Category: Bonds

Upside-Down?

Posted on by David Merkel

Picture Credit: National Library of Ireland on The Commons || Interest rates always move in lockstep, right?

So the Fed loosened 0.50%. Long past the time it should have done so. What was the result on the long end of the Treasury yield curve?

Well, look at that! As the Fed cut the short-term policy rate, yields in the portion of the yield that matter more rose. And as an example, yields on 30-year MBS (mortgage backed securities) rose by 0.04% in yield. 15-year MBS rose by 0.02%. All of the yield curve rose from 1 year our to 30 years.

50 basis points of loosening was an upward surprise, so I take the steepening move in the yield curve as an expression that the market expects fewer cuts in the future, perhaps due to rising inflation, or just an unwillingness to lend more without additional compensation. I mean you two horrendously lousy presidential candidates making extreme promises to make the deficit even bigger. The GDP of the US grew faster when we ran balanced budgets — admittedly long ago. But fools think national credit is unlimited, and the grand enabler of that fantasy is the Federal Reserve.

Now, this just a day. Let ‘s watch what happens. The steepening could reverse, and even more so. But if this persists and goes further, you could see the Fed questioning whether they want to loosen more. Remember, the Fed is a slave to the bond market, not vice-versa.

Anyway, watch the slope of the yield curve. It tells you more about what is going on than the yammering of the Fed.

Don’t Lose Your Head

Posted on by David Merkel

Photo credit: David Seibolid || Oh dear, you lost your head!

So we had a hard market day yesterday. Maybe COVID-19 will resurge in the USA. The great thing about the USA is that no one is ever truly in charge. Power is shared. Most of the time, that’s a good thing.

I am not saying that it is time to buy, unless it is small trades. I bought 0.7% of stocks yesterday as the market fell 5%+. My aggregate cash position is around 20% of assets. After buying as the market fell in March, I was selling off stocks in May.

Did I not believe the rally? Sure I did, but there are degrees of belief, and I kept selling bits as the market rose.

Now let me tell you about two former clients. One was retiring, and wanted to move his assets to a firm I had never heard of. He notified me the second day after the bull market peak in February. I did not argue; I just liquidated the account for him. As the market fell after that, he told me to delay selling — the market would come back. I told him he had already sold.

Now, the new manager was incompetent in rolling over the assets. I was astounded how long it took, even with me helping them. As such, the client got a bad idea, and took 2/3rds of the assets and bought an equity indexed annuity decently past the recent market bottom. The insurance company knew how to roll assets. I wish my client had asked me regarding this — EIAs are “roach motels” for cash. They don’t return well, and you can’t get out of them. Your money dies there.

The incompetent asset manager ended up managing 1/3rd of the cash they thought they would. My former client is ill-served both ways.

Then there was the second client. He seemed to be happy and was interested in good long-run returns. In my risk survey, he scored normally. But when the market fell hard in March, he panicked and wanted to liquidate. But he asked my opinion on the matter. I told him that quick moves of the market tend to reverse, and that the securities that he held were well-capitalized, and even if the market fell further, they would not fall as much.

Then he told me that he never wanted the portfolio to fall below a certain level which we were at that point close to breaching. This was new information to me, and I said to him, if that’s the case, you should not be investing in stocks. Either change your goal, or change your asset allocation.

For a day, he realized he should be willing to take more risk. Than the market fell hard again, and he told me to liquidate.

I did so.

And it was the bottom.

So what is the lesson here?

It’s simple. Choose an asset allocation that you can live with under all conditions, and stick with it. This is the same thing that I tell the risk-averse pastors that I serve on the denominational pension board. And if you are not sure that you can live with it, move the risk level down another notch.

A second lesson is be honest with yourself, and also with your advisor, about your risk preferences. Most advisors that I know are happy to adjust the riskiness of client portfolios. There is no heroism in taking too much risk.

