Jake at Econompic Data had a good post on credit and equity.  (He runs a good site generally.)  They are correlated, but not all of the time.  As I commented:

When yields are low, equities thrive because financing costs are low.

When the defaults come, future equity returns are low, because financing rates rise, killing some and wounding others.

When yield spreads are very high, future equity returns are high, because returns come as spreads tighten.

You can see more on pages 14-22 of this presentation that I gave:

http://alephblog.com/wp-content/uploads/2009/11/SEAC_Presentation.pdf

Though I promised some posts after my presentation to the Southeastern Actuaries Conference, I never followed up.  Here is part of my belated follow-up.

As I noted in my presentation:

• Credit and equity returns are closely correlated in bear markets.
• Illiquidity events become more common when equity prices are falling, and credit spreads rising.
• Complexity and structure raise illiquidity during crises.
• Bonds with negative credit optionality underperform in a crisis.

I would add that credit and equity returns are closely correlated coming out of a crisis as well.  But here are some examples, starting with 2007-2009

and then 1999-2004:

and then 1989-1993:

and then 1980-1983:

and then 1969-1975:

Finally, 1927-1944:

What I concluded:

• Credit booms are different – equities rise, while credit spreads stay low and stable.
• There are sometimes exceptions when selloffs are sharp, like 1987 or 1998.
• Ignore what the government says. It is impossible to eliminate the boom-bust cycle. The best a good businessman can do is try to understand where he is in the cycle, and be prepared.
• Building liquidity looks dumb after credit spreads have been tight for a few years, but can save a lot of performance. The same is true of an “up in credit trade.”
• During the bust phase, illiquid companies and investments get whacked. It is often good to “leg into” such investments during the panic. This is when credit analysis really pays off, because during the panic, everything gets hit.
• Equity risk shows up in insurance lines of business like Surety, D&O, E&O, Mortgage, Financial, etc.
• If you have equity risk in your liabilities, reduce credit risk in your assets. Same is true if you need to regularly buy equity options. When implied option volatility rises, credit spreads tend to rise as well.

Notes:

There are few corporate yield series that date prior to 1990.  Until computers became powerful enough, bonds traded on a dollar price basis, and yields, much less spreads, were not comprehensively recorded.  One of the few corporate yield series with a long history is Moody’s Corporate Bond Indexes, which goes back to 1919.  There are some oddities to that index, but there aren’t many choices if you go back a long way.  It composed of bonds in a given ratings category, 20-30 years long, unweighted average on yields.  The averages tend to yield more than most bond managers that I have talked with think they can get.

My credit spread variable was the yield on the Baa series less that on the Aaa series.  I think it is a really good proxy for credit conditions and overall market volatility.

Anyway, this was part of a talk that I gave to the Southeastern Actuaries Conference.  I’ll do a few more posts from that, but if you want to look at the report, you can find it here.

Unlike most people who analyze investments, I think there are periods of time where domestic long-only investors may be consigned to low or even negative returns.  As investors, we are generally optimists; we don’t like can’t win situations like the Kobayashi Maru.

When money market funds offer near-zero yields, asset allocation becomes complicated.  Near the beginning of such a period, it might pay to take a lot of risk when credit spreads are wide.  But when they are more narrow, but wide by historic standards, the question is tough.

I start analyses like this the way I do the the piece Risks, not Risk.  I look at the individual risks and ask whether they are overpriced or underpriced.  Here is my current assessment:

• Equities — slightly undervalued at present, particularly high quality stocks.  (US and foreign)
• Credit — Investment grade credit and high yield are fairly valued at present.
  
• Real Estate — the future stream of mortgage payments that need to be made is high relative to the present value of properties.  There will be more defaults, both in commercial and residential.
• Yield Curve — Steep.  It is reasonable to lend long, so long as inflation does not take off.
• Inflation — Low, but future inflation is probably underestimated.
• Foreign currency — One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
• Commodities — the global economy is not running that hot now.  There will be pressures on resources in the future, but that seems to be a way off.
• Volatility is underpriced — most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.

