Category: Bonds

Buying Formerly Investment Grade Bonds of LBO Deals

Buying Formerly Investment Grade Bonds of LBO Deals

Posted on by David Merkel

Here was a reader question from yesterday:

I?ve been reading your blog for awhile, and I appreciate all the hard work you put into it. I especially like how you comment on intermarket relationships, and it?s helping to quicken my ever so slowly growing knowledge of the markets.

I read your comments that higher quality bonds should perform better than lower quality, because of a probable rising cost of capital for lower quality companies. In a different environment, or for financially secure companies, is it ever a good idea to make a leveraged buy of higher yielding bonds, where the bond sells at a discount and the coupon is greater than the margin interest rate?

I realize that junk bonds are called such for a reason, and that if reaching for yield was a no-brainer prospect then everyone would be doing this. But I notice that a company like Alltel with a 7/01/2012 maturity has a 7% coupon and 9.156 YTM, and a borderline investment grade rating. While a lot more research would need to go into a bond before buying, would something like this, in theory, be safely bought with any leverage?

Lastly, is debt issued by companies acquired by private-equity firms worth looking at, or is it to be avoided at all costs?

Thank you very much for any help you could provide, and I apologize for the long length of my email,

Yes, in a different environment, a leveraged purchase of lower quality bonds can be a great idea, though I tend to purchase the equity instead. Starting about the time of the Iraq war, we hit a period where low quality bonds outperformed for four years. Since then it has been tough; it goes in cycles. Typically, the time to buy low quality bonds is when everyone is scared to death, the VIX is over 40, and realized defaults are high. This scares everyone away.

Now, with Alltel, this reminds me of an ?Ask Our Pros? question that was asked of me on RealMoney, back when they had that feature. (I think I got asked the most, because of my unconventional skill set, but I don?t know that for sure?) A read asked about Toys ?R Us bonds. Here?s what I wrote back then:

Toys R Us Debt
4/4/05 7:26 AM EDT

Reader: What do you think of buying debt of Toys R Us (TOY:NYSE) now that they are being acquired, I don?t see KKR buying a company and defaulting on its debt. I am specifically looking at the 7 5/8 2011 trading at about 95. ? G.S.

David Merkel: I think you ought to be careful here. Buying the debt of a junk-rated company owned by private investors is not trivial.

Suppose you source the bonds at $95, for a yield to maturity in about 6 1/2 years of 8.66%. The best thing that could happen is that the private buyers turn around and sell Toys R Us to an investment-grade buyer who foolishly decides to guarantee the debt. Less good, but still good, is that the spread compression in the market continues, your bonds get bid up and you sell for a profit. Still less good is that it matures and you make your 8.66%. Now for the bad scenarios.

When the Toys R Us bond in question was issued, it was an investment-grade bond. Toys R Us won?t file financial statements. There are no covenants to protect you. In principle, the private buyers could sell a profitable division like Babies R Us and pay themselves a special dividend with the proceeds. You just lost security as a result. Granted, a case could be made for fraudulent conveyance, but try proving that in the courts against the private buyers? legal team. Also, you could be structurally subordinated by bank debt at Toys R Us. The private buyers could borrow at the bank with Toys R Us as the borrower and pay themselves a special dividend (if the bank lets them). You now have less security.

Or, they could use the money to grow the business. If things go well, they win big, and you get principal and interest. If things go badly, you both could end up with zeroes, but remember, they are private buyers; they probably got some level of dividends out of the deal. Their objective is to skate on a thin equity base to make the highest return on equity that they can. They don?t care about bondholders, unless they are selling bonds.

Their interests and yours are not perfectly aligned. The spread on the bond is weak single-B, which is fair in my opinion for the risks that you would be taking on relative to other securities like it in the market. Those risks are real, and not ones that I typically like to play.

No positions

With Alltel, you are similarly facing a private equity buyout, which will get done if the LBO debt market normalizes (not holding my breath). It is junk-rated by two agencies, and investment grade by two. Unless the deal fails, it is junk grade, with all of the problems listed in my note above for Toys ?R Us.

There is a time in the cycle to buy debts like this, but it is not now. The level of panic is too low. Wait until we see significant defaults in high yield borrowers, and then revisit this question. Spreads have widened on high yield names, but not as much as they will when defaults start coming through.

