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On Learning Compound Interest Math

Saturday, July 19th, 2014

When I read articles like this where people get scammed borrowing money, I say to myself, “we need to teach children the compound interest math.”

Even my dear wife does not get it, and she sends the children to me when they don’t get it.  But beyond learning the math, a healthy skepticism of borrowing needs to be encouraged, especially for depreciating items like autos.

The compound interest math is really one of the more simple items of Algebra 2.  Everyone should be able to calculate the value of a non-contingent annuity at a given interest rate.

Once people learn that, they might have more skepticism regarding the long-dated pension-like promises that the government makes, because they can look at the future payment stream, and say, “I can’t see how we fund that.”

All for now.

On Current Credit Conditions

Friday, July 18th, 2014

This should be short.  Remember that credit and equity volatility are strongly related.

I am dubious about conditions in the bank loan market because Collateralized Loan Obligations [CLOs] are hot now and there are many that want to take the highest level of risk there.  I realize that I am usually early on credit issues, but there are many piling into CLOs, and willing to take the first loss in exchange for a high yield.  Intermediate-term, this is not a good sign.

Note that corporations take 0n more debt when rates are low.  They overestimate how much debt they can service, because if rates rise, they are not prepared for the effect on earnings per share, should the cost of the debt reprice.

It’s a different issue, but consider China with all of the bad loans its banks have made.  They are facing another significant default, and the Chinese Government looks like it will let the default happen.  That will not likely be true if the solvency of one of their banks is threatened, so keep aware as the risks unfold.

Finally, look at the peace and calm of low implied volatilities of the equity markets.  It feels like 2006, when parties were willing to sell volatility with abandon because the central banks of our world had everything under control.  Ah, remember that?  Maybe it is time to buy volatility when it is cheap.  Now here is my question to readers: aside from buying long Treasury bonds, what investments can you think of that benefit from rising implied volatility and credit spreads, aside from options and derivatives?  Leave you answers in the comments or email me.

This will sound weird, but I am not as much worried about government bond rates rising, as I am with credit spreads rising.  Again, remember, I am likely early here, so don’t go nuts applying my logic.

PS — weakly related, also consider the pervasiveness of BlackRock’s risk control model.  Dominant risk control models may not truly control risk, because who will they sell to?  Just another imbalance of which to be wary.

Book Review: The Secret Club that Runs the World

Tuesday, July 15th, 2014

la_ca_0506_the_secret_club_that_runs This is a very good book; I learned a lot as I read it, and you will too.

In this book, Kate Kelly takes on the economic sector of commodities.  This involves production, distribution, trading, hedging, and ultimate use.

There are many players trying to profit in many different ways.  There are hedge funds, commodity trading advisers, investment banks, producers, refiners.  Some do just one facet of the commodities sector; some do everything.

This book is replete with stories from the run-up in commodity prices, and all of the games that went on.   It tells of those who made a lot of money, and those that want  broke working in a very volatile part of the economy.

It is a book that gives a testimony that information is king, and those that understand future supply, demand, and transportation costs can make a great deal of money by buying cheap, transporting, and selling high.

That said, the math can get overly precise versus the real world… the book gives examples of hedging programs that were too clever by half, ending in disaster when prices moved too aggressively.

With hedging, simplicity is beauty.  But after some success in trading well, companies think that instead of hedging, let trading become a profit center of its own .  Far from reducing risk, risks rise beyond measure, until the scheme blows up.

The book also considers non-market players like politicians and regulators, and how they are almost always a few steps behind those they regulate.  A key theme of the book is whether market participants can manipulate prices or not.  I would invite all market participants to consider my writings on penny stocks.  Can the price be manipulated?  Yes.  For how long?  Maybe a month or two at best.  In bigger markets like commodities, I suspect the ability to manipulate prices is less, because there are more players trading, and the power is equal between buyers and sellers.  There are powerful parties on both sides seeking their advantage.