All that said, for retail investors, I am not crazy about the options at present.  I would leave more in money market funds than most would as a part of capital preservation.  I would also invest in high quality dividend-paying stocks, because they are undervalued relative to BBB corporates.

Beyond that, I would consider fixed income investments in the Canadian and Australian Dollars.  I am skittish about the US Dollar, Euro, Pound, Yen and Swiss Franc.  (The least of those worries is the US Dollar itself.)

We live in a world where risk is often not fairly rewarded at present, due to the liquidity trap that the major central banks have enter into.  My view here is to play it safe when conditions are not crazy bad, and take a lot of risk whe credit markets are in the tank.

As for now, I would hold high quality US stocks that pay dividends, US money market funds, and Canadian and Australian short term bond funds.  Commodities and companies that produce them should play a small role as well.

This is a book that gives a feeling for being in hedge fund management, rather than a dry description of what needs to be done if you are in the rare position of being asked to manage a hedge fund.

The author was an ambitious guy.  Growing up in Canada, he wanted to play professional hockey.  He played ably in youth leagues, the minors, and college.  Making the pros was not to be.

So, what does a competitive guy do when he can’t pursue his dream?  He pursues another dream, managing money. He works hard, and gets one break after another, and eventually manages his own firm, which he sells out to a larger one.  He gets a plum job at a firm that proves less than patient with his current performance, and he gets let go.  Even that is a triumph for the author.  He starts his own firm, which is what he is still doing today.

Think of an analogy to sports — every player makes mistakes, but the best players recover from mistakes well and learn from them.  The author definitely got his share of breaks, both good and bad, but he responded to the bad breaks well, and came out the better for it.

Though this book is about hedge funds and other areas of investing, really, this book is about the author.  It tells his story, and as the story gets told, you pick up incidental points along the way:

• What is it like to be an intern at a trading firm?
• How do you learn as you go?
• What was it like inside CSFB during the dot-com bubble?
• How to interview management teams to get an edge.
• How to sense if someone is lying.
• In general, the Fund of hedge funds operators are not desirable clients.
• Get a sense of the strength of consumers
• Get a sense of the three time horizons — days/weeks, months, and years.  (He uses other terms than this, but I appreciated his logic here, because it seemed a lot like what I did as a corporate bond manager.  Have a sense of short-term momentum, medium-term trend and long-term mean-reversion.)
• Very good to good means sell
• Very bad to bad means buy
• The value of keeping a trading journal, and reviewing performance.
• Be careful who you do business with, because eventually they may show you the door for less than good reasons.
• Surviving the credit bubble’s bust.  Buying back in when people are panicking.

The book runs 204 pages, but roughly 30 don’t have much on them.   The book is breezy, and though I mentioned a lot of things that I got out of the book, readers less familiar with the subject matter might miss some of the points.  He does not spend a lot of time on the details. On the other hand, a reader less familiar will get a feel for what it is like to be a part of a fast-paced area in investments.

Who would benefit from the book:  Those that would like to read the tale of an interesting guy who had a tiger-by-the-tail initial career in investments.

If you want to but the book, you can get it here: Diary of a Hedge Fund Manager: From the Top, to the Bottom, and Back Again.

Full disclosure: The publisher sent me this book. They send me a lot of books, and I review as many as I can. I don’t like every book that I receive, but typically I review the ones that seem the best, and let the rest pile up. Anyone entering Amazon through my site, and buying anything, I get a small commission, but your price does not go up. Such a deal.

PS — the blog for the author’s firm is here.

I ordinarily like the writings of Jason Zweig, so this post is not meant as a criticism of him.  He wrote an interesting article suggesting that US investors may suffer reduced performance because they invest too much in US stocks.  Ideally, shouldn’t investors seek out the stocks that are likely to perform the best, regardless of where they are located in our world?

