Category: Quantitative Methods

Best of the Aleph Blog, Part 18

Best of the Aleph Blog, Part 18

Posted on by David Merkel

These articles appeared between May and July 2011:

Most People are not Better off Buying Common Stocks on their own

versus

Why Amateurs Should Invest in Common Stocks

Yes, I wrote them both, but they complement each other.? Yes, most average people get skinned investing in common stocks, but if you apply yourself assiduously to investing, it will improve your performance in other jobs, by broadening your skill set.

Impossible Dream, Part 2

Impossible Dream Project, Part 1

The latter of (part 1) these was my highest day and month for access of my blog.? I came close to eclipsing the monthly total last month, but missed by 2%.? These pieces take up asset allocation via valuation, and momentum.

Learning Leadership

A story of how Roy and I disobeyed orders a little, and created a lot of growth for the company that we served.? Personally, I think this is a great story… I never created more value than when I worked for Provident Mutual.

On Longevity Derivatives

I like to think that I am an intelligent skeptic on derivatives; in this case credit risk fights any real hedging.

Segmenting to Make Better Decisions

The smaller the range of choices is, the better people do in choosing.? One way to facilitate that is to break down decision making into a series of choices with each having few options.

The Rules, Part XXI

All assets represent future goods.? The prices of assets represent the trade-off between present goods and assets.

The Rules, Part XXII

Rapid money supply growth with no consumer price inflation can only really occur within the confines of an asset price bubble, or else, where does the money go?? Interest rates are low at such a time because of the incredible liquidity, and complacency of lenders that they will get an equal amount of purchasing power back.? Perhaps another possibility is when a country?s currency is being used more and more as a shadow currency, like the US in the Third World.? But even that will come home someday.

Learning to Like Lumpiness

This is probably one of the most important articles I have written, because investment returns are lumpy, and we need to learn to live with it.? For those of us that are smart, we need to take advantage of it.

What is Liquidity (V)

Liquidity cannot be created, but it can be redirected.

Got Cash?

Cash is valuable even when interest rates are low.? Cash is flexibility and optionality.

Enduring Ponzi

Madoff’s Ponzi scheme lasted so long because it raked off so little.

The Costs of Illiquidity

On the tradeoff of liquidity in order to get yield.

Silent as Night

It also taught me a lesson.? When fees are deducted daily, no one notices.

?Is He Economically Rational??

Now after all of this, it?s not so much a question of rationality but ethics.? Who will do the right thing for the one he ultimately serves?? Working for those people is a joy, and is beneficial to those that own. Doing right does well for many.

Downgrade Jitters

On why credit ratings are opinions, and not facts.

Where to Hide?

How to preserve purchasing power, even when it is difficult.

The Costs of Illiquidity ? II

Don’t buy REITs that are not publicly traded.

 

Book Review: The Crisis of Crowding

Book Review: The Crisis of Crowding

Posted on by David Merkel

 

I am going to say something that I rarely say: I am grateful that this book was written.? Why am I grateful?

  • It highlights the idea that people, even really bright people, do not behave rationally, but imitatively — they follow recent price action — they mimic.
  • It validates the concept of a “crowded trade,” one that offered high returns in the past, may presently offer low returns to a “buy and hold” investor, but will deliver negative returns in the near future, because the holders of the trade are relying on the trade to deliver positive returns in the short run, and will bail if it doesn’t happen.
  • It points up the nonlinearity of markets, and invalidates the efficient markets hypothesis; it validates the concept of the boom-bust cycle both in micro and macro.
  • It teaches us to not take on too much debt, even if we are really, really smart.? We aren’t as smart as we think we are.
  • In short, it sums up a lot of my philosophy at The Aleph Blog.? Real risk control thinks long term, and considers what will happen if liquidity dries up.? Real risk control knows that large positions in any asset relative to the market must be regarded to be “Buy-and-hold” regardless of what your trading intentions are.? False risk control assumes that markets always function, and that your relative size versus the market does not matter.

The author of the book has led a storied life.? He was a quantitative analyst hired to work in risk control for Long Term Capital Management [LTCM] near its inception, and continued with them through the failure.? After that, he worked for Rydex, built FOLIOfn, and worked for the Bank of International Settlements, and Schroders.? He now works as a professor of finance at the University of San Francisco, after having gotten a PhD from MIT.? He knows the markets both practically and experientially, like me, though he is better than me.

