I haven’t written about my portfolio management methods in a while.  I’ll be writing on this a few more times over the next week or so.  The eighth rule of my investing is:

Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

First I have to get new ideas.  I have two sources for that:

• My industry rank study.  Within those industries chosen, I run a screen that uses financial strength, valuation, and growth potential to highlight promising names.  Of the 34 current names in the portfolio, the screen chose 10 of them, out of 79 suggested names.
• Trolling around on the web and talking to friends.  When I hear a promising idea, I print it out or write it down, and put it in a pile to wait for the next reshaping.  This helps me to forget who suggested it and why, so that I am forced evaluate it independently.  If I don’t fully understand it, I will not know when to buy more or sell it.  That generated 40 additional names.

Anyway, here are the tickers for the replacement candidates:

ABFS ACM AEP AFL AMGN APA APC APOL ATPG AXS BCE BDX BHI BRY BT CAG CALM CAM CDI CL CLX CNQ CPO CVS DFG DLM DO EGN ENR ESLT FDP FISV FLIR FRX FST FTO GD GLRE GMXR HAL HOGS HRL HSII IP JBL KELYA KEX KFT KHDHF LLL LNC LPX MDT MDU MET MMM MOG/A MOT MRO MUR MWV NBR NEMNLC NOV NVDA OCR OII OSG PCCC PG PRU PXD PXP RAH RDS/A RE REP RIG RNR RTN SJM SPR SU SUN SXT TDW TDY TEG THS TK TLM TMK TMO TRH TRP TSO TTI UNM V VZ WAG WAT WMT WPP WY YUM

I will run my quantitative model on these companies versus the current companies in the portfolio, and kick out companies I now own that score poorly and buy some the score well.  This procedure is not absolute; there are often bits of data  that the quantitative factors ignore.  But when all is said and done, I buy companies that I think are better than those that I am selling.

This also forces me to review the whole portfolio, and be dispassionate about what gets sold.  It also forces me to take things slow, and not make hasty decisions.

What factors exist in my scoring model:

• Valuation – Earnings, Book, Sales
• Momentum
• Earnings Quality
• Sentiment indicators — neglect, volatility, etc.

I change the weights over time.  I ask myself, “What is working now?” and, “What has or hasn’t been working for too long?”  What working now should get extra weight, while leaning away from ideas that are too popular, and leaning toward those that are unfairly tarred as dead.

But this is only an aid and a guide.  If I put something into the portfolio, it has to pass my qualitative reasoning tests, which admittedly are subjective, but encompass my reasoning as a businessman.

In short, that is what I do.  I hope to give you an update in a few days to explain how this practically worked out in this reshaping.  If you have other tickers that you think I should consider please let me know in the comments, and I will toss them into the mix.  Thanks.

Illiquidity is an underrated risk.  Most financial company failures are due to illiquidity, which usually takes the form of too many illiquid assets and liquid liabilities.  Adding to the difficulty is that it is generally difficult to price illiquid assets, because they don’t trade often.

So where do we see failures due to illiquidity?

• Banks — too numerous to mention, though FDIC insurance restrains it now.
• Life insurers, particularly those that write a lot of deferred annuities.
• AIG and the GSEs — abominations all.
• Bear and Lehman — waiving the leverage limit was one of the stupidest regulatory decisions ever.
• Hedge funds – LTCM was the granddaddy of failures, but many have choked because redemptions forced liquidation of assets at unfavorable prices.
• No colleges, though those college that were too aggressive on illiquid assets got whupped in 2008.  Some were forced to raise liquidity in costly ways.  Same for many overly aggressive pension plans, many of whom came late to the game with Venture Capital, Hedge Funds, Timber, Commodities, etc.

Face it.  Most alternative asset classes involve additional illiquidity.  That is an additional risk, and when evaluating those investments, the expected rate of return must be greater than that for liquid investments.

As an aside, there is another factor to be considered with alternative investments.  That factor is strategy capacity.  Alternative investments do best when they are new.  Here is my version of the phases that they go through:

• New — few know about it except some business-minded investors.  Only the best deals get done.
• Growing — a modest number know about it, and a tiny number of consultants.  Only very good deals get done.
• Comes of age — many know about it, and most consultants pitch it to their clients as the way to go.  Good deals get done.
• Maturity — almost everyone knows about it, and it is a standard aspect of asset allocation for consultants, who have their means of differentiating between different providers, based on metrics that will later be revealed to be useless.  All reasonable deals get done.
• Post-maturity — Late bloomers make it to the party, and beg to get in, thinking that past is prologue, and do not realize that deal quality has eroded severely.
• Failure, which brings maturity — deals fail, leading the market to scrutinize all investments, leading to true risk-based pricing.  Later adopters abandon the market, and take losses.  Earlier adopters sharpen practices, and prepare for a more normal asset class.

So, when looking at illiquid assets, how do you determine how much to invest?  First determine how much of your funding base will never leave over the next 10 years.  When I was a corporate bond manager, that was 25% of the assets that I was managing, because of structured settlements and immediate annuities.

For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield.  Invest that much in short to intermediate bond investments.  You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.

