Category: Bonds

When Will the Goat Reach the End of the Snake?

When Will the Goat Reach the End of the Snake?

Posted on by David Merkel

Speculation.? Rampant speculation.? This run in the market has to end soon, right?? Right?!

Look, I’m not so sure.? I have a lot to write on this topic, but not so much time.? Market trends have a nasty tendency to persist longer than fundamentally-based market observers would expect.? Let me give you the four things that could derail the markets, and tomorrow I can detail what I have seen in the markets concerning the four potential trouble spots (and more).

  1. The recycling of US dollar claims from the trade deficit ends because the US dollar falls enough to make imports dear and US exports cheap.? US interest rates rise as a result, stopping the substitution of debt for equity, and in some cases, leading to the raising of new equity capital.? We have seen upward adjustments in many foreign currencies so far, but not enough to change the basic terms of trade.
  2. Defaults in the bond and loan markets lead to a closing of the synthetic CDO market, which in turn leads to underperformance of many hedge fund-of-funds.??? Bond spread widen as risk returns to lending, and the substitution of debt for equity slows to a halt.
  3. New supply comes to the equity market, overwhelming cash available.? This could come from private equity seeking to liquefy marginal asses at favorable prices.? Alternatively, this could come from private equity investments that are unable to pay their debt coupons.? It is less well known outside of fixed income investing that most insolvencies occur because companies can’t make a coupon payment, not that they can’t refinance a principal payment.
  4. Rising inflation in countries providing capital to the US forces them to revalue their currencies higher, and not keep sucking in US dollar claims, which don’t provide any goods to their people who want to buy goods to support their lives.

Interest rates need to be around 1.5% higher to shut off the speculation with near-certainty (did not work in 1987… rates got much higher.).? Until then, the party can go on.? I have an article being developed on this topic, but I fear it is a “next week” item.

Bottom Left Hand Drawer Issues

Bottom Left Hand Drawer Issues

Posted on by David Merkel

Back in the saddle.? I have a lot to write about, but not so much time.? The insights developed over vacation will be spread out over the next week or so.

Just a quick one to get started.? In general, I think insurance companies with more than $100 million in assets should have their own investment departments, and not outsource the management of assets.? (Note: to any insurance CEOs reading this — would you like a chief investment officer with experience in all major fixed income classes, equity, and derivatives, and a knowledge of the actuarial side of investing as well?? E-mail me, and we can talk.)

I only know one insurance asset outsourcing larger than this, but Safeco has outsourced their asset management to Blackrock.? I think that it is a mistake.? Why?

  1. Insurance companies excel at creating tailored liabilities, taking individual risks away, and pooling them.? The same should be done with assets.? Anyone can hire Blackrock (a very good firm), but an intelligent management will take the time and effort to develop in-house expertise, which is usually cheaper than most third party solutions.? It gives up what should be a profit center for the enterprise as a whole.
  2. Third-party arrangements miss what I call “The Bottom Left Hand Drawer” issues.? I worked in insurance for 17 years, and I grew to love the competent but uncelebrated people in the company that did excellent work, but management thought were expendable.? Third-party relationships lack the freedom for customization that in-house management allows for.? Often because accounting systems don’t get it quite right, human intervention is needed.? Someone makes an adjustment off of a schedule that they keep in their bottom left hand drawer once a year, and that keeps the system running right.? In a third party solution, those issues can get lost; I have personally seen it fail.
  3. Penny wise, pound foolish.? The explicit expense savings are easy to see, but the implicit losses from not having someone managing the investments that is totally on your side is hard to measure.? Though I can’t prove it, the soft costs are large.

If I served an insurance company again as an asset manager, I would want to serve that company only, and not run a third-party asset management shop.? The work of an insurance company is important enough that it deserves the undivided attention of professionals on staff.

One Dozen More Compelling Articles Around the Web

One Dozen More Compelling Articles Around the Web

Posted on by David Merkel

1)? Picking up where I left off last night, I have a trio of items from Random Roger.? Is M&A Bullish or Bearish?? Great question.? Here’s my answer: at the beginning of an M&A wave, M&A is unambiguously bullish as investors seize on cheap valuations that have gone unnoticed.? Typically they pay cash, because the investors are very certain about the value obtained.

From the middle to the end of the M&A wave, the action is bullish in the short run, and bearish in the intermediate term.? The cash component of deals declines; investors want to do the deals, but increasingly don’t want to part with cash, because they don’t want to be so leveraged.