LTCM is a great example of what happens when some really smart guys find clever ways to make money in the markets, and then overplay them.? The trade that has a buy-and-hold yield of 10% is genius.? When it is 8% it is bright.? At 6% it is average, why are you playing?? At 4% it is dopey.? But what happens when your trade gets big relative to the market?? The rules change, much like JP Morgan recently.? When you are big enough that you are moving the market as a normal practice, that indicates danger.? You have become the market, and are distorting it.? It will eventually come back to bite you, as JP Morgan recently learned.

The failure of LTCM may have been the template, but the author goes on to explain other disequilibrium situations such as:

  • The quantitative equity panic of August 2007
  • The failure of Bear Stearns.
  • The failures of Fannie and Freddie (free money brings out the worst in all of us)
  • The failure of Lehman Brothers.
  • The failure of the banking system both in the US & Europe
  • The failure of LTCM progeny in 2008 (no, we don’t learn)
  • The Flash Crash
  • The failure of the Eurozone, so far. (It is performance art.? How can we create the biggest failure ever?? We will eclipse the Great Depression! Oui! Ya!)

I’ve written about most of these, and I can tell you the author does a good good job.? Aside from that, he took time to interview primary sources as to their own view of the events that happened, particularly at LTCM and its progeny, and it adds to what we know about the crises that he wrote about.

People need to understand that crises are a normal aspect of markets.? Until you understand that crises are normal, you will always take too much risk.

This is an excellent book; buy it and avoid losses.

Quibbles

In the beginning he got the name of Cramer’s firm wrong.

I would have eliminated the appendices if I were the editor, the audience that can benefit from the math is too narrow to be worth printing it in the book.? Better you should put a PDF out on the web, and put out a slimmer book.

Who would benefit from this book: If you want to understand why crises happen, buy this book.? It is well-written but requires some degree of market knowledge for the reader to benefit.? It is not for beginners.?? If you want to, you can buy it here: The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal (Bloomberg).

Full disclosure: The PR flack asked me if I would like the book and I assented.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

 

On the International Business Machines Industrial Average

On the International Business Machines Industrial Average

Posted on by David Merkel

Company

Price

YTD Return

Dow Weight

Ratio to Equal Weight

Ticker

Mkt Cap ($B)

