads to stop falling.  That is a sign that the bull market is getting close to the end, and most of the easy gains have been made.  Watch for telltale signs of cashflow shortfalls where banks are less than willing to plug the gap at a price.

Learn this well, and your ability to play the market will improve considerably.

Book Review: Fault Lines

Saturday, July 31st, 2010

Raghuram Rajan made a name for himself at the Jackson Hole conference in 2005, which was a kind of send-off for the victorious Alan Greenspan.  Alas, but the paper he brought was not appreciated at the time, as it pointed to imbalances in the financial system.

He was ahead of the curve.  Thus his book on the economic crisis deserves our attention. More than most, he sees the problems in a global way, across nations and across asset classes.

His view is that for a variety of reasons, income inequality grew in the US, and in order to paper over that, the government encouraged a credit-oriented society to allow people to stretch for prosperity, hoping that the debts would not catch up with them.

It was a fool’s bargain.  Debt deceives average people.  They overestimate their ability to repay, and end up defaulting at high frequencies.

Like me, he is critical of the Fed’s monetary policy during the ’00s as being too easy.  The “Great Moderation” was a result of over-stimulus, not of sound policy.

Similarly, he faults banking regulation for being too easy, leading to private profits with public risk.

This is a well-written book from a man who was ahead of the curve.  I recommend it.

Quibbles

Where I differ with Dr. Rajan is how easy it would be to fix income inequality in the US.  He suggests a number of policies, many of which sound good, but have the Federal Government intervene in matters that they can’t handle effectively.  Persistent unemployment is a problem, but should that be handled by the Federal Government.  Far better in my opinion that it be handled informally and locally, by family and friends, that there would be more urgency, and more willingness to compromise in finding work.

Retraining is a good thing, but also not something the Federal Government does well.  One of the beauties of the US is that we have community colleges, which can retrain people at modest costs.

He also levels a decent amount of the blame at Fannie and Freddie and the Community Reinvestment Act, for making too many lousy loans.  He is correct in direction, but not likely in degree.  Yes, they were problems, but not the leading problems.

But these are mere quibbles on an otherwise excellent book.  If you want to buy the book, you can buy it here:  Fault Lines: How Hidden Fractures Still Threaten the World Economy

Who would benefit from this book

Anyone who wants a comprehensive view of the crisis would benefit from this book.  It does a fairly complete job, and is not long at ~230 pages.

Full disclosure: The publisher sent me a copy, because I met the author at a conference, and asked to receive a review copy.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

The Education of a Corporate Bond Manager, Part VI

Friday, July 30th, 2010

After 9/11, and and before the merger was complete on 9/30/2001, our investment team got together and came to an unusual conclusion — 9/11 would have little independent impact on the credit markets, so be willing to take credit risk where it is not well-understood by the market.  We bought bonds in hotels, airplane EETCs (A-tranches), anything having to do with confidence in the system at that time.  I consciously downgraded our portfolio two full notches from September to November.

I went to a Chief Investment Officer’s conference for insurance investors in October 2001.  What I remember most is that we were the only company being so aggressive.  In a closed0-door meeting, the representative from Conseco told me I was irresponsible.  To hear that from a company near bankruptcy rang the bell.  I was convinced we were on the right track.

By mid-November, we had almost completed our purchases of yieldy assets, when I received a phone call from the chief actuary of our client expressing concern over the credit risks we were taking; the rating agencies were threatening a downgrade.

Well, what do you know?!  The company that did not understand the meaning of the word risk finally gets it , and happily, at the right time.  We were done with our trade.

We looked like doofuses for three months before the market began to turn, and I began a humongous “up in credit” trade as we began to make a lot of money.  By the time I was done in early June, I had upgraded the whole portfolio three full notches.  A great trade?  You bet, and more.  What’s worse, it was what the client wanted, but not what it should have wanted.

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What should my client have wanted?  Interest spread enhancement with loss mitigation.  That is the optimal strategy for life insurers.  We were ready to do that, but at a meeting in late September 2001, the client said, “The management of assets for this company has been lazy; there is not enough trading.  We want to see the highest returns possible; give us total returns!”

I tried to explain why that was not the best way to manage insurance assets.  After all, I had been doing this for ten-plus years, and knew the difference between current GAAP accounting and long term sustainable GAAP accounting.