One final note, when the cycle turns, you don?t want to mess around with AT paper maturing in 2012. You would want the stuff maturing in 2029 or 2032. If you?re going to play it, play it to the hilt, but only once the cycle has turned.

Tickers mentioned: AT

Watching the Maple Leaves Rise as Fall Approaches, or, Maybe I’m Just Looney

Watching the Maple Leaves Rise as Fall Approaches, or, Maybe I’m Just Looney

Posted on by David Merkel

What a day.? We’ve had too many “What a days” lately, and its late.? Over at RealMoney today, I posted this:


 David Merkel
Watching the Maple Leaves Rise as Fall Approaches
9/20/2007 12:49 PM EDT

It brings a lump to my throat, but the Canadian dollar briefly traded over parity to the U.S. dollar today. My guess is that it decisively moves above the U.S. dollar, and stays there for a while. Why not? Their economy is in better shape.Oh, and to echo one of Doug’s points, watch the 10-year swap yield. Nothing correlates better with the prime 30-year mortgage rate. It’s up 13 basis points since the FOMC move.

Looking at slope of the yield curves 10-years to 2-years, the Treasury curve has widened 20 bp and the swap curve 23 bp. If all Bernanke is trying to do is calm the short-term lending markets, that’s fine, but the long-term markets are getting hit.

Even in the short-term markets, things aren’t that great. We’re past the CP rollover problem, but the TED [Treasury-Eurodollar] spread is 135 bp now, and that ain’t calm.

I’m not a bear here, but there are significant risks that we haven’t eliminated yet… most of them stemming from the need for residential real estate to reprice down 10%-20% in real terms. Hey, wait. Hmm… what if the FOMC doesn’t really care about inflation anymore? They could concoct a rise in the price level of 20% or so, which would presumably flow through to housing, bailing out fixed-rate borrowers with too little margin (ignore for a moment that floating and new financing rates will rise also).

Okay, don’t ignore it. It will be difficult to inflate our way out of the problem. Even as the dollar declines, it will cause our trading partners to decide whether they want to slow their export machines by letting their currencies rise or buying more eventually depreciating dollar assets.

I would still encourage readers to be cautious with real-estate-related assets and those who finance them. Beyond that, just be wary of firms that need financing over the next two years. It may not be available on desirable terms.

Position: none, but who is not affected by this?

Interesting Times

We are within a half percent of taking out the all time low (1992) on the Dollar Index [DXY].? Since the move by the FOMC the ten-year Treasury has moved up 21 basis points.? That’s not stimulative.? Then again, maybe the FOMC wants to address the short term lending crisis, but could care less about stimulating the economy as a whole.? If this is their goal, let’s stand up and applaud their technique, but perhaps not their goals.

All that said life has returned to the investment grade bond market, and may be returning to the junk market, and maybe even the LBO debt market, if the banks will take enough of a loss to get things moving.? What I am finding attractive currently in fixed income right now is prime residential mortgage paper (this is rare — I usually hate RMBS).? Implied volatilities in are high, just look at the MOVE index, but they will eventually come down, at which point, the prices of mortgage bonds should improve (on a hedged basis).

Beyond that, I like foreign bonds, but am uncertain as to what currencies to go for; I still like the Canadian dollar, yen and the Swiss franc, but beyond that, I don’t know.? Aside from that, keep it short and high quality, because the long end isn’t acting well, and the junk credit stress is starting to arrive.

Away from that, I also still like inflation protected bonds, but they have run pretty hard since April.? TIPS overshot on the FOMC announcement, and have undershot since.? What a whipsaw.

So where would that leave me if I were a bond manager?? Foreign, mortgages, inflation-protected, and short duration high quality.? Sometimes the game is about capital preservation, and nothing more.

Investing in a Stagflationary Environment

Investing in a Stagflationary Environment

Posted on by David Merkel

I intend to get back to answering more reader questions, and doing it through posts.? I’ve been somewhat derelict in responding to comments, and I want to do it, but time has been short.? Here is a start, because I think the answer would be relevant to a lot of readers.

From a reader in Canada:

I enjoy your writing as many of your comments generate a wider perspective than my own.? There is always something to learn.