Weight MC

Ratio to Dow Weight
AA?Alcoa Inc

?8.63

-0.23%

0.51%

?0.15

AA

?9.21

0.23%

2.20
AXP?American Express Co

56.42

19.61%

3.35%

?1.00

AXP

63.96

1.62%

2.07
BA?Boeing Co

70.36

-4.08%

4.17%

?1.25

BA

52.90

1.34%

3.12
BAC?Bank of America Corp

?8.15

46.58%

0.48%

?0.14

BAC

87.83

2.22%

0.22
CAT?Caterpillar Inc

87.63

-3.28%

5.20%

?1.56

CAT

57.25

1.45%

3.59
CSCO?Cisco Systems Inc

19.12

5.78%

1.13%

?0.34

CSCO

?101.97

2.58%

0.44
CVX?Chevron Corp

?111.29

4.60%

6.60%

?1.98

CVX

?218.37

5.52%

1.20
DD?E. I. du Pont de Nemours and Co

50.24

9.74%

2.98%

?0.89

DD

46.74

1.18%

2.52
DIS?Walt Disney Co

49.17

31.12%

2.92%

?0.87

DIS

88.22

2.23%

1.31
GE?General Electric Co

20.64

15.24%

1.22%

?0.37

GE

?217.93

5.51%

0.22
HD?Home Depot Inc

56.55

34.51%

3.35%

?1.01

HD

84.88

2.14%

1.56
HPQ?Hewlett-Packard Co

17.64

-31.54%

1.05%

?0.31

HPQ

34.77

0.88%

1.19
IBM?International Business Machines Co…

?195.70

6.43%

11.61%

?3.48

IBM

?223.64

5.65%

2.05
INTC?Intel Corp

25.04

3.26%

1.48%

?0.45

INTC

?125.28

3.17%

0.47
JNJ?Johnson & Johnson

67.74

3.29%

4.02%

?1.21

JNJ

?186.76

4.72%

0.85
JPM?JPMorgan Chase and Co

37.23

11.97%

2.21%

?0.66

JPM

?141.43

3.57%

0.62
KFT?Kraft Foods Inc

41.28

10.48%

2.45%

?0.73

KFT

73.25

1.85%

1.32
KO?The Coca-Cola Co

38.11

8.93%

2.26%

?0.68

KO

?171.57

4.34%

0.52
MCD?McDonald’s Corp

88.25

-12.04%

5.23%

?1.57

MCD

88.99

2.25%

2.33
MMM?3M Co

91.98

12.54%

5.45%

?1.64

MMM

63.59

1.61%

3.39
MRK?Merck & Co Inc

42.80

13.53%

2.54%

?0.76

MRK

?130.35

3.29%

0.77
MSFT?Microsoft Corp

30.26

16.54%

1.79%

?0.54

MSFT

?253.64

6.41%

0.28
PFE?Pfizer Inc

23.74

9.70%

1.41%

?0.42

PFE

?177.33

4.48%

0.31
PG?Procter & Gamble Co

66.68

-0.04%

3.95%

?1.19

PG

?183.65

4.64%

0.85
T?AT&T Inc

36.56

20.90%

2.17%

?0.65

T

?210.91

5.33%

0.41
TRV?Travelers Companies Inc

64.80

9.51%

3.84%

?1.15

TRV

24.97

0.63%

6.09
UTX?United Technologies Corp

79.20

8.36%

4.70%

?1.41

UTX

72.21

1.82%

2.57
VZ?Verizon Communications Inc

42.25

5.31%

2.51%

?0.75

VZ

?120.37

3.04%

0.82
WMT?Wal-Mart Stores Inc

71.56

19.75%

4.24%

?1.27

WMT

?242.16

6.12%

0.69
XOM?Exxon Mobil Corp

87.31

3.01%

5.18%

?1.55

XOM

?403.02

10.18%

0.51
Total

?1,686.33

?3,957.15
High

47%

?3.48

10.18%

6.09
Low

-32%

?0.14

0.23%

0.22
Ratio

24.01

43.76

?27.97

As I was considering the Dow Jones Industrial Average, I considered how much influence IBM has relative to an equal-weighted index.? It has 3.48 times more influence that the average.? Then I considered the lack of influence of Bank of America [BAC], whose influence is 86% less than the average.? It may be up 47% YTD, but it budges the index but little despite its large market cap.

Such is life in a price weighted index that was designed to work around 1900. Add up the prices, divide by a number, and there is the index.

Even an equal weighted index would be more realistic.? But what if we created a market cap (actually float) weighted DJIA, like the S&P 500?

At this point, Exxon Mobil would be the heavy hitter, and small Alcoa the baby.? Prediction: Alcoa and The Travelers will leave the Dow, to be replaced by Oracle and Berkshire Hathaway “B” shares.

Wait! Oracle?! Why not Apple or Google?? Their share prices are too high, and the DJIA is too messed up already.? If Bank of America wanted to help the Dow, they would do a 1-10 reverse split, as should Alcoa, should they stay in the Dow.

The DJIA is a historical accident that has more then outlived its 15 minutes of fame.? It does not represent the market as a whole.? The best that Dow Jones News Corp could do is remake it as a megacap market cap weighted index.? Then it might have real punch and validity.? Call it the News Corp Industrial Average [NCIA].? What might that index look like?

company ticker

mktcap

Percentage
Apple Inc. AAPL

607,542

11.02%
Exxon Mobil Corporation XOM

408,049

7.40%
Microsoft Corporation MSFT

259,047

4.70%
Wal-Mart Stores, Inc. WMT

243,581

4.42%
International Business Machine IBM

229,949

4.17%
General Electric Company GE

221,736

4.02%
Google Inc GOOG

221,447

4.02%
Chevron Corporation CVX

221,055

4.01%
AT&T Inc. T

214,434

3.89%
Berkshire Hathaway Inc. BRK.A

212,869

3.86%
Johnson & Johnson JNJ

186,927

3.39%
Procter & Gamble Company, The PG

184,536

3.35%
Wells Fargo & Company WFC

179,753

3.26%
Coca-Cola Company, The KO

177,961

3.23%
Pfizer Inc. PFE

177,699

3.22%
Philip Morris International In PM

157,413

2.86%
Oracle Corporation ORCL

157,217

2.85%
JPMorgan Chase & Co. JPM

140,478

2.55%
Merck & Co., Inc. MRK

131,998

2.39%
Intel Corporation INTC

131,729

2.39%
Verizon Communications Inc. VZ

125,522

2.28%
PepsiCo, Inc. PEP

114,215

2.07%
Amazon.com, Inc. AMZN

109,025

1.98%
QUALCOMM, Inc. QCOM

107,805

1.96%
Visa Inc V

104,389

1.89%
Abbott Laboratories ABT

103,451

1.88%
Cisco Systems, Inc. CSCO

102,102

1.85%
Schlumberger Limited. SLB

99,235

1.80%
Walt Disney Company, The DIS

90,539

1.64%
Comcast Corporation CMCSA

90,482

1.64%
Grand Total

5,512,183

 