The CEO told me that I knew nothing at all, and that portfolio management needed to be active.  Activity meant more profits.  I told him that he was wrong, and was rudely cut off.  I did not go back to that argument.

After we had a few inconsequential defaults, the client complained loudly.  This was an ignorant client that did not recognize reality.  Defaults are a fact of life; if you run with your capital base so thin that you can’t take a few modest defaults, you are running your insurance company wrong.

As it was, the emphasis on trading did generate capital gains initially, the portfolio began with unrealized capital gains.  But the company took the capital gains to be “free money,” used them as new capital, and began writing more underpriced aggressive insurance/annuity policies.

But then, as capital got tight, the chief actuary came to me saying that they needed to do a financial reinsurance treaty to raise capital for the firm.  I replied that we did not have many bonds with an above market yield.  We had the Prudential
“C” bonds that I mentioned earlier
, and a few more, but not a lot more.  I scraped together what I could, culling the best bonds from the portfolio, realizing that the remainder would be decidedly subpar.  You could say that they hocked the “family silver.”

They did the reinsurance deal over my objections, which technically did not meet the stipulations of the state regulations, and gained more capital to write business against.  There was a cost, though.  We could not sell any of our best bonds, and the regulatory profits of the firm would now be flat to negative.

I did my best to aid their business goals, finding weaknesses in the risk-based capital formulas, and managing the interest rate posture of the company to near-perfection, all of which reduced capital needs.  But when you are running a company that is addicted to making sales, even if the sales are only marginally profitable, and not covering the cost of capital, that is the path that matters will take.

Would that they had listened to me, but they were arrogant.  What price did they pay for their arrogance?

  • The company CEO was encouraged to retire.
  • The CFO and Chief Actuary had to leave.
  • The parent company CEO was forced to resign for all of the money he had plowed into that loser of a subsidiary in the US.
  • The company was put up for sale, but given the dubious operating history, bidders were few and reluctant to spend much.

Any successful insurance enterprise needs bright managers on both sides of the balance sheet.  Bright managers of the assets, and issuers of policies that don’t give away the store.

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PS — I had one bond that was a high interest second-lien loan on one of the most valuable buildings in Baltimore.  At the time, the equity owner of the building called me, and made me a lowball estimate to pay off the loan, a few months before it would spring to first lien status.  I politely told him “No way,” and named a considerably higher price at which I would consider a buyout.  He told me that I was ridiculous, and I said “Fine, but I have read the agreements, and know our rights.”

He then called the client, and made the same offer.  They pestered me to deal with him, and I explained how he was wrong, and that the price should be much higher.  They agreed with me, and that was put to rest… until I left the firm, and the equity own got the deal done, paying up a little more, but by no means what he should have.

As I said many times regarding my client, “You can’t teach a Sneech.”  Sad but true for many who don’t understand investing.

The Education of a Corporate Bond Manager, Part V

Wednesday, July 28th, 2010

There has been a lot of talk lately about systemic risk, a concept that is not well-understood.  Let me simplify it for you.  Anytime debt grows in an area of the economy at a rapid pace, there is an unstable situation to be avoided.  If you are a portfolio manager at such a time, you must take the tough decision and underweight the area of the bond market that is growing the fastest.  That is not easy to do, particularly because that is where most of the new issues are coming from.

I wrote a piece called Fruits and Vegetables Versus Assets in Demand, where I said:

There is a way in which fruits and vegetables and financial products are opposites: when quantities are high for fruits and vegetables, quality is high, and prices are low. With financial products, when issuance is high, quality is low, and pricing is expensive, leading to poor future returns from lower yields, and higher future defaults. I offer this for what it is worth, but is there something more to it, than the seeming oppositeness?  Why are they opposites?

I had a follow-up piece here that answered the questions.  It takes time and effort to farm, but financial products can be whipped up easily in any season.

In the present environment, this would mean avoiding government debt.  If you believe in inflation coming you can buy the short end, and if deflation, the long end, but aside from that, the ability of the US Government to repay is not growing as rapidly as their debts are.

When I came on the scene in 2001 as a corporate bond manager, there were several areas of the bond market that had a lot of issuance: autos and telecommunications.  I began selling the weaker bonds in those areas; I sold all of my auto bonds (including GMAC and FMCC) except for $10 million of an illiquid issue of a Dutch Ford subsidiary, and limited my holdings in Telecom bonds to the Baby Bells.