As I have said a number of times before, I have run my portfolio at 70/30 risky/safe all of my life plus or minus 10%. I personally could run at a higher level of risk, but I would rather not take the mental toll of doing so.

And when the market moves, I trade against it — but not aggressively. I am always moving in the right direction, but slowly, because I am never 100% certain where mean-reversion will kick in.

Yesterday was tough. Big deal. Days like that will happen. It’s part of the game. As for my second client, he took more risk than he was comfortable with, and ended up leaving the game, which is the worst outcome under normal conditions.

Sun Tzu said the most important task of a general was to understand himself and his enemy. My second client did not understand his own desires, and he did not understand how volatile the market can be.

As such he lost out — as did the first client in other ways. And thus to all I say, “Choose an asset allocation you can live with under all conditions, and stick with it.” You will be happier, and you will do better if you do so.

Saving, Investing, and Storage

Posted on by David Merkel

Photo Credit: Jason Woodhead || Forget the United States Oil Fund — if you want to own oil, buy a tank and store the oil on your own property. 😉

This should be a short post. Buffett likes to own T-bills when he doesn’t have anything that he wants to buy. Why? He is storing value until the time comes when he can buy something that he thinks offers a superb return over the long haul.

And now for something that seems completely different: commodity investing, when it was introduced in the nineties, offered “yield” from rolling the futures contracts from month-to-month. That ended when the trade got too crowded, and the “yield” went negative. The ETFs that pursued these strategies were inventory financing charities in disguise. They still are, even though their strategies are more complex than they were.

Think for a moment. Why should you earn a yield-type return off of owning a commodity? Really, that should not exist unless there is a scarcity of speculators willing to let producers hedge their risk with them. There is a speculative return, positive or negative, from holding a commodity, but in the present environment, where there is no lack of people willing to hold commodities, there is no yield-like return, unless it is negative.

As a result, commodities should be viewed as storage, not an investment. Do you think in the long run that gold will be more valuable than it is today? It might be wise to store some away. That said, you have to be careful here. In inflation-adjusted terms, most commodities have gotten cheaper over time, with occasional violent rallies that convince people to speculate (all too late).

Storage is not investing. Storage tucks something away, and it will not change, even if its price changes because of changes in the economy.

Investing is far less certain — you can lend to or buy equity in a venture which could produce astounding returns, or you could lose it all, or something in-between. With investing, it is rare that you will end up with what you started with.

This is not to say that storage is a bad thing — we exchange our savings in bank balances to store value in a different form. A bank could go bust. If enough go bust at the same time, value could be lost if the government does not back up the FDIC. Holding T-bills preserves value to the degree that the government is willing to pay on its own debts in fiat currency, which is pretty likely.

Holding a commodity with a price you think will correlate strongly with the prices you will experience in retirement is not a bad idea. That said, it is storage. It will not grow your purchasing power the way that investment will.

As such, I encourage you to mostly invest, and store a little. Storage is more certain, but has no return. Investing has returns, both positive and negative, but generally over time provides more value than storage.

PS — owning a home, except in a crowded area that is growing, is not an investment but is storage. You should not expect capital gains in real terms from owning a house. That said, it will provide you with rent-free living for a long time once the mortgage is paid off. (Please ignore the property taxes, insurance and maintenance costs.)

Too Much Debt

Posted on by David Merkel

Photo Credit: Steve Rotman || As Simon and Garfunkel sang, “The words of the prophets are written on the subway walls…”

Debt-based economies are unstable. Economies with a lot of short-term debt are more unstable. The Fed is like Johnny One-Note, or Fat Freddie with a hammer. They only know one tool, and it will solve all problems.

Are there problems from too much debt? More debt will solve the problem. Shift debts from the private to the public sector. Don’t let the private market solve this on its own.

Though the bed debt is not in the same place as the last crisis, we are once again trying to play favorites through the Federal Reserve and rescue entities that took too much risk.