What are the new companies? Comcast, Schlumberger,? Abbott Labs, Visa, QUALCOMM, Amazon, Pepsico, Oracle, Philip Morris, Wells Fargo, Berkshire Hathaway, Google, and Apple.

Who leaves? Alcoa, Travelers, United Technologies, 3M, McDonalds, Kraft Foods, Hewlett-Packard, Home Depot, Du Pont, Caterpillar, Bank of America, Boeing and American Express.

Now, that said, give the folks at News Corp Dow Jones some credit.? They created a flawed Behemoth index, but it is the only widely quoted Behemoth index, and my adjustment of it only improves the market capitalization by ~40%.? That said, capitalization-weighting makes it a much more rational index, and so I call upon Dow Jones News Corp to make the changes that the sentimental at Dow Jones never would, and turn the DJIA into the NCI.? Not an average, but a real Behemoth index that measures the performance of the largest companies of the US, which comprise ~30% of the total market capitalization.

There is the challenge, and taking it on will benefit investors for the next 100 years.? Are you man enough to take it on, News Corp?

Full disclosure: Long CSCO, CVX, HPQ, INTC, TRV, WMT, ORCL

On the Poway School District

On the Poway School District

Posted on by David Merkel

I am not an expert on Municipal Bonds, so if an expert reads this, and has corrections for me, please leave corrections in the comments.

In general, I am a conservative guy who avoids situations with a lot of debt.? I am also an actuary and a financial analyst who has a lot of experience with long dated assets.? I know how illiquid they can be, and how violent the price moves can be when they happen.

Most of the discussion here stems from this article: Where Borrowing $105 Million Will Cost $1 Billion: Poway Schools.

There are a few other notable writers who have picked up on this:

But unlike them, I want to give you more data, and less opinion.? For a start, here is the dense prospectus, should you want to review it.

As an aside, I looked at buying a house in Poway back in 1989, when I was considering a job in San Diego with the soon-to-be gone First Capital Holdings.? Poway was what I could afford in such an expensive area.

Financial crises always come at the wrong time.? In 2007, the Poway School District borrowed money to fix up the physical plant of the schools.? They financed it short-term, then in early 2009 issued the “A” notes, financing much of the project, encumbering tax revenues out to 2032, and allowed the rest to float via General Obligation Anticipation Notes.? The “A” series were also capital appreciation bonds, which means they are zero coupon bonds, and the interest comes from buying the bonds at a discount to the face value, and receiving the face value at maturity.? The time period was shorter then the “B” notes, so they were cheaper, and hence less odious.

Given that they had already encumbered tax revenues all the way out to 2032, and had a large amount of debt that they needed to refinance, they needed to issue more permanent debt.? They were already at their maximum level of what they could expect given assumed growth in the property tax base, so what could they do if they wanted to issue more general obligation debt without raising the tax rate?

After getting the assent of the voters in February 2008, to extend tax rates for an estimated additional 11 to 14 years, they issued the “A” notes, and then in 2011, the “B” notes.? The “B” notes picked up where the “A” notes left off.? They would make payments from 2033 through 2051.

Now, anyone who has worked with long duration fixed income (there aren’t many of us) know a few things:

  1. It’s illiquid because there aren’t that many that can fund it for so long.?? It becomes the province of strong balance sheets and speculators.
  2. It’s rare for people to give up current income for capital appreciation over the long haul.? Most people need income over the next 20-30 years.
  3. Slight changes in the interest rate can make a lot of difference to the value of the debt.
  4. When you issue very-long-dated credit-sensitive notes, expect to pay a high yield.? Poway SD is rated Aa2/AA-.? That’s a high rating, but when you say you will pay nothing for 20 years, that injects a lot of uncertainty/risk into the likelihood of payment.