But after that, there is an additional way of controlling illiquidity risk — time once again for the fusion solution! Money market funds run a ladder of maturities.  Stable value funds run a longer ladder, as should commodity ETFs, rather than floating at spot.  Then there are clever advisers who run municipal and other bond ladders for wealthy and semi-wealthy clients.  Running a ladder of maturities is one of the most robust management techniques as far as interest rate risk is concerned.  There is always money coming out and in every year, which slowly leads the portfolio yield in the direction of average rates.

Now, if these bonds are less liquid muni bonds, but the credit risk is low, you don’t care as much about the illiquidity, because the ladder produces its own liquidity as bonds mature.  The key question is sizing the length of the ladder, which comes down to a question of analyzing the liquidity/income needs of the client, combined with a forecast on the secular direction of rates.  The forecast is the least important item, because it is the toughest to get right.  (An aside: who has been right on bond yields consistently for the last 20+ years?  Hoisington, my favorite deflationists.  Wish I had listened more closely.)

The same principle applies to pension funds, endowments, life insurers with a few twists.  Divide your liabilities in two.  What obligations do you know cannot be changed, except at your discretion?  That group of liabilities can have illiquid assets to fund them.  Try to match the payout streams, but if not, try to match them in broad with a ladder, keeping in mind what mismatches you will likely face over the next 1-2 years in order to properly size your cash position.

The rest of the liabilities need more intensive modeling, analyzing what could make them change.  You can try to buy assets that change along with the liabilities, but in practice that is hard to do.  (That said, there are no end of clever derivative instruments available to solve the problem in theory.  Caveat emptor.)  The assets have to be liquid for this portfolio.  Other aspects of portfolio choice will depend on valuation parameters, credit spreads, yield curve shape, market volatilities, as well as macroeconomic factors.

Three Closing Notes

1) Now, all that said, just because you can take on illiquidity doesn’t mean that you should.  A good manager has a feel from history for what the proper liquidity give up is in valuations for stocks and other risk assets, and credit spreads for fixed income assets of all sorts.

Was it worth moving from the:

• Relatively liquid AAA tranche to the illiquid AA, A or BBB tranche for 0.10%, 0.20%, 0.40%/year respectively?  As a bond manager at much larger insurance company said back in 2000 — “It’s free money.”  (That is almost always a dangerous phrase.) My view was there was more illiquidity and credit risk than we could consider.
• Relatively liquid large-issue BBB bank bond to the relatively illiquid small-issue BBB bank bond for 1% more in yield?  Hard to say.  There are a lot of factors involved here, and your credit analyst will have to be at the top of his game.  It also depends on where you are in the speculation cycle.
• Liquid public equities to private equity or hedge funds with lockups?  Tough question.  Try to figure out what the unlevered returns are for comparative purposes.  Analyze long-term competitive advantage.  Look at current deal quality and valuation metrics.  For hedge funds, look at how credit spreads moved over their performance horizon.  Anyone can make money when spreads are tightening, but who makes money when spreads are blowing out?  Analyze them over a full credit cycle.

2) Institutions that did not previously do more liquidity analysis because we had been in near-boom conditions for decades need to at least do scenario testing to assure that they aren’t overplaying their hands, such that they might be forced to make bad decisions if liquidity gets tight.  Safety first.  (This applies to governments and industrial corporations too, as we will experience over the next three years.)

3) Finally, if you decide to make a large illiquid purchase like Mr. Buffett did last year, make triple-sure of your logic and your liquidity positioning.  Nothing lives forever, but you can prolong the life of the institutions you serve by careful reasoning and planning, particularly regarding liquidity.  Get financing when you can, not when you need it. It takes humility to do so, but it yields the quiet reward of continued existence at a modest price.

1) Kind of like my thesis that the States give a better picture of the economy than the Federal Government, I agree with the idea that small banks better represent that health of the US economy.  Most small an medium-sized businesses rely on small banks.  Growth in employment relies on small and medium-sized businesses, because they typically have more room to expand.

2) I’ve been arguing for a weak economy before the double dip concept was derided.  Not that I make the Philly Fed survey a big part of my analysis, but the weak report is consistent with my view that the US economy is weak.

3) All developed markets where there is still confidence are finding long government yields hitting new lows.  No surprise, with so many investors and nations scared, that many would focus on sovereign governments for repayment.

4) So there are failures to deliver in the MBS market.  Part of it is due to the Fed sucking up a large part of the market.  Part due to the low cost of short term funds.  My question to anyone reading, are there any significant costs?

5) A crisis like this is divisive.  In the US, it separates the strong versus the weak states.  In the EU, it separates the strong versus the weak countries.  That is the nature of financial crises — they divide the healthy from the sick,with some slight tweaking from government action.  As it is now, there is a divergence where countries with some flexibility fight to maintain their independence.

6) Jake makes the argument that one would pay a lot for certainty of return of principal in this environment. SO, don’t sniff at low short term rates.

7) Ordinarily I agree w/Jesse.  For example, I agree that there could be a lot more extracted from the rich in taxes.  But I don’t think it would succeed.  There are too many holes in the tax code, and the wealthy would hire bright people to make the tax obligation go away.  I speak as one that has seen this in action.  Rich people are much smarter than poor people when it comes to money. It would take radical tax reform to change matters.

8 ) The ultimate stories on GM and AIG, as well as FNMA and FHCC, is that the government loses money on the deals, but spins them positively, in saying, “look, they are operational again.” Truth, better that they all failed, but the government aims at fixing things, even when it can’t.