My view is let them fail. The whole system is not at risk, and the COVID-19 crisis will pass in two weeks. The great risk is not from the disease, but from the ham-handed response from policymakers who are short-sighted, and highly risk averse to the point of not wanting to cross the street for fear of dying.

Have we become like the Chinese, who bail out their banks and non-banks regularly? Who can’t bear to see any significant institution fail?

(Yes, I know they are getting more willing to see entities fail in China, but why are we getting less that way in the US? Let market discipline teach companies to not have so much debt.)

Here are three things to consider:

  1. Bond ETFs Flash Warning Signs of Growing Mismatch — The Fed now think its purview extends to managing the discounts of bond ETFs? Let the system work, and let profit seeking institutions and individuals benefit from artificially high yields. Let insurance companies do what I did: purchase a cheap package of bonds in an ETF, and convert it into the constituent bonds, and sell those that you don’t want for a profit. (Losses from ETFs premiums and discounts are normal, and it is why the dollar weighted returns are lower than the time-weighted returns.)
  2. The same applies to repo markets. As I have said before, the accounting rules need to be changed. Repo transactions should not be treated as a short-term asset, but as a long asset with a short-term liability, because that is what it is. With Residential Mortgage-Backed SecurIties in trouble, the market should be allowed to fail, to teach those who take too much risk to not do that. This failure will not cascade.
  3. The same applies to the crony of Donald Trump — Tom Barrack. He pleads his own interest, seeking for the Fed or the Treasury to bail him out, and those who are like him. Let him fail, and those who are like him.

Market participants need to know that they are responsible for their own actions, particularly in a small and short-lived crisis as this one. COVID-19 as a systemic crisis will be gone within weeks.

My statement to all of those listening is “When will we set up a more rational system that discourages debt?” We could made dividends tax-exempt, and deny interest deductions for non-financial corporations, including financial subsidiaries of non-financial corporations. Of course we would grandfather prior obligations.

Are we going to wait for the grand crisis, where the Fed will continue to extend credit amid roaring inflation, or where extend no credit amid a tanking economy? This is what eventually faces us — there is no free lunch. The Fed can’t create prosperity via loose monetary policy, and Congress cannot create prosperity via loose fiscal policy.

The bills eventually come due. The USA might get the bill last after the failure of China, Japan, and the EU, but it will eventually get the bill.

As such, consider what you will do as governments can’t deal with the economic and political costs of financing the losses of the financial system.

The Worst Policies are Made During Crises

Posted on by David Merkel

Photo Credit: Mike Licht || As a culture, we are very much “live for the moment.” But what happens when buyers of Treasuries decide that it’s not worth it anymore?

I am not a fan of the Democrats or of Big Government Republicans like Bush Jr. and Trump. In general, I think we need to shrink our government, decentralize, and de-lever our economy such that we make debt a smaller component of how we finance our lives. The Democrats talk about inequality, but they don’t really mean it. Increasing marginal tax rates is good show, but the real game is how income is calculated, and they won’t touch that, because their richest donors find ways to hide their income — the same as donors to the Republicans.

That’s why I call the governing elite in DC “The Purple Party.” A blend of red and blue, with just enough difference to get politically motivated donors to give, but practically doing the same thing, serving wealthy elites.

I’m going to make a post on COVID-19 next week, but my last post on the topic was too optimistic. That said, the politicians, particularly governors, are being scaremongers. They are vastly overestimating the size of the crisis.

What really bugs me are the foolish ideas being propounded by the Fed and politicians. Let me talk about a few of them.

1) Don’t close the stock or bond markets. Closing the markets does not eliminate volatility. It only hides it. Practically, it makes the price of securities to be zero for those who want to sell them. And, for those who left some cash on the side, it denies them the opportunity to profit from their wisdom.

2) The Fed should only hold short government debt. That is a neutral asset. Anything else makes the Fed play favorites in what they buy, whether it is mortgage-backed securities, municipal bonds, or corporates. Don’t let the Fed become a political institution, creating ad hoc policy by whose debt they do and don’t buy.