After all, what will the courts be like 20 years from now?? What will the nation be like?? What will we default on or inflate away?? I know that present rules make it difficult for any entity to not repay General Obligation debt, but 20 years from now, things could be different.

The “B” notes, capital appreciatin bonds, that they offered in 2011 refinanced prior debts, and left $21 million to be used as they wished, which raised the hackles of the California Attorney General, though nothing came of that.? Letter from the Attorney General Article on the topic — Second article on the topic

Take a look at the sources an uses of funds:

ESTIMATED SOURCES AND USES OF FUNDS

The proceeds of the Series B Bonds are expected to be applied as follows:

Sources of Funds

Principal Amount of Series B Bonds??? $105,000,149.70
Original Issue Premium?????????????????????????????? 21,360,189.45
Total Sources???????????????????????????????????????????? $126,360,339.15

Uses of Funds

Deposit relating to partial payment of
Lease Revenue Bonds(1)????????????????????? ?? ? $98,707,473.55
Deposit for full payment of 2010 Notes 26,270,000.00
Costs of Issuance(2) ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ??? 569,114.44
Underwriter?s Discount????????????????????????????????????? 813,751.16
Total Uses????????????????????????????????????????????????? $126,360,339.15
____________________
(1) Includes $98,327,473.55 for partial payment of the Lease Revenue Bonds and $380,000 for payment of costs associated with refinancing the Lease Revenue Bonds.
(2) Includes, among other things, the fees and expenses of Bond Counsel, the fees and expenses of Disclosure Counsel, the fees and expenses of District Counsel, the fees and expenses of the Paying Agent, the fees and expenses of School District consultants, rating fees, the cost of printing the preliminary and final Official Statements and other costs associated with issuing, selling and delivering the Series B Bonds, as well as costs associated with refinancing the 2010 Notes.

I would note that the premium was entirely applied to the reduction of existing debts.? They may not be debts of the same class, and that makes me wonder.

Now capital appreciation notes are politically controversial.? Here is a White paper from the LA Treasurer, and here is an article about it.? It’s not that different than what you have heard already.? Borrowing using long zero coupon notes is expensive.

Let me show you the cash flow table for the “A” and “B” bonds.

Year

Series A

?

Compounded

Series B

Total

Ending

Total Annual

Principal

Interest

Total Annual

Combined

August 1st

Debt Service

Payment

Payment

Debt Service

Annual

?

?

?

?

?

