Search Results for: "education of a corporate bond manager"

Post 2000

Post 2000

Posted on by David Merkel

This has been a lot of fun.? This has been a lot of work.? This has been a “labor of love.”

When I wrote for RealMoney, I would sometimes say to my editor Gretchen, “Here’s another labor of love piece,” to which she would give a hearty response, because she liked editing me.? She told me she always learned a lot from me.? I liked working with her a lot.

Unlike some writers at RealMoney, I would sometimes troll through the comments on Cramer’s blog.? Sometimes I would defend him, at minimum I would try to explain him.

At the time, there were some financial blogs that I liked a lot — Jeff Miller, Barry Ritholtz, Roger Nusbaum, Steven Randy Waldman, Eddy Elfenbein, Alea… I know there are more, but I can’t remember now.? I resisted starting a blog for 1-2 years, because I felt RealMoney was my blog.? I especially liked participating in the Columnist’s Conversation.? (Note: if RealMoney would like to invite me back, I am open to the idea.? That said, the CFA Institute has encouraged me to blog for them as well — just don’t know how much content I can produce, because everyone wants original content.)

But I realized that RealMoney and I had different goals, and in talking with some of those that commented at Cramer’s blog, I decided to launch Aleph Blog.? Why call it Aleph Blog?? Many reasons, as noted in the link, but part of the fun was getting to read Borges, who I had not previously read.

When I launched Aleph Blog, I had no idea what I was getting into, and I did not intend on leaving RealMoney.? I liked the editorial freedom, though, and liked the broader interaction with many voices across the internet, rather than only RealMoney columnists, good as they were.? I did research when I started, and so I created my own domain, signed up with Seeking Alpha, and launched just prior to the mini-crisis where the Chinese stock market crashed in Shanghai.? When that happened, I wrote a popular piece that Seeking Alpha picked up that my friend Cody Willard promoted as well.

And off we went!? A grand experiment, allowing me to spread my wings more wide than at RealMoney.? My goal was to do a brain dump of areas where I thought I had competence.? I didn’t want to be like many bloggers where over 50% of their post is quoting others — I wanted to write from my heart, expressing my views on a wide number of topics relating to economics, finance and investment, from my unusual framework, which is Evangelical Christian, mostly libertarian (but not for financials), actuarial, value investor, doubting neoclassical economics and modern portfolio theory.

I was recently at a Baltimore CFA Society meeting, when a few people came up to me telling me how much they liked my blog.? Some quoted to me recent pieces I had written.? This was new; I was surprised.? I have never had local people come to me and say that.? Yes, stats for Maryland on my blog are above average, but my work helping the local CFA Society always seemed to be detached from other things that I do.? My worlds are merging, maybe.

My worlds are also merging from the many evangelical Christians who write to me.? This is a blog written by a Christian, not a Christian blog.? I’m here to serve everyone, but my views on ethics will color all that I write.

At the beginning, I tried focused linkfests, where I drew together posts on a hot topic, and narrated them to give my thoughts.? Those were a lot of work.? Today, my linkfests occur through Twitter.

Twitter: it took me even more pain to decide to do Twitter.? Given that my blogging is more long-form than most — why should I do Twitter?!? My answer for today is simple: to have good conversations, and push good content to readers.? And, for those who don’t do Twitter, they can read my weekly sorted tweets.? I got the idea from History Squared, a newer blog that I like.? Sorting the tweets makes them more useful to readers, so if it takes half an hour to do so each week, it is worth it.

But now I have more followers on Twitter than on RSS.? 6000 vs 5300.? I prefer RSS because people see the whole post, but I understand how the lower bandwidth on Twitter allows people to choose what attracts them.? Twitter makes us all epigram writers in AOL-ese.? It is challenging to do, but I like a good challenge.

I’ve written a number of series that have been significant:

I’m sure there are more, but I can’t think of them now.? At the same Baltimore CFA Society meeting as mentioned before, one person asked me, “How do you write about the wide variety of topics that you do?”

Part of it is my varied career, and educational background.? I have worked in a large number of areas, and have not been afraid to branch out and try things slightly outside my grasp.? You only learn when you fail.? I’ve learned a lot. I’ve failed a lot.

If you don’t take reasonable chances, you won’t grow.? Look for opportunities to expand your abilities — who can tell where you will go?!? Opportunities go to those who are there, grab hold of them, and win.? If you don’t try, you won’t win.

I know that my blog is an acquired taste, and best for professionals and advanced amateurs.? If you are a beginner, best you should focus on my personal finance category.

My goal has been to give something back to my readers.? I’ve had an interesting career, with many unusual and entertaining experiences.? I don’t have to have more fame or clients.? I enjoy relating the truths of the markets to others, whether they are beautiful or ugly.

To my readers: I don’t know if I will last another thousand posts, but I appreciate that you read me, eclectic as I am.? The one thing I promise: I will do my best for you, poor as that may be.

Your Servant,

David

PS — I know that my views on Fed policy and economics will win me few friends, but someone has to point out that the paradigm is broken.? Same for Modern Portfolio Theory….

 

The Dilemma of Adding Yield

The Dilemma of Adding Yield

Posted on by David Merkel

Back when I was exclusively a bond manager, 2001-2003, which I chronicled in my series “The Education of a Corporate Bond Manager,” I successfully struggled with one concept: when do you try to add more yield to your portfolio, and when don’t you?

This is a tough question, because in the short run, it almost always makes sense to add yield to any portfolio.? Additional yield seems like free money.? What’s worse, your sales coverages at the major investment banks are programmed to offer more yield, so what do you do?