3) Don’t close businesses. Let all businesses set their own policies. They don’t want their workers to infect others. Let them operate.

The idea that there are “necessary businesses” is foolish. The “necessary businesses” rely on other businesses to be their suppliers.

What would be better would be to have extensive testing for COVID-19, and to quarantine those who are infected, and those who are not tested who had contact with those who are infected. Leave the rest of society free. Don’t close firms down, and then give some lame amount of government assistance to them. We do best when we are working. People staying at home lack the healthy stress that working provides.

4) Now, if you have to give assistance, giving it to people directly is the best way. I advocated for that in the last financial crisis. But you should give it to all Americans equally, to avoid favoritism. Now, there is the issue of those who buy US Treasury debt objecting to the concept, and I can respect that. Why else do you think that the yield on 30-year Treasury Bonds has risen 0.8% over the last ten days?

There is no such thing as a free lunch, and with all those advocating excessive deficit spending, I would say “Yes, the past efforts have not disrupted the markets, but if you read economic history closely, no one can tell what will make the paradigm shift. Are you feeling lucky?”

Summary

From my reading of the data, I don’t see how this crisis lasts past the end of April. Yet there are governors of states foolishly shutting down businesses, and thinking that they are doing something good. “Shelter in place” is a recipe for turning all Americans into lawbreakers in the same manner as is with highway speed limits. Do you really want to ruin our culture via overly strict laws?

What of the poor people running out of money? What of the small businesses that go broke? Governments should focus on testing for the virus, and quarantining those who have it and those who have had contact and are untested.

In closing, I would encourage all readers to vote all incumbents out of office. They are not serving the interests of average Americans well. They are cowards who listen to scaremongers, and that includes Trump.

PS — some people might suggest that I am not kind to those that are hurting. It’s not true. I give over 10% of my income to charity each year. Beyond that, I would challenge people to consider Venezuela. Many small to medium-sized actions by Chavez and Maduro slowly robbed the country of economic vitality. The wealthiest nation in South America became the poorest.

The same could happen here. Economic disasters often spring from something small — remember Ben Bernanke saying that the risk from subprime mortgages was “well contained?” Yes, subprime mortgages were small, but they represented the marginal buyers of residential real estate, so when they failed, so did property prices. Like dominoes, they fell.

Thus I am saying to urge the government to not engage in policies that increase its deficits. You can’t tell when the last bit of debt will be the straw that breaks the back of the camel.

Estimating Future Stock Returns, December 2019 Update

Posted on by David Merkel

Graphic Credit: Aleph Blog, natch… same for the rest of the graphs here. Data is from the Federal Reserve and Jeremy Siegel

Here’s my once a quarter update. If you owned the S&P 500 at the end of 2019, it was priced to give you a return of 2.26%/year over the next 10 years. That said, the market has changed a lot in the last 2.6 months –as of the close of business on March 18th the market was priced to give you a return of 7.28%/year over the next 10 years. Finally, you have a chance to double your money over the next ten years, while a 10-year Treasury would give you 1.5%/year over the same horizon. To match the expected returns on stocks at this point in bonds, you would have to invest in junk debt, but junk typically doesn’t go longer than 10 years, and who knows what the defaults will be over the next two years?

Now, actual returns from similar levels have varied quite a bit in the past, so don’t take the 7.28%/year as a guarantee. WIth a 2%/year dividend yield, price returns have ranged from -0.95%/year to 6.89%/year, with most scenarios being near the high end.

At the end of 2019, valuations were higher than any other time in the past 75 years, excluding late 1964, and the dot-com bubble. It is not surprising there was a bear market coming. Because “there was no alternative” to stocks, though, it took an odd external event or two (COVID-19, oil price war) to kick bullish investors into bear mode. This was not a supply and demand issue in the primary markets. This was a shift in estimates of investors regarding the short-term effects of the two problems extended to a much longer time horizon.