Ideally, yes.  Practically, there are difficulties.  I write this as one who has always allocated more than the average to international stocks.  Investing internationally assumes several significant things:

• There will be no war that changes the amount or terms of commerce.
• There will be no legal changes that affect property rights abroad.  This includes exchange controls.
• I will get the same flow of news that an investor in the target country will get.
• I understand the differences in the accounting rules, and will not get tripped up if they are more liberal than in the US.
• I understand that regulations are different in foreign countries as well.
• Transacting in non-ADR foreign stocks from the US can be expensive for retail accounts.  Buying mutual funds that invest in foreign stocks carries expensive management fees.
• Economic policy will remain rational in the target country, or at least, better than that of the US.
• I understand the trading nuances of the target country.

Home bias is normal, around the globe.  We understand the business dynamics of our own countries far better than foreign countries, together with our understandings of accounting, regulation, exchange controls, information disclosure, legal systems, economic policy, etc.

Even within the US, there is home bias among investors to the extent that we tend to invest more in companies that are near to us — perhaps it is a greater flow of informal information.

I would encourage all of my readers to invest abroad but to do it selectively.  Does the country allow for relatively free capital flows?  Do they honor the rule of law?  Is their accounting as good as that in the US?  Are there war risks?

There are risks in investing abroad that do not exist locally.  Make sure you minimize those risks if you invest abroad.

I resisted getting this book when it first came out.  Much as I enjoy Ken Fisher as a writer, and appreciate the interaction that I have had with him over the years, the title turned me away.  “Three questions? Only three?  Investing is far more complex than that.”  I would say that to myself.

After reviewing his most recent book, I said to myself, “Well, you’ve reviewed all of his books but one; you may as well do it.”  So, I borrowed the book from a friend.

I wish I had read it sooner.  The three questions are simple ones, and they have been mentioned elsewhere on the internet, so here they are:

• What do you believe that is actually false?
• What can you fathom that others find unfathomable?
• What the heck is my brain doing to blindside me now?

The idea is to get us to think more deeply.  Test the received wisdom to see if it is really true.  Look for unusual areas of competitive advantage that you have that are possessed by few.  Your emotions will often lead you astray: look for opportunity amid fear; look for shelter amid wild abandon.

Competitive advantage in investing is an elusive thing.  The clever idea that you might discover is just one journal article away from an academic toiling in obscurity, but will go to a  hedge fund two years from now.

Patterns that work in one market should work in most markets.  If your discovery seems to work in most places, it might work well, until it is discovered and used heavily.

I found a number of insights useful.  Like me, he uses E/P relative to bond yields to try to estimate whether markets are rich or cheap.  I also found his insights about how the yield curve affects style investing to be useful.  I do something like that through my industry rotation.

Now, in the intermediate-run, most things that people are scared about don’t affect the market much.  Government deficits seem to be a positive for stocks in the short run.  Trade deficit?  Little effect on stocks.  Weak dollar?  Little effect.  This book debunks a number of common worries, though I would say that if the problem got significantly bigger, perhaps the result would be different.

Ken Fisher offers what I would deem to be good advice on Asset Allocation, and how to make sell decisions, amid many other issues.  I enjoyed the book a lot, and would recommend it to my readers.

Quibbles

Occasionally, the book seems disjointed.  Ken Fisher is covering a lot of ground, and he takes a decent number of “side trips” to explain concepts.  The flip side of that is that the book covers many areas of the equity markets, and helps to explain what drives them.

Now, sometimes I wonder if multivariate approaches might reveal different conclusions than what Ken Fisher comes to.

Who would benefit from the book: Investors with moderate experience in investing who are finding the going harder than they expected.  This book will help them take a step back, and think twice about investment decisions.

If you want to buy the book, you can buy it here: The Only Three Questions That Count: Investing by Knowing What Others Don’t (Fisher Investments Press)

Full Disclosure: Book reviews are my main profit center at my blog.  They allow me  to create a win-win situation for me and my readers.  I don’t want my readers to waste their money to reward me.  I would rather they buy things that they want to buy at competitive prices through Amazon.  If they enter Amazon through my site, I get a small commission, and their price does not change at all.  Such a deal.