I was too young to appreciate the last stagflationary period.? Yet, I need to manage my portfolio.? My approach is more ETF based, whereas, I see that you prefer specific stocks.

I struggle in anticipating the currency impact on my foreign holdings.? I’m a Canadian based investor.? The simple solution is to pull in my exposure and be more Canada centric.? This idea conflicts with my goal to have my portfolio weighted in similar fashion to the global markets (i.e., Canada is a very small percentage relative to the total).? I also do not subscribe to the excessive weighting in gold as a major investment theme.? To me, it’s insurance to help offset risk elsewhere.

I’m not asking for specifics as you are not familiar with my situation.? Do you have any recommended reading or suggestions to help me test my thoughts and to identify options, so that I can arrive at a better decision?

Well, I’m not that old either.? During the last stagflation, I was aged 13 to 22, from junior high through my Master’s Degree in Economics at Johns Hopkins.? That said, I have read a lot on economic history, so I understand the era reasonably.? I also spent many of my Friday evenings as a teenager watching Wall Street Week with my first teacher on investments.? (Hi, Mom! 🙂 )? Another thing I remember is being the student representative to the school board for two years 1977-1979, when our district in Brookfield, Wisconsin decided to do a wide number of capital improvements in order to save energy, at the peak of the “energy crisis.”? I remember that the payback periods were 15 years or so, not counting interest that they would have to pay on the munis that they issued.? No way that project saved money on a net present value basis.? (And it was depressing to see 2/3rds of the windows covered up.)

During the last Stagflation, bonds were called “certificates of confiscation” by many professionals in fixed income.?? It paid to have your fixed income assets as short as possible.? Money market funds, a new invention at the time, were the optimal place to be until about 1982, when the cycle shifted, and the longest zero coupon bonds were the new best place to be.? Timing the shift between cycles is difficult, so don’t try to time it exactly, but add more longer bonds as long rates rise.? Right now, I would stay in money market funds, inflation protected bonds, and foreign currency denominated bonds.? You have enough Canadian exposure, so aside from you money market funds, consider bond investments in the yen, Swiss franc and Euro.

As for equities, pricing power is critical.? Who can raise prices more than the cost of their inputs?? Producers of global commodities like oil, metals, etc., typically do well here.? Financial companies with short duration assets or exposure to hard assets should do better here.? Staples should do better versus durables.? Growth investing should beat value investing (uh, oh, what do I do?? All of my processes are geared toward value investing).?? Cyclical names may beat them both.

If inflation really takes off, hard assets will offer some shelter though housing will lag until the inflation of real estate exceeds the deterioration of the debt.? I occasionally like gold, but it’s not a panacea.? I’d rather own the economically necessary commodities.

But what if stagflation does not become a reality?? That’s why we diversify.? I don’t tie my whole portfolio to one macroeconomic view.? Instead, I merely tilt it that way, leaving enough exposure elsewhere to compensateif my economic forecast is wrong.? I am a value investor, and almost always have a a few companies that will do well even if my economic forecast fails.

In summary: keep your domestic bonds short.? Diversify into foreign currency bonds.? Keep a diversified equity portfolio, but focus on companies that are immune to, or can benefit from inflation.