That took effort.  Debt-based industry expansions rarely work out well.  If the idea was that promising, it could be funded with higher cost equity, rather than debt.

Now, what would this rule have meant 2004-2007?  Avoid financials, especially banks, S&Ls and mortgage companies.  Though financials are always a large part of issuance, they were even larger then.

I can hear some manager saying, “But I can’t vary that much against the index!  That’s an impossible strategy for big fixed income managers to follow.”  I understand, there are tradeoffs in investing.  If I am underweight, someone else must be overweight versus the index.  Someone has to absorb all of the paper of the hot sector; don’t let that be you.

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Credit analysts understand the creditworthiness of bonds.  What are portfolio managers good for?  Portfolio managers should grasp three things at least:

  1. Portfolio composition versus the needs of the client.
  2. The trading dynamics of the marketplace, and whether a bond might be temporarily mispriced.
  3. The dirty details of a bond.  What are the covenants, terms, etc.

I will handle #1 at a later point in time.  As for #2, a good portfolio manager attempts to explain to his credit analyst why he is ignoring his opinion for a time, because the market for a given bond seems promising in the short run.  There is momentum in bond pricing, and it is better to sell a little late rather than early.

As for point #3, it is the responsibility of the portfolio manager to understand all the special features of a given bond, and why there are pricing differences across the bonds of a given main obligor (borrower), taking advantage of those differences when they get out of whack.

Having been a mortgage bond manger, where document review was a bigger part of what we did, in the minority of corporate bonds that need that review, there is a lot of value to be added.  Often I would review a complex prospectus to find out a big negative: amid all of the legalese, the bonds were as secure, or more so than the senior unsecured of the main obligor.

In a time of panic, those insights are golden, because other managers toss out illiquid bonds that they don’t fully understand.

Even understanding what a put bond is worth is valuable; after deducting yield because of the illiquidity of the smaller put bond issue.  The same is true of trust preferreds, preferred stock, premium bonds versus discount bonds, call features, etc.

The portfolio manager has to balance all of those factors off, along with client factors, in order to manage the assets properly.

I’ll talk more about client factors in a later post; those are always fun, or at least controversial.

The Education of a Corporate Bond Manager, Part IV

Tuesday, July 27th, 2010

When I started this series, I did not think that it would expand as much as it has.  Part of that is getting great questions, such as:

Hi David,

Great series!

You mention that reputation/size matters. Are there any “poker” aspects of reputation that can be detrimental? For example, if you develop a reputation for consistently making good purchases do brokers catch on and markup prices with the idea that your interest in a bond is evidence of underpricing?

Josh

Mmm… poker; I use gambling analogies freely, but I don’t gamble.  You have a point, Josh.  If you do have skill as a manager, how do you deal with the Street if you think they will use your knowledge against you?

First, it helps if you are honest, keep your word on trades, and never try to weasel out of a trade once you have said “done.”  Your word is your bond, and the Street quickly learns who can’t be trusted.  Second, it also helps if you have a genuinely fair reputation; that you don’t try to pull fast ones on the broker community.  A few things that help in that regard: 1) most trades are “low information” trades — you need to raise some cash, and so you look down your list of bonds that your analysts have tagged as “please sell in the next few months” and select a few bonds on which to solicit bids.  When you talk to the brokers in question, tell them how many brokers you are talking to about this bond, and that you just need to raise some cash.  That sets them at ease, and does not reveal that your analyst has a negative opinion on the bond.

Third, that reputation for fairness should be reinforced by other actions.  a) When an investment bank is quoting a price/spread out of the market context, let them know what you know.  If they insist that they are right, then trade against them. b) If their risk control desk comes to you with a trade because they have to cover a short, and you own the bonds, help them out.  This is an “Androcles and the Lion” situation.  Make them pay up, but don’t “gouge their eyes out,” to use the technical term.  Just make them pay a little more than the ask.  If you do that, they will be grateful, and might offer you the long cross-hedge bond at a very nice price (happened to me twice).

Fourth, in general, have an “openness policy.”  Many bond managers conceal 80% of what they are thinking and reveal 20%.  I would reveal 80% and conceal 20% — the most critical 20%. (Imagine a poker game where you, and only you, get dealt all of your cards face down, and you get to choose which one card remains face down.)  Truth is, most investors and investment banks are not set up to copy everything their bright investors do; it would quickly become an overload.