Two more graphs, and then some commentary on portfolio management. First, the graph on the channel the market travels in, subject to normal conditions:

This graph shows how the model estimates the price level of the S&P 500. It is most accurate at the present, because the model works off of total returns, not just the price level. The gap between the red and blue lines is mostly the effect of the present value of future dividends, which are reflected in the red line and not the blue.

The maximum and minimum lines have hindsight bias baked into them, but it gives you a visual idea of how high the market was at any given point in time — note the logarithmic scale though. If you are in the middle using linear distance, you are a little closer to the bottom than the top.

And finally, that’s how well the model fits on a total return basis. Aside from the early years, it’s pretty tight. The regression explains more than 88% of the total variation in returns.

Implications for Asset Allocation

If you haven’t read it, take a look at my article from yesterday. I am usually pretty disciplined about rebalancing, but this bear market I waited a while, and created two schedules for my stock and balanced fund products to adjust my cash and bond versus stock levels. I decided that I would bring my cash levels to normal if the market is priced to give its historical return, i.e. 9.5%/year over the next ten years. That would be around 2100 on the S&P 500. Then I would go to maximum stock when the market is offering a 16%/year return, which is around 1300 on the S&P 500.

The trouble is this is psychologically tough to do when the market is falling rapidly. I am doing it, but when I rebalance at the end of the day I sometimes wonder if I am throwing my money into the void. Remember, I am the largest investor in my strategies, and if my ideas don’t work, I will lose clients, so this is not an idle matter for me. I’m doing my best, though my call on the market was better during the first decade of the 2000s, not the second decade.

In the process, I bought back RGA at prices at which I love to have it, and have been reinvesting in many of the companies I own at some really nice levels… but for now, things keep going down. That’s the challenge.

In summary, we have better levels to invest at today. Stocks offer better returns, but aren’t screaming cheap. Some stocks look dirt cheap. Most people are scared at the speed of the recent fall. I view my job as always doing my best for clients, and that means buying as the market falls. I will keep doing that, but I have already lost a few clients as a result of doing that, even though I tell them in advance that I will do that. So, I will soldier on and do my best.

Full disclosure: long RGA for clients and me

SImilarities of the Coronavirus to 9-11

Posted on by David Merkel

Photo Credit: Gene Han || This picture was taken four years after the attack.

I am going to reprint here the beginning of the article The Education of a Corporate Bond Manager, Part VI. I am doing this because it describes how our investment department dealt with 9-11. Here it is:

After 9/11, and and before the merger was complete on 9/30/2001, our investment team got together and came to an unusual conclusion ? 9/11 would have little independent impact on the credit markets, so be willing to take credit risk where it is not well-understood by the market.? We bought bonds in hotels, airplane EETCs (A-tranches), anything having to do with confidence in the system at that time.? I consciously downgraded our portfolio two full notches from September to November.

I went to a Chief Investment Officers’ conference for insurance investors in October 2001.? What I remember most is that we were the only company being so aggressive.? In a closed-door meeting, the representative from Conseco told me I was irresponsible.? To hear that from a company near bankruptcy rang the bell.? I was convinced we were on the right track.

By mid-November, we had almost completed our purchases of yieldy assets, when I received a phone call from the chief actuary of our client expressing concern over the credit risks we were taking; the rating agencies were threatening a downgrade.

Well, what do you know?!? The company that did not understand the meaning of the word risk finally gets it , and happily, at the right time.? We were done with our trade.

We looked like doofuses for three months before the market began to turn, and I began a humongous ?up in credit? trade as we began to make a lot of money.? By the time I was done in early June, I had upgraded the whole portfolio three full notches.? A great trade?? You bet, and more.? What?s worse, it was what the client wanted, but not what it should have wanted.