9) This piece gets it right on Social Security in minor, blows it in major.  Yes, the bonds built up over the last 20 years will be paid out of current tax revenues, but will the US Government be able to bear the total burden as Medicare expenses go through the roof?

10) What a fight on stocks vs. bonds.  I favor bonds in the short run, stocks in the long run.  Where I disagree with both is that government action is needed to preserve value.

11) Are we turning into Japan? I have argued yes for some time because we are following the same government actions that Japan did.

12) How bad is the economy?  Bad enough that average people are liquidating 401(k)s.

13) China might finally be getting smart on population policy.  But getting women to have more kids once you have convinced them of the short-term value of not doing it — you will have a better career, and the long-term benefit of not doing it — we have too many people for the planet already; it’s pretty tough.  They take the easy road of not having kids, and it doesn’t matter how many economic incentives get kicked up — once women decide they don’t want to have children, there is no amount of economic policy that will change their minds.

But, there are other ways to do it: show reruns of happy families with many kids.  Waltons, Brady Bunch, Eight is Enough, etc.  We had eight kids, (we adopted five) and there is a lot of value in the many relationships that exist in a large family.

Okay, enough for now.  Time for sleep.  Just don’t go shorting bonds thinking I told you to do it.

In a panic, only two attributes of a financial instrument get priced — liquidity and quality/survivability.

In a panic, all risky assets become highly positively correlated with each other.

Given that correlations tend to rise in a panic, a reasonable measure of sentiment is to measure the average absolute value of 10-day correlations.

Markets cannot survive for long periods of time at high levels of actual or implied volatility.  They eventually revert to normal.

Panics and booms are different — they may be opposites, but they behave differently.  Panics are events, often multiple events, and booms are processes.  The nature of this is best explained through the credit cycle.  The boom phase of the credit cycle involves rising profits of corporations.  Stocks and bonds behave differently here.

Say the expectation of income moves from negative to a low positive figure.  Stocks will rally; bond may rally more, because the threat of bankruptcy is lifted.

Now suppose that the expectation of income moves from a low positive to a normal positive figure.  Stocks will rally a lot, but bonds will rally a little.  The odds of the bonds being paid rise a minuscule amount.  The stocks estimate of future distributable profits rise a great deal.

Now suppose that the expectation of income moves from a normal positive to a high positive figure.  Stocks will rally some, but bonds will not rally much.  The odds of the bonds being paid don’t change.  The stocks estimate of future distributable profits rise, but with a sense of possible mean reversion.

So in a boom, credit spreads [the difference between the yields of corporate bonds and Treasury bonds] tighten quickly, tighten slowly, and then stop tightening, even though things seem to be going great.  The end of the boom, as far as the credit market is concerned, can last a long time.

The end of the boom comes when a significant amount of companies the overextended their balance sheets during the boom find themselves in a compromised condition, and have a hard time gaining financing.  The suspicion of credit troubles travels fast, and all of the companies where investors waved their hands at problems now get a fresh look with a different set of eyes.

The moment incremental financing seems less likely or more expensive, companies that will need financing get re-evaluated by the market — stock prices move down, bond yields go up.  This is when analysis of the balance sheet and the cash flow statement are worth the most, and the income statement is worth the least.  The bull phase of the cycle is all about income statements, and estimating what future income will be.  The bear phase of the cycle is about estimating  cash flows, and the strength of balance sheets, to identify who might not survive the bear phase well.

During the boom phase of the cycle, the degree of correlation of asset returns is low.  There is noise, and not everything does equally well.  There are multiple risk factors and strategies that are working.  But in the bust phase, the acid test of survival dominates.  One factor gets priced, whether an asset is money good or not. [For bonds, "money good" means the par value of the bond will be repaid at maturity.]

But panics don’t last long — usually two years or so.  As the panic drags on three processes take place:

• Companies in horrible shape default.
• Investors examine companies in okay shape, and find weaknesses.  Some will default, and some will clean their acts up.
• Companies clean up their acts, and it becomes obvious that they will survive.

Toward the end of the bust phase, like a fire running out of fuel, there is a moment of clarity where some realize that things aren’t getting worse.  Most companies have cleaned up, and there will be fewer future defaults.  That sets the scene for the next rally.

Through the bust, equity volatility and credit spreads remain high; they are correlated phenomena, but there is a point of exhaustion.  High yields attract needed financing to companies that are mis-financed, rather than insolvent.  Credit spreads can only get so high before money comes in willing to buy no matter what the future may hold.  Equity volatility can only get so high before players begin writing short straddles, knowing that the odds of winning are tipped in their favor.

It pays to watch both the equities and bonds, and other related securities — it gives a richer picture of what is going on.  In particular, when the bull phase has gone on for two full years, watch for equity volatility and credit spreads to stop falling.  That is a sign that the bull market is getting close to the end, and most of the easy gains have been made.  Watch for telltale signs of cashflow shortfalls where banks are less than willing to plug the gap at a price.

Learn this well, and your ability to play the market will improve considerably.

I’ve read a number of articles on hedging tail risk of late.  Most of them were pretty good; I just want to add in my thoughts.

