Photo Credit: Mike Beauregard || Frozen solid, right?

Photo Credit: Mike Beauregard || Frozen solid, right?

The talk regarding an illiquid public corporate bond market goes on, and if you’ve read me over the past year on this topic, you know that I don’t think it is a serious issue.  One of the reasons why it is not a big issue is that the public bond market is designed to be low liquidity.

It starts with how bonds are originally issued.  New bonds and new stocks are issued in similar ways, but with a few differences:

  • IPOs of stocks have a higher retail component.  Bonds, aside from muni bonds, are typically almost entirely institutional
  • IPOs are typically priced cheap, but with bonds the cheapness is smaller and more frequent.
  • Bond IPOs usually happen with companies that have issued other bonds before
  • Bond IPOs happen more frequently, except in a bear market
  • Bond IPOs typically happen more rapidly, minutes to a few days, except in a bear market

IPOs on Wall Street get allocated if they are oversubscribed.  When they are oversubscribed, the deal is typically good, and everyone wants more, so they put in huge orders.  The dealer desks on Wall Street solves this problem by allocating proportionate to the size that they have come to understand the managers in question typically buy and sell at, with some adjustment for account profitability.

Those that flip cheap bonds for a quick profit typically get penalized, and their allocations get reduced.  Those that buy bonds in the open market when the deal breaks and becomes “free to trade” can become eligible for larger allocations.  The dealer desks work in this way because they want the buyers to be long-term holders, and not seekers of easy profits from flipping.  That doesn’t mean you can never trade a bond you have bought — just not in the first month, subject to a few exceptions like a small allocation, your credit analyst rejected it, etc.  (Oh, and if one of those exceptions exists, the primary dealers want to do the secondary trade.  If the exceptions don’t exist, they don’t want to know about it.)

If flippers ever get big, despite the efforts of the dealer desks, they will price a deal very tight, and let the flippers take a big loss, with no one wanting to buy the excess bonds unless they are much, much cheaper.

The main effect of this is that once a deal is allocated, it is typically “well-placed,” with few secondary trades after the IPO.  This is even more pronounced with mortgage bonds, which aside from the AAA tranches, have very small tranche sizes, making them very illiquid.

In this environment, where yields have fallen over the past few years, it is difficult for financial companies that have bought bonds to replace the income if they sell the bond.  Thus, few bonds will be sold unless they are in the hands of buyers that don’t have a formal balance sheet, or, when credit quality is deteriorating badly.

Add in one more factor, and you can see why the market is so illiquid — the buy side of the market is more concentrated than in prior years, with big buyers like PIMCO, Blackrock, Metlife, Prudential, etc. being a larger portion of the market.  Concentrated markets with few holders tend to be less liquid.

All Good/Bad Things Must Come to an End

Some of these factors can be reversed, and others can be mitigated.

  • There’s no reason why the buy side has to stay concentrated.  Big institutions eventually break up because diseconomies of scale kick in.  Management teams typically do worse as companies get more complex.
  • Eventually interest rates will rise.  Once bonds are in a nearly neutral to negative capital gains positions, parties with balance sheets will trade bonds again.
  • Even mutual funds that own a lot of yieldy bonds can have a strategy for dealing with the illiquidity.  Yieldy bonds have excess yield relative to bonds of similar duration and credit quality, and are often less liquid because there is something odd about them that makes some portion of the market skeptical, which reduces liquidity.  A mutual fund holding a lot of less liquid bonds, can deal with illiquidity by selling opportunistically, selling more liquid bonds in the short-run, while discreetly inquiring on a few less liquid issues to see where real bids might be.  Remember, the amount of underperformance is likely to be limited, if any, so a run on a mutual fund is not likely, but in the unlikely case of a run, this can mitigate the effects.  Personally, I would not be concerned, so long as you keep your pricing marks conservative if cash outflows become a rule in the short-run.

In closing, don’t worry about illiquidity in the bond markets.  If there is a need for liquidity, the problem will solve itself as sellers lose a little bit in order to gain cash to make payments.  It’s that simple.

Simulated Constant Maturity Treasury Yields 8-1-14_24541_image001


Source: FRED

Above is the chart, and here is the data for tonight’s piece:


Source: FRED   |||     * = Simulated data value  |||  Note: T1 means the yield on a one-year Treasury Note, T30, 30-year Treasury Bond, etc.

Above you see the seven yield curves most like the current yield curve, since 1953.  The table also shows yields for Aaa and Baa bonds (25-30 years in length), and the spread between them.

Tonight’s exercise is to describe the historical environments for these time periods, throw in some color from other markets, describe what happened afterward, and see if there might be any lessons for us today.  Let’s go!

March 1971

Fed funds hits a local low point as the FOMC loosens policy under Burns to boost the economy, to fight rising unemployment, so that Richard Nixon could be reassured re-election.  The S&P 500 was near an all-time high.  Corporate yield spreads  were high; maybe the corporate bond market was skeptical.

1971 was a tough year, with the Vietnam War being unpopular. Inflation was rising, Nixon severed the final link that the US Dollar had to Gold, an Imposed wage and price controls.  There were two moon landings in 1971 — the US Government was in some ways trying to do too much with too little.