My advice: watch two things. One, the cash component of deals, and two, the reaction of the market as deals are announced.? Here’s a quick test: good deals increase the overall market cap of the acquirer and target as a whole.? Bad deals decrease that sum.? Generally, deal quality by that measure declines over the course of an M&A wave.

2) Ah, the virtues of moderation, given that market timing is so difficult. This is why I developed my eight rules, because they force risk control upon me, making me buy low and sell high, no matter how painful it seems.? It forces me to buy when things are down, and sell when things are running up.? Buy burned out industries.? Reshape to eliminate names tht are now overvalued.? These rules cut against the grain of investors, because we like to buy when comapnies are successful, and sell when the are failures.? There is more money to be made the other way, most of the time.

3) From Roger’s catch-all post, I would only want to note one lesser noticed aspect of exchange traded notes.? They carry the credit risk of the issuing institution.? As an example, my balanced mandates hold a note that pays off of the weighted average performance of four Asian currencies.? In the unlikely event that Citigroup goes under, my balanced mandates will stand in line with the other unsecured debtholders of Citigroup to receive payment.

4) Bespoke Investment Group notices a negative correlation between good economic reports and stock price performance.? This should not be a surprise.? Good economic news pushes up both earnings and bond yields, with the percentage effect usually greater on bond yields, making new commitments to bonds relatively more attractive, compared to stocks.

5) From a Dash of Insight, I want to offer my own take on Avoiding the Time Frame Mistake.? When I take on a position, I have to place the idea in one of three buckets: momentum (speculation), valuation, or secular theme.? What I am writing here is more general than my eight rules.? When I was a bond manager, I was more flexible with trading, but any position I brought on had to conform to one of the three buckets.? I would buy bonds of the brokers when I had excess cash, and I felt the speculative fervor was shifting bullish.? If it worked, I would ride them in the short run; if not, I would kick them out for a loss.

Then there were bonds that I owned because they were undervalued.? I would buy more if they went down, until I got to a maximum position.? If I still wanted more, I would do swaps to increase spread duration.? But when the valuations reached their targets, I would sell.

With bonds, secular themes don’t apply so well, unless you’re in the mid-80s, and you think that rates are going down over the next decade or two.? If so, you buy the longest noncallable bonds, add keep buying every dip, until rates reach your expected nadir.? Secular themes work better with equities, where the upside is not as limited.? My current favorite theme is buying the stock of companies that benefit from the development of the developing world.? That said, most of those names are too pricey for me now, so I wait for a pullback that may never come.

6) I’ve offered my own ideas of what Buffett might buy, but I think this article gets it wrong.? We should be thinking not of large public businesses, but large private businesses, like Cargill and Koch Industries.? Even if a public business were willing to sell itself cheap enough to Buffett, Buffett doesn’t want the bidding war that will erupt from others that want to buy it more dearly.? Private businesses can avoid that fracas.

7) And now, a trio on accounting.? First, complaints have arisen over the discussion draft that would allow companies to use IFRS in place of GAAP.? Good.? Let’s be men here; one standard or the other, but don’t allow choice.? We have enough work to do analyzing companies without having to work with two accounting standards.

8) SFAS 159?? You heard it at this blog first, but now others are noticing how much creative flexibility it offers managements in manipulating asset values to achieve their accounting goals.? My opinion, this financial accounting standard will be scrapped or severely modified before long.

9) Ah, SFAS 133. When I was an investment actuary, I marveled that hedges had to be virtually perfect to get hedge treatment.? Perfect?? Perfect hedges rarely exist, and if they do, they are more expensive than imperfect ones.? Well, no telling where this one will go, but FASB is reviewing the intensely complex SFAS 133 with an eye to simplifying it.? This could make SFAS 133 more useful to all involved… on the other hand, given their recent track record, they could allow more discretion a la SFAS 159, which would be worse for accounting statement users, unless disclosure was extensive. Even then, it might be a lot more work.

10) ECRI indicates better growth and lower inflation coming soon.? I’ll go for the first; I’m not so sure about the second, with inflation rising globally.

11) What nation has more per capita housing debt then the US?? Britain. (And its almost all floating rate…)? With economics, it is hard to amaze me, but this Wall Street Journal article managed to do so.? Though lending institutions bear some blame for sloppy underwriting, it amazes me that marginal borrowers that are less than responsible can think that they can own a home, or that people who have been less than provident in saving, think that they can rescue their retirement position by borrowing a lot of money to buy a number of properties in order to rent them out.? In desperate times, desperate people do desperate things, but most fail; few succeed.? We have more of that to see on this side of the Atlantic.