Eight Notes on a Distinctive Day

Eight Notes on a Distinctive Day

Posted on by David Merkel
  1. My broad market portfolio trailed the market a little today. I’ve been a little out of favor over the past three months; I’m not worried, because this happens every now and then. That said, we are coming up on another portfolio rebalancing, where I will swap out 2-3 stocks, and swap in 2-3 others. Watch for that in the next few weeks.
  2. Every group in the S&P 1500 was up today. I can’t remember when I have seen breadth like that before. Financials and Energy led the pace. Names like Deerfield Triarc flew on the Fed cut. They will benefit from cheaper repo rates, and the excess liquidity injected the system should eventually ease repo collateral terms.
  3. If the US dollar LIBOR fix at 6AM (Eastern) tomorrow follows the move in the US futures markets today, then we should see LIBOR drop by 27 basis points or so. Given the smaller move down in T-bill yields, 14 basis points, that would leave the TED spread at 132 basis points, which is still quite high, and higher than the 10-year swap spread. (LIBOR would still be higher than the 10 year swap yield.) This indicates that there is still a lack of confidence among banks to lend to each other on an unsecured basis. Things are better than they were two weeks ago, but still not good.
  4. The short term crunch from the rollover of CP, especially ABCP is largely over. The good programs have refinanced, the bad programs have found new ways to finance their assets, or have sold them, or used backup guarantors, etc.
  5. Watch the slope of the yield curve. It is my contention that the slope of the yield curve changes relatively consistently through loosening and tightening cycles. In the last tightening cycle, the curve flattened dramatically through the cycle, making the word “conundrum” popular. This is only one day, but the yield curve slope, measured by the difference in yields between 10-year and 2-year Treasuries, widened 10 basis points today. (The curve pivoted around the 7-year today.) If I were managing bonds at present, I would be giving up yield at present by selling my speculative long bond positions that served me well over the past few months in my model portfolio. I would be upping my yen and Swiss Franc positions.
  6. We learned some new things about the FOMC today: a) They don’t talk their book publicly, so don’t take their public comments too seriously. b) They are willing to risk more inflation for the sake of the non-bank financial system (which is under threat), or economic growth (which may not be under threat). c) They are flagging the Fed funds rate changes any more by letting rates drift nearer the new target in the days before the meeting. d) Beyond that, we really can’t say yet whether this is a “one and done” or not yet. We just don’t have enough data. e) The FOMC really isn’t interested in transparency.
  7. It would be historically unusual for this to be a “one and done.” Fed loosenings are like potato chips. It’s hard to stop at one. Just as there is a delay in the body saying, “that’s enough,” with the potato chips, the in the economy in reacting to monetary policy is slow as well, often leading policy to overshoot, as the FOMC reacts to political complaints to do more because things aren’t immediately getting better. It’s hard to sit in front of the short-term oriented Congress, or listen to the manic media, and say, “But the FOMC has done enough for the economy. It doesn’t look good now, but in 18 months, our policy will take effect and things will be better. Just trust us and wait.” That will not fly rhetorically; it will take a strong-headed man to not overshoot policy. On that Bernanke is an unknown.
  8. To me, it’s a fair assumption then that this cut will not be the last. Investment implications: in fixed income stay in the short to intermediate range, and remain high quality. Buy some TIPS, and have some foreign bonds as well. I like the Yen, Canadian Dollar, and the Swiss Franc. In equities, think of high quality sectors that can use cheap short-term credit, and sectors that benefit from inflation and a weaker dollar. So, what do I like? High quality insurers, mortgage REITs that have survived, (maybe trust banks?), basic materials, energy, goods transportation, staples, some areas in healthcare and (yes) information technology (if I can find any more cheap names there that I like).

Full disclosure: long DFR

Seven Reasons Why the FOMC Will Not Cut 50 Basis Points

Seven Reasons Why the FOMC Will Not Cut 50 Basis Points

Posted on by David Merkel

As I have said before, my view on the FOMC has gone cloudy.? That said, I’ll put forth my best guess for you what the FOMC will do and say today.? I think the FOMC will ease the Fed funds target 25 basis points, or maybe a little more, but not 50 basis points.? (Stuck my neck out there, hope I don’t get chopped.)? Here’s why:

  1. Not all lending crises are over, but the crisis in the CP market largely is over.? There was some paper that had to be taken back by the banks, and some that had to be rolled over at relatively high rates, but the refinancing of the bulk of short term credit is done for now.
  2. Total bank liabilities are growing smartly since the change in the discount window, leverage changes, and temporary liquidity adjustments took effect.? Little effect on the Fed’s monetary base, M1, MZM, or M2 yet.? This is just a bank leverage thing.
  3. The NY Fed Open Markets desk continues to be sloppy on the upside.? Over the last four days, three times Fed funds finished over 5.25%, with the close yesterday at 5.4325%.? This is not what you would expect to see from a Fed that expects to loosen aggressively.
  4. The discount window finally got good demand last week.? With that strategy seeming to work, the FOMC has less pressure to cut the funds rate.? Might they cut the discount rate more than the funds rate?? Yes. because seeming success often breeds more of the same.
  5. Business conditions aren’t that bad nationally yet.? Real estate is a drag, and will get worse, but it is not an immediately obvious reason to loosen.
  6. A 25 basis point move validates the temporary policy move of the Fed, and does not change policy, beyond making the more semi-permanent.
  7. There are more hawks with votes on the FOMC now, and Bernanke is not pushing to get his way, the way that Greenspan did.