Monetary policy remained loose for most of 1972, tightening late in the years, with the result coming in 1973-4: a severe recession accompanied by high inflation, and a severe bear market.  I remember the economic news of that era, even though I was a teenager watching Louis Rukeyser on Friday nights with my Mom.

April 1977

Once again, Fed funds is very near its local low point for that cycle, and inflation is rising.  After the 1975-6 recovery, the stock market is muddling along.  The post-election period is the only period of time in the Carter presidency where the economy feels decent.  The corporate bond market is getting close to finishing its spread narrowing after the 1973-4 recession.

The “energy crisis” and the Cold War were in full swing in April 1977.  Economically, there was no malaise at the time, but in 3 short years, the Fed funds rate would rise from 4.73% to 17.61% in April 1980, as Paul Volcker slammed on the brakes in an effort to contain rising inflation.  A lotta things weren’t secured and flew through the metaphorical windshield, including the bond market, real GDP, unemployment, and Carter’s re-election chances.  Oddly, the stock market did not fall but muddled, with a lot of short-term volatility.

December 1991

This yield curve is the second most like today’s yield curve.  It comes very near the end of the loosening that the FOMC was doing in order to rescue the banks from all of the bad commercial real estate lending they had done in the late 1980s.  A wide yield curve would give surviving banks the ability to make profits and heal themselves (sound familiar?).  Supposedly at the beginning of that process in late 1990, Alan Greenspan said something to the effect of “We’re going to give the banks a lay-up!”  Thus Fed funds went from 7.3% to 4.4% in the 12 months prior to December 1991, before settling out at 3% 12 months later.  Inflation and unemployment were relatively flat.

1991 was a triumphant year in the US, with the Soviet Union falling, Gulf War I ending in a victory (though with an uncertain future), 30-year bond yields hitting new lows, and the stock market hitting new all time highs.  Corporate bonds were doing well also, with tightening spreads.

What would the future bring?  The next section will tell you.

August 1993

This yield curve is the most like today’s yield curve.  Fed funds are in the 13th month out of 19 where they have been held there amid a strengthening economy.  The housing market is doing well, and mortgage refinancing has been high for the last three years, creating a situation where those investing in mortgages securities have a limited set of coupon rates that they can buy if they want to put money to work in size.

An aside before I go on — 1989 through 1993 was the era of clever mortgage bond managers, as CMOs sliced and diced bundles of mortgage payments so that managers could make exotic bets on moves in interest and prepayment rates.  Prior to 1994, it seemed the more risk you took, the better returns were.  The models that most used were crude, but they thought they had sophisticated models.  The 1990s were an era where prepayment occurred at lower and lower thresholds of interest rate savings.

As short rates stayed low, long bonds rallied for two reasons: mortgage bond managers would hedge their portfolios by buying Treasuries as prepayments occurred.  They did that to try to maintain a constant degree of interest rate sensitivity to overall moves in interest rates.  Second, when you hold down short rates long enough, and you give the impression that they will stay there (extended period language was used — though no FOMC Statements were made prior to 1994), bond managers start to speculate by buying longer securities in an effort to clip extra income.  (This is the era that this story (number 2 in this article) took place in, which is part of how the era affected me.)

At the time, nothing felt too unusual.  The economy was growing, inflation was tame, unemployment was flat.  But six months later came the comeuppance in the bond market, which had some knock-on effects to the economy, but primarily was just a bond market issue.   The FOMC hiked the Fed funds rate in February 1994 by one quarter percent, together with a novel statement issued by Chairman Greenspan.  The bond market was caught by surprise, and as rates rose, prepayments fell.  To maintain a neutral market posture, mortgage bond managers sold long Treasury and mortgage bonds, forcing long rates still higher.  In the midst of this the FOMC began raising the fed funds rate higher and higher as they feared economic growth would lead to inflation, with rising long rates a possible sign of higher expected inflation.  The FOMC raises Fed fund by 1/2%.

In April, thinking they see continued rises in inflation expectation, they do an inter-meeting surprise 1/4% raise of Fed funds, followed by another 1/2% in May.  It is at this pint that Vice Chairman McDonough tentatively realizes [page 27] that the mortgage market has now tightly coupled the response of the long end of the bond market to the short end the bond market, and thus, Fed policy.  This was never mentioned again in the FOMC Transcripts, though it was the dominant factor moving the bond markets.  The Fed was so focused on the real economy, that they did not realize their actions were mostly affecting the financial economy.

FOMC policy continued: Nothing in July, 1/2% rise in August, nothing in September, 3/4% rise in November, nothing in December, and 1/2% rise in February 1995, ending the tightening. In late December 1994 and January of 1995, the US Treasury and the Fed participated in a rescue of the Mexican peso, which was mostly caused by bad Mexican economic policy, but higher rates in the US diminished demand for the cetes, short-term US Dollar-denominated Mexican government notes.

The stock market muddled during this period, and the real economy kept growing, inflation in check, and unemployment unaffected.  Corporate spreads tightened; I remember that it was difficult to get good yields for my Guaranteed Investment Contract [GIC] business back then.

But the bond markets left their own impacts: many seemingly clever mortgage bond managers blew up, as did the finances of Orange County, whose Treasurer was a mortgage bond speculator.  Certain interest rate derivatives blew up, such as the ones at Procter & Gamble.  Several life insurers lost a bundle in the floating rate GIC market; the company I served was not one of them.  We even made extra money that year.

