yield curve shifts_22703_image001I’m a very intellectually curious person — I could spend most of my time researching investing questions if I had the resources to do that and that alone.  This post at the blog will be a little more wonky than most.  If you don’t like reading about bonds, Fed Policy, etc., you can skip down to the conclusion and read that.

This post stems from an investigation of mine, and two recent articles that made me say, “Okay, time to publish the investigation.”  The investigation in question was over whether yield curves move in parallel shifts or not, thus justifying traditional duration [bond price interest-rate sensitivity] statistics or not.  That answer is complicated, and will be explained below.  Before I go there, here are the two articles that made me decide to publish:

The first article goes over the very basic idea that using ordinary tools like the Fed funds rate, you can’t affect the long end of the yield curve much.  Here’s a quote from Alan Greenspan:

“We wanted to control the federal funds rate, but ran into trouble because long-term rates did not, as they always had previously, respond to the rise in short-term rates,” Greenspan said in an interview last week. He called this a “conundrum” during congressional testimony in 2005.

This is partially true, and belies the type intelligence that a sorcerer’s apprentice has.  The full truth is that long rates have a forecast of short rates baked into them, and reductions in short term interest rates usually cause long-term interest rates to fall, but far less than short rates.  There are practical limits on the shape of the yield curve:

1) Interest rates can’t be negative, at least not very negative, and if they are negative, only with the shortest highest quality debts.

2) It is very difficult to get Treasury yield curves to have a positive slope of more than 4% (30Yr – 1Yr) or 2.5% (10Yr – 2Yr).

3) It is very difficult to get Treasury yield curves to have a negative slope of more than -1.5% (30Yr – 1Yr) or -1% (10Yr – 2Yr) in absolute terms (i.e., it’s hard to get more negative than that).

On points 2 and 3, when the yield curve is at extremes, the real economy and fixed income speculators react, putting pressure on the curve to normalize.

Aside from that, on average how much do longer Treasury yields move when the One-year Treasury yield moves?

3-year T94.64%
5-year T89.31%
7-year T85.17%
10-year T81.14%
20-year T75.41%
30-year T72.89%

The answer is that the effect gets weaker the longer the bond is, bottoming out at 73% on 30-year Treasuries. But give Greenspan a little credit — in 2005 the 30-year Treasury yield was barely budging as short rates rose 4%.  Then take some of the credit away — markets hate being manipulated, so as the Fed uses the Fed funds rate over a long period of time, it gets less powerful.  In that sense, the Fed and the bond market integrated, as the market began looking past the tightening to the long-term future of US borrowing rates, what happened to short interest rates became less powerful on long yields.  This is particularly true in an era where China was aggressively buying in US debt, and interest rate derivatives allowed some financial institutions to escape the interest rate boundaries to which they were previously subject.

Also note my graph above.  I took the Treasury yield curves since 1953, and used an optimization model to estimate 10 representative curves for monthly changes in the yield curve, and the probability of each one occurring.  If yield curves moving in a parallel direction means the monthly changes at different points in the curve never vary by more than 0.15%, it means that monthly changes in yield curves are parallel roughly 70% of the time.

When do the non-parallel shifts occur?  When monetary policy moves aggressively, long rates lag, leading the yield curve to flatten or invert on tightening, and get very steep with loosening.

Later, the article hems and haws over whether rising long rates would be a good or a bad thing, ending with the idea that the Fed could sell its long Treasury bonds to raise long yields if needed.  That brings me to the second article, which says that long interest rates are at record lows, as measured by average Treasury yields on bonds with 10 years or more to mature.

The graph in the second article shows that it takes a long time for inflation to come back after the economy has been in a strongly deflationary mode, where bad debts have to be eliminated one way or another.  Given the way that monetary policy encouraged the buildup of the bad debts from 1984-2007, it should be little surprise that long rates are still low.