I had to learn the hard way myself, with few to teach me.? There are two aspects to this question: the micro, and the macro.

Micro

Know how to compare bonds so that you are able to figure out what a good swap is.? Thus you must understand:

  • The yield gained for illiquidity — public, 144A, private.
  • The yield lost for size — micro, small, medium, large.
  • The yield gained from duration — what is the proper yield give-up for investing “x” fewer years?
  • The yield gained from going down in credit — what names are mispriced, and offer value, though lower-rated?? What is the proper yield give up at various ratings, and how do you adjust them to reflect reality?
  • The yield differences regarding premium vs discount bonds — this is a relatively simple one, as you can take any spread of a bond over Treasuries, and recalculate it to be the spread against a par bond.? You’d be surprised how few people do that.? As a result two things happen: people buy expensive premium bonds that look cheap but aren’t, and some firms never buy premium bonds, even in cases where it makes sense.
  • The yield change for optionality, whether positive for puts, or negative for calls.
  • The yield differences across industries
  • The yield differences across special names — there are always a variety of names that trade wide or narrow — consult your analysts to understand which ones are mispriced.
  • The risk of a “special situation.”? Why are you the smart one, and others not?

Macro

This is the risk cycle. Think about:

  • How quickly are deals completed
  • How tight is the pricing in new deals
  • The tone of voice from your brokers
  • Your intermediate-term view of economics — if things are getting better be bullish, if worse be bearish.
  • Failures. Be wary as they begin, but be a buyer when you think things are at their worst. You will get the best prices for the recovery.? Few do this.

As a Wall Street Journal article pointed out, many bond mutual funds are reaching for yield now.? This is a time to be wary, but if you are playing for the end of cycle we aren’t there yet.? We have not had a significant default, or a series of small defaults.

So be on your guard, I am neutral at present, but I am watching for items that would make me more bullish or bearish.

The Education of a Mortgage Bond Manager, Part I

The Education of a Mortgage Bond Manager, Part I

Posted on by David Merkel

You might remember my “Education of a Corporate Bond Manager” 12-part series.? That was fun to write, and a labor of love, but before I was a corporate bond manager, I was a Mortgage Bond Manager.? There is one main similarity between the two series — I started out as a novice, with people willing to thrust a promising novice into the big time.? It was scary, fun, and allowed me to innovate, because in each case, I had to rebuild the wheel.? I did not have a mentor training me; I had to figure it out, and fast.? Also, in this era of my career, I had many other projects, because I was the investment risk manager for a rapidly growing life insurer.? (Should I do a series, “The Education of a Financial Risk Manager?”)

One thing my boss did that I imitated was keep notebooks of everything that I did; if this series grows, I will go down to the basement, find the notebooks, and mine them for ideas.? When you are thrust into a situation like this, it is like getting a sip from a firehose.? Anyway, I hope to do justice to my time as a mortgage bond manager; I have been a little more reluctant to write this, because things may have changed more since I was a manager.? With that, here we go!

Liquidity for a Moment

In any vanilla corporate bond deal, when it comes to market for its public offering, there is a period of information dissemination, followed by taking orders, followed by cutoff, followed by allocation, then the grey market, then the bonds are free to trade, then a flurry of trading, after which little trading occurs in the bonds.

Why is it this way?? Let me take each point:

  1. period of information dissemination — depending on how hot the market is, and deal complexity, this can vary from a several weeks to seven minutes.
  2. taking orders — you place your orders, and the syndicate desks scale back your orders on hot deals to reflect what you ordinarily buy and even then reduce it further when deals are massively oversubscribed.? When deals are barely subscribed, odd dynamics take place — you get your full order, and then you wonder, “Why am I the lucky one?”? After that, you panic.
  3. cutoff — it is exceedingly difficult to get an order in after the cutoff.? You have to have a really good reason, and a sterling reputation, and even that is likely not enough.
  4. allocation — I’ve gone through this mostly in point 2.
  5. grey market — you have received your allocation but formal trading has not begun with the manager running the books.? Other brokers may approach you with offers to buy.? Usually good to avoid this, because if they want to buy, it is probably a good deal.
  6. bonds are free to trade — the manager running the books announces his initial yield spreads for buying and selling the bonds.? If you really like the deal at those spreads and buy more, you can become a favorite of the syndicate, because it indicates real demand.? They might allocate more to you in the future.
  7. flurry of trading — many brokers will post bids and offers, and buying and selling will be active that day, and there might be some trades the next day, but…
  8. after which little trading occurs in the bonds — yeh, after that, few trades occur.? Why?

Corporate bonds are not like stocks; they tend to get salted away by institutions wanting income in order to pay off liabilities; they mature or default, but they are not often traded.

By this point, you are wondering, if the title is about mortgage bonds, why is he writing about corporate bonds?? The answer is: for contrast.