For those who haven’t read the articles, tail risk is when even safe investments get hit hard.  Those market outcomes are rare but severe, so some people look for insurance to clip their risks when everything is getting whacked.

Possibly a reasonable goal, and the best time to aim for it is when things are pretty good, because it is best to buy insurance when it is cheap to do so.

But what form should the insurance take?  I can think of three broad categories:

• Assets that come into existence during the disaster.
• Ready liquid assets — short-term and high quality.
• Liabilities that disappear with the disaster.

The first category is the one most people think about.  What can I buy that will do well when the disaster comes?  There are two branches to that question:

• Do I want my downside clipped on this trade (for a price)?
• Do I want to make the bet without paying much, and I could win or lose?

In the first category are puts and buying protection via CDS, which will protect for a time, but cost money to put on the trade.  Worse, you could be right on the event, but wrong on the timing, and they end up expiring worthless.

Note: be wary of products Wall Street would like to sell you here.  Most often, they sell something mispriced to you, though it looks attractive.

But even if you are right, your counterparty/exchange  has to remain solvent in order for the trade to work.  Few factor in the cost of insolvency there.  Think of those who though they were clever laying off risk to AIG, a trade which only worked due to government intervention.

In the second category, there are assets like precious metals and long Treasury zero coupon bonds, each of which will do well in a specific crisis, but not just any crisis.  But there is also the shorting of equities and high-yield bonds, which could potentially deliver big gains, or big losses if the rally continues.

I would offer this test to anyone offering a hedge against tail risk: is it any better than puts or buying protection through CDS, or shorting equities or high yield bonds?  I would suspect in most cases the answer is no.

Then there is my preferred solution: hold cash.  Cash is unique; it can be used for anything; it can be used for almost every contingency.  Cash may offer little to nothing; it may even yield negatively, but that is the cost of security and flexibility.

Then there is the third option: offering catastrophe [cat] bonds.  Why should the guys following hurricane, quake, typhoons, and European windstorms have all of the fun?  There are more and bigger disasters than those in the financial markets.

In simple terms, here’s how a cat bond works: after a disaster that meets the terms of the cat bonds occurs, the principal of the bond diminishes by the size of the covered loss, if it is in excess of certain thresholds.  The advantage of an arrangement like this is that an insurer or reinsurer can get reinsurance against a disaster, by issuing a high-yielding cat bond.

The high-yield investors are happy to buy it because typically cat bonds are highly rated, and offer a good return that is uncorrelated with the returns on other high yield bonds.  Physical disasters seem to happen independently from financial market disasters.

The bond issuer gets reinsurance capacity, which is sometimes scarce, at a price that reinsurers would not match.  Cat bonds can never replace reinsurers, though, because the reinsurers offer more tailored coverages, while cat bonds tend to be more broad-brush.  They are usually cross-hedges for the issuer, covering something that is likely to be highly correlated with their loss exposure in a disaster.

What Might be a New Idea

What if we applied the concept of a cat bond to hedging risky security portfolios?  Think of it as an odd sort of margin account.  A hedge fund borrows money via a special purpose vehicle [SPV], which holds high quality collateral.  The hedge fund pays the SPV for insurance coverage; the SPV pays interest to the cat bond investors.  If a loss event happens, say a large decline in the S&P 500 index below a stated level, the principal of the cat bond is written down, and the SPV pays the amount of the writedown to the hedge fund.

Compared to a cat bond based on a physical event, there is one advantage and one disadvantage.  The disadvantage is that the loss trigger on a financial cat bond is highly correlated with bad high yield bond market performance, eliminating a lot of the diversification advantage.  This would mean that a financial cat bond would have to pay a higher premium than a physical cat bond.

There is an advantage, though: it can be hard to set up a large hedge without disrupting the market, and it is difficult to gain protection over long periods of time.  Most hedging instruments are short dated, and limited in the amount of capacity available for laying off risk.

Would this be attractive to a large hedge fund?  I’m not sure.  This sort of protection has the same sort of drip, drip, drip of cash out that most managers hate to see, whether for writing puts or buying protection via CDS.  It would come down to a question of cost versus a locked-in solution that could last for ten years, with little to no counterparty risk.

Conclusion

But personally, my best solution is lower your leverage and hold some cash.  Nothing beats the flexibility and simplicity of cash in a disaster.  Cash is also an index of humility; we are willing to leave something to the side in case we are wrong.  Being wrong is a normal state of affairs in investing, so take time to prepare for the next time you will be wrong.

A reader MorallyBankrupt, asked,

What I am wondering here is the following, how fast was the decision process? For those of us that have never worked in the new-issue market for corps, the timeline is not obvious. How did it all flow, from getting notice of the deal, to getting a feel for the demand for it, to knowing what the offering price was going to be? How long did you have before requesting allocation in the deal?

Good question.  I answered part of this in the last piece.  It would vary based on three things:

• The complexity of the deal — more complexity, more time
• The creditworthiness of the issuer — lower creditworthiness, more time
• The speculative nature of the market — less speculative, more time

Most new issue corporates do not require explanation; they are just straight bond deals.  Senior unsecured, do the credit work, do you want into the deal or not?  But some deals require thought.  When Prudential (US) went public, they securitized the business associated with their oldest policies, and issued debt against it.  Thick prospectus.  Many scared away in the midst of the credit troubles in 2002.  I looked at it and said, “They are offering more yield than on their surplus notes, but with better protection.  Time to buy.”