12) I am not a fan of what I view as naive comparisons to other markets and time periods.? There has to be some significant similarity in the underlying economics to make me buy the analogy.? Thus, I’m not crazy about this comparison of the current US market to the Nikkei in the late 80s.? Japan was a much more closed economy, and monetary policy was far more loose than ours is today.? I can even argue that the US is presently relatively conservative in its monetary policy versus the rest of the developed world.? So it goes.

A Half-Dozen Comments on the Current Market Environment

A Half-Dozen Comments on the Current Market Environment

Posted on by David Merkel

Here’s my take on a large part of what is going on it the markets now.

  1. Bond market implied volatility is low. Tony Crescenzi comments about that on the Treasury market, but it is also true of the agency and swap markets. Less true of corporates, because rumored LBOs are making market players jumpy, but spreads are still pretty tight. People are too complacent…
  2. What did well in the first four quarters of this year? Borrowing from Merrill Lynch, in terms of sectors, it would be utilities and materials, follow by healthcare and energy. In terms of quality, low quality continues to win, which is a function of tight credit spreads. Growth strategies are working — low PEG ratios, small caps, and high ROE are doing well so far in 2007.
  3. China may take the global economy over the edge. Between tightening interest rates and raising deposit requirements, they are moving to slow their economy. One thing that fights against them is the currency; much stimulus comes from keeping the yuan low.
  4. One factor that helps to keep oil prices high is the inefficiency of the average state-owned oil company. Venezuela, Iran, and Indonesia are great examples of the damage that can be done by negligent government-sponsored companies tha don’t reinvest enough in their businesses.
  5. Fascinating to see copper and gold up, Baltic freight up and timber prices down. US housing is damaging timber, but demand outside of the US is driving the rest at the margin.
  6. Even more amazing is the foreign buying of Treasuries, which proceeds unabated to recycle the shrinking current account deficit.

I have more, but I am tired, and will post more on Monday.

Twelve Unusual Items Affecting the Markets Now

Twelve Unusual Items Affecting the Markets Now

Posted on by David Merkel

1) The TED [Treasury-Eurodollar] spread, which is a measure of market confidence, is up dramatically over the past two months, from 18 basis points to 52 at present. That indicates decreased confidence in the banking system, though swap spreads have not widened to confirm that judgment.

2) The Indian Rupee has rallied almost 10% against the dollar over the past two months, because of the need to recycle the US current account deficit, and restrain inflation at home, tighter monetary policy is needed in India, and many other developing nations. That means upward pressure on their local currencies, which will hurt their exporters. India is letting that process happen at present, other developing countries are allowing dollar liquidity to further inflate their economies.

My view is that the next major blow-up will happen as a result of a neophyte developing large country central bank overshooting on their tightening of monetary policy. China is my lead candidate, but India could do it as well.


3) Ordinarily I like what Jack Ciesielski has to say. He is far beyond me in terms of understanding the nuances of accounting standards, and I recommend his work to all professionals. I think his recent Barron’s article misses a nuance of SFAS 159, though. If SFAS 159 were mandatory, Fannie and Freddie might have some difficulties. But SFAS 159 can be ignored by any company that wants to ignore it, and used to the degree that any company wants to use it, so long as they disclose where they are using it and where they aren’t using it. So, I’m not sure the SFAS 159 has much relevance to Fannie and Freddie over the short run. Over the long run, it might be different if SFAS 159 becomes mandatory, or if the US adopts International Financial Reporting Standards.


4) I have posted at RealMoney on numerous occasions regarding overvaluation of many risky asset classes versus safe asset classes. I appreciated the piece at TheStreet.com regarding Jeremy Grantham, and the piece over at The Big Picture discussing it. I think he is right, but early. We haven’t run out of liquidity yet, and perhaps we get an exponential rise in risky assets that signifies the end. On the other hand, tightening global central banks in aggregate could be the end. For the cycle to change, we need a fall in profit margins, and a rise in discount rates. I think both are on the way, but they don’t come like clockwork.

As an aside, if managed timber is still cheap to Mr. Grantham, that could be a good place to hide. Decent return, and some inflation protection.

5) Dig this article from Businessweek. Know what it reminds me of? Manufactured housing back in 2000-2003. Lenders bent over backwards to keep loans current, at a price of future credit quality, and only gave up when their companies were facing death. Most died; a couple survived and much of the remaining corpus is part of Berky now.

The banks will keep marginal lending alive until it becomes a serious threat to their well-being; after that they will act to protect the banks. The severity of loan defaults thereafter will be very high.

6) How much international goodwill has the US lost through unilateralism? Part of that cost is measured by the fall in the dollar. The current account deficit presumes on the good graces of the rest of the world, but at the edges, if our policies aren’t well-liked, the deficit will get cleared at lower exchange rates for the dollar. Just another reason that I am long foreign currencies.