  1. period of information dissemination — depending on how hot the market is, and deal complexity, this can vary from a several weeks to a few days.? Sometimes the rating agencies provide “pre-sale” reports.? Collateral inside ABS, MBS & CMBS vary considerably, so aside from very vanilla deals, there is time for analysis.
  2. taking orders — you place your orders, and the syndicate desks scale back your orders on hot deals to reflect what you ordinarily buy and even then reduce it further when deals are massively oversubscribed.? When deals are barely subscribed, odd dynamics take place — you get your full order, and then you wonder, “Why am I the lucky one?”? After that, you panic.
  3. cutoff — it is exceedingly difficult to get an order in after the cutoff.? You have to have a really good reason, and a sterling reputation, and even that is likely not enough.
  4. allocation — I’ve gone through this mostly in point 2.
  5. grey market — there is almost no grey market.? There is a lot of work that goes into issuing a mortgage bond, so there will not be competing dealers looking to trade.
  6. bonds are free to trade — the manager running the books announces his initial yield spreads for buying and selling the bonds.? If you really like the deal at those spreads and buy more, you can become a favorite of the syndicate, because it indicates real demand.? They might allocate more to you in the future.
  7. no flurry of trading — aside from the large AAA/Aaa tranches very little will trade.? Those buying mezzanine and subordinated bonds are buy-and-hold investors.? Same for the junk tranches, should they be sold.? These are thin slices of the deal, and few will do the research necessary to try to pry bonds out of their hands at a later date.
  8. after which little trading occurs in the AAA bonds — yeh, after that, few trades occur.? Same reason as above as for why.? Institutions buy them to fund promises they have made.

Like corporate bonds, but more so, mortgage bonds do not trade much after their initial offering.? The deal is done, and there is liquidity for a moment, and little liquidity thereafter.

Again, if you’ve known me for a while, you know that I believe that liquidity can’t be created through securitization and derivatives.? Imagine yourself as an insurance company holding a bunch of commercial mortgage loans.? You could sell them into a trust and securitize them.? Well, guess what?? Only the AAA/Aaa tranches will trade rarely, and the rest will trade even more rarely.? The mortgages are illiquid because they are unique, with a lot of data.? You would have a hard time selling them individually.

Selling them as a group, you have a better chance.? But as you do so, investors ramp up their efforts, because the whole thing will be sold, and it justifies the analysts spending the time to do so.? But after it is sold, and months go by, few institutions have a concentrated interest to re-analyze deals on their own.

And so, with mortgage bond deals, even more than corporate bond deals, liquidity is but for a moment, and that affects everything that a mortgage bond manager does.? More in part 2.

 

The Best of the Aleph Blog, Part 15

The Best of the Aleph Blog, Part 15

Posted on by David Merkel

This stretches from August 2010 to October 2010:

The Education of a Corporate Bond Manager, Part VII

On the value of credit analysts.

The Education of a Corporate Bond Manager, Part VIII

On price discovery in dealer markets, and auctions gone wrong.? I never knew that I could haggle so well.

The Education of a Corporate Bond Manager, Part IX

On the vagaries of bulge-bracket brokers, and how a good reputation helps on Wall Street.

The Education of a Corporate Bond Manager, Part X

On how we almost did a CDO, and how it fell apart.? Also, how to make money in the bond market when you reach the risk limits. 😉

The Education of a Corporate Bond Manager, Part XI

On my biggest mistakes in managing bonds.? Also, on aggressive life insurance managements.

The Education of a Corporate Bond Manager, Part XII (The End)

On bond technical analysis, and how to deal with a rapidly growing client.?? Also, the end of my time as a bond manager, and the parties that came as a result.?? Oh, and putting your subordinates first.

Queasing over Quantitative Easing

Queasing over Quantitative Easing, Redux

Queasing over Quantitative Easing, Part III

Queasing over Quantitative Easing, Part IV

Queasing over Quantitative Easing, Part V

Queasing over Quantitative Easing, Part VI

The problems with the Fed’s seemingly “free lunch”strategy.? Pushes up asset prices and commodity prices, benefiting the rich versus the poor.

The Economic Geography of Publicly-Traded Companies in the United States by Sector

The Economic Geography of Publicly-Traded Companies in the United States by Sector (II)

Shows what US states have diversified vs concentrated economies by sector, and what states dominate each sector.

Portfolio Rule One

Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.

Portfolio Rule Two

Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.

Portfolio Rule Three

Stick with higher quality companies for a given industry.

Portfolio Rule Four

Purchase companies appropriately sized to serve their market niches.

Portfolio Rule Five

Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.

Portfolio Rule Six

Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.

Portfolio Rule Seven

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

Portfolio Rule Eight

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.

The Portfolio Rules Work Together

How the portfolio rules work together to create a “margin of safety.”

The Rules, Part XVIII

When rules become known and acted upon, the system changes to incorporate them, making them temporarily useless, until they are forgotten again.

When a single strategy becomes dominant, it can become temporarily self-reinforcing.? Eventually, it will become self-reinforcing on the negative side.

A healthy market ecology has multiple strategies that are working in separate areas at the same time.

The Rules, Part XIX

There is room for a new risk model based on the idea that risk is unique among individuals, and inversely related to the price paid for an asset.? If a risk control model has an asset becoming more risky when prices fall, it is wrong.

?The Rules, Part XX

In the end, economic systems work, and judicial systems modify to accommodate that.? The only exception to that is when a culture is dying.

?Managing Illiquid Assets

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.

Of Investment Earnings Assumptions and Century Bonds

If we could turn back the clock 65 or so years and set up a more conservative method of accounting for pension liabilities, we would be much better off today.

Who Dares Oppose a Boom?

This piece won a small prize, and in turn, I received three speaking engagements.

Fairness Versus Economics

Fairness Versus Economics (2)

People care more about fairness than improving their own economic/social position.

Earnings Estimates as a Control Mechanism, Flawed as they are

Earnings Estimates as a Control Mechanism, Flawed as they are, Redux

Earnings estimates have their problems, but they exist to give us a flawed method of estimating the future performance of companies.