The Glencore/Xtsrata merger and Delta Airlines hedging program/buying a refinery occupy a decent amount of the book.  Glencore/Xstrata illustrates the desire for scale and control in owning production in trading assets in commodities.  Delta Airlines illustrates the difficulties involve in being a heavy energy user in a cyclical, capital-intensive business that carries a lot of debt.  It’s too early to tell whether owning their own oil refining operation was the right decision or not, though typically companies do better to specialize, rather than vertically integrate.

One you have read this book, you will have a good top-level view of how the commodities sector operates, and thus I recommend the book.

Quibbles

The book title is vastly overstated.  There is no secret.  Just becuse many people don’t know about them doesn’t mean they are secret.  There is adequate data about them if you look.

There is no club.  Yes, some move from one position in one firm to a position in another.  Some even become regulators.  That is common to most industries.

They don’t run the world.  At most, they have a weak hold over commodities markets, because the traders have better data on global supply and demand than most large producers and consumers do.  That information allows them to profit on spreads, but it doesn’t let them move markets.

Summary

Given my quibbles, I thought it was a great book.  A marketing guy probably wrote the title, so I give the author a pass on that.  If you want a readable high-level view of the commodities markets, you can get it in this book.  If you want to, you can buy it here: The Secret Club That Runs the World: Inside the Fraternity of Commodity Traders.

Full disclosure: The PR flack asked me if I would like a copy and I said “yes.”

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.

Aiming for Transparency

Saturday, July 12th, 2014

Here’s another letter from a reader:

David,

I’m starting this fund, and I wanted to get your opinion.

 It is best explained on YouTube in 55 seconds: let me know what you think https://www.youtube.com/watch?v=frwOrQd3f6w. It (hopefully) will provide incentive for transparency in funds.

 Thank you!

Okay, I can’t embed the short video, so click on the link above and watch it — it is less than a minute, and well-done.

To the writer:

I admire your efforts at providing transparency here, but let me tell you where I think this may have unintended negative consequences.

Anytime you provide total transparency, you invite front-running, if the manager is any good.  New ideas are often most potent at their beginning, and given the delay between notifying mutual fund shareholders, voting and implementation, critical time is sacrificed, and some of your shareholders may front-run you.

Imagine a person investing the minimum in your fund so that he could front-run your picks with a greater amount of money.  But even if front-running does not happen, it is generally wise to move rapidly once the manager has come to a decision.  The delay from having shareholders vote on it is likely a money-loser.  Also during times of crisis, the manager may have some of his best ideas, but when average people are scared, will they be willing to pull the trigger?  I have my doubts.

In general, I favor investment methods where decision-making is done by individuals.  If I were running a hedge fund, or a large mutual fund, I would delegate all decisions to the sector/industry analysts.  Let sharp opinions prevail.  I’ve worked in areas where groupthink muddies investment decisions — it does not lead to outperformance.

Transparency

You don’t need to have shareholders vote on investments to have transparency.  You could do what I do, because all of my investors have full transparency.

I manage separate accounts using Interactive Brokers.  We buy and sell as a group.  We all get the same buy and sell prices.  I don’t trade often, but any investor can monitor his/her account all day long.  They can set up a daily download so that they can see what actions have been taken, if any.  There is total transparency, to the degree that my investors want to make the effort.  And remember, making investors go through a lot of effort is a negative.

If I Were in Your Shoes

If I wanted to give your investors transparency, I would give them access to a website showing the portfolio in real time, set up in such a way that only they could see it.  I would not let them vote on investments.  If you are hiring a manager, let him manage.  Second-guessing and delay are a waste of time and money.

Now those are my thoughts, and maybe your views on running a democratic fund are important to you.  Do what you think is best — just remember that democracy is not the same as transparency, and to achieve transparency, democracy is not needed.  Information is power, and you want to be careful in how you share it.

All that said, I hope you succeed, and that it works out well for you and your shareholders!

Book Review: Taking Down the Lion

Tuesday, July 8th, 2014

taking down the lion This is a tough book for me to review.  The credit distress of Tyco caused me considerable stress, and let me explain to you how that was.

I was the leading corporate bond manager at the fastest growing life insurance company 2001-2003.  We had a significant position in Tyco bonds, and as thy fell, we were concerned.  As a new corporate bond manager, I drew upon all of my analysts and portfolio managers, and asked them, “Who can give me the bear case here?”  I did my own analysis as well.  No one could come up with a way that Tyco could go broke.