So what should the Fed do?  If they weren’t willing to try a more radical solution, I would tell them to experiment with selling long Treasuries outright, and not telling the market that it was doing so.  The reason for this is that it would allow the Fed to separate out the actual effect of more Treasury supply on yields, versus how much the market might panic when it learns that the long Treasuries might be available for sale.  The second effect would be like Ben Bernanke mentioning the word “taper” without thinking what the effect would be on the forward curve of interest rates.  It would be an expensive experiment, but I think it would show that selling the bonds in small amounts would have little impact, while the fear of a flood would have a big but temporary impact.

If the Fed doesn’t want to raise long rates, it could try moving Fed funds up more quickly.  Historically, long rates would lag more than with a slow rise. (Note: 2004-2007 experience does not validate that idea.)

What do I think the Fed will do?  I think that eventually they will let all long Treasuries and MBS mature on their own, and replace them with short Treasuries, should they decide not to shrink the balance sheet of the financial sector as a whole.  That’s similar to what they did after the 1951 Accord, which restored the Fed’s independence after monetizing some of the debt incurred in WWII.  Maybe this is the way they eliminate the debt monetization now, if they ever do it.

I think the present Fed will delay taking any significant actions until they feel forced to do so.  They have no incentive to take any risk of derailing any recovery, and will live with more inflation should it arrive.

PS — that long rates move more slowly than short rates may mean that duration calculations for longer bonds are overstated relative to shorter bonds.  It might mean that 30-year notes would be 2-3 years shorter relative to one year notes than a parallel shift would indicate.

Photo Credit: Richard.Asia

Photo Credit: Richard.Asia

Recently, I had a client leave me.  I’m not sure why he did — I didn’t ask, because that’s his business.  It *is* his money, after all, not mine.  After deducting the accrued fee, I thanked him for his business, and wished him well.

I try to be low pressure in my work.  I also try to discourage the idea that if someone uses my services, they will do better than the average, much less phenomenally.  I remind potential clients of what happened to stocks in the Great Depression (down almost 90% during a period in 1929-1932).  I ask potential clients to stick with me through a full cycle of the market, but I don’t require it because:

It’s their money.

One thing I do promise them is that my money is on the line in the exact same proportion as their money.  Over 90% of my liquid wealth is invested in my stock portfolio.  I don’t make any decisions for clients that I would not make for myself, mostly for ethical reasons.  But I make sure of it, because I am still my largest client, and I am always on the same side of the table as my clients, aside from my one and only source of revenue, my fee.

It’s their money, but, when it is under my care, it gets the close treatment that my own money receives — no more and no less.

Many wealth/asset managers want as much of a client’s assets as possible.  Me?  I get uncomfortable when more than 50% of their assets are riding on me, but if that’s what the client wants, I will do it if they ask, because:

It’s their money.

Jesus, inverting Hillel, said “Do unto others, as you would have them do unto you.”  That guides my marketing, because I know that many people feel pestered by those who market to them, including those who once they have their foot in the door, now want the whole relationship.  Thus I avoid as much pressure as possible in marketing, and leave it to the good judgment of my clients as to how much they want to entrust to my care, and for how long.

It’s their money.

I don’t pretend to have all of the answers, or even all of the questions.  If one of my clients asks me an unrelated question, and I have the time and expertise to aid them as a friend (i.e., you can’t sue me), I will take some time to help.  They may ask me about what other managers are doing for them, asset allocation, insurance policies, and other things also.  I will give them friendly advice, without any other expectation. I thank them that they are a client of mine — I try to end all of my client letters with that.  In the end, I want them to be happy that they chose me to aid them, and to be happy when they leave as well.

That’s the way I would like to be treated as well — low pressure, transparency of services and fees, and alignment of interests with an ethical adviser who is a fiduciary.

Back to the beginning, aside from the client leaving me, the other reason I write this is all of the pitches I have been getting via e-mail, web, radio, etc., where I say to myself “How can they promise that?” “Doesn’t that break the ‘No Testimonials’ rule?” “Great to be selling advice and seminars — why not start an investment business and prove your theories?”