But there is another reason why if you are a bright investor that you don’t have to worry so much.  Brokers make money off of trades.  They thrive off of differences in information.  They like nothing better than to facilitate the trades of bright investors at the expense of not-so-bright investors, because it gives them a reliable series of trades, where they clip a little for themselves.  They aren’t dumb; they don’t want to kill you on one trade if they know they can have a continued stream of trades.

Fifth, your broker at the investment bank is proud of his best clients.  He does not want to lose you if you are bright, or if you trade a lot, or run a big account.

Sixth, never tell your whole story to any broker.  The intelligent portfolio manager breaks up his business among many brokers, each of which is working on specific deals, with no overlap, unless the brokers have been so informed.

Seventh, it is very good to have a reputation for being bright, or at least, not being a pushover.  It restrains the brokers from taking advantage of you and your client.

So I look at being bright in the bond business another way.  It is an advantage that needs to be manager through proper communications.

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On the Trading Log

My first boss had a trading log, and when he left, I imitated him, and copied down my notes from when I was trading.  In the short-run, it avoided confusion; in the long run it encouraged consistency of thought.

But, it is one thing to keep a log, and another thing to remember prices and spreads.  I did my utmost to forget where I entered trades, and then focused on what was the best thing I could do with any given bond, even of I sold it at a loss; at least I avoided a bigger loss.

It is freeing to avoid thinking about whether any trade will generate a gain or a loss, and rather, as how the portfolio can be improved.  We can’t control market prices, but we can choose the companies in our portfolio.  And though humans might be bad at making choices when there are thousands of options, we can be very good at evaluating whether swapping one asset for another can be bright, dumb, or too close to call.

More on this in future segments.

The Market Goes to the Dogs, Which Chase Their Tail Risk

Monday, July 26th, 2010

I’ve read a number of articles on hedging tail risk of late.  Most of them were pretty good; I just want to add in my thoughts.

For those who haven’t read the articles, tail risk is when even safe investments get hit hard.  Those market outcomes are rare but severe, so some people look for insurance to clip their risks when everything is getting whacked.

Possibly a reasonable goal, and the best time to aim for it is when things are pretty good, because it is best to buy insurance when it is cheap to do so.

But what form should the insurance take?  I can think of three broad categories:

  • Assets that come into existence during the disaster.
  • Ready liquid assets — short-term and high quality.
  • Liabilities that disappear with the disaster.

The first category is the one most people think about.  What can I buy that will do well when the disaster comes?  There are two branches to that question:

  • Do I want my downside clipped on this trade (for a price)?
  • Do I want to make the bet without paying much, and I could win or lose?

In the first category are puts and buying protection via CDS, which will protect for a time, but cost money to put on the trade.  Worse, you could be right on the event, but wrong on the timing, and they end up expiring worthless.

Note: be wary of products Wall Street would like to sell you here.  Most often, they sell something mispriced to you, though it looks attractive.

But even if you are right, your counterparty/exchange  has to remain solvent in order for the trade to work.  Few factor in the cost of insolvency there.  Think of those who though they were clever laying off risk to AIG, a trade which only worked due to government intervention.

In the second category, there are assets like precious metals and long Treasury zero coupon bonds, each of which will do well in a specific crisis, but not just any crisis.  But there is also the shorting of equities and high-yield bonds, which could potentially deliver big gains, or big losses if the rally continues.

I would offer this test to anyone offering a hedge against tail risk: is it any better than puts or buying protection through CDS, or shorting equities or high yield bonds?  I would suspect in most cases the answer is no.

Then there is my preferred solution: hold cash.  Cash is unique; it can be used for anything; it can be used for almost every contingency.  Cash may offer little to nothing; it may even yield negatively, but that is the cost of security and flexibility.

Then there is the third option: offering catastrophe [cat] bonds.  Why should the guys following hurricane, quake, typhoons, and European windstorms have all of the fun?  There are more and bigger disasters than those in the financial markets.

In simple terms, here’s how a cat bond works: after a disaster that meets the terms of the cat bonds occurs, the principal of the bond diminishes by the size of the covered loss, if it is in excess of certain thresholds.  The advantage of an arrangement like this is that an insurer or reinsurer can get reinsurance against a disaster, by issuing a high-yielding cat bond.