So I called my broker at Goldman and expressed interest in the deal.  He sounded a little surprised, and said that few had offered orders yet.  I said that I was interested, and he said that the syndicate would be interested in pricing guidance.  I gave him a schedule where I would be willing to buy more as the pricing went higher in spread.

But after that, I asked for protection on my order.  Early orders deserve protection.  Protection means you will get everything that you asked for, while others get pro-rated if the deal is successful.  They protected my order, which was large for us, while the marketing of the deal continued.

As it was, in the midst of the chaos of 2002. there were few takers for the low risks in a complex deal like that of Prudential’s old business.  So as the deal came to pricing, the yield rose.  The eventual yield for the non-guaranteed bonds was 8.695%, yielding a price in the $98s.  The first trade was $104, and went up from there.  What could be better  for us?  I bought some more when my credit limit expanded at $108.  What a great misunderstood bond.

But that is the way things work when credit markets are slow.  When they are fast, deals close rapidly, and syndicates allocate bonds proportionately to where their estimate of buying power is.  There is no protection there, aside from any big investors who move very early.

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But now onto the times when markets go nuts.  Deals are closing in less than 10 minutes.  You have to get your order in rapidly, or you will get nothing.  My one minute drill helps, but is not perfect.  On a deal on Disney bonds, they had a great yield in a hot market.  I bid for $30 million in bonds, and found myself trapped with 30 million of Disney long bonds, after an allocation that went bad.  I flipped 10 million for a small gain, and another 10 million at par, leaving me with 10 million that I did not want to hold.  I waited, and took my losses later.

But more often, I would avoid the deals when they got hot, and let others buy them.  I had strong opinions on what would work and what would not.  I remember several large deals where the syndicates begged me to buy (GE Capital, and AT&TWireless) and I refused.  The speculative cycle was high, and it was fun to refuse Wall Street when it was trying to stuff accounts full of promises that were underpriced.  I did not play in those deals, and it was fun to see the deals fail, and prices fall considerably versus the original offer.

In order to keep the system honest, some deals had to fail, and not provide profits to those who would flip.  Otherwise, many managers would beg for more bonds than they could hold onto, just so they could flip them.  When the market runs hot, the odds rise that the syndicates will overprice a deal, to deliver losses to those that foolishly ask for overly large allocations.

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Once you had notice of a bond deal, you could act. You could put in for bonds if you wanted.  But when conditions were speculative you had to move rapidly, and ask for an allocation quickly, or risk getting nothing at all.  Once the books closed, that was it.  Also, if multiple dealers controlled the books, it paid to put in through all of them.  One might have influence that the others did not on very rare occasions.  You wanted all of the bookrunners fighting for you.

All of that said, on some deals you would end up with a lousy allocation, and get less than 10% of what you asked for.  At times like that, one would typically flip the bonds to the highest bidder, because it was not worth the bother to hang onto a small position.  On massively oversubscribed deals, the percentage profits on the flip were high, but they weren’t big in dollar terms.

As an aside, occasionally, shortlyafter the deal closed, if you had a sterling reputation, and could say to your brokers that you had been hindered from putting in for bonds but had wanted to, you could still squeeze in.  Reputation and size matters.

Some deals were highly subscribed by large sponsoring buyers before deals went public.  Those deals would open and close in a minute shutting everyone else out but the large buyers, and what few got some crumbs.  I remember getting crumbs on a few occasions.

One way you could get the syndicates to notice you, was that if you really liked a deal, you would buy on the break.  The break is where bonds become free to trade.  Now, truth, there is what is called the “grey market” where after bonds are allocated but before they are “free to trade,” you could deal them away, or, buy some more.  Dealing in the grey market has some taint, and you don’t want to be seen doing it, lest your allocations be reduced.  The opposite is true for those who buy through a syndicate dealer on the break.  It shows the syndicate that you are a real money buyer, as opposed to  a flipper.  Syndicates want to place bonds entirely with long term holders if they can; that is their goal, because it means they priced it right, leaving little money for mere speculators.

As for me, I employed one second tier broker who would buy lousy allocations from me on oversubscribed deals.  No reason to make the analyst write it up.  It wasn’t worth holding onto, and the yield after the break was not attractive enough to buy more.

More to come in part 4.

Part I is here.

For a new corporate bond manager with very little apprenticeship-type training, I had to learn some things on the fly.  Of my first tier brokers, roughly half of them took pity on me initially and explained to me the rules of the road.  That happened partly because I wanted to try some things that my old boss rarely did, and as I did that one of my brokers would explain to me, “If you’re going to do that, you have to do it this way…” which I would confirm with one or two of my major brokers.

If I wanted to buy a bond that was not presently being offered, I learned to find out who brought the deal and made a market in the bond issue, and told them, “If you find a few million bonds in a such and so spread context, I would be happy to pick some up.  Now, the less I knew about the price context, the more conservative I would be about price and size.  If I found a large amount offered to me at my level (rare), I would honor it by buying a small amount, and then backing up my price level to where I would not be offered so much, and try for more at better prices.