-==-=-=-=-=–=-=

That’s all for now.? Never thought I would do so many long series when I started blogging.

The Best of the Aleph Blog, Part 14

The Best of the Aleph Blog, Part 14

Posted on by David Merkel

This period of the Aleph Blog covers May through July of 2010.? The one big series that I started in that era was “The Education of a Corporate Bond Manager” series.? The idea was to describe how a neophyte was thrust into an unusual position and thrived, after some difficulties.

The Education of a Corporate Bond Manager, Part I

How I learned the basics, and survived 9/11.

The Education of a Corporate Bond Manager, Part II

How I learned to trade bonds, and engage in intelligent price discovery.

The Education of a Corporate Bond Manager, Part III

What is the new issue bond allocation process like, and what games get played around it?

The Education of a Corporate Bond Manager, Part IV

On the games that can be played in dealing with brokers.

The Education of a Corporate Bond Manager, Part V

On selling hot sectors, and dealing with the dirty details of unusual bonds.

The Education of a Corporate Bond Manager, Part VI

On dealing with ignorant clients, and taking out-of-consensus risks.

Then there was the continuation of “The Rules” series:

The Rules, Part XIII, subpart A

On the biases the come from yield-seeking.

The Rules, Part XIII, subpart B

Repeat after me, “Yield is not free.”

The Rules, Part XIII, subpart C

Reaching for yield always has risks, but the penalties are most intense at the top of the cycle, when credit spreads are tight, and the Fed?s loosening cycle is nearing its end.? It is at that point that a good bond manager tosses as much risk as he can overboard without bringing yield so low that his client screams.

The Rules, Part XV

Securitization segments a security into liquid and illiquid components.

The Rules, Part XVI

“Governments are smaller than markets; markets are smaller than cultures.“

A fundamental rule of mine, but one with a lot of punch.

The Rules, Part XVII

On the differences between panics and booms.

The Journal of Failed Finance Research

Much research fails quietly, but other researchers don’t learn about the dead ends.? Better that they should learn of the failures, and avoid the dead ends.

How I Minimize Taxes on my Stock Investing

Sell low tax cost lots and donate appreciated stock to charities.

Place Political Limits on Overly Compliant Central Banks

Gives a simple rule to control central banks so that they avoid the present troubles.

Yield, the Oldest Scam in the Books

Yes, offering yield is the oldest way to trick people into handing over their money.

A Summary of my Writings on Analyzing Insurance Stocks

A good place to get started if one wants to get up to speed on insurance stocks, but there is a lot there.

Economics is Hard; the Bad Assumptions of Economists Makes it Harder

Going over Kartik Athreya?s letter criticizing nonprofessional economics bloggers.? Why the math behind macroeconomics and microeconomics doesn’t work.

Why Are We The Lucky Ones?

When you are a part of a small broker-dealer, all manner of harebrained deals get offered to you.? This explores three of them.? Note: management did not ask my opinion on the fourth deal, and that is a large part of why they no longer exist.

One more note: the guy who was going to pledge $5 million of stock in example 2 for a $1 million loan?? The stock is worth $7,000 today.

Watch the State of the States

The economics of the states tells us a lot more about the national health because they can’t print money to buy national debts.? (Though they can can raid accrual accounts…)

We Might Be Dead In The Long-Run, But What Do We Leave Our Children?

My view is that neoclassical economists are wrong.? Aggregate demand has failed for four reasons:

  1. Overleveraged consumers will not readily buy.
  2. Citizens of overleveraged governments will not readily spend, for fear of what may come later from the taxman, or from fear of future unemployment.
  3. Aggregate demand is mean-reverting.? It overshot because of the buildup of debt, and is now in the process of returning to more sustainable levels.? The same is true of private debt levels, which are being reduced to levels that will allow consumers to buy more freely once again.
  4. When the financial system is in trouble, people get skittish.

The Market Goes to the Dogs, Which Chase Their Tail Risk

Complex and expensive hedging solutions, many of which embed some credit risk, can be less effective than lowering leverage, and (horrors) holding some cash.

Fishing at a Paradox. No Toil, No Thrift, No Fish, No Paradox.

This one had its detractors, because I believe the paradox of thrift is wrong.? Too much aggregation, and it does not allow the dynamism of the economy to adjust over time, even from severe conditions.

Five Years at the Aleph Blog!

Five Years at the Aleph Blog!

Posted on by David Merkel

When Jim Cramer asked me to write for RealMoney, it was a dream come true, and I didn’t ask for it.? After year of writing him on bond issues, he told me I wrote better than most he knew.? Trouble was, in 2003, I had a new job at a hedge fund, and was doing well at it.? It took some doing, but eventually my boss (a good guy, generally) agreed that I could do it, and my public writing on investing began.

Writing for RealMoney, I always felt a little odd.? As I do at Aleph Blog, it is my goal to help you think better, not shovel “buy this now” ideas at you.? I wrote more comments relative to articles than any other writer; I was told that I was RealMoney’s most profitable writer, because people re-read my articles & comments.? Oddly, I had less feedback from Cramer than when I was an e-mailer.? That said, if I ever e-mailed him, which I did rarely 1-2 times/year, he would always give me a short gracious response.? Long before I actually did so, he encouraged me to start my own asset management shop, when I asked his advice in the matter.

Roughly one year before I left RealMoney (which I did unceremoniously, never said goodbye), I started Aleph Blog.? I did it for greater freedom of expression.? I also never read RealMoney anymore, and as such, did not feel the compulsion to contribute to a publication that I had loved.