The investment business has more than its share of those who don’t deliver value, and I labor to be on the positive side of that ledger, as do many others.  Choose those who will treat you as you deserve to be treated, and enjoy the benefits, because:

It’s your money.

The No-Lose Line_14068_image001How long can you hold a Treasury Note or Bond, and not suffer a loss in total return terms, if yields rise from where they are today?  Maybe the answer will surprise you, and maybe not — it depends on how fixed-income literate you are.

Okay, here’s the scenario: I start off with the current yield curve for 2-, 5-, 10-, and 30-year Treasuries (0.51%, 1.61%, 2.32% and 3.04%).  I make the following assumptions:

  • Annual Coupon Payment at the end of the year (at the current bond equivalent yield)
  • The bonds are priced at par, so they are current coupon bonds.
  • They are new bonds with the full maturity to go.
  • Each year, the coupon payment is reinvested in bonds of the same type.
  • Each scenario is run until there is one year left to go.  The rate in the last year is the total return earned in the scenario if the notes/bonds pay off.
  • I’m not considering inflation, so these will be real losses if inflation is positive on average.
  • Those that hold don’t need to earn any income, unlike insurers, banks, pension plans and endowments.  We could do the same analysis for them, but the lines would look flatter, because they can’t afford to lose as much.

So, what higher yield rate on the bonds will make the total return zero as the years elapse?  That’s what the above graph shows… so what can we learn from that?

For 5-,10- and 30-year Treasuries, a yield rate near 3.03% will hold the package to roughly a zero total return after 2 years.  After 3 years, that same figure is around 3.74%.

As time elapses, scenarios above the lines would represent losses on a total return basis, and below the line would be gains.  The path itself would matter a little, but the latest position more.  The graph can be used in another way also… if you have an idea of how high you think interest rates will go, you will have a have an idea of how long it would take to break even.  Remember, if the Treasury is “money good,” you get it all back at the maturity of the note/bond.

Or, if you are holding bonds for a little while, if you think the stock market is too high, this can give you an idea on how long to buy the bonds if you don’t want to take losses if you decide to reinvest in stocks.  (Yes, I know… in a hard down market, you will likely be grateful that you held the Treasury notes/bonds.  That is, unless the US Dollar is no longer viewed as a reliable international store of value… and then we will have bigger fish to fry.)

The main lesson: choose your maturity preference with care for slack balances that you don’t want to invest in risk assets… you get more yield as you go longer, but the longer bonds lose money more rapidly for a given rise in interest rates.

Final notes: the lines are a little cockamamie at the end — they aren’t wrong, but the economic scenario producing such a path of interest rates would imply very high inflation or capital scarcity — the latter would tank the stock market as well, at least in the short run, and the former might tank the dollar, or lead to a run in commodities.

Those scenarios are also unusual because they highlight how bond investors investing to a fixed term earn more reinvesting coupon payments in a rising interest rate environment.  At least that is true nominally prior to taxes and inflation, but those are separate issues.

All for now.  Thanks for reading.

Photo Credit: .SilentMode || Doubts that the deal is legitimate?

Photo Credit: .SilentMode || Doubts that the deal is legitimate?

I’ve written a lot about financial fraud at Aleph Blog.  I try to encourage people to be skeptical, because it is genuinely rare when a deal is exceptionally good for an average person.  Most of the time in life, you are doing pretty well if you are getting a fair deal, particularly when it comes to financial matters.  Most people selling financial products know more about the product than the prospective buyer.

Thus, Aleph Blog has written about a wide number of deals that are bad, and those that are outright fraudulent.  (At the end of this article, there will be a sample of articles that I have written.)  Not that anyone appointed me, but I regard this as one of my sub-missions, in writing this blog.  Cleaning up the investment world should be a goal of many legitimate investors, because the cleaner things are, the better the culture of trust will be for legitimate financial products.