So I asked the next question: Is there anyone on Wall who thinks Tyco could go broke?  We found one.  We read the analysis.  We thought the argument was ridiculous, and so we wanted to buy more.  We had a problem: our client was under pressure from the rating agencies to decrease our exposure to Tyco.

We had a large block of two-year Tyco bonds that were trading near par, and I sold them, and reinvested into a smaller market value of 30-year Tyco bonds.  Problem solved, but we were now taking more risk in Tyco debt, a bet that we would win.

The Book

Taking Down the Lion takes the view that Kozlowski had a subpar legal team which made many blunders in representing him.  It also notes how the informal management culture played against Kozlowski as things that were formal at many other corporations, and thus could not be argued, were not so at Tyco.

If the book is correct, this was a perfect storm for Kozlowski, leading to an unjust conviction and sentence.  Having worked at firms that were informal, I can believe that Kozlowski was framed during a witch-hunt era that produced the dreadful Sarbox law.  Few legislators think of what the side-effects will be from their legislation.

My Thoughts

Tyco as a corporation was not a fraud.  Yes, Kozlowski was tone-deaf regarding some conspicuous consumption that he did, or was done on his behalf.  There is no crime for being a vulgar consumer.  Supposedly Kozlowski paid for it all, but still he got judged for it in court.

Truth,  don’t know whether Kozlowski was guilty or not, but the company was well-run, and what company could you not find a few things that have some taint?

Summary

I think it is a good book, and I lean toward the idea that Kozlowski should not have been convicted,  If you want to, you can buy it here:Taking Down the Lion: The Triumphant Rise and Tragic Fall of Tyco’s Dennis Kozlowski.

Full disclosure: The PR flack asked me if I would like a copy, and I said yes.

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.

Pity the Multiemployer Pension Plans

Wednesday, July 2nd, 2014

Most of the efforts to encourage defined benefit pension plans in the US have been an exercise in wishful thinking.  Then there are the efforts to discourage defined benefit plans, which came about because the IRS felt that they were losing too much tax revenue to overfunded plans.  Thanks, IRS… many plans were not really overfunded, but you discouraged a healthy funding of DB plans.

But if things are bad with corporate DB plans, it is much worse with Multiemployer Pension Plans.  These are plans meant to cover union laborers in a given industry.  What led me to write this evening were the problems with pensions in the coal-mining industry.  From the article:

Union miners are among the 10.4 million Americans with retirements tied to multiemployer pension plans, the large investment pools considered low risk because they don’t rely on a single company for financing. Two recessions, industry consolidation, and an aging workforce have the multiemployer funds facing a $400 billion shortfall. Dozens already have failed, affecting 94,000 participants.

Strong investment returns helped lift the average funding level of pension plans by three points, to 88 percent, from 2013 to 2014, according to Segal Consulting, which advises multiemployer trust funds. Yet, more plans were added to the “endangered” or “critical” lists that require fund managers to take steps to improve their financial status, including adding cash or adjusting future benefits.

“In 2001, only 15 plans covering about 80,000 participants were under 40 percent funded,” the government pension agency reported June 30. “By 2011, this had grown to almost 200 plans covering almost 1.5 million participants.”

The pension plan for union miners had about $5.8 billion in liabilities in 2012 and was only 71.2 percent funded at the end of 2013, according to Labor Department filings.

The trouble with multiemployer plans is that as some employers fail, the remainder of the employers have to pick up the bill for pensions.  In a declining or cyclical industry, that is a recipe for disaster.  As a result UPS spent $6.1 billion to exit the multiemployer plan, while still guaranteeing benefits to its own employees.  The $6.1B was the ransom payment to escape something far worse in an underfunded multiemployer plan.

Though average multiemployer plan may be better funded, the average hides a lot, as there are more people expecting benefits from plans that are dramatically underfunded.  What’s worse, is that those in multiemployer trusts have a maximum guarantee that is around 30% of what a single-employer plan would receive.

As such, to the degree that unionized industries as a whole suffer, so will benefits to unionized laborers, present and past.  People need to understand that pensions aren’t magic.