The high-yield investors are happy to buy it because typically cat bonds are highly rated, and offer a good return that is uncorrelated with the returns on other high yield bonds.  Physical disasters seem to happen independently from financial market disasters.

The bond issuer gets reinsurance capacity, which is sometimes scarce, at a price that reinsurers would not match.  Cat bonds can never replace reinsurers, though, because the reinsurers offer more tailored coverages, while cat bonds tend to be more broad-brush.  They are usually cross-hedges for the issuer, covering something that is likely to be highly correlated with their loss exposure in a disaster.

What Might be a New Idea

What if we applied the concept of a cat bond to hedging risky security portfolios?  Think of it as an odd sort of margin account.  A hedge fund borrows money via a special purpose vehicle [SPV], which holds high quality collateral.  The hedge fund pays the SPV for insurance coverage; the SPV pays interest to the cat bond investors.  If a loss event happens, say a large decline in the S&P 500 index below a stated level, the principal of the cat bond is written down, and the SPV pays the amount of the writedown to the hedge fund.

Compared to a cat bond based on a physical event, there is one advantage and one disadvantage.  The disadvantage is that the loss trigger on a financial cat bond is highly correlated with bad high yield bond market performance, eliminating a lot of the diversification advantage.  This would mean that a financial cat bond would have to pay a higher premium than a physical cat bond.

There is an advantage, though: it can be hard to set up a large hedge without disrupting the market, and it is difficult to gain protection over long periods of time.  Most hedging instruments are short dated, and limited in the amount of capacity available for laying off risk.

Would this be attractive to a large hedge fund?  I’m not sure.  This sort of protection has the same sort of drip, drip, drip of cash out that most managers hate to see, whether for writing puts or buying protection via CDS.  It would come down to a question of cost versus a locked-in solution that could last for ten years, with little to no counterparty risk.

Conclusion

But personally, my best solution is lower your leverage and hold some cash.  Nothing beats the flexibility and simplicity of cash in a disaster.  Cash is also an index of humility; we are willing to leave something to the side in case we are wrong.  Being wrong is a normal state of affairs in investing, so take time to prepare for the next time you will be wrong.

The Education of a Corporate Bond Manager, Part III

Thursday, July 22nd, 2010

A reader MorallyBankrupt, asked,

What I am wondering here is the following, how fast was the decision process? For those of us that have never worked in the new-issue market for corps, the timeline is not obvious. How did it all flow, from getting notice of the deal, to getting a feel for the demand for it, to knowing what the offering price was going to be? How long did you have before requesting allocation in the deal?

Good question.  I answered part of this in the last piece.  It would vary based on three things:

  • The complexity of the deal — more complexity, more time
  • The creditworthiness of the issuer — lower creditworthiness, more time
  • The speculative nature of the market — less speculative, more time

Most new issue corporates do not require explanation; they are just straight bond deals.  Senior unsecured, do the credit work, do you want into the deal or not?  But some deals require thought.  When Prudential (US) went public, they securitized the business associated with their oldest policies, and issued debt against it.  Thick prospectus.  Many scared away in the midst of the credit troubles in 2002.  I looked at it and said, “They are offering more yield than on their surplus notes, but with better protection.  Time to buy.”

So I called my broker at Goldman and expressed interest in the deal.  He sounded a little surprised, and said that few had offered orders yet.  I said that I was interested, and he said that the syndicate would be interested in pricing guidance.  I gave him a schedule where I would be willing to buy more as the pricing went higher in spread.

But after that, I asked for protection on my order.  Early orders deserve protection.  Protection means you will get everything that you asked for, while others get pro-rated if the deal is successful.  They protected my order, which was large for us, while the marketing of the deal continued.

As it was, in the midst of the chaos of 2002. there were few takers for the low risks in a complex deal like that of Prudential’s old business.  So as the deal came to pricing, the yield rose.  The eventual yield for the non-guaranteed bonds was 8.695%, yielding a price in the $98s.  The first trade was $104, and went up from there.  What could be better  for us?  I bought some more when my credit limit expanded at $108.  What a great misunderstood bond.

But that is the way things work when credit markets are slow.  When they are fast, deals close rapidly, and syndicates allocate bonds proportionately to where their estimate of buying power is.  There is no protection there, aside from any big investors who move very early.