The Education of a Corporate Bond Manager, Part VI

9-11 was a shock to the system, but one where our investment team concluded that everything would return to normal, and relatively soon. We thought that the terrorists had gotten lucky, and that there was no persistent threat. Thus, prosperity would return, well, as long as the economy would hold up, which was in question at that time. The second-order effects of the deflation of the dot-com bubble were more severe than 9-11 would ever be.

From October 2001 through October 2002, our department bravely soldiered on, and during that time I played the speculation cycle relatively well, as noted in other episodes of “Education of a Corporate Bond Manager.”

The main challenge was trying to separate the transitory from the medium-term from the permanent. 9-11 was transitory. Deflation of the dot-com bubble was medium-term, and general prosperity was the long term — and definitely so at the valuations experienced in October 2002.

The same is true today. The coronavirus, no matter how ugly it will be, is transitory, as are the effects on the supply chain, travel, etc. But if you can believe it, valuations are still absolutely high (5.5%/year over the next 10 years), though not high relative compared to bonds and cash.

So, if you have courage, buy the damaged industries. People will still travel, and not a lot of people will die. Buy the strongest companies that you know will survive.

My main point to you is this: the coronavirus is transitory. Act as if it is so, and think about what the economy will be like 3-5 years from now. Do that, and you will likely prosper, unless the effects of too much debt finally comes to bear on the market. We can’t tell when the day of reckoning will come on that topic.

Focus on the Long-term

Posted on by David Merkel

Photo Credit: Sacha Chua || Planning is a good thing.

In any investment decisions, one must look at the long term. Don’t pay any attention to news that does not permanently change business conditions.

The thing that drew my attention here is the rather weak coronavirus. Stalin supposedly said, “A single death is a tragedy; a million deaths is a statistic.” My sympathies to the families of those who have died from the coronavirus. But to society as a whole, the coronavirus has done less damage than influenza does every year.

As such, I don’t pay attention to the coronavirus. Stocks are long-term assets, and if the coronavirus will have no impact on the economy past 2025, I don’t see why I need to pay attention to it.

The same applies to politics. Is there someone coming like Chavez or Maduro who will radically reshape business/industry? No? Well, don’t worry so much. Money votes for itself. Few genuinely want to slay the processes that make society well-off in aggregate, even if they are getting a lesser portion of the increase.

In healthy societies, there is a tendency to protect property rights. Property rights are an aspect of human rights, let the liberals note this. We can argue about the edges of the rights, but fundamentally property rights must be protected, or society falls apart.

Now, at present, I am not a bull on the stock markets, but it is not because of any event risk, but rather high valuations. We aren’t at the same valuations that we experienced at the top of the dot-com bubble, but we are in the range of valuations that only existed from 1998-2000. At present the S&P 500 is expecting gains of just 2.24%/year over the next ten years.

Even this is not the long term. Okay, bad returns for ten years, and after that, back to historic norms. Fine, that’s right. But how many will panic in the process of a crash, and not hang on for the long-term?

I think it is worth edging asset allocations toward caution as valuations are so high. We can’t predict when the disaster will happen, but when it does, there will be better opportunities to deploy free cash.

As such, lighten up on risk assets, and prepare for the next drop in the stock market.

Limits

Posted on by David Merkel

Photo Credit: David Lofink || Most things in life have limits, the challenge is knowing where they are

I was at a conference a month ago, and I found myself disagreeing with a presenter who worked for a second tier ETF provider. The topic was something like “Ten trends in asset management for the next ten years.” The thought that ran through my mind was “Every existing trendy idea will continue. These ideas never run into resistance or capacity limits. If some is good, more is better. Typical linear thinking.”

Most permanent trends follow a logistic curve. Some people call it an S-curve. As a trend progresses, there are more people who see the trend, but fewer new people to hop onto the trend. It looks like exponential growth initially, but stops because as Alexander the Great said, “There are no more worlds left to conquer.”

Even then, not every trend goes as far as promoters would think, and sometimes trends reverse. Not everyone cares for a given investment idea, product or service. Some give it up after they have tried it.