The main point of August 1993 is this: holding short rates low for an extended period builds up imbalances in some part of the financial sector — in this case, it was residential mortgages.  There are costs to providing too much liquidity, but the FOMC is not an institution with foresight, and I don’t think they learn, either.

This has already gotten too long, so I will close up here, and do part II tomorrow.  Thanks for reading.

I’m bringing this series to a close with some odds and ends — a few links, a few stories, etc.  Here goes:

1) One day, out of the blue, the Chief Investment Officer walked into my office, which was odd, because he rarely left the executive suite, and asked something like: “We own stocks in the General Account, but not as much as we used to.  How much implicit equity exposure do we get from our variable annuities?”  The idea was this: as the equity markets go up, so does our fee stream.  If the equity market goes up or down 1%, how much does the present value of fees change?  I told him I would get back to him, but the answer was an easy one, taking only a few hours to calculate & check — the answer was a nickel, and the next day I walked up to the executive suite and told him: “If we have 20% of our liabilities in variable annuities it is the equivalent to having 1% of assets invested in the stock market.

2) This post, Why are we the Lucky Ones? could have been a post in this series.  At a small broker-dealer, all sorts of charlatans bring their ideas for financing.  The correct answer is usually no, but that conflicts with hope.  Sadly, Finacorp did not consult me on the last deal, which is part of the reason why they don’t exist now.

3) The first half of the post, The Education of a Mortgage Bond Manager, Part IX, would also fit into this series — the amount of math that went into the analysis was considerable, but the regulatory change that drove it led us to stop investing in most RMBS.

4) While working for a hedge fund, I had the opportunity to sit in on asset-liability management meetings for a bank affiliated with our firm.  I was floored by the low level of rigor in the analyses — it made me think that every bank should have at least one actuary to do analyses with the level of rigor in the insurance industry.

Now, this doesn’t apply to the big banks and investment banks because of their complexity, but even they could do well to borrow ideas from the insurance industry, and do stress testing.  Go variable by variable, on a long term basis, and ask:

  • At what level does this bring line profits to zero?
  • At what level does this bring company profits to zero?
  • At what level does this imperil the solvency of the company?

5) This story is a little weird.  One day my boss called me in and said, “There’s a meeting of corporate actuaries at the ACLI in DC.  You are our representative.  They will be discussing setting up an industry fund to cover losses from failures of Guaranteed Investment Contracts.  Your job is to make sure the fund is not created.”

His concern in 1996 was that it would become a black hole, and would encourage overly aggressive writing of GICs.  He didn’t want to get stuck with losses.  I told him the persuasion was not my forte, but I would do my best.  I said that my position was weak, because we were the smallest company at the table, but he said to me, “You have a voice at the table.  Use it.”

A few days later, I was on the Metroliner down to DC.  I tried to understand both sides of the argument.   I even prayed about it.  Finally it struck me: what might be the unintended consequences from the regulators from setting up a private guaranty fund?  What might be the moral hazard implications?

At the meeting, I found one friend in the room from AIG.  We had worked together, and AIG didn’t like the idea either.  In the the early parts of the meeting it seemed like there were 10 for the industry fund, and 3 against, AIG, Principal, and us.  Not promising.  We talked through various aspects of the proposal, the three representatives taking the opposite side — it seemed like no one was changing their minds, but some opinions were weaker on the other side.

By 3PM the moderator asked for any final comments before the vote.  I raised my hand and said something like, “You have to think of the law of unintended consequences here.  What will be the impact on competition here?  What if one us, a large company decides to be more aggressive as a result of this?  What if regulators look at this as a template, and use it to ask for similar funds more broadly in life insurance?   The state guaranty funds would certainly like the industry to put even more skin into the game.”

The room went silent for a few seconds, and the vote was taken.

4-9 against creating the guaranty fund.

The moderator looked shocked.

The meeting adjourned and I went home.  The next day I told my boss we had won against hard odds.  He was in a grumpy mood so he said, “Yeah, great,” barely acknowledging me.  This is the thanks I get for trying something very hard?

6) In early 2000, I had an e-mail dialogue with Ken Fisher.  I wanted to discuss value investing with him, but he challenged me to develop my own proprietary sources of value.  Throw away the CFA syllabus, and all of the classics — look for what is not known.

So I sat down with my past trading and looked for what I did best.  What I found was that I did best buying strong companies in damaged industries.  That was the key idea that led to my eight portfolio rules. Value investing with industry rotation may be a little unusual, but it fit my new view of the world. I couldn’t always analyze changes in pricing power directly, but I could look at industries where prices had crashed, and pick through the rubble.

In Closing

My career has been odd and varied, which has led to some of the differential insights that I write about here.  In some ways, we are still beginning to understand investment risks — for example, how many saw the financial crisis coming — where a self-reinforcing boom would give way to a self-reinforcing bust?  Not many, and even I did not anticipate the intensity of the bust.  At least I didn’t own any banks, and only owned sound insurers.

Investment risk is elusive because it depends partly on the collective reactions of investors, and not on external shocks like wars, hurricanes, bad policy, etc.  We can create our own crises by moving together in packs, going from bust to boom and back again.