Debt Service

2012

2013

2014

2015

2016

2017

$3,720,000

$3,720,000.00

2018

4,580,000

4,580,000.00

2019

5,525,000

5,525,000.00

2020

6,560,000

6,560,000.00

2021

7,690,000

7,690,000.00

2022

8,925,000

8,925,000.00

2023

10,275,000

10,275,000.00

2024

11,745,000

11,745,000.00

2025

13,355,000

13,355,000.00

2026

15,095,000

15,095,000.00

2027

17,005,000

17,005,000.00

2028

19,070,000

19,070,000.00

2029

21,350,000

21,350,000.00

2030

23,800,000

23,800,000.00

2031

26,455,000

26,455,000.00

2032

48,960,000

48,960,000.00

2033

16,615,000

6,570,615.00

23,929,385.00

30,500,000.00

47,115,000.00

2034

9,192,225.60

37,487,774.40

46,680,000.00

46,680,000.00

2035

8,803,904.00

39,516,096.00

48,320,000.00

48,320,000.00

2036

8,305,119.90

41,464,880.10

49,770,000.00

49,770,000.00

2037

7,923,383.30

43,086,616.70

51,010,000.00

51,010,000.00

2038

7,522,497.40

44,507,502.60

52,030,000.00

52,030,000.00

2039

7,107,169.80

45,702,830.20

52,810,000.00

52,810,000.00

2040

6,607,225.80

46,732,774.20

53,340,000.00

53,340,000.00

2041

6,072,404.70

47,537,595.30

53,610,000.00

53,610,000.00

2042

5,268,942.40

48,470,788.40

53,739,730.80

53,739,730.80

2043

4,900,657.60

48,974,867.45

53,875,525.05

53,875,525.05

2044

4,557,796.80

49,449,334.50

54,007,131.30

54,007,131.30

2045

4,239,633.60

49,909,078.80

54,148,712.40

54,148,712.40

2046

3,942,536.00

50,332,464.00

54,275,000.00

54,275,000.00

2047

3,237,210.90

51,177,273.40

54,414,484.30

54,414,484.30

2048

3,000,734.10

51,554,365.20

54,555,099.30

54,555,099.30

2049

2,780,993.25

51,904,836.75

54,685,830.00

54,685,830.00

2050

2,577,771.00

52,248,044.00

54,825,815.00

54,825,815.00

2051

2,389,328.55

52,575,671.45

54,965,000.00

54,965,000.00

The “B” bonds kick in after the “A” bonds give out, which means that if future politicians want to do capital improvement projects in the Poway school district, they will have to wait a while, until debt gets paid down.? The present has stripped flexibility from the future.? Who should be surprised, this is the USA.

Now one should argue over whether the expenditures reflect the life of the bonds.? Poway SD says that structures have a 45 year lifespan, and this fits inside that.

But maybe there was a cheaper way to fund this.? Rather than using Capital Appreciation Bonds, maybe a mortgage-style note could have done it, even over 40 years, and at a much cheaper rate.? Even accepting the premium boosted the combined yield of the “B” notes from around 6.9% to 7.6%.

As it is the deal bets on the appreciation of real estate:

Right now, the district receives about $11 million a year from homeowners towards paying off its bonds.

So, to be able to afford its debt payments 20 years from now, the total assessed value of property within the taxed area would have to quadruple.

That’s about 7%/year, which is not impossible if inflation comes.? It is still a difficult target to manage against.

Personally, I think it would be cheaper to do with out the improvements, or add user fees, or raise taxes.? The benefits are going to those living there in the short run, taxes should be similar.

Finally, I would like to note that the “B” bonds appreciated dramatically from their issue prices.? You can see it here: data for the “B” series.? My view is that it was a period of falling interest rates, but that the rate on the Poway “B” note fell more.? Whoever bought and held has made a lot of money, and at the expense of Poway SD taxpayers, who will have to pay more, because of the lame way that the district borrowed.

That said, if you think your area is in better shape, spend some time digging into the numbers, and prove it.

PS — Who would buy a bond like this?? P&C insurers with long tail liabilities, like asbestos and environmental.? But Buffett is cutting down on his munis.

Limitations of Credit Default Swap Spreads

Limitations of Credit Default Swap Spreads

Posted on by David Merkel

Once I was talking to my boss at Provident Mutual about exotic options, like barrier, knock-out, and knock-in options.? As I described them to him his reactions were:

  • Why would I want to take that risk?
  • But when describing the other side of the trade, he would say “That’s an attractive proposition.”

And vice-versa.? He was a bright guy, but I don’t think his opinions were very different from what most people would think who have a moderate knowledge of the markets.? Asymmetric payoffs are typically favored by those that can earn a lot, even if the odds are small.

The same is true of Credit Default Swaps [CDS].? There are a lot of players that want to speculate on the demise of companies, hoping for a big payout, even if the odds are small, partly because the amount they pay to gamble on the risk is also small.

The markets for single company CDS are thin because there are few natural counterparties that want to nakedly go long credit risk. Those wanting to nakedly short credit risk therefore have to pay a premium to do so, usually higher than the credit spread inherent on a corporate bond of the same maturity.

And if one or two hedge funds want to do it “in size,” guess what? The dealers in the CDS market will back off considerably, and make them pay through the nose. No dealer wants to take the risk that an informed trader knows something he doesn’t.? They will raise the levels that one would have to pay to bet on the risk so high that some others might be willing to take the other side of the trade.

Now some investment journalists naively think that there is a strong correlation between CDS prices and probability of default.? The CDS market is a thin market, for reasons mentioned above.? Before I would say that there is a “creditor panic” going on, I would look at the corporate bonds of the company in question, and see if the yield spreads are “blowing out.”

Typically, the CDS market is quick to react, but with a lot of false signals.? The corporate bond market is slow to react, and sometimes misses problems.? The stock market is in-between, which is why I would look at the stocks of the companies when I was a corporate bond manager.

So, when I read articles like these:

I say to myself, “What is happening in the corporate bond market? Is it panicking?”? The CDS markets say this:

But when I look at the corporate bond market for the same names, I see no panic. Here is the yield for a similar maturity HPQ bond:

And for a similar maturity DELL bond:

and for a similar maturity Xerox [XRX] bond:

Finally, for a similar maturity Lexmark [LXK] bond:

Aside from the Lexmark bond, there is no hint of trouble.? Lexmark is a small company, with two small bond deals, and as such is more volatile. Still, there is no real panic there.? Panic means the prices of the bonds is below $80, and these bonds still trade over $100.