Now, Aleph Blog does this service on two bases: free and paid.  Free is for the simple stuff.  If you write an e-mail to me asking “Is this legit?” and it is simple enough for me to give a quick answer through a blog post, I will likely (but not certainly) write a post on it, or point you to one I have written.  I may even answer the companion question, “Is it a smart thing to do?”  Most of what I do here will fall into the free category.

The complex stuff is another matter.  I have done analyses like these for prior employers, and on a freelance basis for wealthy individuals and corporations.  Examples have included:

  • Analyzing whether the Permanent Portfolio idea works or not (and other investing theory questions).
  • Analyzing a complex tax avoidance deal that involved insurance, securitization, and other factors.
  • Analyzing whether a private business deal looks legitimate.
  • Analyzing whether a securitization deal looks legitimate.
  • Analyzing complex bonds or other securities for value.
  • Giving a second opinion on an investment question.
  • Giving a second opinion on a new investment product.
  • Giving a second opinion on a financial plan.

I like an occasional complex project because it keeps my skills sharp.  I am a good financial modeler, and though I did not go to the finals the last two years in the Modeloff competition, I placed well in the first round the last two years, and in the second round in 2013 was in the top half, and though I qualified, this year I could not compete in the second round due to a schedule conflict (presbytery meeting).

If a project does not fit my expertise, I will turn it down.  Why waste your time and mine?  If I don’t have slack time, I will turn it down — my investment clients come first.  But if you have an interesting project that you think might fit me, email me, and let’s talk.  I am willing to sign confidentiality agreements, and not publish the results if need be.

Beyond that, let’s make the financial world better, and eliminate as many scams as we can.


Hey, thanks for reading… 😉 and play it safe, please.



This book has two significant types of insights: on people and on market failure.  It does well with both of them, but spends most of its time on the former, because it is more interesting.  That said, the second set is more important, and is buried in a few places in the second half of the book.

With people, this book answers the following questions:

  • Why does this book largely take place in Buffalo, NY? Because entrepreneurs got started there, and found it easy to acquire talent there.
  • Why does the industry employ a lot of ex-convicts? There are some crossover benefits to having been through the rough-and-tumble of street life that gives an edge in dealing with desperate people who have bad debts.
  • Is there an ethical code for debt collectors? Well, yes, sort of.  Kind of like “the code” from the movie Repo Man – don’t tell debtors they are in legal trouble, don’t threaten, treat them with kindness, don’t buy debt where you don’t have a clear chain of title, don’t sell lists of debts to collect where the debtors have already been verbally flogged.
  • Do all debt collectors follow the code? Well, no, and that is one place where the book gets interesting, as various debt collectors look for edges so that they can make money off of debts that creditors have given up on.  There *is* honor among thieves, and be careful if you cross anyone powerful or desperate enough.
  • Can’t you use the legal system to try to recover money on the debts? Well, only at the end, and even then it is difficult, because if the debtor asks for evidence on the debt that is being collected, the debt collector usually doesn’t have it, and the case will be dismissed.  It is best for collectors to come to settlements out of court.

The book follows around debt collectors and those associated with them, a colorful bunch, who see their see their opportunities flow and ebb as the financial crisis first produces a lot of bad debts to work on, and they mine that ore until the yields get poor.  Some of these people you will gain sympathy for, as they are trying to make a buck ethically.  Others will turn you off with their conduct.

As for market failure issues, you might wonder why the credit card companies and other creditors don’t pursue the debtors themselves.  Why do they sell the right to collect on unsecured debts at such deep discounts to the face value of the debts? [Pennies on the dollar, or less…]

The creditors don’t want to make the effort to dig up the necessary data to make the case in court a slam-dunk.  It would not pay for them to do so in most cases given the large number of cases to pursue, and the relatively small amounts that would be recovered.  That’s why the debts are sold at a discount.

Some debts don’t get removed from databases when payments are made to close them out, and as such some debt collectors try to collect on debts that were once in default, but paid off in a compromise.  This could be remedied if there were a comprehensive database of all debts, but the costs of creating and updating such a database would likely be prohibitive.