It is my hope after all these words that some will approach investing realizing that avoiding risks is as important as seeking returns, and sometimes, more important.  It is not what you earn, but what you keep that matters.

“So you’re the new investment risk manager?”

“Yes, I am,” I said.

CA: “Well, I am the Chief Actuary for [the client firm].  I need you to do a project for me.  We have five competitors that are eating our lunch.  I want you to figure out what they are doing, and why we can’t do that.”

Me: “I’ll need to get approval from my boss, but I don’t see why not.  A project like this is right up my alley.”

CA: “What do you mean, right up your alley?”

Me: “I’m a generalist.  I understand liabilities, but I also understand financing structures, and I can look at assets and after a few minutes know what the main risks are and how large they are.  I may not be the best at any of those skills, but when they are combined, it works well.”

CA: “When can you have it to me?”

Me: (pause) “Mmm… shouldn’t take me longer than a month.”

CA: “Great.  I look forward to your report.”

The time was late 1998, just prior to the collapse of LTCM.  Though not well understood at the time, this was the “death throes” of the “bad old days” in the life insurance industry for taking too much asset risk.  Yes, there had been bad times every time the junk bond market crashed, and troubles with commercial mortgages 1989-1992, but the industry had not learned its lessons yet.

The 5 companies he picked were incredibly aggressive companies.  One of them I knew from going to industry meetings came up with novel ways of earning extra money by taking more risk.  I thought the risks were significant, but they hadn’t lost yet.

So what did I do?  I went to EDGAR, and to the websites of the companies in question.  I downloaded the schedule Ds of the subsidiaries in question, as well as the other investing schedules.  I read through the annual statements and annual reports.  I had both my equity investor and bond investor “hats” on.  I went through the entirety of their asset portfolios at a cursory level, and got a firm understanding of how their business models worked.

Here were the main findings:

  • These companies were using double, and even triple-leveraging to achieve their returns.  Double-leveraging is a normal thing — a holding company owns an operating insurance subsidiary, and the holding company has a large slug of debt.  Triple leveraging occurs when a holding company owns an operating insurance subsidiary, which in turn owns a large operating insurance subsidiary.  This enables the companies to turn a small return on assets into a large return on equity, so long as things go well.
  • The companies in question were taking every manner of asset risks.  With some of them I said, “What risks aren’t you taking?”  Limited partnerships, odd subordinated asset-backed securities, high yield corporates, residential mortgage bonds with a high risk of prepayment, etc.

So, when I met with the Chief Actuary, I told hid him that the five were taking unconscionable risks, and that some of them would fail soon.  I explained the risks, and why we were not taking those risks.  He objected and said we weren’t willing to take risks.  As LTCM failed, and our portfolios did not get damaged, those accusations rang hollow.

But what happened to the five companies?

  • Two of them failed within a year — ARM Financial and General American failed because they had insufficient liquid assets to meet a run on their liquidity, amid tough asset markets.
  • Two of them merged into other companies under stress — Jefferson Pilot was one, and I can’t remember the other one.
  • Lincoln National still exists, and to me, is still an aggressive company.

Four of five gone — I think that justified my opinions well enough, but the Chief Actuary brought another project a year later asking us to show what we had done for them over the years.  This project took two months, but in the end it showed that we had earned 0.70%/yr over Single-A Treasuries over the prior six years, which is  a great return.  The unstated problem was they were selling annuities too cheaply.

That shut him up for a while, but after a merger, the drumbeat continued — you aren’t earning enough for us, and, in 2001-2, how dare you have capital losses.   Our capital losses were much smaller than most other firms, but our main client was abnormal.

To make it simple, we managed money for an incompetent insurance management team who could only sell product by paying more than most companies did.  No wonder they grew so fast.  If they had not been so focused on growth, we could have been more focused on avoiding losses.

What are the lessons here?

  • Rapid growth with financials is usually a bad sign.
  • Analyze liability structures for aggressiveness.  Look at total leverage to the holding company.  How much assets do they control off of what sliver of equity?
  • If companies predominantly buy risky assets, avoid them.
  • Avoid slick-talking management teams that don’t know what they are doing.  (This sounds obvious, but 3 out of 4 companies that I worked for fit this description.  It is not obvious to those that fund them.)

And sadly, that applied to the company that I managed the assets for — they destroyed economic value, and has twice been sold to other managers, none of whom are conservative.  Billions have been lost in the process.

It’s sad, but tons of money get lost through some financials because the accounting is opaque, and losses get realized in lumps, as “surprises” come upon them.

Be wary when investing in financial companies, and avoid novel asset risks, credit risk, and excess leverage.

There’s kind of a rule of thumb in Asset-Liability management, that you match liquidity over the next 12 months, and match interest rate sensitivity overall.  I would do more than that, creating my own randomized interest rate models, as well as a new way of creating structured randomness in simulation models.  For a brief period of time, I had one of the best multivariate randomness programs out there, eliminating the problem of correlations in higher dimensions common with Hammersly points.  (My work was not theoretical, but intuitive… once I saw how the randomness was created, I figured out how to de-correlate the higher dimensions (since it was based on prime numbers, create more number than you need, and use a higher prime number to select observations.)