  • Adequate contributions need to be made.
  • Investment returns must be adequate.
  • Benefits promised must be reasonable relative to contributions.
  • Anti-selection should be limited in multiemployer trusts.  Perhaps employers need to put up extra capital that they would forfeit if they wanted to leave the collective industry pension promises.

As it is, participants in the worst multiemployer pension plans will suffer losses, and the PBGC will guarantee small amounts of the benefits, and that is as it should be, because the ability to drag money out of a shrinking industry is hard, very hard.

So pity participants in multiemployer defined benefit pension plans.  A significant portion of them will get far less than they expected.

Book Review: The Big Con

Sunday, June 29th, 2014

9780385495387This is an unusual book for me to review.  This is a book about Confidence Men, first published in 1940, and recently republished in 1999.  It was written by David W. Maurer, who was a professor of linguistics, and used his skills to analyze the slang of the underworld.

This book deals with Con Men — men who try to gain the confidence of another man in order to get him to hand over money to them.

I have often said, and many grifters would agree, that it is very hard to cheat an honest man.  Honest men know that there are no easy pickings in life, and if there are some holes in the system, no one will share them with you for free.  Grifters trick those who think that the world is unfair, and want to be cut in on the inside action.

Sam Israel was tricked in that way in the book “Octopus.”  Clever actors convinced him that there was easy money to be made, and they milked him and his hedge fund clients, while he lost it all.

This book takes you through the human systems that con men create in order to convince their targets that they can make easy money, until the con men fleece them.  The two key characters are ropers, who attract victims, and the insiderman, who is the boss and is the one who directs the whole scam.

They design a system that delivers a few small wins to the victim, who gets greedy and puts up a lot of money, and then the rigged system delivers a loss, cheating him of his money.  Mot often, since the victim was an willing participant in an illegal scheme, even though he was cheated, he will not be willing to press charges, even though was cheated, because he wants to protect his reputation.

The book describes the many players involved as actors, to make the enterprise look legitimate.   It also describes the games that they played, and how they would entice a victim into an unfair scheme in which they would profit off others, but end up cheating the victim.  The book talks about how the justice system was often bought by the insiderman, thus protecting the activities of those he employed.

It also describes how the ropers would figure out whether a victim would go along with a scam or not.  It gives the history of confidence games — how they developed, and how some faded, and others grew, at least for a time.

Along with all of that, it describes the lives of the grifters, and how few of them truly prospered.  Most wasted the money that they earned in riotous living. As Proverbs 13:11 says, “Wealth obtained by fraud dwindles, But the one who gathers by labor increases it.” [NASB]

To the Modern Era

Breaking from the book review, is our era so much different, or do we have the same problems in different ways?

I’ve been down enough roads in the investing world to know that there are a lot of parties who try to get people to take bad deals.  It can be as simple as guys who use the “straight-line” pitch to get people to invest with them.  It can be institutional investors who try to trick naive institutions.

It can be seminars with shills and other accomplices like Rich Dad and their ilk.  We still have Nigerian Scams and other Scams on the Internet, many of which involve identity theft.  We have promoted penny stocks, structured notes, and Ponzi schemes.  I have written about all of these.  Is the current era less prone to con men than the era from 1890-1940?

I would argue no, though it was more colorful and personal in the past.  Today’s scams are more virtual and anonymous, leaving aside Madoff’s Ponzi Scheme which was highly personal, and psychologically design to harvest money from those that wanted a high yield with safety.

Why you should consider this book

By reading about all of the ways that people get cheated, you will be deterred from greed, and distrust those who incite greed.  These problems are alive and well today.  Can you learn that there are no free lunches, and no free money?  If you can learn that, you are well on the way to not being cheated.

Quibbles

The book is repetitive.  It does not condemn the grifters for the sins they commit against others.  The book is almost amoral.  At least, it posits a human morality, where there is a code of honor among thieves, but thievery is not in itself wrong if the victim is a greedy person.