I have long been a fan of immediate annuities, particularly those that are inflation indexed, as retirement products for seniors.  Yet, they do not get bought by retirees.  Why?  Well, insurance products are sold, not bought, typically, and when the agent sells an immediate annuity, that is his last sale on that money.  They would rather sell a less suitable product that offers them another sale down the road.  And, people like having flexibility with and control over their investments, even if that leads to less money for them in the long run.  Annuitizing a portion of one’s lump sum lowers risk, and takes the place of investing in bonds in the asset allocation.

Most people like the reliability of their pensions, and Social Security, should it be paid, but do not seek the same thing when investing their private money.  One would think they would invest that money for growth if they had a strong stream of income elsewhere, but often that money is conservatively invested as well.

People get fooled by yield, and in an environment like this, more so.  People try to make their investments do more through targeting higher yields, while ignoring the possibility of capital losses.

Most people can budget, if pressed to do so.  Few can manage a lump sum of capital, and know what to invest it in, and how much to take from it per year.  Few have the discipline to buy an immediate annuity or limit their withdrawals to 4% of assets per year.

But where there is chaos and confusion, some in our government will seek to create a “solution.”  The ill-defined solution that sounds a bit like a Stable Value Fund is what is getting called “R Bonds.”  Here’s the idea: for those with 401(k)  or IRA balances, if they should retire, and not decide what to do with the money, the assets would get automatically get placed into a Retirement Bond, and for two years, the retiree would receive income.  They can opt out before that happens.  If after two years they still don’t decide, the income continues.  There is nothing mandatory about this program, should it come into existence; people who are asleep about their finances may find themselves trapped in it, at least for a time. [Note: there are scandalmongers alleging out-and-out theft being planned by the US Government.  From what I can see that is not true for anyone that keeps his wits about him.  All the proposals allow people to "opt out."]

But let me go further.  Scrap the idea of “R bonds.”  Issue a limited number of Trills for retirees to use, or create a special variant of TIPS that pays until someone dies.  These are easy solutions that do not require a lot of changes to the legal codes, or changes in investment behavior.

Now, there is not just one proposal out there.  Let me give the two most comprehensive:

• Increasing Annuitization in 401(k) Plans with Automatic Trial Income
• Guaranteed Retirement Accounts Toward retirement income security — less desirable.  People should not be coerced into investments for retirement.  People should have a right to choose or not choose.

With interest rates so low on the short end, I don’t see how the returns could be that great from “R Bonds.”   I would play for higher returns given the risk of inflation.  Today that would mean safe stuff that yields little, while waiting for a correction in the fixed income markets, and high quality common stocks with some yield.  And, annuitization at present?  I would wait for higher rates.

Other posts on the topic worthy of your consideration:

• Americans Oppose Proposals to Limit 401(k)s, ICI Says
• Administration explores ‘R bond’ as option for retirement accounts
• Rating the Idea of R Bonds
• Retiree Annuities May Be Promoted by Obama Aides
• Obama Administration Wants to Annuitize 401k’s and IRA’s – Mandatory “R Bonds”

Now, all that said, there is a reason to be politically aware here.  Governments have in the past forced people to convert assets that were more valuable for those that were less valuable.  And, we have the example of Argentina doing it in the present with pension assets, and also when their currency blew up — most debtors faced a forced conversion to less valuable bonds.  With the pension nationalization, it was done in the name of protecting people’s pensions, but ended up benefiting the finances of the Argentine Government.

So, be aware.  R Bonds, as currently proposed, are a bad idea.  But there are worse ideas not yet proposed that might be proposed in the guise of protecting your future.  Let us work to make sure they never get implemented.

My first real post at the blog was Yield = Poison.  In late February 2007, prior to the blowup in the Shanghai market, I felt frustrated and wanted to simply say that every fixed income class seemed overvalued.  Short and safe seemed best.

It reminded me of a discussion that I had with a colleague two jobs ago, where in mid-2002, the theme was “yield is poison.”  I did the largest credit upgrade trade that I could in the second quarter of 2002, prior to the blowup of Worldcom.  Moved the whole portfolio up three notches in four months.  Give away yield; preserve capital for another day.