Anyway, when I brought my full-interest rate curve scenarios to the investment department in 1994, they said to me, “These are the first realistic interest rate scenarios we have ever seen.  Did you constrain them?”  I told them “No, just weak mean reversion.  Noise dominates in the short run, mean reversion dominates in the long run.”

As a result, for the lines of business over which I had oversight, we measured our interest rate mismatch in terms of days, weeks, and months, but never years.  Please ignore this incident where things drifted, but worked out exceptionally well (really, that should be a part of this series).  We published a document to show everyone how well we managed interest rate risk in Provident Mutual’s pension division.  We used scenarios far beyond what was required to show how well we did our work.  The regulators never complained.

At that point in time, the ability to integrate residential mortgage-backed securities into cash flow analyses was rudimentary at best.  But I found ways to make it work, most of the time.  That said, I remember joking with the MBS manager in late 1993, and saying there was a new term for a well-protected PAC bond.  He asked, “What is it?”  I replied, “Cash.”  He sarcastically said, “Oh, you are so funny.”   That said, I pointed out to the investment department that some of their bonds that they thought would last another four years would disappear in 2-3 months.

Then there was the floating rate guaranteed investment contract project that I eventually killed because it was impossible.  You can’t argue with expectations that are unrealistic.  Even better, I beat the Goldman Sachs representative.

In running the GIC desk at Provident Mutual, I had to review a lot of strategies because making money on short-term bonds/loans was difficult, and difficult the degree that I doubted as to whether we were in a good business.  On the bright side, I protected the firm until the day that we  could not write any more  GICs, because our credit quality was too low.  That was the fault of the less entrepreneurial part of the company, so I couldn’t so much about it, except close my operations down.  I asked the senior management team to provide a guarantee to my GICs, but they refused.

As such, I shut the line of business down.  With clients that were unreasonable over credit quality, and management unwilling to extend credit protection to GICs, the battle over GICs was ended, and I sent the line into runoff.

Five years later, as we were now part of the same firm I stood at the estate of John Dwight, with a young woman that I had sold the last GIC of Provident Mutual to, I said, “The end of the GIC business of Provident Mutual.”  We talked, she smiled, but it was part of the end of an era, because GICs were a minority of the assets in Stable Value funds.

If nothing else, this helps to highlight the impermanence of all that is done in financial firms.  I know this in my own life, but I am sure that it is true for most people in finance.

There has been a lot of talk lately about systemic risk, a concept that is not well-understood.  Let me simplify it for you.  Anytime debt grows in an area of the economy at a rapid pace, there is an unstable situation to be avoided.  If you are a portfolio manager at such a time, you must take the tough decision and underweight the area of the bond market that is growing the fastest.  That is not easy to do, particularly because that is where most of the new issues are coming from.

I wrote a piece called Fruits and Vegetables Versus Assets in Demand, where I said:

There is a way in which fruits and vegetables and financial products are opposites: when quantities are high for fruits and vegetables, quality is high, and prices are low. With financial products, when issuance is high, quality is low, and pricing is expensive, leading to poor future returns from lower yields, and higher future defaults. I offer this for what it is worth, but is there something more to it, than the seeming oppositeness?  Why are they opposites?

I had a follow-up piece here that answered the questions.  It takes time and effort to farm, but financial products can be whipped up easily in any season.

In the present environment, this would mean avoiding government debt.  If you believe in inflation coming you can buy the short end, and if deflation, the long end, but aside from that, the ability of the US Government to repay is not growing as rapidly as their debts are.

When I came on the scene in 2001 as a corporate bond manager, there were several areas of the bond market that had a lot of issuance: autos and telecommunications.  I began selling the weaker bonds in those areas; I sold all of my auto bonds (including GMAC and FMCC) except for $10 million of an illiquid issue of a Dutch Ford subsidiary, and limited my holdings in Telecom bonds to the Baby Bells.

That took effort.  Debt-based industry expansions rarely work out well.  If the idea was that promising, it could be funded with higher cost equity, rather than debt.

Now, what would this rule have meant 2004-2007?  Avoid financials, especially banks, S&Ls and mortgage companies.  Though financials are always a large part of issuance, they were even larger then.

I can hear some manager saying, “But I can’t vary that much against the index!  That’s an impossible strategy for big fixed income managers to follow.”  I understand, there are tradeoffs in investing.  If I am underweight, someone else must be overweight versus the index.  Someone has to absorb all of the paper of the hot sector; don’t let that be you.


Credit analysts understand the creditworthiness of bonds.  What are portfolio managers good for?  Portfolio managers should grasp three things at least:

  1. Portfolio composition versus the needs of the client.
  2. The trading dynamics of the marketplace, and whether a bond might be temporarily mispriced.
  3. The dirty details of a bond.  What are the covenants, terms, etc.

I will handle #1 at a later point in time.  As for #2, a good portfolio manager attempts to explain to his credit analyst why he is ignoring his opinion for a time, because the market for a given bond seems promising in the short run.  There is momentum in bond pricing, and it is better to sell a little late rather than early.

As for point #3, it is the responsibility of the portfolio manager to understand all the special features of a given bond, and why there are pricing differences across the bonds of a given main obligor (borrower), taking advantage of those differences when they get out of whack.