I wanted to write more article-length pieces about issues that were deeper to investing, and not simple buy/sell this asset pieces.? So, beginning with the Shanghai Market crisis in February 2007, we were off and running.? Most of my initial pieces were shorter; I would write two per evening, six days a week.? That morphed into one longer piece once an evening.

It was my goal to try to take my generalist experiences and turn them into something valuable for the general public.? I did not want to be an “all crisis, all the time” blog.? When the crisis was hot, or promising to be so, I would write.? And though I have distinct views on how economic policy should be done, that is not what defines me.? We have to act and live in the face of suboptimal policies.

There are many pieces and series that I could never have done at RealMoney that I have done at Aleph Blog.? As a sampler:

  • Education of a Corporate Bond Manager (12 parts)
  • Flavors of Insurance (12 parts)
  • The Rules (30 parts so far, and may go to 60 if I do them all)
  • A Day in the Life of John Davidson (my one attempt at fiction, 8 parts)
  • Most of my articles dealing with flaws in institutional investment strategies, accounting rules, etc.
  • My occasional rants on how I thank neoclassical economics is wrong, and sometimes, very wrong.
  • Articles on accounting rules and the effect on investing.? In some circles, this is (wide eyes here) an accounting blog. (I’ve never taken an accounting course in my life.? I’ve had to create accounting statements for 12-18 years of my life corporately.? I have read through accounting standards, and theories on accounting polices repeatedly.)
  • Many of my quantitative posts they would have blinked at, and said, “Uh, who will benefit from that?”? My view is, you may not get any initial benefit from such a piece, but if you get some idea into how the markets interact, you may be better prepared when things get weird.
  • All of the book reviews. That was not an early goal of the blog, but has become 10% of what I do.
  • The interactions I have had with agencies of the US Government.
  • The (7 part) first blogger summit at the US Treasury.? It was a pleasure to meet Steven Randy Waldman, Yves Smith, Kid Dynamite, Accrued Interest, John Jansen, Michael Panzner, and Tyler Cowen.

That said, RealMoney gave me more room to run than most columnists.? They rarely turned down my ideas, but they did want me to become more “practical,” and crank out more investment ideas.? The hard thing for me was/is, I have no lack of investment ideas/opinions, but the response I get to giving them is far less civil than sharing ideas on how to think about investing.? To that end, I appreciate Tom Brakke, who does that in a very structured way.? We had tea together last June or so, and I started to write about it but could never get it out.

In late summer of last year, Josh Brown came through the area, and we had lunch together.? Great guy; a ton of fun and ideas.? A man like him in some ways is my pal Cody Willard, who is a fountain of ideas and connections.? Add in James Altucher, who is prolific, and has been willing to give me time on two occasions.

Last fall I had a late dinner with Miguel Barbosa of Simoleon Sense.? Very bright guy; great conversation.? During the same trip to Chicago, got to talk with Eric Falkenstein for a few hours.? Wish I could have met up with Tadas Viskanta then; maybe another time.

Yet that reminds me of those I interact with.? Though I have never physically met them, I appreciate Barry Ritholtz, Jeff Miller, Felix Salmon, Bruce Krasting, Howard Simons, Roger Nusbaum, Gonzalo Lira, Michael Pettis, Victor Shih, Carl Walter, jck at Alea, the crew at FT Alphaville, and more.

There was the Aleph Blog lunch in late 2010, and the relationships that engendered.? I am very grateful for all of the relationships that blogging has created for me, whether close or distant.

And, with all of the virtuality of blogging, the relationships are what make it for me.? I am happy to write bits on the sites of others, and give them content.? I appreciate those that I read and comment on.

And to the many who have written me, though I may have never responded, thanks for writing me.? I get fifty+ messages per day and can’t keep up.? So, thanks to all have interacted with me, that’s what has made it valuable to me.

PS — If I forgot you, my apologies, I have so many interactions that it is difficult to keep track of them all.

 

Against Risk Parity, Redux

Against Risk Parity, Redux

Posted on by David Merkel

Here are two articles to read on risk parity:

Pro: Pick Your Poison

Con: The Hidden Risks of Risk Parity Portfolios

I’m on the “con” side of this argument, because I am a risk manager, and have traded a large portfolio of complex bonds.? For additional support consider my article Risks, Not Risk.? Or read the second half of my article, “The Education of a Corporate Bond Manager, Part X.” There is no generic risk in the markets.? There are many risks.? Interest rate risk and credit risk are different topics.?? There are bonds that have interest rate risk but not credit risk — long Treasuries.? There are bonds that have credit risk but not interest rate risk — corporate floating rate notes, my favorite example being floating rate bank trust preferred securities.

It is not raw price volatility that drives investment results as much as the underlying drivers of the volatility.? For fixed income, I described those in the two articles linked in the last paragraph.? During non-credit-stressed times, a bank’s 30-year floating rate trust preferred security is roughly as volatile as a five-year noncallable bond that it issues.? But during times of credit stress, the first security becomes volatile, whereas the second one doesn’t.? The first moves in line with 30-year swap yields, LIBOR, and long junior bank spreads.? The second moves in line with 5-year Treasury yields, and short senior bank spreads.? The underlying drivers have little in common, and when things are calm, their volatilities are similar, because the drivers aren’t moving.? But when the drivers move, which in this case is one correlated driver, credit stress (30-year swap & junior bank spreads go a lot higher), the volatilities are very different, the first one being high and the second one low.