7) Central bank tightenings? Look at Japan and China. I have a little more belief that China will continue to tighten; they have been doing so for the last year. The acid test is how much they are willing to let their currency appreciate, and I think China will let that happen.

I am more skeptical about Japan. Their central bank is not very independent, and regardless of the article I cited, there isn’t a lot of reason for the Bank of Japan to act rapidly. Central Banks are political creatures that avoid pain; they are not entrepreneurs, particularly not in Japan.


8) What’s better in accounting, rules or principles? The current mood in accounting leads toward principles. The idea is that principles allow for a more accurate description of the corporate economics than the application of rules that though consistent, may not fit all companies well.

I split the difference on this issue. We need rules and principles. Rules for consistency and comparability, and principles for accuracy to individual situations. That is why I would have two income statements and two balance sheets. One off of amortized cost that would be consistent and comparable across all firms, and one off of fair market value, that would give management’s view of the economics of their firm.

9) I had been critical of the FOMC over at RealMoney because they had not been injecting enough reserves into the banking system in order to keep the Fed funds rate at 5.25%. Over the last week they have amended their ways. They have bought bonds and sold cash, and now Fed funds resides more comfortably near 5.25%. (I would post a link, but as I write the Fed website is not responding.


10) A harbinger of things to come: Fitch downgrades some 2006 subprime deals.


11) The Wall Street Journal was “dead on” this morning about talking about the degree of leverage being applied to the markets. I’ve been writing about this at RealMoney for some time, and I would advise everyone to look closely at their asset portfolios, and ask what assets would be at the most risk if financing were interrupted. For equity investors, I would encourage you to be long stocks with high ROAs, not high ROEs.

Do derivatives make a mockery of margin requirements? You bet they do, and we can start with furures and options, before moving on to private agreements.


12) Leave it to Caroline Baum to catch the mood of the government, and apologists for the current economy. Ex-housing, we are doing fine. Another way to say it is housing is doing lousy, and export-oriented sectors have not made up the difference.


-=-=-=-=-=-

That’s what I am seeing now. Are you seeing thing I am missing, or do you disagree with what I have said? Post here, and let’s discuss it.

My Stray Mortgage REIT

My Stray Mortgage REIT

Posted on by David Merkel

A personal note before I start; I’ve been gone the last two days because I am part of the leadership of my denomination, and we had a regional meeting for the better management of our congregations. The hotel that I stayed at promised internet service, but did not deliver on that promise; that’s why I didn’t post yesterday. My intention with this blog is to put up one or two good posts every day, excluding Sundays.

I don’t trade that often, so being away is not a problem Sometimes when I get home, there is a surprise waiting for me.? This time the surprise was a positive one, where Nelson Peltz does some house cleaning, and gives his shareholders a gift in the process. He has simplified his life by selling his stake in Deerfield Capital Management to the mortgage REIT that they manage, Deerfield Triarc Capital [DFR]. Also, he reduces his stake in DFR down to a 10% level. He gets to focus on the restaurants that he owns through Triarc [TRY].

I would encourage interested readers to look through the presentation that they did for this acquisition, and this presentation that they did to describe their management style. At my previous employer, I suggested that we start a REIT like DFR. Good as that firm was, they did not take my advice.

The price as a ratio of EBITDA for purchasing Deerfield Capital Management was around 7.5x. Pretty good acquisition price, considering that capital is not a constraint for the growth of the combined enterprise. I think the stock goes higher from here. My main concern is this: once they get to full deployment of alternative assets, this company will be very profitable, but also risky. You will likely see me sell my shares once the company reaches maximum portfolio risk. At that point, I might miss some upside, but with Meyer Rothschild, I will have sold too soon.

Full Disclosure: Long DFR

Pity the Poor Investment Grade Corporate Bond Manager

Pity the Poor Investment Grade Corporate Bond Manager

Posted on by David Merkel

When I was an investment grade corporate bond manager (2001-2003), my analysts would come to me and explain the credit metrics of the company whose bond we might buy. Now, that was a period of great stress in the credit markets. Often my analysts would stress that the low enterprise value to EBITDA ratio would help protect us, and it did.

Fast forward to 2006-2007. Companies with low enterprise value to EBITDA ratios are being taken private, and the corporate bonds with no change-of-control covenants are being downgraded to junk, because of the additional senior bank debt subordinating the old corporate bonds.