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But now onto the times when markets go nuts.  Deals are closing in less than 10 minutes.  You have to get your order in rapidly, or you will get nothing.  My one minute drill helps, but is not perfect.  On a deal on Disney bonds, they had a great yield in a hot market.  I bid for $30 million in bonds, and found myself trapped with 30 million of Disney long bonds, after an allocation that went bad.  I flipped 10 million for a small gain, and another 10 million at par, leaving me with 10 million that I did not want to hold.  I waited, and took my losses later.

But more often, I would avoid the deals when they got hot, and let others buy them.  I had strong opinions on what would work and what would not.  I remember several large deals where the syndicates begged me to buy (GE Capital, and AT&TWireless) and I refused.  The speculative cycle was high, and it was fun to refuse Wall Street when it was trying to stuff accounts full of promises that were underpriced.  I did not play in those deals, and it was fun to see the deals fail, and prices fall considerably versus the original offer.

In order to keep the system honest, some deals had to fail, and not provide profits to those who would flip.  Otherwise, many managers would beg for more bonds than they could hold onto, just so they could flip them.  When the market runs hot, the odds rise that the syndicates will overprice a deal, to deliver losses to those that foolishly ask for overly large allocations.

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Once you had notice of a bond deal, you could act. You could put in for bonds if you wanted.  But when conditions were speculative you had to move rapidly, and ask for an allocation quickly, or risk getting nothing at all.  Once the books closed, that was it.  Also, if multiple dealers controlled the books, it paid to put in through all of them.  One might have influence that the others did not on very rare occasions.  You wanted all of the bookrunners fighting for you.

All of that said, on some deals you would end up with a lousy allocation, and get less than 10% of what you asked for.  At times like that, one would typically flip the bonds to the highest bidder, because it was not worth the bother to hang onto a small position.  On massively oversubscribed deals, the percentage profits on the flip were high, but they weren’t big in dollar terms.

As an aside, occasionally, shortlyafter the deal closed, if you had a sterling reputation, and could say to your brokers that you had been hindered from putting in for bonds but had wanted to, you could still squeeze in.  Reputation and size matters.

Some deals were highly subscribed by large sponsoring buyers before deals went public.  Those deals would open and close in a minute shutting everyone else out but the large buyers, and what few got some crumbs.  I remember getting crumbs on a few occasions.

One way you could get the syndicates to notice you, was that if you really liked a deal, you would buy on the break.  The break is where bonds become free to trade.  Now, truth, there is what is called the “grey market” where after bonds are allocated but before they are “free to trade,” you could deal them away, or, buy some more.  Dealing in the grey market has some taint, and you don’t want to be seen doing it, lest your allocations be reduced.  The opposite is true for those who buy through a syndicate dealer on the break.  It shows the syndicate that you are a real money buyer, as opposed to  a flipper.  Syndicates want to place bonds entirely with long term holders if they can; that is their goal, because it means they priced it right, leaving little money for mere speculators.

As for me, I employed one second tier broker who would buy lousy allocations from me on oversubscribed deals.  No reason to make the analyst write it up.  It wasn’t worth holding onto, and the yield after the break was not attractive enough to buy more.

More to come in part 4.

Book Review: Book of isms

Wednesday, July 21st, 2010

This book is different, and it will get a different book review from me.  I have not read it, but I have scanned it.

This book aims to give extended yet compact explanations of the definitions of words that end in -isms.  It does so with varying success.

Here is my thesis: the more you care about a given ism, the less you will like the explanations in the book.  The entries are long compared to a dictionary, but short compared to an encyclopedia.  Personally, I found entries in areas that I have detailed knowledge of to be too short, and in some cases inaccurate.  This applies to many of the entries on Christianity, and some on economics.

Aside from that I found that it was less than consistent to add in isms that were not belief structures.  In that were a variety of diseases, and words like prisms and schisms.  Also there were behaviors, like Bushisms and Spoonerisms. I would have stuck to belief structures, and expanded them.  A brief volume focused on comparative religion and philosophy would have been more valuable.

Then there are the accidents of spelling: Cataclysms and Paroxysms.  Why don’t they get into the book, if prisms and schisms can get in?

I did not find this to be a book that one can sit down and read.  It is worthy for reference to understand the basics of an ism.