Thus equating volatilities across a bunch of asset subclasses, investing less in the volatile, and levering up the non-volatile, is hard to do.? History embeds all the curiosities of the study period, and calls them normal, and that past is prologue.

From the Pick Your Poison article above, what I think is the (lose) money quote:

Gundlach insists most money managers misunderstand junk bonds, comparing them to 5-year Treasurys to determine how rich their yields are, when the correct comparison should be to 30-year Treasurys.

How can Gundlach compare junk bonds, which do better when the economy heats up, with long-term Treasurys, which get killed when the economy revs up and the Fed raises interest rates?

That?s irrelevant, he responds. The thing to look at is volatility, because that tells you the odds you will have to sell at a loss when you need to raise cash in an emergency. On that basis, junk bonds that were trading at a seemingly reasonable spread of 5 percentage points, or 500 basis points, to 5-year Treasurys in mid-2011 were actually trading at an intolerably low 250-basis-point spread to the proper bond. (By then DoubleLine had cut its junk bond allocation from 10% to 1%.) Sure enough, junk fell 12% as the year went on, and the spread to 30-year Treasurys has doubled since mid-2011.

?It?s called risk parity,? Gundlach says. ?There?s only two investors who seem to understand it?me and Ray Dalio,? the highly successful manager of $122 billion (assets) Bridgewater Associates.

Personally, I don’t think Gundlach makes his money that way for his funds, but in case he does, how should a good bond manager view junk bonds?

First, ignore Treasuries — they aren’t relevant to the price performance of junk bonds.? I’ve run the regression of Treasuries vs junk bond index yields many times.? It’s barely significant for BBs, and insignificant thereafter.? Second, look at stock market indexes of industries that lever up and issue junk debt.? Junk corporate debt is a milder version of junk stocks, i.e., the stocks that issue junk debt.

Third, a corollary of my first reason, realize that risks with junk aren’t driven by spreads, but yields.? With highly levered, or very junior debt, it does not trade on a spread basis, but on a price basis.? Anyone looking at spreads will see too much volatility versus yields and prices.

But mere volatility won’t tell you the riskiness.? Indeed, when economic times are good, junk will do well, and long Treasuries do poorly.? Now, maybe that makes for a very noisy hedge, but I wouldn’t rely on it.

And, volatility is a symmetric measure, which as bond yields get closer to zero, the symmetry disappears.? Most asset classes display negative skew and fat tails, which also makes volatility problematic as a risk measure.

Going back to my first piece on the topic, if I were applying risk parity to a bond portfolio, it would mean that I would have to buy considerably more of shorter and higher quality instruments, and lever them up to my target volatility level, somehow with spreads large enough that they overcome my financing costs.? Now, maybe I could do that with mispriced mortgage securities, but with the problem that those aren’t the most liquid beasties, particularly not in a crisis if real estate is weak.

I guess my main misgiving is that levered portfolios are path-dependent, as pointed out in the GMO piece above.? You can’t be certain that you will be able to ride through the storm.? The ability to finance short-term disappears at the time it is most needed.

Now, if you can get leverage after the bust, and invest in beaten-up asset classes, you can be a hero.? But that’s a time when only the most solvent can get leverage, so plan ahead, if that’s the strategy.? If an investor could consistently time the liquidity/credit cycle, he could make a lot of money.

As the GMO piece concludes, the only benchmark that everyone could hold would be a proportionate slice of all of the assets in the world, which implicitly, would strip out all of the leverage, because one would own both the shares of the company, and the debt it owes, and in the right proportion.

So I don’t see risk parity as a silver bullet for asset allocation.? I think it will become more problematic, as all strategies do, as more people show up and use it, which is happening now.?? First in the hands of the master, last in the hands of a sorcerer’s apprentice.? Be careful.

PS — I have respect for the skills of Gundlach and Dalio.? I’m just skeptical about what happens to risk parity when too many use it, and use it without understanding its limitations.? And, here is a nice little piece about Bridgewater and its strategies.

Learning to Like Lumpiness

Learning to Like Lumpiness

Posted on by David Merkel

Simplistic financial plans assume a smooth return that the client will earn.? Why?? No nefarious reason, but planners don’t know the future, so they either:

1) Assume an average rate as a baseline for calculations, or

2) Display the average, median, or some? percentiles from a series of randomly estimated possible futures.

But life isn’t that way.? Markets are lumpy.? High and low returns happen more frequently than average returns.? What’s worse, returns tend to streak over years and decades.? So much for the Efficient Markets Hypothesis.

So what to do?? Better to be like the great moral philosopher Linus van Pelt, who carried a candle at night, and his sister Lucy asked him why he was doing so.? Linus replied, “It is better to light a single candle than to curse the darkness.”? After Linus left, Lucy mused for a moment, and shouted, “YOU STUPID DARKNESS!”

Volatility is a fact of life, and even the volatility is volatile, with regions of seeming stability, and regions of extreme booms and busts.

My “single candle” is simple — it is an adjustment of expectations, which involves reasoning that when things have been horrible, after some amount of time, it is time to take risk again, before it is perfectly obvious to do so.? Same thing when things are great, it may be time to take risk off the table.? I would add that delay in doing so is not a failure — lumpiness means that trends run further than would be reasonable.? But when the momentum wanes it is time to change.

I’ve been in the situation multiple times, but it is really difficult to get permabulls or permabears to recognize that something has shifted.? I wrote about this a number of times in my series “The Education of a Corporate Bond Manager.”? I was constantly fighting those who were hanging onto the old trend too long.

