The Education of a Corporate Bond Manager, Part V

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.