Summary

This is a classic book that if you read it should make you more skeptical about “sure things,” and “get-rich-quick schemes.”  Away from that, it is a commentary on the human condition, showing how many men are willing to compromise their ethics in order to make a lot of money.  Anyway, if you want to, you can buy it here: The Big Con: The Story of the Confidence Man.  It’s not expensive for what you get, and it is a colorful book.

Full disclosure: I bought a copy with my own money.

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.

 

A Stream of Hot Air

Saturday, June 28th, 2014

Let’s roll the promoted stocks scoreboard:

TickerDate of ArticlePrice @ ArticlePrice @ 6/27/14DeclineAnnualizedSplits
GTXO5/27/20082.450.022-99.1%-53.9% 
BONZ10/22/20090.350.001-99.8%-72.7% 
BONU10/22/20090.890.000-100.0%-83.4% 
UTOG3/30/20111.550.001-100.0%-90.7% 
OBJE4/29/2011116.000.083-99.9%-89.9%1:40
LSTG10/5/20111.120.011-99.0%-81.6% 
AERN10/5/20110.07700.0001-99.9%-91.3% 
IRYS3/15/20120.2610.000-100.0%-100.0%Dead
RCGP3/22/20121.470.080-94.6%-72.4% 
STVF3/28/20123.240.430-86.7%-59.3% 
CRCL5/1/20122.220.013-99.4%-90.7% 
ORYN5/30/20120.930.026-97.2%-82.2% 
BRFH5/30/20121.160.620-46.6%-26.1% 
LUXR6/12/20121.590.007-99.6%-93.3% 
IMSC7/9/20121.51.000-33.3%-18.6% 
DIDG7/18/20120.650.047-92.8%-74.2% 
GRPH11/30/20120.87150.077-91.2%-78.6% 
IMNG12/4/20120.760.025-96.7%-88.8% 
ECAU1/24/20131.420.047-96.7%-90.9% 
DPHS6/3/20130.590.008-98.7%-98.3% 
POLR6/10/20135.750.051-99.1%-98.9% 
NORX6/11/20130.910.110-87.9%-86.8% 
ARTH7/11/20131.240.213-82.8%-84.0% 
NAMG7/25/20130.850.087-89.8%-91.5% 
MDDD12/9/20130.790.097-87.7%-97.8% 
TGRO12/30/20131.20.181-84.9%-97.9% 
VEND2/4/20144.342.090-51.8%-84.5% 
HTPG3/18/20140.720.090-87.5%-99.9% 
6/27/2014Median-96.7%-87.8%

 

My, but aren’t they predictable.  Onto tonight’s loser-in-waiting Windstream Technologies [WSTI].  This is another company with negative earnings and net worth, though it has a modest amount of revenue.

Think of it for a moment: this company has a “breakthrough technology,” and yet they were a hotel company within the last year or two.  That’s not how real businesses work.  I you have an incredible technology, but little capital, private equity investors will happily fund you.  You won’t try to do it in some underfunded corporate shell which tempts crooked financial writers to write fantasy.

Now, you might look at the disclaimer in the glossy brochure which came to my house, which in 5-point type takes back all of things that they about in bold headlines and readable text.  For example:

  • It begins with: DO NOT BASE ANY INVESTMENT DECISION UPON ANY MATERIALS FOUND IN THIS REPORT.
  • The Wall St. Revelator is neither licensed nor qualified to provide financial advice. As such, it relies upon the “publisher’s exclusion” as provided under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws.
  • The Wall Street Revelator and/or its publisher, Andrew & Lynn Carpenter, dba The Wall Street Revelator has received a total amount of twenty five thousand dollars [DM: $25,000] in cash compensation to assist in the writing of this Advertisement, as well as potential future subscription and advertising revenues, the amount of which is not known at this time with respect to the publication of this Advertisement and future publications.
  • Mandarin Media Limited paid nine hundred thousand dollars [DM: $900,000] to marketing vendors to pay for all the costs of creating and distributing this Advertisement, including printing and postage, in an effort to build investor and market awareness.
  • Mandarin Media Limited was paid by non-affiliate shareholders who fully intend to sell their shares without notice into this Advertisement/market awareness campaign, including selling into increased volume and share price that may result from this Advertisement/market awareness campaign.
  • The non-affiliate shareholders may also purchase shares without notice at any time before, during or after this Advertisement/market awareness campaign.
  • Non-affiliate shareholders acted as advisors to Mandarin Media Limited in this Advertisement and market awareness campaign, including providing outside research, materials, and information to outside writers to compile written materials as part of this market awareness campaign.