I feel much the same, but not as intensely in the present environment.  Spreads could come in further if the government keeps providing low cost liquidity to those who make money on the spread they earn on financial assets.  But most fixed income assets do not reflect likely default costs.  Perhaps the long end of the Treasury curve is worth a little allocation of assets here, if only as a deflation hedge, but if the Fed is going to start lightening up on their QE, and the Treasury will be having high issuance, I might want to stand back for a while  while supply will be high, and try to buy near the end of the quarterly refunding.

There is another sense in which I say “yield = poison,” though.  When rates for safe assets are low, retail and professional investors are both tempted to stretch for yield.   Wall Street is more than happy to deliver on your desire for yield.  It is their top illusion, in my opinion.

Two examples from my bond trading days: the first was some local brokers asking to buy a small amount relatively highly-rated junk bonds from us.  They were offering a full dollar over the usual market price.  They called me, since I ran the office, but I handed them over to the high yield manager, who said, “Jamming retail, are we?”  [DM: placing overpriced bonds in customer accounts.]  After a lame reply which amounted to,”Look, don’t ask us about what we are doing, we’re offering you a good deal, do you want to sell your bonds or not?”  the high yield manager sold them a small amount of the bonds, and we didn’t hear from them again.

The second example was when a bulge bracket firm called me and asked me if I owned a certain very long duration bond.  I said yes, and he made me an offer several dollars above what I thought they were worth.  With a bid that desperate, I said I could offer a few there, and more a little back, but for the block he would have to pay more still.  He offered something close to the “more still” price, and I sold the block to him there.

As we were settling the trade, I asked him, “Why the great bid?”  He said, “We need the bonds for retail trusts.  They get an above average yield, but if rates fall, after five years, we buy them out at par, and keep the bonds.  If rates rise, they take the loss.”

Even on Wall Street, if you have a good relationship, you get an honest answer.  That said, it made me sorry that I sold the bonds, even though it was the best thing for my client.

There are many ways to frame the yield question at present, here are two:

• You are on a fixed income, and you are having a hard time making ends meet.  Should you lend longer to earn more, go for lower rated credits, or do nothing?
• You are earning almost nothing on your money market fund.  You need liquidity, but where else could you invest it?

I would be inclined to buy a mix of foreign-denominated bonds, but most people can’t deal with that.  So, I would advise them to build a “bond ladder” where they have high quality issues maturing every year for the next 10 years.  As each bond matures, I would use the proceeds to buy bonds ten years out, re-establishing the 10-year ladder.

But don’t reach for yield.  Odds are, you will get capital losses great than the excess yield you hoped to receive.  And remember this, don’t buy products someone else wants to sell you.  Specifically, don’t buy high yielding investment products that Wall Street sells to enhance your income.  They prey upon those who want more money, and are weak in their knowledge of how the markets work.

To professionals: don’t reach for yield now; long-run, you are not getting paid for the risks.  You have seen how illiquid structured products can be in the face of credit uncertainty, and impaired balance sheets of holders and likely purchasers.  You have seen how spreads can blow out (bond prices fall), and roar back in (prices rise again) in the absence of safe places to invest money.

I’ll give the Treasury and the Fed this: they have created an environment where savers are punished, and have to take significant risks to get yield.  They have created a situation where the markets are dependent on subsidized credit, and speculation dominates over lending to the real economy.  They are pushing us deeper into a liquidity trap, as low-to-negative return investments in autos, homes, and banks get supported by cheap public credit, rather than getting reconciled in bankruptcy, so that capital can be redeployed to higher returning projects.

Anyway, enough for now — more later.

James Picerno writes the popular blog  The Capital Spectator. One of his main topics is asset allocation.  He has a book coming out in February called Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor.

Asset allocation is important.  It determines much of the returns investors will receive.

