Letters from Two Readers

I wanted to drop you a line to commend you on your blog which I read with interest and almost universal agreement.

Your investment ideology and style is very similar to my own, and I enjoy the snippets of personal insight and glimpses of your life that you share.

I have worked in investment management for a number of life and general insurers in the UK and with a number of actuaries, some of these have been extremely able and had an outlook very similar to that which you hold. The more risk averse, countercyclical heads have tended to perform very strongly when given the time for their ideas to mature.

It is far easier to identify a good idea than to know when the market will come into line with your thinking!

Performance can be poor whilst you wait for the market to adjust, so you need have established your investment credentials beforehand. I have also seen a company destroyed by the unwillingness of a board to wait for investment performance switching managers and strategy at the peak of the TMT bubble, which ended up putting one of the strongest life funds into run-off.

Thanks for the words of encouragement.  It’s always challenging to strike the balance between earning returns and avoiding undue risk, much less having any sense of timing the risk cycle.  With bonds, it is a little easier, because you can tell when debt covenants, etc., and other terms of lending weaken.  We can see when incremental yield is most likely not going to be compensate for the risks involved.

The same applies to insurance – stylistically, first pricing declines to technical levels, then terms and conditions deteriorate, then pricing declines further, until there is a disaster, capital reduces and pricing strengthens.

Thanks for writing.

I really appreciate the way you do twitter and blog.  You always include your thoughts to some degree in your tweets, which I appreciate; and your blogging is great!  I often read to hear about what your thinking and you do a good job of translating a lot of technical or specific information into applicable or at least thoughtful steps I can take.

I’m probably most amazed by your ability to find “truth” through mathematics due to your skills as an actuary.  As a younger man in this business I’ve been from awed to disillusioned from the market and I still struggle to have a grasp.  We use mutual funds predominantly so I don’t have to worry about knowing so much about the market and the individual goings-on but I still do a lot of asset allocation.  Frankly, I think there is more risk in a poor asset allocation than a poor asset selection within that allocation.

Right now I’m thinking that high yield spreads are too tight and credit too frothy, but I read Third Avenue on high yield and they argue that we have a few years before that’s a problem.  I guess what I’m asking for is advice on how to find the truth of where we are in the market cycle and how to take smart risks with my clients’ money.  Should I be reducing or eliminating HY debt because of the “seemingly clear” overheated risk?  If so, where do I find a decent return in fixed income or do I bite the bullet and stay short with little/no yield.

Especially for the more conservative investors who really need every penny to work out – it’s a hard balance to find right now.  I don’t think I’m alone.  Nevertheless, sorry for the long email. I hope to see something on your blog or a response if you find a minute of what must be a very busy life.

Yes, high yield is frothy, but it could get frothier.  Cramer had a saying, “Absurd is like infinity.  Twice absurd is still absurd; twice infinity is still infinity.”  I read through the Third Avenue report… I generally like the way they do things though Marty Whitman got whacked in the financial crisis for owning too many low quality financials.

I learned early on from a junk bond manager who currently has five stars from Morningstar, that spreads are less critical to junk bond than dollar prices.  His view is that there is some irreducible risk in high yield, such that you need yield, not just spread, to guide your decisions.  Particularly when junk bond prices get so high that they are likely  to be called.  With such a steep yield curve for Treasuries, it is possible for option-adjusted spreads to rise as the bond price rises.

I can’t tell you what to do.  I can tell you what I am doing.  For my bond clients, I have assets  allocated half to emerging markets, both local currency and dollar denominated.  The governments of most emerging markets are run in a more orthodox manner than most of the developed markets, so I am comfortable with the risks.   The rest is invested in short and longer investment grade corporate, and a small wager on the Swiss Franc appreciating.

I am happier getting yield from emerging markets than getting it from weak corporate credits.  There are risks in the world today, and we could see high yield strategies fail.  After all, no one thinks about a moderate-sized war changing risk preferences.

That’s what I am doing.


To all my readers, risk is sometimes not obvious.  In this time of abnormal monetary policy and large budget deficits, it pays to be careful.