These are reasons why I wrote the Problems with Constant Compound Interest series. No tree grows to the sky. Time and chance happen to all men. Thousand year floods happen every 50 years or so, and in clumps. We know a lot less than we think we do when it comes to quantitative finance. Without a doubt, the math is correct — trouble is, it applies to a world a lot more boring than this one.

I have said that the ES portion of ESG is a fad. Yet, it has seemingly been well-accepted, and has supposedly provided excess returns. Some of the historical returns may just be backtest bias. But the realized returns could stem from the voting machine aspect of the market. Those getting there first following ESG analyses pushed up prices. The weighing machine comes later, and if the cash flow yields are insufficient, the excess returns will vaporize.

In this environment, I see three very potent limits that affect the markets. The first one is negative interest rates. There is no good evidence that negative interest rates stimulate economic growth. Ask those in nations with negative interest rates how much it has helped their stock markets. Negative interest rates help the most creditworthy (who don’t borrow much), and governments (which are known for reducing the marginal productivity of capital).

It is more likely that negative rates lead people to save more because they won’t earn anything on their money — ergo, saving acts in an ancient mold — it’s just storage, as I said on my piece On Negative Interest Rates.

Negative interest rates are a good example of what happens you ignore limits — it doesn’t lead to prosperity. It inhibits capital formation.

Another limit is that stock prices have a harder time climbing as they draw closer to the boundary where they discount zero returns for the next ten years. That level for the S&P 500 is around 3840 at present. To match the all time low for future returns, that level would be 4250 at present.

Here’s another few limits to consider. We have a record amount of debt rated BBB. We also have a record amount of debt rated below BBB. Nonfinancial corporations have been the biggest borrowers as far as private entities go since the financial crisis. In 2008, nonfinancial corporations were one of the few areas of strength that the bond markets had.

One rule of thumb that bond managers use if they are unconstrained is that the area of the bond market that will have the worst returns is the one that has grown the most during the most recent bull part of the cycle. To the extent that it is possible, I think it is wise to upgrade corporate creditworthiness now… and that applies to bonds AND stocks.

Of course, the other place where the debt has grown is governments. The financial crisis led them to substitute public for private debt in an effort to stimulate their economies. The question that I wonder about, and still do not have a good answer for is what will happen in a fiat money world to overleveraged governments.

Everything depends on the policies that they pursue. Will the deflate — favoring the rich, or inflate, favoring the poor? No one knows for sure, though the odds should favor the rich over the poor. There is the unfounded bias that the Fed botched it in the Great Depression, but that is the bias of the poor versus the rich. The rich want to see the debt claims honored, and don’t care what happens to anyone else. The Fed did what the rich wanted in the Great Depression. Should you expect anything different now? I don’t.

As such, the limits of government stimulus are becoming evident. The economic recovery since the financial crisis is long and shallow. The rich benefit a lot, and wages hardly rise. Additional debt does not benefit the economy much at all. We should be skeptical of politicians who want to borrow more, which means all of them.

One of the greatest limits that exists is that of defined benefit pension plans vainly trying to outperform the rate that their risky assets are expected to earn. They are way above the level expected for the next ten years, which is less than 3%. Watch the crisis unfold over the next 15 years.

Finally, consider the continued speculation that shorts equity volatility. You would think that after the disaster that happened in 2018 that shorting volatility would have been abandoned, but no. The short volatility trade is back, bigger and badder than ever. Watch out for when it blows up.

Summary

Be ready for the market decline when it comes. It may begin with a blowout with equity volatility, but continue with a retreat from risky stocks that offer low prospective returns.

Another Way to Deal with the Rare Problem of Closed-end Fund Premiums

Posted on by David Merkel

Photo Credit: Matt M. || Some things are just too big for their own good.