Beyond that, we have the language of the statement, where the FOMC will attempt to sound a balanced view between the risks of inflation and economic weakness.? After the announcement, I expect the stock market to fall back and then rally modestly.? Bonds won’t do much.

That’s my view, though I must state that this is not one of my more strongly held views.? I am still gathering data on the current Fed, because they are so new to their roles in loosening environment.

Fifteen Notes on the State of the Markets

Fifteen Notes on the State of the Markets

Posted on by David Merkel

1)? Start with the pessimists:


2)? Move to the optimists:

3) Hedge funds are getting outflows at present (and here), and August performance was pretty bad (and here — look at? “Splutter”).? I began toting up a list of notable losers, but it got too big.? One positive note, many of the large quant funds bounced back from their mid-August stress.

4)? When muni bonds get interesting, you know it’s a weird environment.? It starts with the fundamental mismatch of muni bonds.? Muni issuers want to lock in long term financing, but most investors want to invest shorter.? Along come some trusts that buy long bonds and sell short-dated participations against them, and hedge the curve risk with Treasuries.? When credit stress got high, long munis were sold because they could be, and long Treasuries rallied, which was the opposite of what was needed for a hedge.? (Note: hedging with Treasuries can work in normal markets, but fails utterly in panics, as happened in 1998.)? When the selling was done, in many cases high quality muni yields were high than Treasuries even before adjusting for taxes.? That didn’t last long, but munis are still a good deal here.

5) Large caps are outperforming small caps.? Foreign exposure that large caps have here is a plus.

6) Not all emerging markets are created equal.? Some are more likely to have trouble because they are reliant on foreign financing. (Latvia, Iceland, Bulgaria, Turkey, Romania)? Others are more likely to have trouble if the US economy slows down, because they export to us. (Mexico, Israel, Jordan, Thailand, Taiwan, Peru)? I would be more concerned about the first group.

7) Are global banks cheap?? Yes on an earnings basis, probably not on a book basis.? We need to see some writedowns here before the group gets interesting.

8) I’ve talked about SFAS 159 before, and you know I think it is a bad accounting rule.? This article from my friend Peter Eavis helps to point out some of the ways that it allows too much freedom to managements to revalue assets up.? What I would watch in financial companies is any significant increase in their need for financing, which could point out real illiquidity, even though the balance sheet might look strong; this one is tough because financials are opaque, and the cash flow statement is not so useful.? Poring over the SFAS 159 disclosures will be required as well.

9) As I have suggested, pension plans will probably end up with a decent amount of the hit from subprime lending, through their hedge fund-of-funds.

10) Hedge funds do better if the managers went to schools that had high average SAT scores?? I would not have guessed that.? Many of the best investors I have known were clever people who went to average schools.

11) My but bond trading has changed.? When I was a corporates manager, hedge funds weren’t a factor in trading.? Now they are 30% of the market.? Wow.? Surprises me that volatility isn’t higher.

12) Rich Bernstein of Merrill (bright guy) is getting his day in the sun.? His call for outperformance of quality assets seems to be happening.? Now the question is whether the cost of capital is going up globally or not.? If so, he says to avoid: “1) China, 2) emerging market infrastructure, 3) small stocks, 4) indebted U.S. consumers, 5) financial companies, 6) commodities and energy companies.“? Personally, I think the cost of capital is rising for companies rated BBB and below, which brings it back to the quality trade.

13) Econocator asks if markets have priced in a recession, and he says no. My problem with the analysis is that we would need 10-year Treasury yields in the 2.5% area to fully price it in by his measure, and that makes no sense, outside of a depression, and then, nothing is priced in.

14) Morningstar moves into options research.? Could be interesting, though Value line has had a similar publication, and I’m not sure that the market for publications like this is big enough.? They make a good point that most people use options wrong, and get the short end of the stick.

15) Oil is amazing, but wheat is through the roof.? I’ve seen articles about bread prices rising.? Fortunately, the cost of grain is a small part of the cost of foods that rely on grain.

With that, I bid you good night.