Having been a mortgage bond manger, where document review was a bigger part of what we did, in the minority of corporate bonds that need that review, there is a lot of value to be added.  Often I would review a complex prospectus to find out a big negative: amid all of the legalese, the bonds were as secure, or more so than the senior unsecured of the main obligor.

In a time of panic, those insights are golden, because other managers toss out illiquid bonds that they don’t fully understand.

Even understanding what a put bond is worth is valuable; after deducting yield because of the illiquidity of the smaller put bond issue.  The same is true of trust preferreds, preferred stock, premium bonds versus discount bonds, call features, etc.

The portfolio manager has to balance all of those factors off, along with client factors, in order to manage the assets properly.

I’ll talk more about client factors in a later post; those are always fun, or at least controversial.

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.

Photo Credit: Boston Public Library

Well, I never thought I would get this question, but here it is:

Thank you for your dedication to your blog.

I was wondering if you have any skill development advice for recent graduates to gain a job in insurance – is technical or programming skills the most important or perhaps making business cases, or showing that you can make sound and reasonable conclusions?

Thank you for your time.

Kind regards,

There are many things to do in insurance.  Some are technical, like being an actuary, accountant, investment analyst/manager/trader, underwriter, lawyer or computer programmer.  Some take a great deal of interpersonal skills, like being an administrator, marketer or agent.  Then there are the drones in customer service and claims.  Ancillary jobs can include secretaries, janitors, human resources, and a variety of other helpers to the main positions.

Before I begin, I want to say a few things.  FIrst, if you work in insurance, be kind to the drones and helpers.  It is the right thing to do, but beyond that, they don’t have to go beyond their job description — they know their opportunities are limited — it is only a job.  Treat them with respect and kindness, and they will go above and beyond for you.  I learned this positively first-hand, and a few of them 20-30 years older explained it to me when I noticed they weren’t helping others who were full of themselves.

Second, the insurance industry does a lot to train drones, helpers, agents, marketers, underwriters, and younger people generally, if they are willing to work at it.  There are self-study courses and exams that vary based on what part of the industry you are in.  Take the courses and exams, and your value goes up — it is not obvious how that will work, but it often pays off.

Third, it is not a growing industry, but lots of Baby Boomers are retiring, and leave openings for others.  Also, drone and helper positions often don’t pay so well at the entry level, and turnover is somewhat high.  The same is true of agents — more on that later.

Fourth, watch “The Billion Dollar Bubble,” and episodes of Banacek if you want.  The actual practices of how they did things in the ’60s and ’70s don’t matter so much, but it gets the characterization of the various occupations in insurance right.

FIfth, insurance is a little like the “Six Blind Men and the Elephant.”  Actuaries, Accountants, Administrators, Marketers, Underwriters, and Investment Managers (and Lawyers and Programmers) each have a few bits of the puzzle — the challenge is to work together effectively.  It is easier said than done.  You can read my articles on my work life to get a good idea of how that was.  I’ve written over 30 articles on the topic.  Here are most of the links:

DId I leave out the one on insurance company lawyers?  Guess not.

Sixth, it is easier to teach those with technical skills how the business works than to teach drones and helpers technical skills.  It’s kind of like how you can’t easily teach math and science to humanities and social science majors, but you can do the reverse (with higher probability).  It is worth explaining the business to computer programmers.  It is worth explaining marketing and sales to actuaries.  Accountants get better when they understand what is going on behind the line items, and maybe a touch of what the actuaries are doing (and vice-versa).

Seventh, only a few of the areas are close to global — the administrators, the underwriters, the actuaries, and the marketers — and that’s where the fights can occur, or, the most profitable collaborations can occur.

Eighth, insurance companies vary in terms of how aggressive they are, and the dynamism of positions and ethical conundrums vary in direct proportion.

So, back to your question, and I will go by job category:

  1. Drones and helpers typically don’t need a college education, but if they show initiative, they can grow into a limited number of greater positions.
  2. Computer programmers probably need a college degree, but if you are clever, and work at another insurance job first, you might be able to wedge your way in.  While I was an actuary, I turned down a programming job, despite no formal training in programming.
  3. Lawyers go through the standard academic legal training, pass the bar exams, nothing that unusual about that, but finding one that truly understands insurance law well is tough.
  4. Accountants are similar.  Academic training, pass the accounting exams, work for a major accounting firm and become a CPA — but then you have to learn the idiosyncrasies of insurance accounting, which blends uncertainty and discounting with interest.  The actuaries take care of a lot of it, but capturing and categorizing the right data is a challenge.
  5. Actuaries have to be good with math to a high degree, a college degree is almost required, and have to understand in a broad way all of the other disciplines.  The credentialing is tough, and may take 5-10 years, with many exams, but you often get study time at work.
  6. Agents — can you sell?  Can you do a high quality sale that actually meets the needs of the client?  That may not require college, but it does require significant intelligence in understanding people, and understanding your product.  Many agents can fob some bad policies off on some simpletons, but it comes back to bite, because the business does not last, and the marketing department either revokes your commissions, or puts you on a trouble list.  “Market conduct” is a big thing in insuring individuals.  The agents that win are the ones that serve needs, are honest, and make many sales.  Many people are looking for someone they can trust with reasonable returns, rather than the highest possible return.  One more note: there are many exams and certifications available.
  7. Marketers — This is the province of agents that were mediocre, and wanted more reliable hours and income.  It’s like the old saw, “Those who cannot do, teach. Those who cannot teach, administrate.”  It is possible to get into the marketing area by starting at a low level helper, but it is difficult to manage agents if you don’t have their experience of rejection.  Again, there are certifications available, but nothing will train you like trying to sell insurance policies.
  8. Underwriters — as with most of these credentials, a college degree helps, but there is a path for those without such a degree if you start at a low level as a helper, show initiative, and learn, learn, learn. Underwriters make a greater difference in coverages that are less common.  Where the law of large numbers applies, underwriters recede.  The key to being an underwriter is developing specialized expertise that allows for better risk selection.  There are certifications and exams for this, pursue them particularly if you don’t have a college degree.  Pursue them anyway — as an actuary, I received some training in underwriting.  It is intensely interesting, especially if you have a mind for analyzing the why and how of insured events.
  9. Investment personnel — this is a separate issue and is covered in my articles in how one can get a job in finance.  That said, insurance can be an easier road into investing, if you get a helper position, and display competence.  (After all, how did I get here?)  You have to be ready to deal with fixed income, which  means your math skills have to be good.  As a bonus, you might have to deal with directly originated assets like mortgages, credit tenant leases, private placements, odd asset-backed securities, and more.  It is far more dynamic than most imagine, if you are working for an adventurous firm.  (I have only worked for adventurous firms, or at least adventurous divisions of firms.)  Getting the CFA credential is quite useful.
  10. Administrators — the best administrators have a bit of all the skills.  They have to if they are managing the company aright.  Most of them are marketers, and  a few are actuaries, accountants,or lawyers.  Marketing has an advantage, because it is the main constraint that insurance companies face.  It is a competitive market, and those who make good sales prosper.  VIrtually all administrators are college educated, and most have done additional credentialing.  Good administrators can do project, people and data management.  it is not easy, and personally, few of the administrators I have known were truly competent.  If you have the skills, who knows?  You could be a real success.

Please understand that I have my biases, and talk to others in the field before you pursue this in depth.  Informational interviewing is wise in any job search, and helps you understand what you are really getting into, including corporate culture, which can make or break your career.  Some people thrive in ugly environments, and some die.  Some people get bored to death in squeaky-clean environments, and some thrive.

So be wise, do your research, and if you think insurance would be an interesting career, pursue it assiduously.  Then, remember me when you are at the top, and you need my clever advice. 😉


I was approached by a younger friend for advice.  This is my response to his questions below:

Thank you for agreeing to do this for me. I would love to have an actual conversation with you but unfortunately, I think that between all of the classes, exams, and group project meetings I have this week it would prove to be too much of a hassle for both of us to try to set up a time.

1. What professional and soft skills do you need to be successful in this career and why?
2. What advice would you give to someone considering working in this field?
3. What are some values/ethics that have been important to you throughout your career?
4. I understand that you currently run a solo operation, but are there any leadership skills you have needed previously in your career? Any examples?
5. What made you decide to make the switch to running your own business?

Thanks again,


What professional and soft skills do you need to be successful in this career and why?

I’ve written at least two articles on this:

How Do I Find a Job in Finance?

How Do I Find a Job in Finance? (Part 2)

Let me answer the question more directly.  You need to understand the basics of how businesses operate.  How do they make money?  How do they control risk?

Now, the academics will show you their models, and you should know those models.  What is more important is understanding the weaknesses of those models because they may weakly explain how stocks in aggregate are priced, but they are little good at understanding how corporations operate.  The real world is not as ideal as the academic economists posit.

It is useful to read broadly.  It is useful to dig into a variety of financial reports from smaller firms.  Why smaller firms?  They are simpler to understand, and there is more variation in how they do.   Learn to read through the main financial statements well.  Understand how the income statement, balance sheet, and cash flow statement interact.  Look at the footnotes and try to understand what they mean.  Pick an industry and compare all of the companies.  I did that with trucking in 1994 and learned a boatload.  This aids in picking up practical accounting knowledge, which is more powerful when you can compare across industries.

As for soft skills, the ability to deal with people on a firm and fair basis is huge.  Keeping your word is big as well.  When I was a bond trader, I ate losses when I made promises on trades that went wrong.  In the present era, I have compensated clients for losses from mistaken trades.

Here’s another “soft” skill worth considering.  Many employers are aghast at the lousy writing skills of young people coming out of college, and rightly so.  Make sure that your ability to communicate in a written form is at a strong level.

Oral communication is also important.  If you have difficulty speaking to groups, you might try something like Toastmasters.

Many of these things come only with practice on the job, so don’t think that you have to have everything together in order to do well — the important thing is to improve over time.  Young people are not expected to be as polished as their older colleagues.

What advice would you give to someone considering working in this field?

It’s a little crowded in finance.  That is partially because it attracts a lot of people who think it will be easy money.  If you are really good, the crowding shouldn’t be much of a hurdle.  But if you don’t think that you are in the top quartile, there are some alternatives to help you grow and develop.