The disclaimer exists to cover the writers from legal risk, and what it tells us is that there are largish shareholders looking to profit by running up the stock price as a result  of the advertisement, enough to cover the $925,000 cost.

Such it is with a pump and dump.  One thing is virtually certain, though.  This is not a stock to hold onto.  Look at the stocks in the table above.  No winners, and most are almost total losses in the long run.  Manipulators love working with stocks that have no earnings and no net worth, because they are impossible to value for the grand majority of people.  New buyers, if they come in a group, can create a frenzy that raises prices.

That’s the goal of the advertising campaign: a short term “pop” that the sponsoring shareholders can sell into, letting a bunch of muppets take losses.

Again, never buy promoted stocks.  If they have to buy the services of others to promote the stock, it is a fraud.  Good stocks do not need promotion.  It’s that simple.

PS — the pretentiousness of the word “revelator” should be replaced by the simpler “revealer.”

But They are not Actuaries, nor CFAs

Friday, June 27th, 2014

I am grateful that risk managers inside banks have more clout these days.  That said, I want it to persist, and the best way to do it is to have risk managers beholden to an ethics code, like actuaries or CFAs.

This is valuable, because the risk manager can point to a body of ethics that says to his manager, “I am sorry, but those of my discipline say that this action is unethical,” when line managers complain that the risk manager is killing business by insisting that certain risk standards should be maintained.

Actuarial risk models cover the life of the business, unlike Wall Street models that measured risk in terms of days.  Cash flows mater, and the ability to meet the demand for cash matters.  Long-term risk models tend to surface risks better than short-term models because an intelligent businessman can ask what are the odds that we will have a crisis over the duration of our existing business?

Once on a task force of the Society of Actuaries, when discussing non-traditional actuaries going to Wall Street, I said, “Great idea, but the line managers will eventually kill anyone that gets in their way.  They don’t want people who have an ethics code.  It inhibits business.”  After that, there were some nervous chuckles on the phone, and the conversation moved on.

Ethics codes are needed when the disparity of knowledge between the designers and ultimate consumers/investors/regulators is so great that there are many ways that the consumers/investors/regulators could be cheated.

My view is controversial but simple.  Every professional in investing and finance needs to have an ethics code, making them more sensitive to their clients.  The easy solution is that every investment/finance professional needs to hold a CFA charter.  The three exams are pretty minimal, and can be passed by most people with some study.  Give the actuaries a pass, their exams are far harder — far, far, far harder.

But set some boundary for ethics and examinations of competence, to clean up finance and send the flim-flam men to the edges of the market, where they belong.

 

 

A Few Notes on Bonds

Wednesday, June 25th, 2014

My comments this evening stem from a Bloomberg.com article entitled Bond Market Has $900 Billion Mom-and-Pop Problem When Rates Rise.  A few excerpts with my comments:

It’s never been easier for individuals to enter some of the most esoteric debt markets. Wall Street’s biggest firms are worried that it’ll be just as simple for them to leave.

Investors have piled more than $900 billion into taxable bond funds since the 2008 financial crisis, buying stock-like shares of mutual and exchange-traded funds to gain access to infrequently-traded markets. This flood of cash has helped cause prices to surge and yields to plunge.

Once bonds are issued, they are issued.  What changes is the perception of market players as they evaluate where they will get the best returns relative expected future yields, defaults, etc.

Regarding ETFs, yes, ETFs grow in bull markets because it pays to create new units.  They will shrink in bear markets, because it will pay to dissolve units.  That said when ETF units are dissolved, the bonds formerly in the ETF don’t disappear — someone else holds them.

But in a crisis, there is no desire to exchange existing cash for new bonds that have not been issued yet.  Issuance plummets as yields rise and prices fall for risky debt.  The opposite often happens with the safest debt.  New money seeks safety amid the panic.