This is another situation where the manager wants Goldilocks. Not too hot, lest it be taken private. Not too cold, lest it default. It’s a tough situation to be in, and if I were managing a bond portfolio, I would move to higher quality with corporate bonds (not much yield give-up), while buying junk-rated corporate loans, so long as they have protective covenants.

It’s a tough situation. Clients want yield and safety, and the trade-off is tough. The best a corporate bond manager can do is to play it safe with spreads so tight, and wait for a better day to take credit risk.

Another Boon from RealMoney.com

Another Boon from RealMoney.com

Posted on by David Merkel

Well, my RealMoney column from April 9th got republished on the free site, and got syndicated out to Yahoo! as well. When I write a piece where I mention a company, like Assurant, it’s fun to see the piece appear on the Yahoo! news. But when I don’t mention a ticker, I know that if they put it on the free site, I know they also syndicate it out to Yahoo!, and a number of other places as well. I get amazed at times where my stuff ends up. Well, I hope it makes money for them, and most of all, I hope it benefits those who read it.

That’s particularly true for this piece, because it focuses on risk control in a very direct way. Too many market players don’t realize that risk control is a way to make more money on average over the long term. How does that work?

  1. It keeps you in the game. Absent war on your home soil and aggressive socialism, being an owner in society is a winning strategy over the long haul.
  2. Rebalancing allows you to pick up an incremental 2-3% annually on average. It forces you to buy low and sell high.
  3. There will be drawdowns. You will get drawn down less, and if you stay with strong companies in industries that have previously underperformed, when the bottom arrives, you will outperform the market.

I view risk differently than most market players, and than almost all academics. Risk means trying to avoid loss on every name in my portfolio, not avoiding loss on the portfolio as a whole, and certainly not standard deviation of returns, or even worse, beta.

“Don’t keep all your eggs in one basket.” True enough. “Keep all your eggs in one basket, and watch that basket carefully.” Also true. “Watch every egg.” That’s what I try to do. I’m a singles hitter, not a home-run hitter with attendant strikeouts. I try to make money on every company, by following my eight rules. That doesn’t guarantee success, but my losers over the last 6.5 years have been less than 10% of the names that I invested in. And, in each case where I lost, the error of judgment came from neglecting one of the eight rules.

All that said, I encourage you to focus on risk control. It’s a lot easier to make money if you don’t lose it.

 

Full disclosure: long AIZ

Worth the Fuss

Worth the Fuss

Posted on by David Merkel

I would like to draw your attention to this free Wall Street Journal article on Dan Fuss of Loomis Sayles. Dan Fuss is a fundamental genius in bond investing, and anything you hear about him is worth reading. Largely because of his reasoning, I own a decent slug of Canadian bonds for my balanced mandates.

I will contrast him with the better known Bill Gross of PIMCO. PIMCO is largely a quantitative shop, implicitly writing out-of-the-money calls against their fixed income positions to generate incremental income. Dan Fuss makes big investments on what he believes the world will be like 3-5 years out. His view of the world has been uncanny for several decades. No surprise that he has been the best in bond management over the long haul.

Let Them Eat Yield!

Let Them Eat Yield!

Posted on by David Merkel

An article in Friday’s Wall Street Journal described the creation of new closed-end funds dedicated to the production of yield. I am simultaneously horrified at the concept, and yet wondering whether I couldn’t create one with multiple strategies to smooth out the difficulties of single strategy yield creation. I could buy:

  • unusual bonds with high yields.
  • certain fixed income closed end funds at a discount.
  • dividend paying stocks, and occasionally (ugh) preferred stocks.
  • non- or low dividend paying stocks that fit my eight rules, and sell out-of-the-money calls against them.
  • lever the fund by borrowing at LIBOR.
  • Use my mean reverting REIT, utility, LP strategy. Backtests have it generating a 20% return annually, and I haven’t tweaked it.

The thing is, though, yield is a conceit. People like to think that they are merely scraping the income off of the portfolio, when in many cases, they are truly consuming capital, but the accounting doesn’t make it look that way. Think of a high yield fund with a single-B average credit quality. During good times, the full yield, and maybe a tiny amount of capital gains comes into income. During bad times, the yield shrinks, and capital losses get passed through. Over a full cycle, the NAV of a high yield fund shrinks.

Logical people would not invest in income vehicles like that, but invest they do. Two parting bits of advice. One, there is no reason to ever invest in a closed-end fund IPO. Closed-end funds should trade at a discount equal to the annual fee times five (or so). Two, be conservative in yield investing. It is little known that lower yielding REITs tend to outperform higher yielding REITs. The only time to stretch for yield is when everyone is scared. Even then be careful; make sure the yield that you are getting is secure.

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