In most cases, you could short the corporate bonds, and offer credit protection through CDS, and make risk free profits.

There is no panic going on in the technology company bond market, aside from Lexmark, of those names that have been mentioned.

It’s hard to spook the bond market for a liquid bond issuer; it is easy to spook the CDS market.? That’s why I don’t trust? appeals to rising CDS spreads if the bond market does not validate them.? Big markets do not need small markets for validation; rather, small markets need big markets for validation.

An Appeal to Journalists

When talking about default, you need to spend more time on the bond market and less time on the CDS market.? Yes, the CDS market tends to lead the bond market, but this relationship has a lot of noise, and offers a lot of false positives.? Far better to look at the bond market.? When the bonds of any company drop below $80 per $100 of par, there is trouble, and usually a juicy story, with considerable concern as to whether the company can survive.

The CDS market is driven by speculators who are probably right more often than wrong, but not by a large margin.? Avoid using that market to write stories, because it only lends to sensationalism, and does not reveal imminent trouble, unless the bond market agrees.

Final note: it is easy to go over to FINRA TRACE and get the bond yield data, even easier then getting CDS data if you don’t have a Bloomberg terminal.

 

Forget Your Cost Basis

Forget Your Cost Basis

Posted on by David Merkel

All good investment decision-making is forward looking.? Whether you are buying or selling, it doesn’t matter where prices have been in the past.

Now, that said, price and volume charts may occasionally indicate where there is support or resistance.? That might be worthy of consideration in the short-run.? When I was an institutional bond manager, competing against few others, but larger others, that was more important.? Not sure it is so important when competitors are smaller.

My main concern is that investors focus forward.? Use your best data. and estimate future advantage.? Be aware of mean reversion, so don’t let mere changes in price affect your opinion.? Always aim for the best possible future return.

We win and lose constantly in the market.? Don’t let past successes delude you, they may be historical accidents. Instead, focus forward to try to see what opportunities and threats are in front of you.

There were two hard things I had to learn when I was a corporate bond manager: 1) learning to sell lower than my original sell. 2) Learning to buy higher than my original buy.? That meant I had to forget my original cost basis, and try to estimate the best forward value that I could.

That is a tough place to be, but it is rational.? Always look forward, and estimate where you will have the best outcomes going forward.? You will get superior results from doing that.

Sorted Weekly Tweets

Sorted Weekly Tweets

Posted on by David Merkel

 

LIBOR

 

  • Six ways big banks screwed Grandma http://t.co/ltisCJ2P Poorly argued. It’s as if LIBOR could be manipulated without reaction. $$ Jul 28, 2012
  • Fidelity Joins BlackRock in Weighing Libor Action Against Banks http://t.co/9DKR48NY This isn’t as easy as it seems; much 2 prove $$ Jul 26, 2012

 

Eurozone

 

  • Draghi Said to Hold Talks With Weidmann on Bond Purchases http://t.co/SunXLadO If the Buba plays ball, the sky is the limit. $$ #inflation Jul 28, 2012
  • Draghi Says ECB Will Do What?s Needed to Preserve Euro http://t.co/xc4iQ9ji Uncertain that the ECB will buy lots of Italian & Spanish debt Jul 26, 2012
  • Europe Is Cheap?So Why Can?t I Pull the Trigger? http://t.co/yHGHjmoN Wait until things stop getting worse $$ Jul 25, 2012
  • Spanish, Italian Notes Rise on Bets for ESM Enhancement http://t.co/3CBLXOmK ?The idea of making the ESM a bank is a game changer,? $$ #no Jul 25, 2012
  • Spain to struggle to fund 2012 debt crunch http://t.co/iOefCfxz How long until the next last minute rescue? 10-yr yields over 7.5% $$ Jul 25, 2012
  • Europe Stymies Private Equity as Corporate Buyouts Stall http://t.co/QXNGEnQj If the banks won’t lend, private equity deals don’t fly $$ Jul 24, 2012
  • Hollande Transaction Tax Drives Investor Quest for Loopholes http://t.co/hDvZnQfL New trans tax drives investors2use contracts4difference Jul 24, 2012
  • Euro-Zone Government Debts Hit Record http://t.co/o9lXW7f1 Govt debt / GDP 4 whole E-Zone goes from 87.3% @ 12/11 -> 88.2% @ 3/12 $$ Jul 24, 2012
  • Greece Back at Center of Euro Crisis as Spain Yields Soar http://t.co/GLCWfi9e IMF/Core begins to doubt ability to hold it together $$ Jul 23, 2012
  • YIKES: Spanish Yields Are Surging To Record Highs http://t.co/qIQhvlUE Time 4 the Germans to buy summer homes in Spain $$ #evercloserunion Jul 23, 2012