Finally, you might ask where the regulators are in all of this.  Between the States and the Feds, they try to clip the worst aspects of debt collection, but they are stretched thin.  This means that for many people, the optimal strategy is not to pay on defaulted unsecured debts, and challenge them if they take you to court.


Lots of foul language, but you’re dealing with the lowest rungs of society, so what do you expect?

Summary / Who Would Benefit from this Book

This is a good book if you want to understand the unsecured debt collection business.  If you have friends who are troubled by debt collectors, it might be worth a purchase, and lend the book to them.  If you still want to buy it, you can buy it here: Bad Paper: Chasing Debt from Wall Street to the Underworld.

Full disclosure: I received a copy from the author’s PR flack.

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.

Photo Credit: Phineas Jones || Beyond the destruction, honesty?

Photo Credit: Phineas Jones || Beyond the destruction, honesty?

Few like revenue misses, but let me point out a few significant things that investors should care about:

  • If a company misses revenue estimates around 50% of the time, that can be an indicator that it doesn’t play around with revenue recognition, which is probably the most common way of shading accounting results.  Honest accounting is worth a lot in the long-run, even if the market won’t pay up for it in the short-run.
  • If a company beats revenue estimates nearly all the time, do a little digging into revenue recognition policies.  Have they changed?  It may be that the company is hitting on all cylinders, but that is difficult to keep up for a long time.  How do accounts receivable look?
  • If a company misses revenue estimates nearly all the time, take a look at what they are saying about their marketing, and analyze the industry and competition.  If it is due to the industry, that might not be so bad if you are getting the company’s shares at a cheap valuation.  If it is due to other reasons, it might be time to look elsewhere…
  • If you are late in the company’s product pricing cycle, and competitors are overly aggressive, good companies may take a step back and emphasize profitable business over volume, if fixed costs aren’t too high.  In a pricing war, analyze who has the capability of living through it — maybe it is time to avoid the sector, or simply own the strongest company there, as you wait for capacity to rationalize.

Regardless, it can be a good exercise to look at the current asset accruals of the non-financial companies that you own to see if they look high, because of the higher odds of an earnings disappointment if those accruals are too aggressive.  If you need a summary statistic to look at, perhaps use normalized operating accruals or the days outstanding in the cash conversion cycle for receivables plus inventories minus payables as a fraction of revenues.

That’s all for now.

Photo Credit: Hans and Carolyn || Do you have the right building blocks for your model?

Photo Credit: Hans and Carolyn || Do you have the right building blocks for your model?

Simulating hypothetical future investment returns can be important for investors trying to make decisions regarding the riskiness of various investing strategies.  The trouble is that it is difficult to do right, and I rarely see it done right.  Here are some of the trouble spots:

1) You need to get the correlations right across assets.  Equity returns need to move largely but not totally together, and the same for credit spreads and equity volatility.

2) You need to model bonds from a yield standpoint and turn the yield changes into price changes.  That keeps the markets realistic, avoiding series of price changes which would imply that yields would go too high or below zero. Yield curves also need ways of getting too steep or too inverted.

3) You need to add in some momentum and weak mean reversion for asset prices.  Streaks happen more frequently than pure randomness.  Also, over the long haul returns are somewhat predictable, which brings up:

4) Valuations.  The mean reversion component of the models needs to reflect valuations, such that risky assets rarely get “stupid cheap” or stratospheric.

5) Crises need to be modeled, with differing correlations during crisis and non-crisis times.

6) Risky asset markets need to rise much more frequently than they fall, and the rises should be slower than the falls.

7) Foreign currencies, if modeled, have to be consistent with each other, and consistent with the interest rate modeling.

Anyway, those are some of the ideas that realistic simulation models need to follow, and sadly, few if any follow them all.

Photo Credit: Moyan Brenn || Relax, you know less than you think...