Eight Notes on Residential Real Estate

Eight Notes on Residential Real Estate

Posted on by David Merkel

For those wanting a road map of where I am likely to post over the next few days, tonight is mortgages and real estate, tomorrow is speculation, and Friday should involve longer dated topics. For those that commented on the blog redesign, I want to say that I appreciated your comments, particularly the critical ones. In the next two months, I’ll be doing a minor redesign to fix some of the flaws that I introduced in the process. I’m not perfectly happy with the result, and it can be improved. Trivia: I co-edited the best high school yearbook in the nation back in 1979, so I do have some eye for design. It’s more of a question of the computer implementation.

Onto real estate:

1) After a bubble bursts, it’s amazing the details that come out on the ethical lapses that transpired. With Countrywide, people were steered into loans that were worse than what they might have qualified for there or elsewhere. Now, they should have shopped around; I always do that on mortgage loans. That Countrywide is still facing problems after the Bank of America infusion might not be too surprising; companies that cut corners with their customers are more likely to be aggressive in their accounting practices. After the post-bailout bounce, the convertible preferred that Countrywide got is now under the $18 strike price.

CFC price chart

2) Can the mortgage crisis swallow a town?? Yes.? I know this personally, as some friends of mine on the Eastern Shore of Maryland are finding out right now.? They are not in one of the best areas, and demand has dropped off a cliff.? Entire neighborhoods near them are in bad shape, making everything else less salable.? They need to sell their home for medical reasons, and they can’t do it without taking a loss, which would impoverish them.

3) The internals of the housing market are now such that no one is arguing over the troubles faced.? Consider:

4) But won’t the President and Congress bail out strapped homeowners?? Tough task.? Current proposals are just dust on the scales, and doing anything big would be a budget-buster.? I agree with Accrued Interest; a bailout is bad policy.? I suspect one will happen anyway.? Washington, DC specializes in bad policy, if it wins votes.

5)? After a bubble bursts the second order effects can be quite significant.? Consider:

6) Now, I wonder if Merrill Lynch will have any significant hits from subprime.? I would expect it, but who can tell for sure?

7)? Was it such a good idea for the US government to promote home ownership so vigorously?? I have generally said no, and Caroline Baum questions the wisdom of the policy as well.

8) Finally, we keep them in a bubble to make sure that their theories on how the economy works do not get contaminated by data.? I’m partly kidding here, but the Fed is very optimistic that any spillover from residential real estate to the general economy will be light.? I think the effect will be moderate; it will definitely hurt, but not destroy the US economy.

Tickers mentioned: BAC CFC GS MER

Looking Beyond the US

Looking Beyond the US

Posted on by David Merkel

So, what’s happening in the global economy?? Let’s start with the weak dollar.? As Fed policy tilts toward loosening, the already weak dollar hits a 15-year low, and is less than 2% from an all time low.? The carry trade currencies, the yen and the Swiss franc, rallied the most during the dollar sell-off.? (Here’s a good summary article on the carry trade.)

It’s not that foreigners are fleeing the dollar (unlike this article), though Treasuries are getting less attractive, because the dollar-based investments must be bought by someone.? That doesn’t mean the exchange rates don’t shift down in the process, though, and exports seem to be improving because of the weaker dollar.? Also, the idea that China would try to ruin the US through selling all of their dollar-based reserves is unlikely, though not impossible.? China is too big of a holder to sell without driving the dollar down massively, which would force down the value of their remaining holdings, and harm their ability to export to the US.

Besides, what would they trade into?? The US has the largest, most diverse debt markets in the world.? One reas
on why the US is the world’s reserve currency, despite all of its flaws, is that there is no other economy with a currency capable of filling the role.? Perhaps this article should have been titled, “Why isn’t the dollar falling more?” because the dollar has been falling, yet there are some things good about the dollar, and the US economy.

China is bumping up against the boundaries of its economy’s current capacity.? With few additional young laborers, wage rates are rising.? Inflation is now at a 10-year high.? That’s leading the government to tighten monetary policy.? Beyond that, it is raising the prices of their exports, which slowly forces inflation into the US and other trading partners.