If you want to buy the book, you can buy it here:  The Economist Book of isms: From Abolitionism to Zoroastrianism

Who would benefit from this book

This book impresses me as a good book to give to someone that you’re not sure what he would like.  Even new, the book is modestly priced, interesting, and doesn’t poke anyone in the eye, at least too hard.  The book is small at ~240 pages, and 4X6″.  It would make an excellent small gift for those for which you have no idea what to get.

Full disclosure: The publisher sent me a copy, but I did not ask for it.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Linus : Security Blanket :: David : Bloomberg Terminal

Tuesday, July 20th, 2010

Dear Readers,

New asset management shops start small.  One of the luxuries I have had for the past 18 years is access to a Bloomberg Terminal.  I will not be able to afford one ($20-25K/year), at least not initially, as I start up what is likely to be called Aleph Investments.

I will miss having a Bloomberg Terminal.  At every firm that I have worked at, I have been good at getting it to do tough projects, whether with stocks, bonds (government, corporate, mortgage, bank debt, default swaps), economics, or other investments (munis, money markets, preferred, commodities, currencies, etc.), or getting data on competitors.  I have a deep knowledge of what it can do, compared to most users.

But who needs all of that scope for an average equity management business?  Granted, it’s nice to have the details on all aspects of the capital structure when making decisions, but who has that luxury when your resources are thin?  There is always leafing through the 10-K, a good exercise for all of us who invest.

In my younger days, say 10-15 years ago, I would get most of my investment data via paper.  I would get my kids together and we would stuff envelopes to send out to corporations. Over the next three weeks, the flood of data would be huge, but I would sit down with the kids (they were so cute then) as they reports came in, and show them what the company did and where it was located.  One of them would look at one of the smaller reports and say “10-Q,” to which I would reply “You’re welcome,” which would elicit some giggles.

Ah, the simpler days.  Where was I?

Yeah, I can’t afford a Bloomberg Terminal, but I need a service or a set of services that provides the following (US Traded stocks):

  • Current and Historical fundamental data.
  • Real time equity prices.
  • Price histories.
  • Industry fundamental data (I wish, but don’t have to have it)
  • Reasonable summaries of common ratios and growth rates. (If need be, I can calculate them.)
  • Some economic data (but I can probably cobble that together myself)
  • Some technical work (money flow, RSI, intraday RSI, but that’s just a nicety, and I could do it myself…)
  • International economic data (dreaming, I know, and I can do without it)
  • Commodities, Futures (but I could do without it)
  • Option implied volatilities (but I could do without it)

I’m an investor, not a trader.  I trade a 30-40 stock portfolio about 100 times/year, and most of the trades are rebalancing trades, where I buy or sell to bring a company up to its target weight when it hits a portfolio weight 20% above or below my target weight.  I hold companies on average 3 years.

Now, I could probably get by with:

  • AAII Professional Stock Screener
  • Value Line (paper, limited online, and only the large- and mid-caps)
  • Yahoo! Real-Time Quotes
  • WSJ & Barron’s market data
  • Bloomberg.com
  • FRED at the Federal Reserve
  • SEC Edgar
  • Maybe subscribe to the Financial Times online.
  • And free stuff around the web.  Yahoo! Finance is excellent in a pinch for individual company analysis.

But, could I do better?  Many of my readers use sources that I am not aware of.  If you would, would you describe the data sources that you use for data analysis.  It would not only be of value to me, but would be of value to all of our readers.

When I am up and running with Aleph Investments, I will post to let you know what I finally settled on, but for now, let me know what you would use if you were in my shoes.  If you are posting a reply to somewhere other than the comments at my site, please send a copy here.

Thanks to all,

David

The Education of a Corporate Bond Manager, Part II

Saturday, July 17th, 2010

Part I is here.

For a new corporate bond manager with very little apprenticeship-type training, I had to learn some things on the fly.  Of my first tier brokers, roughly half of them took pity on me initially and explained to me the rules of the road.  That happened partly because I wanted to try some things that my old boss rarely did, and as I did that one of my brokers would explain to me, “If you’re going to do that, you have to do it this way…” which I would confirm with one or two of my major brokers.

If I wanted to buy a bond that was not presently being offered, I learned to find out who brought the deal and made a market in the bond issue, and told them, “If you find a few million bonds in a such and so spread context, I would be happy to pick some up.  Now, the less I knew about the price context, the more conservative I would be about price and size.  If I found a large amount offered to me at my level (rare), I would honor it by buying a small amount, and then backing up my price level to where I would not be offered so much, and try for more at better prices.