And at another firm, I could not convince my boss to go long once the nadir of the credit crisis had passed.? He expected more trouble to come, while I looked at the bond market and found an absence of distressed credits.

The lesson of both cases is that opportunities to earn total returns or preserve capital are lumpy.? If the market is longing for safety now, it will likely do so for a while, and the same is true for bull markets.

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Many retirees say “I just need a certain reliable income of X%/year. Please get that for me.”? We may as well tell these people to buy a CD or annuity, except that Fed policy makes the rates inadequate for their needs.? And yes, this is a deliberate policy of the Fed, picking on the elderly and the conservative in order to fund marginal lending that might? result in some tiny increment of growth.

It is far better to ask three questions:

1) Where are we now in the credit risk cycle? Rising, Peak, Falling, or Trough?

2) Where are yields on high-grade corporate bonds now?

3) Can you afford to spread your yield needs over five years?

Bond investors need to realize that most returns of the bond market are earned at three times: first, after the nadir of the credit cycle, credit-sensitive bonds soar.? Second, during deflationary times, buying long-dated Treasuries.? Third, when inflation is running, rolling over short-dated fixed income claims.? Beyond that, one can clip bond coupons during abnormal times of stability.

By asking the above first two questions, we can ascertain whether it is a favorable time to take risk or not, and what sort of risks to take.? The last question is more of a reasonableness check on the client.? If he has to have the return every year without fail, tell him to seek it at a bank or insurer, and see if he is pleased with the results.

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But now take it one step further.? When will our stupid economists and politicians get it through their heads that lumpy economic growth is normal, and even that it is desirable that growth is not smooth?? Effort to produce a smooth economy led to a debt build-up, which ultimately sabotaged growth.? Far better to let small recessions do their work, and leave the Fed funds rate high until marginal investments are repriced, with the attendant bankruptcies.

The US economy grew more rapidly when there were no efforts at stimulus.? Yes, there were severe recessions, but the booms thereafter more than made up for it.? Though it would hurt a lot in the short-run, far better to end the deficits of the US government, and the pitiful efforts of the Fed, giving greater certainty to the private sector, that businessmen could make long-term decisions without worries that taxes, regulations, or interest rates might change dramatically.

Like it or lump it, some say.? Why choose?? Learn to like the lumpiness of the asset markets and the economy in general, and many things will go more easily for you.

Everything Old is New Again in Bonds

Everything Old is New Again in Bonds

Posted on by David Merkel

Unconstrained strategies for bonds are hot now with yields so low.? But wait. Let’s take a step back.? What do we mean by a constrained strategy?

A constrained strategy is one that limits the investments one can engage in either through:

  • Specifying an index that the manager is charged with beating
  • Specifying percentage limits for investments, split by categories such as credit quality, interest rate sensitivity, asset subclasses (ABS, RMBS, CMBS, Corporates, Agencies, etc.), and other variables
  • Barring investment in more funky fixed income instruments such as preferred stock, trust preferreds, junior debts, CDOs, ABS, RMBS, CMBS, etc.
  • Or some combination of the above.

There have been unconstrained strategies in fixed income before — they just weren’t called that.? Many value investors in the old days didn’t care what the legal form of the investment was — they only looked for an adequate margin of safety.? Their portfolios were a hodgepodge of debt and equity instruments.? Specialization in only doing debt instruments wasn’t common.

Most debt-only investments were constrained, particularly those from bank trust departments.? Of course, this was an era where investing in junk debt was not respectable for all but the most intrepid of investors.

With the advent of the 1980s we had two innovations: junk bonds and bond index funds.? The first took the world by storm with the demand for yield; I experienced that at the first insurance company that I worked for — they overloaded on junk bonds.? This was before the regulators began regulating bond credit quality more strictly.

The second took a longer time to germinate.? The first bond index fund came into existence in 1986 at Vanguard.? They couldn’t call it a bond index fund, because they could not exactly replicate the index.? There were too many bonds that were illiquid, and they could not buy them at any reasonable price.? Instead, they took an approach that we would call “enhanced indexing” today.? Match the interest rate sensitivity of the index, and the credit quality, but choose bonds that had more potential than the bonds in the index.

In that sense, though the SEC allows bond funds to be called index funds today, all bond index funds are enhanced index funds because there is no way to source all of the bonds.? And from my own days as a corporate bond manager, I learned that bonds in major indexes always trade rich.? From my piece, The Education of a Corporate Bond Manager, Part IX:

There was another example where I crossed bonds where it was legitimate ? if it was done to help a broker in distress.? One day, someone offered me a rare type of Capital One bonds at a normal level, and I asked whether the bonds in question were the ones that were in a major bond index, without saying that per se.? After figuring that out, I bought them at the level, and called a broker that was likely to be short the bonds to see if he wanted them.? He certainly did, and offered them at a three basis point concession to where I bought them, as opposed to ripping the eyeballs out (as the technical term went).

The whole set of two transactions took 15 minutes, and made $15,000 for my client.? What was funnier, was that my whole family came to visit me that day, my wife and at that time, seven kids.? They heard the two transactions, though I had to explain it to them later. To the second broker, I had each of the kids say ?Hi,? ending with the then three-year old girl who squeaked ?Hi.?? He said something to the effect of, ?I knew you had a large family, but it only really struck me now.?

That three-year old is now a beauty at twelve, and bright as anything, but I digress.? (They grow so fast… the nine-year old girl is cute as a button too.)