India is facing similar difficulties.? Wages are rising rapidly, amid rapid real growth, putting pressure on interest rates to rise.? In one sense, this is what you get for taking back US assets in exchange for selling goods and services to the US.? So long as your labor pool appears inexhaustible, you can avoid inflation at home, because you aren’t paying new workers much.? But when workers become more scarce, the absence of imported goods for those workers to buy means that there will be inflation.? Also, excess dollar reserves often produce excess credit, if the central bank allows the money supply to grow from the dollar reserves, which can lead to credit-induced inflation.

Final quick notes:

In summary, we are in a situation where the dollar is likely to remain weak.? If currency calm returns, the carry-trade currencies will do badly, but if volatility picks up, the opposite will happen.? (I can make a case either way.)? China and India are on fire, and the developed nations are largely on ice.? We are living in interesting times; in the long run, the development of the poorer areas of the world will be a big plus, particularly for US agriculture and resource extraction industries, but there will be bumps along the way.? Keep your positions flexible enough to be able to benefit from volatility; I sense we are entering a more volatile period.

My 9/11 Experience

My 9/11 Experience

Posted on by David Merkel

Six years ago, I was a neophyte (2 months) corporate bond manager, also doing mortgage bonds, and nominally Chief Investment Officer of a medium-sized life insurance company. I was leading our asset management team through a merger with another firm as well. On 9/11, I was going to have a meeting with my new bosses and the management of our one and only life insurance client.

I was running a little late, so I got to the office as the first tower fell. I talked with a few of my brokers, and concluded that nothing would be trading today. After the second tower fell, our offices were crowded from people in the insurance company watching the spectacle on CNBC. I told my staff to prepare a broad threat report, describing what parts of our portfolio would be harmed by the events; after that, they could go home and grieve. (Our KBW coverage died that day; he was a good fellow.) I went to the meeting, where we canceled our agenda, and I gave a brief threat report, and told them they would have full threat report every day at 4PM until the markets normalized. Aside from owning part of a mortgage on a building near the World Trade Center (One Liberty Plaza) which was rumored to be leaning (not true), the problems were pretty light; liquidity was adequate.

That evening I showed my family video clips from the Internet, and explained what had happened. We’re a pretty matter of fact bunch, so they took it in stride, and realized that the world had changed for the worse.
Because of the merger, the portfolio was relatively high quality. Good thing, too. The markets were closed for the whole week, and reopened the next week. Bond markets are networks, and so, they come back proportionally to the square of the nodes. After one week, the bond market was half functional. After two weeks, 80% functional. After three weeks, 100% functional. We started trading sooner than most, and offered liquidity in exchange for good deals. When our merger closed on 9/30, was began a massive down-in-credit trade, buying bonds in sectors most affected by the disaster. Our logic was that the terrorist event was a “one off” matter where the highjackers got really lucky, and that the odds of a second event were nil, now that the US was on alert.

When I went to a Chief investment Officer’s forum in October, there was a “closed door” meeting with “peer companies” to discuss problems and strategies. One of the early questions was how investment strategy had changed since 9/11. I was the odd man out. We were the only one in the room taking more risk. Everyone else was running up-in-credit trades, and avoiding affected sectors. Not only did I get a “you’re weird” look from the other participants, but I got the “you’re irresponsible” look as well. Not fun.

We continued the down-in-credit trade for another month until we had gone as far as we thought prudent. Then our client came to us and said that the ratings agency heard what we were doing, and told us to knock it off, or face a downgrade. We were done, so we agreed. By this time, it was mid-November. By December, a little more willingness to take risk took hold, and by the first quarter of 2002, there was a full-fledged scramble for yield. We sold into it, doing a massive up-in-credit trade that left the portfolio higher quality than it was prior to 9/11, and giving us room for the upset that would happen as Worldcom went down, and the corporate bond markets doing a double dip in late July and early October. We played the risk cycle very well.


There are four investment points here:

  • Don’t follow the crowds during panics.
  • Don’t follow the crowds during manias.
  • Know your limits. No matter how good an idea will work out eventually, don’t overplay it, because the market can be crazy longer than you can stay solvent.
  • After a panic event, analyze what has truly changed, and ask what things will be like when the next steady state comes, and how long it will likely take to get there.

It was not a consensus view at the time, but the idea that not much had changed permanently proved to be a valuable idea. Capitalist economies tend to be resilient, bending but not breaking. With that, guard your emotions, and try to be analytical toward investing, even when times are abnormal, and people think you are nuts.

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