Price discovery is tough business, because some bonds trade rarely.  There are things to help you:

• Comparable bonds in the same industry
• Credit spreads across rating categories
• Credit spreads across the maturity spectrum within rating categories
• Spreads on credit default swaps on the same name.
• Value of scarcity vs cost of illiquidity, and vice versa
• Proper spread tradeoffs on premium vs discount bonds, call features, put features, off-the-run vs on-the-run issues, etc.
• Calculating the spread on the last few trades, however dated, and then massaging the spread into what it is likely to be today.

My client was growing rapidly, and 30% of its liability structure was long because they wrote a lot of structured settlements.  [Geek note: structured settlements arise when a plaintiff wins a court case, and a stream of payments must be made by a defendant for the rest of the plaintiff's life.  There are often inflation clauses, which makes the stream grow over time.  The defendant has insurance companies bid on paying the liabilities, and low bidder wins.]  I could buy a lot of long illiquid securities if my credit analysts liked the credit risk on the companies in question.

As such, I had a list of issues at various brokers that I wanted to buy if they became available.  Those ranged from moderately liquid to very illiquid.  I had a list that I sent out every now and then that I called the “Odd Duck” list; for fun, the last name on the list was the ultimate odd duck, AFLAC.  That got a few chuckles.

But with a rapidly growing client, much as I liked to source bonds that I fundamentally liked on the secondary market, I had to buy a lot of bonds in the new issue primary market.  Under normal conditions, the bond market has a lot of IPOs each day, as new bonds get issued, most often from companies that have issued before, but the characteristics of the new bond are different.

Now sometimes, when the corporate bond market is cold, or a deal is complex, it will take days for the deal to close, and sometimes a week or more.  But when things are hot, deals can close in seven minutes.  When I would see a new deal, the first thing I would do is analyze where we were in the speculation cycle for new deals.  As I said in my last piece, on average, new deals are brought a little cheap, because there is a price to gain liquidity that the issuer pays.

When deals were closing slowly, like say in half a day or more, I would send the deal terms to the analyst, and ask if she liked the credit.  If she said no, I would refuse the deal.  Otherwise I would put in for my normal allocation of bonds, subject to my limit for the company in question, and varying with the attractiveness of the deal, and how much cash I had to put to work.  When the market was rational, typically I would get good allocations, and deals would trade up a decent amount after issue.

But when the market was hot, and deals would close within an hour, I would work differently.  When the deal would come, I would put in for bonds, so that I would get some allocation.  I would ask for the high end of what I would normally ask for, knowing that I would get scaled back considerably.  Then I would send the details to my credit analyst, telling them that if they did not like the company, I would sell the bonds.

Eventually, most of my analysts during the times when the market was hot would come to me and say, “How can you put in for bonds without an opinion from us?”  First I would reassure them, and tell them that I valued their opinions, and that I would not hold onto a bond permanently unless they liked it.  I would sell all bonds they did not like, but when the technicals favored it, within a few months.

Second, I would tell them, “I do the one-minute drill,” which elicited the obvious question, “What’s the one minute drill?”  I then led them through a series of Bloomberg screens that would allow me to get a quick read on creditworthiness:

• GPO – how has the stock price moved over the last year?  Down hard is a deal killer.
• HIVG – how have option implied volatilities moves of late? Up considerably more than the market is a bad sign.
• CH6 – how is operating cash flow doing?  If it is considerably worse than earnings, that ‘s a bad sign.
• DES – what industry is it in?  Do I hate that industry?  If so, don’t play.
• DES3 – all of the major financial ratios for the company.  What do the typical bond ratios look like?  Are they materially worse than those for the industry?
• CH2 or ERN, are earnings declining?  If so beware.
• CRPR – what are the credit ratings?

Then I would tell the credit analyst that if a company passes these tests, the odds of the company doing badly while I wait for the analysis of the credit analysts was slim.  Then I would get a smile from the analyst, who would go and do their analysis without fear of something going badly wrong while they do their analysis.

But there is one last complexity here.  When deals are running hyper-hot, and are closing in minutes, it is good to take a step back and ask on each deal if the yield spread is too tight. Bond syndicates price some deals too tight, and instead of the deals rising after issuance, something horrible happens.  I will bring that up, and other matters, in part III.

When I reviewed the book Priceless, I thought I had reviewed “Fortune’s Formula,” because I had written several pieces on the Kelly Criterion at the blog and at RealMoney (free at TSCM).  But I found that I had not, so I offer you this review of a book I greatly enjoyed:

The book asks a simple question: in making a bet, investment, or business decision, what is the optimal amount of capital to allocate?

But the author, William Poundstone, is not going to give you the answer immediately.  He is going to take you on a journey where you can meet many odd personalities from the ’50s to the early ’00s, and how they came to look at the problem.

Ed Thorp was fascinated with Blackjack, and originated card-counting to improve the probability of winning, to what the card counter had and edge versus the casino.   He meets John Kelly, Jr. while working together at Bell Labs on Information Theory.  He discovered that an economic actor with an edge could size his bets as a ratio of his edge in  betting divided by the odds received on the bet.

Thorp eventually published a paper, “Fortune’s Formula: A Winning Strategy for Blackjack,” which led to a torrent of interest from gamblers.  With the aid of several backers, Thorp tried out the methods with some success in Reno, with two wealthy gamblers as backers.  That tale was hairy, to say the least, but they more than doubled their money.