Photo Credit: Moyan Brenn || Relax, you know less than you think…

So, the Republicans swamped the Democrats in the midterm elections.

Big deal.

The differences between the varying wings of the Purple Party are smaller than you think.  What’s more, their willingness to magnify those differences and do little as a result is a high probability outcome.

Add in that the Republicans don’t have a coherent set of policies as a group. Will the t-party and Establishment wings of the GOP come to a meeting of the minds? (Democrats may insert easy cheap joke here.)  Even if they do, who will take the blame when Obama vetoes their bills?  They aren’t called the “stupid party” for nothing.  They have a peculiar knack for snatching defeat from the jaws of victory, and letting their less presentable members define them.

Even if in theory, the markets do better from Republicans, in practice the reverse seems to be true.  But the track record has so few data points that statistical credibility is low.

And, if there is something to the Republicans being in power moving the markets, how would you know if it wasn’t anticipated in the recent run-up of prices?  Many parties may have bought into the concept of greater prosperity as result of the then-forthcoming elections.  The time to buy the rumor is gone.  The time to sell the news may be here.

The same applies to the presidential cycle.  Many argue that we are heading into a good time for the markets in the third and fourth year of a presidential term.  Too many are arguing this in my opinion, and even if there is some real impact from presidential terms, perhaps the market is anticipating this as well.  After all, the bad part of the presidential cycle looked pretty good this time around.

Add in that again we are working with the law of small numbers — the presidential cycle could just be due to randomness.  Some part of the presidential cycle had to look better.  Is it so much better than any other subset could have been?

The same thing applies to the argument I am seeing trotted around that we are coming into the best six months of the year.  Cue the comments on the law of small numbers and randomness.  Even if there is a structural reason like tax-based selling, might it have been anticipated this time around?  Markets tend to anticipate.  Some six month period had to be best… but is it due to randomness?

Going back to politics, I would point out that few significant things change in politics off of party affiliation.  How many states have their budgets balanced on an accrual basis, taking into account the need to spread out the cost of infrastructure projects, and pensions funded assuming a realistic 5% earnings assumption on assets, together with fully funded accrual accounts?  None.  All of the states put off paying for the accruals of what should be current expenses.

We’ve talked about entitlement reform, but action never happens, except further expansion, as under Bush, Jr.  Will we see GSE reform, or will Congress continue to use the GSEs for their own ends?  Will there ever be significant cuts in defense?  Will we ever see truly balanced budgets on an accrual basis?

Beyond that, consider the Fed, the Supreme Court, and the bureaucracy generally… they don’t change rapidly, if at all.  Admittedly, the Supreme Court has been more activist over the recent past… so maybe I am wrong there.

And truly, Congress changes only at the edges.  The grand majority of the same faces will be there, only the majority and committee assignments shift.  That may not mean much.

But do we want lots of change?  Individually, many of us do, but if you add us all together, it often nets to something near zero.  Perhaps most of us are happy with that, given the alternative that those of us with the opposite views might impose them on the rest of us.

I leave you with this: don’t make too much out of the election results, the presidential cycle, the “sell in May and go away” phenomenon, etc.  The world is complex, with many people trying to anticipate market reactions.  Untangling them is close to impossible, so stay calm, and pursue the ordinary strategies that you always do.  For me, I will continue my value investing.

On Thursday, November 23rd, I was recorded to be on RT Boom/Bust. The first half of it played that day, and the video of it is below:

We covered a lot of ground in a short amount of time.  Here are the topics, with articles of mine that flesh out my thoughts in more detail (if any):

The second half of it played today on October 31st, and the video of it is below:

Here we talked about the following:

I really appreciated being on the show.  Hope you enjoy the videos.  Thinking fast is a challenge, and you can often see me trying to gather my thoughts.

My thanks to Erin, the producer Ed Harrison, and their segment producer, Bianca.

Full disclosure: long LUKOY, ESV, NAVI and SBS for clients and me