Bond management was once unconstrained by those who looked for total returns in the old days, and constrained in the old days by those who looked for yield.? (Many managers would not buy bonds that traded at a premium.)? Then the bond indexes became popular as a management tool.? In one sense, it freed bond management, because rather than hard constraints, they matched credit and interest rate sensitivities of the index.

But what that constrains is credit policy and interest rate policy.? One managing to beat a benchmark index has limited options.? What if you want to position for:

  • Widening credit spreads
  • Narrowing credit spreads
  • Rising interest rates
  • Falling interest rates
  • Yield curve steepening
  • Yield curve flattening
  • Outperformance/underperfomance of a given sector

Any sort of directional bet could go wrong, and more often than bonds that fit the idea of replicating the index parameters, but are special in ways that the index does not appreciate.? So rather than going “whole hog” with the bet, you merely lean toward it, such that if you are wrong, you won’t destroy the outperformance versus the index.

But in this modern world where derivatives are widely accepted as fixed income instruments, a la Pimco, fixed income managers can do a lot more.? There is more freedom to make or lose a lot of money.

The unconstrained strategy can be thought of? in two ways: always trying to earn a positive return with high probability (T-bills are the benchmark, if any), or being willing to accept equity-like volatility while the bond manager sources obscure bonds, or takes large interest rate or credit risks.

I prefer the first idea, because it is more conservative, and fixed income management should aim for safety on average.? As I have said before, I only believe in taking risks that are well-compensated.

But here’s a hard one.? With the yield curve so wide, shouldn’t a bond manager with an unconstrained mandate put a little into long bonds or long zeroes?? I would think so, but I wouldn’t put a lot there unless the momentum started to favor it.

I like the concept of the unconstrained strategy; indeed, it is what I am doing for clients, but it is of the first variety, try to make money for clients in all markets, and not just be a wild man in search of yield or total return.

I find the move to unconstrained mandates to be a return to what value managers did long ago, but in a more complex fixed income environment.? I wonder though, as to whether the future failures will invalidate the idea for most.? It is tough to manage any asset class while adjusting the risk level to reflect what should not be done in a given era, whether in equities or debt.? The danger comes from trying to maintain yield levels that are higher than what is sustainable.

Musings on Yield

Musings on Yield

Posted on by David Merkel

When I closed my piece on Warren Buffett’s Annual Letter, I ended with an important statement tat when I read it in the morning, I thought many would find it cryptic.? Here it is:

And much as I like Buffett and Ray DeVoe, I would like my readers to internalize that there is no such thing as yield.? Yield is the decision of the company, but what you should? ask is what is the increase in value of the company.? Look for investments that increase your net worth the most.

And I would add “With an eye toward safety.”

When I say there is no such thing as yield, I am overstating a matter to make a point.

  • Will the debtor make the interest (or principal) payment?
  • Will the company pay the regular dividend?? Will they increase it?
  • Will you be able to hold the instrument so that you can realize the yield over the long haul?

During times of stress, yield has a nasty tendency to disappear, often with significant principal losses.? Thus I am skittish whenever I hear someone say that they need to get a certain yield.

Individuals and Institutions, for better, but usually for worse, often rely on getting a certain yield from fixed income investments.

  • If I don’t get this yield, I won’t be able to meet my monthly expenses.
  • If I don’t get this yield, my quarterly earnings will miss.
  • If I don’t get this yield, our ability to support our charitable endeavors will suffer.

Sigh.? Look, this could have been entitled “Education of a Corporate Bond Manager, Part 13,” but I didn’t because this is more broad and important.? It affects everyone.

Once there are no wages/nonfinancial profits, investors usually move into a yield-seeking mode.? I experienced this in spades for the insurance company that I helped to manage money for.

And yet, in the midst of the furor 2001-2003, we often acted against the insurer’s wishes in order to save their hide.? Particularly me; I could not bear doing the wrong thing, thinking that I would have the failure of an insurer on my conscience.

So in the midst of the nuttiness of 2002, I often did up-in-credit trades, reducing complexity trades, etc., when the market favored it.? Lose yield, gain safety, when the market is hot.? (Not when it is cold.)

I preserved the capital of the insurer, and it survived.? I even made extra money for them in the process, which they wasted on writing underpriced annuity business.

There was no level of yield that could have satisfied that client, even assuming that we could get it with safety.

But now as I start my asset management business, I deal with clients that are aiming for a certain yield.? To my surprise, even my Mom, the one who taught me the rudiments of investing is seeking for yield now.

You might or might not recall that the fourth real post at this blog was entitled Yield = Poison.? There are times to look for yield, and times not to.? The times not to are when yields and spreads are low.? At such a time, the best decision is not to reach for yield, but rather to forgo yield and preserve capital.? Buy TIPS, foreign bonds, and move up in quality and down in maturity in dollar terms.

I did this for an internal client 2004-2007, and made money for them, but it was utterly unconventional.? They could afford to deal with my idiosyncracies, because they didn’t need a current yield.

So, as I move to offer a fixed income strategy, I find myself butting heads with those that want a reliable income from bonds, and other fixed income instruments.? I’m sorry, but preserving principal is more important than getting yield.? Far better to eat into principal a little when spreads are tight, than to meet the spread target and get whacked in the bear phase of the credit cycle.

So, do I have a market for such investing in bonds, or is human nature so unchangeably mixed up that there will be few if any takers for my fixed income management?? Sadly, I think the answer is the latter.

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