Thorp later applied himself to the sleepy market for stock warrants in the 1960s. He developed delta-hedging along with a colleague.  As the book progresses, gambling ceases to be the focus, and advanced strategies for making money on Wall Street with little risk becomes the rule.  And, as in Vegas, as they took steps to lessen the edge in blackjack, on Wall Street competition itself eroded the edge.  But Thorp set up a hedge fund to take advantage of securities mispricing.

One odd sidelight is the number of parties that came up with the option pricing formula known as Black-Scholes, long before B-S wrote their paper.  Life reinsurance actuaries had a version of it in the ’60s, Bachelier had a version of it around 1900. And there were others, but the point was that no one took advantage of the knowledge, except in rough ways, prior to the B-S paper.

Yet option theory could be applied to a wide number of situations, convertible bonds and preferred stocks, even corporate bonds themselves, in addition to warrants and options.  Those that did it early made a lot of money.

A more generalized version of the Kelly Criterion says to focus on the choice that offers the highest geometric mean return.  This led to a conflict with academic economists who insisted the optimal strategy was derived from utility maximization.  What is not disputable is that the Geometric mean will maximize terminal wealth, a result found by Bernoulli and Latane.

The book takes us through financial crisis after crisis, showing how bet sizes were too large relative to the results.  It also takes us to the end where a number of the protagonists end up decidedly wealthy from their attempts to beat the market.

Quibbles

Though Poundstone’s aim is the Kelly Criterion, more of the book is dedicated to finding edges, whether beating the dealer in blackjack, or arbitrage of securities.

If you want to buy the book, you can buy it here:  Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street

Who would benefit from this book

Many people would enjoy this book, written in 2005.  Poundstone tells a good story and illustrates how a number of clever men found edges, pursued them, and triumphed.  The reader may not be able to beat the world after reading this, but it may teach him about how bright men found ways to pursue their advantages.

Full disclosure: I bought my 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.

In 2001, I became a corporate bond manager by accident.  I had been the mortgage bond manager and risk manager of a unit managing the assets of a medium-to-large life insurer, when the boss left to take another job in the midst of a merger.

The staff and I got together, and the credit analysts told me that I should lead the organization during the merger.  When I asked why, they said they trusted me, appreciated my growing bond skills, that I was the only one who understood the client, and said that I had a better call on credit than the boss had.  I was surprised by that last comment, but upon meeting with the management of our parent company that was selling us, along with the life insurance company that we managed, they told me that yes, I should lead the unit until the merger closed, but rely on the high yield manager in our group to advise me for the duration, which was going to be three months.

The first thing that I did was a bond swap, trading away an older bond of a company for a new issue.  There was some hurry in the matter, so I entered into the swap before I could consult the high yield manager.  After I could talk with him, he pointed out that I had offered terms more favorable than I should have.  On a $5M swap, I ended up losing $20K.  We worked through the swap a number of different ways, which solidified my knowledge of corporate bond pricing.  I did not make that error again.

In the corporate bond market, new deals come frequently.  My former boss would do almost all of his bond buying on new deals, and almost never in the secondary market, because he knew that new deals almost always came cheap.  There is a price to be paid by corporations to gain liquidity.  The life company that I managed money for was growing like a weed (their products were perpetually underpriced), so I had a lot of money to put to work.

But, I already had a large portfolio of corporate names.  I was familiar with many of them to some degree because of my stock investing.  How could I go through the whole portfolio to look for bombs that might be lurking? Ask the credit analysts to give me a review on every name?  I did not want to kill them, or me for that matter.

I took the idea home , and thought about it, and then it struck me.  Thinking of bonds as having sold a put option to the equity, why not look at the amount that the stocks of the companies issuing the bonds had fallen in price since issuance of the bonds?  I set a threshold of 50%, and that gave me a list of about 30 names to hand to the analysts.  Manageble.  Cool.  (Oh, and tell me briefly about these 20 private bonds where there is no stock price.)

The analysts came back with their opinions, and surprisingly they advised selling half of the bonds and keeping the other half.  That was more than I expected.  But I started selling away, and began to learn the art of price discovery.  When you want to sell a bond, you first have to look at what investment banks ran the books of the deal.  There is an unwritten rule that if they play that large role in origination, they have to make a market in the bonds thereafter.  So, I consulted the various investment banks and inquired about levels, and then said something to the effect of, “If there is a reasonable bid (naming the spread over Treasuries) we would be interest in losing a few million bonds.  If there is an aggressive bid, we could be induced into selling a few more.  We might even be willing to sell the whole wad if they make us the offer that we can’t refuse.”

If there were multiple banks that traded the bond, I would set the above up with just one bank.  You never wanted to make it look like there were two sellers out there, or bids would vanish.  Beyond that, it was bad etiquette to employ two banks without telling them that they were in competition with each other.  If not. you could end up with two orders to buy your bonds, and you would have a moral obligation to meet both orders, even if that was against your interests.

Usually the broker would ask for the total size of the wad available for sale.  The idea was to get the buyers to think economically.  Yes, they could get a small amount of bonds if they met the spread, but was it worth it to bid for more?  Also, if they bought the wad, they would know that there were likely no more bonds on offer, the selling pressure would be gone, and the bonds would likely trade up from there.