This book goes into a long discussion of modern portfolio theory, and the author finds MPT to be valuable, but needs to be supplemented by other factors other than the market portfolio.  Market capitalization, individual stock valuation, and overall market cheapness/dearness plays a role in asset allocation.  This rectifies the main complaint of value investors regarding asset allocation, in that relatively lower prices should lead investors to allocate more to an asset class.

There are elements of my own view here, which says that asset allocation should look at sustainable yield levels adjusted for the likelihood of those yields occurring, and the potential for downside risk.

Also, the author spends time on the special situations of asset allocation for the individual or institution — how old you are, or, what industry you are in.  I experienced that at one firm I was at where I managed the profit sharing assets.  We underweighted financials because our firm did well when financials did well.  We did not want employees worrying about their assets if the firm was having a bad year.

I recommend the book, but it is not a popular book.  Average people will not get a lot out of it.  The book requires a moderate knowledge of finance to make it valuable to the reader.

Who would benefit from this book: those who have a strong interest in asset allocation, and like or are willing to tolerate a decent amount of academic discussion of modern portfolio theory.  As academic views go, this is a better one.  That said, many people will find this book a tough slog because they don’t want to deal with the academic arguments.

If you want to buy it, you can get it here: Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor.

Full disclosure: I earn a small commission from Amazon for anyone entering Amazon through my site, and buying anything there.  Your price does not rise from my commission.  Don’t buy anything you don’t want to buy if you want to reward me for my writing.  Only buy what you need if Amazon offers you the best deal.

Before I begin, I want to thank longtime readers, and ask them to give me some feedback.  I have a category entitled Best Articles; what would you nominate to be in there.  Also, what would you take out?  I’ve tagged a few articles from the early days, but since then, have not done much with it.  If you have ideas, please let me know.  Thanks again.

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As bond investors go, I tend to focus on what can go wrong more than most, so when I looked at the cover of Barron’s today, I said, “Oh, no.  Pushing yield now?”

It’s no secret that most safe investment grade debt does not yield much now.  Many investors, hungry for yield, must look for other ways to earn income, even if it means greater hazard of capital loss.  That is another impact of the federal reserve flooding the debt markets with liquidity — the safe investments yield little, forcing those that want yield to take significant risks, whether those risks are lending long, high credit risk, operational risk (common stock and MLP dividends), or subordinated credit risk (preferred stocks).

The history of chasing yield is not promising.  In general, average retail investors reach for yield at the wrong time, and Wall Street is more than happy to facilitate that through structured notes and other high yielding investments where the risk is greater than the excess yield.

But wait — I can endorse some of the article.  I like utilities here.  I don’t own Verizon or AT&T, but I could imagine owning them.  MLPs in energy distribution?  Probably safe; consider their competitive positions and consider where things might go wrong.  I’m not jumping to buy them, though.

Where I can’t sign on is with preferred stocks and convertibles.  All of the preferred stocks that the article cites are financials with marginal investment grade ratings.  The convertibles are from a grab bag of low junk-rated securities.

How quickly we forget the ugliness of 2008.  If we have a second dip in the financial economy for whatever reason, the preferred and convertible securities will do the worst.  In order to get significant yields one must take credit risks in excess of average loss costs — it is safe to say at times like this, the purchase of risky securities is not rewarded.  Be wary with all purchases of risky debt at present.

I like investing internationally, because of the diversification it offers, both in stocks and bonds.  Or, think of it as a hedge.  Will the American Experiment continue to prosper?  We have come a long way from the Founding Fathers, and more than half of it is not good.

But there are some place in our world that I will not invest in.  I have two requirements.

• Contract law must be close to that in the US, or better.
• Accounting practices must be close to the quality of the US, or better.

Sounds simple, but foreign tales are beguiling.  There is an exclusiveness about them, and a sense of greater knowledge for the one who has bothered to learn a trifle.  My acid test is watching over a long period and seeing how they treat foreign shareholders.  That is a good measure of the morality of management.  If they cheat foreign shareholders, they will eventually cheat domestic shareholders as well.

So, what don’t I invest in?