Price discovery is tough business, because some bonds trade rarely.  There are things to help you:

  • Comparable bonds in the same industry
  • Credit spreads across rating categories
  • Credit spreads across the maturity spectrum within rating categories
  • Spreads on credit default swaps on the same name.
  • Value of scarcity vs cost of illiquidity, and vice versa
  • Proper spread tradeoffs on premium vs discount bonds, call features, put features, off-the-run vs on-the-run issues, etc.
  • Calculating the spread on the last few trades, however dated, and then massaging the spread into what it is likely to be today.

My client was growing rapidly, and 30% of its liability structure was long because they wrote a lot of structured settlements.  [Geek note: structured settlements arise when a plaintiff wins a court case, and a stream of payments must be made by a defendant for the rest of the plaintiff's life.  There are often inflation clauses, which makes the stream grow over time.  The defendant has insurance companies bid on paying the liabilities, and low bidder wins.]  I could buy a lot of long illiquid securities if my credit analysts liked the credit risk on the companies in question.

As such, I had a list of issues at various brokers that I wanted to buy if they became available.  Those ranged from moderately liquid to very illiquid.  I had a list that I sent out every now and then that I called the “Odd Duck” list; for fun, the last name on the list was the ultimate odd duck, AFLAC.  That got a few chuckles.

But with a rapidly growing client, much as I liked to source bonds that I fundamentally liked on the secondary market, I had to buy a lot of bonds in the new issue primary market.  Under normal conditions, the bond market has a lot of IPOs each day, as new bonds get issued, most often from companies that have issued before, but the characteristics of the new bond are different.

Now sometimes, when the corporate bond market is cold, or a deal is complex, it will take days for the deal to close, and sometimes a week or more.  But when things are hot, deals can close in seven minutes.  When I would see a new deal, the first thing I would do is analyze where we were in the speculation cycle for new deals.  As I said in my last piece, on average, new deals are brought a little cheap, because there is a price to gain liquidity that the issuer pays.

When deals were closing slowly, like say in half a day or more, I would send the deal terms to the analyst, and ask if she liked the credit.  If she said no, I would refuse the deal.  Otherwise I would put in for my normal allocation of bonds, subject to my limit for the company in question, and varying with the attractiveness of the deal, and how much cash I had to put to work.  When the market was rational, typically I would get good allocations, and deals would trade up a decent amount after issue.

But when the market was hot, and deals would close within an hour, I would work differently.  When the deal would come, I would put in for bonds, so that I would get some allocation.  I would ask for the high end of what I would normally ask for, knowing that I would get scaled back considerably.  Then I would send the details to my credit analyst, telling them that if they did not like the company, I would sell the bonds.

Eventually, most of my analysts during the times when the market was hot would come to me and say, “How can you put in for bonds without an opinion from us?”  First I would reassure them, and tell them that I valued their opinions, and that I would not hold onto a bond permanently unless they liked it.  I would sell all bonds they did not like, but when the technicals favored it, within a few months.

Second, I would tell them, “I do the one-minute drill,” which elicited the obvious question, “What’s the one minute drill?”  I then led them through a series of Bloomberg screens that would allow me to get a quick read on creditworthiness:

  • GPO – how has the stock price moved over the last year?  Down hard is a deal killer.
  • HIVG – how have option implied volatilities moves of late? Up considerably more than the market is a bad sign.
  • CH6 – how is operating cash flow doing?  If it is considerably worse than earnings, that ‘s a bad sign.
  • DES – what industry is it in?  Do I hate that industry?  If so, don’t play.
  • DES3 – all of the major financial ratios for the company.  What do the typical bond ratios look like?  Are they materially worse than those for the industry?
  • CH2 or ERN, are earnings declining?  If so beware.
  • CRPR – what are the credit ratings?

Then I would tell the credit analyst that if a company passes these tests, the odds of the company doing badly while I wait for the analysis of the credit analysts was slim.  Then I would get a smile from the analyst, who would go and do their analysis without fear of something going badly wrong while they do their analysis.

But there is one last complexity here.  When deals are running hyper-hot, and are closing in minutes, it is good to take a step back and ask on each deal if the yield spread is too tight. Bond syndicates price some deals too tight, and instead of the deals rising after issuance, something horrible happens.  I will bring that up, and other matters, in part III.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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