I sold away a decent amount of the bonds that the analysts wanted gone, and then 9/11 hit.  What a day.  Since we worked inside the insurance company that we manager money for, and we had two TVs on the corners of our trading floor, all of a sudden our area was flooded with people staring at the spectacle.  I almost felt like Crocodile Dundee as I had to maneuver my way around and over them.

I gathered my staff and told them to look at their portfolios, and e-mail me threat reports so that I could inform our client.  After that, take the rest of the day off, as there is nothing to do here; many of them wanted to mourn friends that might be dead (I lost two acquaintances).  I summarized the threat reports, and submitted them to the client by 4PM.  We repeated that process for the next eight business days, until the crisis was past.

I had worries over One Liberty Plaza, next to the former World Trade Center, which seemed to be leaning, and might fall.  We owned the AAA portion of the CMBS that contained the loan for that building.  As I scoured the web, I concluded there was no danger, the building only looked like it was leaning; the dark coloration was deceptive.

Eventually trading resumed.  If you remember Metcalfe’s Law, the value of a telecommunications network is proportional to the square of the number of connected users of the system.  Well, after 3 days, 2 of 12 major brokers were running, which meant that there was no trading.  After 4 days, 6 brokers were up, so I made an offer on some AA Manufactured Housing ABS, deeply below where there market was prior to the crisis.  I got hit, and I owned the bonds.  Some said to me, “Why not wait?  Why offer liquidity now?  I said that some had to make some bids to restart the market; my client had ample liquidity, and I was offering liquidity at a price; if someone was that desperate for liquidity, they could have it at my price.

After 5 days 8 of the 12 were up, and after 6, 10 of 12.  The last two took a while to re-emerge, but were back after 10 days.  Even so, things seemed sluggish.

I began to do the same with corporate bonds, doing a large auction offering liquidity, specifying bonds that I wanted at certain levels, and the amounts.  I ended up buying half of my list, and still my client had ample liquidity.  What a high quality problem to have.  More in my next segment.

These three book reviews are for books that I scanned, and did not read in depth.

Quantitative Equity Investing

The first book: Quantitative Equity Investing, is a book for practitioners with strong math skills, not average investors.  It reviews basic econometrics and factor analysis, and then applies these tools in an effort to sort out anomalies in investment markets, tease out important factors driving markets, and find workable trading strategies, considering execution costs, slippage, etc.  It has a brief section on algorithmic and high frequency trading.

On the whole, I didn’t find anything that new or amazing in the book.  Though there were a few things in the book that I hadn’t seen before, they were trivial things that I looked at and said, “Oh, yeah, of course.”

The book is generic in the way that it deals with the topic.  It is no going to give you ideas to pursue, but only tools that you can use if you have ideas tht you want to analyze, and turn into strategies.

Who would benefit from this book?

You have to have a very strong math background, including the type of Matrix Algebra that one would use in graduate-level Econometrics.  To that end, this book would be most useful to grad students wanting an introduction to how to apply their math skills to the markets.

The book is available here: Quantitative Equity Investing: Techniques and Strategies (The Frank J. Fabozzi Series)

The New Science of Asset Allocation

This book uses Modern Portfolio Theory in order to analyze asset allocation decisions.  Those that have read me for a while know that I think that is a flawed paradigm, in need of replacement.  For those that want a reasonable understanding of that paradigm in a short space, the book does that very well.

That said, the book has its virtues.  The chapter on the “Myths of Asset Allocation” shows that the authors have some depth of insight into the foibles and misunderstandings that surround asset allocation.  The book also goes into the importance of qualitative analysis of managers, looking up from the numbers so that you can avoid allocating money to the next Madoff.  It also describes the use of derivatives in order to control risk exposures.

Each chapter ends with a short summary of the takeaways from the chapter, which serves to reinforce the points of the book.

Though the book has the word “new” in the title, I did not find much new in it.  If one is looking for novel implementation methods for asset allocation, best to look elsewhere.

Who would benefit from this book?

This is not a book for average investors.  It is for professionals who want to brush up their asset allocation skills, and young professionals wanting insight into asset allocation.

The book is available here: The New Science of Asset Allocation: Risk Management in a Multi-Asset World (Wiley Finance)

The Economics of Food: How Feeding and Fueling the Planet Affects Food Prices

To me, this was the most interesting book of the three, but I feel it was mistitled.  A better title would have been: “Fueled: The Effects of  Using Food for Fuel” or something like that, because the central question of the book is to what degree has using crops to produce biomass for fuel production (usually ethanol) affected the costs of food and fuel.

I found the book is very even-handed, to a fault.  It argues that the use of crops for fuel production had little impact on food costs, and that there were many other factors that made food prices rise when ethanol production was going gangbusters.  Weather, domestic and foreign demand and many other factors had a role in moving food prices, not just ethanol.

After reviewing the book, I have a better sense of the complexity of the question, and that it will not admit easy answers.

Who would benefit from this book?

Anyone who wants a basic understanding of food economics, and how that is impacted by a wide number of factors including using crops for the production of fuel would benefit from this book.  The book is well written, and seemingly balanced.

The book is available here: The Economics of Food: How Feeding and Fueling the Planet Affects Food Prices

Full disclosure: The publishers sent me copies of these books, hoping that I would review them.  I review about 80% of the books that get sent to me.

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.