• Russia
• China
• Most of the Middle East.
• Venezuela
• And other places that do not protect foreign shareholders on a level that is at least close to that of citizens.

The idea is to avoid situations where your rights as a shareholder might be ignored.  It does not matter how cheap an asset is; if the ability of the asset to be liquidated is low, so should the valuation of the asset be low.  Don’t buy pigs in pokes.

This has application today with Dubai.  The Dubai government is telling creditors that it will not stand behind Dubai World, and nor will the UAE, but Abu Dhabi will stand behind UAE banks.  This is tough on foreign creditors because foreign creditor rights in Dubai have not been tested until now.  Even domestic rights are unclear.

A Note on Debt Risks

Much Islamic debt, because of the prohibition on interest, acts like an extremely volatile hybrid bond during times of stress.  This incident will prove instructive on how these bonds keep or lose value in a reorganization.  What happens here will probably have an impact on how much money will be willing to flow into these vehicles in the future.  Personally, I never found them compelling, and probably won’t in the future.  There is something compelling about straight senior unsecured debt that pays interest.  I think the guarantees involved, together with straightforward reorganization processes, create a fair game where it is easier to decide whether lending or borrowing makes sense.

Complexity in bonds is usually a loser for the lender — whether complexity of the borrower’s finances, complexity of holding company structures, complexity of the governing laws, or even enforcing a complex contract where the lender duped the less-knowledgeable borrower.

What applies to corporate debt — long term buy and hold investors do okay with investment grade debt, but less well with junk debt, and worse the junkier it gets.  Layer on top of that the difficulty of being able to psychologically buy and hold during a crisis.  Even if you personally have the fortitude to do so, there may be others that influence you that don’t.  (E.g., the rating agencies come along near the trough of the crisis, and tell the CEO that they will downgrade you if you don’t sell bonds with the risk du jour.  Or, your clients look at their statements, and see the unrealized losses and beg you to sell — it doesn’t matter, the screaming is always the loudest at the bottom (in hindsight).

A Final Note on Sovereign Risks

Sovereign and quasi-sovereign risks like Dubai World may play a larger role in overall credit risk as the broader crisis plays out.  When I was younger, I thought the great risk of the Euro was that it would be too weak.  Bite my tongue.  The risk is that it could be too strong, and marginal European countries (Greece, Iceland, Ireland, Spain, Portugal, and many Eastern European countries) that have too much Euro-denominated debt relative to their ability to tax and pay will find themselves pinched — and they can’t inflate their way out.

When I first came to bond investing (early 90s), sovereign risks were viewed  skeptically, excluding the large Western nations — bond managers had been taught by the greyheads who had seen sovereign defaults, and the difficult of recovering money in default, still had a bias against sovereign and quasi-sovereign risks.  That bias is largely gone today, after a period of few sovereign losses.  Yes, Mexico, Russia and Argentina have given their share of heartburn, but the significant growth in the emerging markets has made bondholders forgiving.  Add in the long term structural deficits of the US and Japan, and it makes for a really interesting investment picture.

Be aware.  If you hold sovereign debts, look at the ability of the government to tax and pay over the long haul.  On quasi-sovereigns, analyze the explicit guarantees, if any, and the governing law — as you can see with Dubai World, in a crisis, only the guarantees matter, and only to the degree that they are enforceable under law.  With Dubai World, it will be judged in Dubai courts by a judge appointed by the ruling family of the emirate, which owns the equity of Dubai World.  Not a strong bargaining position in my opinion.  The only thing worse than relying on the kindness of strangers, is relying on the kindness of adversaries.

A Final Aside

I knew about how dodgy the investments were that Dubai and its corporations were undertaking, so I was always a skeptic, though I never wrote about Dubai, because it is so far afield for me.  What I did not know was the near slavery of foreign workers tricked to go to Dubai, and then forced to work with little to no rights.  Read the story, it is not pretty, but reinforces a belief of mine that governments and corporations willing to cheat one group of people, will cheat other groups of people as well.  Character is important in any credit decision, and the government of Dubai does not have good character in my book.