  • Consider developing your skills at a small bank or insurer.  You will be forced to be a generalist, which sets you up well for future jobs.  It also forces you to confront how difficult the economics of smaller firms are, and how costly/difficult it is to change strategy.  For a clever person, it offers a lot of running room if you work for a firm that is more entrepreneurial
  • Or, consider working in the finance area of an industrial firm.  Finance is not only about selling financial products — it is about the buyers as well.
  • Work for a government or quasi-governmental entity in their finance area.  If you can show some competence there, it would be notable.  The inefficiencies might give you good ideas for what could be a good business.

What are some values/ethics that have been important to you throughout your career?

Here are some:

  • Be honest
  • Follow laws and regulations
  • Work hard for your employer
  • Keep building your skills; at 57, I am still building my skills.
  • Don’t let work rob you of other facets of life — family, friends, etc.  Many become well-paid slaves of their organization, but never get to benefit personally outside of work.
  • Avoid being envious; just focus on promoting the good of the entity that you work for.
  • Try to analyze the culture of a firm before you join it.  Culture is the most important aspect that will affect how happy you are working there.

I understand that you currently run a solo operation, but are there any leadership skills you have needed previously in your career? Any examples?

This is a cute story: Learning Leadership.  I have also written three series of articles on how I grew in the firms that I worked for:

There’s a lot in these articles.  They are some of my best stories, and they help to illustrate corporate life.  Here’s one more: My 9/11 Experience.  What do you do under pressure?  What I did on 9/11 was a good example of that.

I know I have a lot more articles on the topic on this, but those are the easiest to find.

What made you decide to make the switch to running your own business?

I did very well in my own investing from 2000-2010, and wanted to try out my investing theories as a business.  That said, from 2011-2017, it worked out less well than I would have liked as value investing underperformed the market as a whole.

That said, I proceed from principle, and continue to follow my investment discipline.  It follows from good business management principles, and so I continue, waiting for the turn in the market cycle, and improving my ability to analyze corporations.

Nonetheless, my business does well, just not as well as I would like.

I hope you do well in your career.  Let me know how you do as you progress, and feel free to ask more questions.

In my view, these were my best posts written between February and April 2013:

Wall Street Hates You

I have a saying, “Don’t buy what someone wants to sell you. Buy what you have researched.”

And so I would tell everyone: don’t give brokers discretion over you accounts, and don’t let them convince you to buy unusual bonds, or obscure securities of any sort.  By unusual bonds, I mean structured notes, and eminent men like Joshua Brown and Larry Swedroe encourage the same thing: Don’t buy them.

The Education of a Mortgage Bond Manager, Part III

Why being careful with credit ratings is smart.

The Education of a Mortgage Bond Manager, Part IV

Be wary of odd asset classes; they are odd for a reason.

The Education of a Mortgage Bond Manager, Part V

Where I do odd things in order to serve my client.

The Education of a Mortgage Bond Manager, Part VI

The Education of a Mortgage Bond Manager, Part VII

The Education of a Mortgage Bond Manager, Part IX

Odd stuff, but particularly insightful into some of the perverse dynamics inside investment departments.

The Education of a Mortgage Bond Manager, Part VIII

How I led the successful effort to modify the Maryland Life Insurance Investment Law, and acted for the good of the public.

The Education of a Mortgage Bond Manager, Part X (The End)

Where I explain the odd bits of being portfolio manager, while succeeding with structured bonds amid difficult markets.

Berkshire Hathaway & Variable Annuities

I explain the good, bad, and ugly off of Berkshire Hathaway’s reinsurance deal with CIGNA.

Advice to Two Readers

Where I opine on some Sears bonds, and also on flu pandemic risk at RGA.

What I Would & Would Not Teach College Students About Finance

Mostly, I would teach them to think broadly, and realize the most of the complex investment math is easy to get wrong.

My Theory of Asset Pricing

My replacement for MPT using contingent claims theory.

On Insurance Investing, Part 4

On finding companies with conservative insurance reserving

On Insurance Investing, Part 5

On the squishy stuff, where there are no hard guidelines.

On Time Horizons

People shorten and lengthen their time horizons at the wrong time.

The Education of an Investment Risk Manager, Part IV

On two odd situations inside a life insurance company.

The Education of an Investment Risk Manager, Part V

On how we replaced a manager of managers.

Value Investing Flavors

Explains how there are many ways to do value investing.

Classic: Using Investment Advice, Part 1

Classic: Using Investment Advice, Part 2

Classic: Using Investment Advice, Part 3

Classic: Using Investment Advice, Part 4 [Tread Warily on Media Stock Tips]

Understand yourself, understand the advisor, understand the counsel that is offered, and finally, we wary of what you here through the media, including me.

Classic: Avoid the Dangers of Data-Mining, Part 1

Classic: Avoid the Dangers of Data-Mining, Part 2

There are many ways to torture the data to make it confess what you want to hear.  Avoid that.

Classic: The Fundamentals of Market Tops

Where I explain what conditions are like when market tops are near.

At the Towson University Investment Group’s International Market Summit, Part 5

Where I answer the question: Where does academic theory fail in finance and in economics?

Classic: Separating Weak Holders From the Strong

Classic: Get to Know the Holders’ Hands, Part 1

Classic: Get to Know the Holders’ Hands, Part 2

Articles that explain the fundamental  basis that underlies technical analysis.

Classic: The Long and Short of Trend Investing

How to play trends without getting skinned.

Full Disclosure: long RGA and BRK/B