Three years ago, I wrote an unusual piece called “How do you Manage a Company when the Stock is Considerably Overvalued?” Part of it dealt with the simpler case of dealing with closed-end funds that trade at a consistent premium to NAV. Quoting that portion of the article:

…what should a the managers/board of a closed end fund do if it persistently trades at a large premium to its net asset value [NAV]? ?I can think of three ideas:

1) Conclude that the best course of action is to?minimize the eventual price crash that will happen. ?Therefore issue stock as near the current price level as possible, and use it to buy non-inflated assets, bringing down the discount. ?What?s that, you say? ?The act of announcing a stock offering will crater the price? ?Okay, good point, which brings us to:

2) Merge with another closed end fund, trading at a discount, but offering them a premium to their NAV, hopefully a closed end fund?related to the type of closed end fund that you are. ?What?s that, you say? ?Those that manage other closed end funds are financial experts, and would never agree to that? ?Uhh, maybe. ?Let me say that not all financial experts are equal, and who knows what you might be able to do. ?Also, they do have a duty to their investors to maximize value, and for those that?sell above net asset value this is a big win. ?In the meantime, you have reduced your effective economic discount for those that continue to hold your fund.

3) Issue bonds or preferred stock convertible into common stock at a level that virtually guarantees conversion. ?Use the proceeds to invest in your ordinary investment strategy, bringing down the effective discount as dilution slowly takes place.

Of all the ideas, I think 3 might work best, because it would have the best chance of allowing you to issue equity near the overvalued level. ?If the overvaluation was 50%, maybe you could get it down to 25% by doubling the asset base, in which case you did your holders a big favor. ?If it works, maybe repeat it in two years if the premium persists.

How do you Manage a Company when the Stock is Considerably Overvalued?

Tonight, I want to suggest a fourth method, which would work and for the most part not upset existing holders. It would also benefit the fund manager. Do a rights offering.

A rights offering would give each shareholder a certain number of rights per original share held, allowing them to buy shares of stock at a price lower than the current price at the time of the announcement. The rights are typically tradeable, so someone not wanting to put more money in can trade their rights away — to them it is like a dividend. Others can buy the rights traded away, and buy shares in the offering. There are sometimes “oversubscription rights” which allow those subscribing in the rights offering to get additional shares at the offering price pro-rata to their subscriptions, if there are shares not purchased in the rights offering. Finally, rights not exercised expire worthless on the closing date of the offering.

Sound like a fun game? I participated in a number of these in the ’90s, particularly with some small-cap mortgage REITs that were busted from playing around with interest only securities using borrowed money. Messy stuff, but they had tax losses that were worth more than the price of the stock. The rights offerings were a means of raising capital to give them breathing room so that they could wind up their operations on more favorable terms than a forced sale that would endanger the value of the tax losses. But I digress…

Rights offerings are typically a small-cap phenomenon. They are one of the financing methods of last resort. But they could play a meaningful role in bringing down the premium over NAV of a closed-end fund.

Picture Credit: Aleph Blog

In this case, every old share receives one right, and it takes $15 plus four rights to buy a new share. The above assumes that all rights are used, and all the additional 2.5 million shares are subscribed.

Two things happen: the closed-end fund gets bigger, and the premium to NAV drops. Now, there is no guarantee that the price would not be affected by the rights offering — some people might mistakenly sell out in a panic, or the shareholders might bid up the price back to $21, illogical as that might seem. But if everyone behaved rationally in an offer like this, the premium over NAV would fall, and more so if fewer rights were needed to buy a share.

Now the managers of the fund would have more assets to manage, but might find that they can’t absolutely replicate the prior composition of the fund — many funds that trade at a premium are relatively high yielding bond funds. It’s possible that as a result of the additional money to put to work that the yield of the fund might fall, inducing some people to sell, and the premium to NAV would drop further.

It would be in the interests of the managers to try something like this to monetize the premium of the fund. If fund investors are rational, they wouldn’t lose any money in the process. But would the managers ever try doing it? Time will tell.

Theme: Overlay by Kaira.