Last week, Fed Chair Janet Yellen said she didn’t see more than a moderate level of risk to financial stability from leverage or the ballooning volumes of debt. Even though it may be concerning that Bank of America Merrill Lynch index data shows yields on junk bonds have plunged to 5.6 percent, the lowest ever and 3.4 percentage points below the decade-long average, the outlook for defaults does look pretty good.

Moody’s Investors Service predicts the global speculative-grade default rate will decline to 2.1 percent at year-end from 2.3 percent in May. Both are less than half the rate’s historical average of 4.7 percent.

Janet Yellen would not know financial risk even if Satan himself showed up on her doorstep offering to sell private subprime asset-backed securities for a yield of Treasuries plus 2%.  I exaggerate, but yields on high-yield bonds are at an all-time low:

Could spreads grind tighter?  Maybe, we are at 3.35% now.  The record on the BofA ML HY Master II is 2.41% back in mid-2007, when interest rates were much higher, and the credit frenzy was astounding.

But when overall rates are higher, investors are willing to take spread lower.  There is an intrinsic unwillingness for both rates and spreads to be at their lowest at the same time.  That has not happened historically, though admittedly, the data is sparse.  Spread data began in the ’90s, and yield data in a detailed way in the ’80s.  The Moody’s investment grade series go further back, but those are very special series of long bonds, and may not represent reality for modern markets.

Also, with default rates, it is not wise to think of them in terms of averages.  Defaults are either cascading or absent, the rating agencies, most economists and analysts do not call the turning points well.  The transition from “no risk at all” in mid-2007 to mega-risk 15 months later was very quick.  A few bears called it, but few bears called it shifting their view in 2007 – most had been calling it for a few years.

The tough thing is knowing when too much debt has built up versus ability to service it, and have all short-term ways to issue yet a little more debt been exhausted?  Consider the warning signs ignored from mid-2007 to the failure of Lehman Brothers:

  • Shanghai market takes a whack (okay, early 2007)
  • [Structured Investment Vehicles] SIVs fall apart.
  • Quant hedge funds have a mini meltdown
  • Subprime MBS begins its meltdown
  • Bear Stearns is bought out by JP Morgan under stress
  • Auction-rate preferred securities market fails.
  • And there was more, but it eludes me now…

Do we have the same amount of tomfoolery in the credit markets today?  That’s a hard question to answer.  Outstanding derivatives usage is high, but I haven’t seen egregious behavior.  The Fed is the leader in tomfoolery, engaging in QE, and creating lots of bank reserves, no telling what they will do if the economy finally heats up and banks want to lend to private parties with abandon.

That concern is also revealed in BlackRock Inc.’s pitch in a paper published last month that regulators should consider redemption restrictions for some bond mutual funds, including extra fees for large redeemers.

A year ago, bond funds suffered record withdrawals amid hysteria about a sudden increase in benchmark yields. A 0.8 percentage point rise in the 10-year Treasury yield in May and June last year spurred a sell-off that caused $248 billion of market value losses on the Bank of America Merrill Lynch U.S. Corporate and High Yield Index.

Of course, yields on 10-year Treasuries (USGG10YR) have since fallen to 2.6 percent from 3 percent at the end of December and company bonds have resumed their rally. Analysts are worrying about what happens when the gift of easy money goes away for good.

With demand for credit still weak, it is more likely that rates go lower for now.  That makes a statement for the next few months, not the next year.  The ending of QE and future rising fed funds rate is already reflected in current yields.  Bloomberg.com must be breaking in new writers, because the end of Fed easing is already expected by the market as a whole.  Deviations from that will affect the market.  But if the economy remains weak, and lending to businesses stays punk, then rates can go lower for some time, until private lending starts in earnest.

Summary

  • Is too much credit risk being taken?  Probably.  Spreads are low, and yields are record low.
  • Is a credit crisis near?  Wait a year, then ask again.
  • Typically, most people are surprised when credit turns negative, so if you have questions, be cautious.
  • Does the end of QE mean higher long rates?  Not necessarily, but watch bank lending and inflation.  More of either of those could drive rates higher.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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