 

US Politics

 

  • There. MMF reform that works, fit into a single tweet. $$ 🙂 Jul 27, 2012
  • Let MMFs keep a stable NAV, pass through losses thru unit reduction if real NAV<.995, reset real NAV @ 1.0025. Runs would strengthen NAV $$ Jul 27, 2012
  • Why Investors Are Dumping Money Market Funds For Short-Duration ETFs http://t.co/TNEpH9F9 My point: treat MMFs like modified ETFs $$ Jul 27, 2012
  • Maryland Governor Defends ‘Millionaires’ Tax’, Denies Job Losses http://t.co/yqfVRYCB Can bend rules, since MD is next 2 DC, which slurps $$ Jul 27, 2012
  • Drilling Strains Rural Roads http://t.co/2tUr6bJY Simple solution: tell energy companies you will not repair roads. They will do it $$ Jul 27, 2012
  • Treasury Eyes Funds Hidden Overseas http://t.co/g38s8z1c IRS goes after foreign trusts, seems 2ba piddling amount of money 2 go after $$ Jul 27, 2012
  • Wrong: How2Break NRA?s Grip on Politics: Michael R. Bloomberg http://t.co/I9vm6KKg The Ethanol lobby is a lot weaker than the gun lobby $$ Jul 27, 2012
  • Estate Tax: Ezra Klein is Wrong! http://t.co/1o5sumfN Never trust anyone whose profession starts w/an “A.” 😉 Accts, Attys, Advisors &c $$ Jul 26, 2012
  • Making the Rich Poorer Doesn?t Enrich the Middle Class http://t.co/fvsUgDfk The govt exists to grow itself until we die. Sad but true $$ Jul 26, 2012
  • The gender wage gap is a myth http://t.co/cNpTi1uZ Diana Furchtgott-Roth makes the same case that many economists have since the 70s $$ Jul 26, 2012
  • New Geithner disclosures further cloud his record http://t.co/heblaDAH Geithner was point man 4the Fed on derivatives. Dropped ball $$ Jul 26, 2012
  • Justice Scalia Disputes Accuracy Of ‘Leak’ http://t.co/OMVCtlAg Wide-ranging interview of Scalia, whose juridical impact may outlive him $$ Jul 25, 2012
  • Former Citigroup CEO Weill Says Banks Should Be Broken Up http://t.co/zftFGEQ6 Good, he changed his view, my view changed on that also $$ Jul 25, 2012
  • 10 Everyday Items That Cost Way More Because of US Taxes http://t.co/KjXUu8Im Interesting list, mostly comprised of protectionist taxes $$ Jul 25, 2012
  • The hidden Mitt Romney http://t.co/rPVcQR7C Romney & Obama have one thing in common: the more you know about them, the less you like them $$ Jul 24, 2012
  • Romney to Attack Obama on Leaks, Defense Cuts http://t.co/hiCrTCtX ?the greatest force for good the world has ever known? US naivete $$ Jul 24, 2012
  • Scalia Offers Up 57 Varieties for Interpreting Legal Texts http://t.co/sSdqUE1m His manifesto on originalism/textualism $$ Jul 23, 2012

 

China

 

  • Lies, Damned Lies, and China’s Economic Statistics http://t.co/Fqpn8YMS I have some skepticism to US statistics, how much more China? $$ Jul 27, 2012
  • Xi Jinping Millionaire Relations Reveal Fortunes of Elite http://t.co/iFz7e6dg Communist Party members have access2loans & IPO allocations Jul 27, 2012
  • Capital Outflows Chime With China?s Bears http://t.co/GIaMbM8g “any currency exchange >$2,000 needs to have a prior reservation made.? $$ Jul 25, 2012

 

Companies

 

  • Alierta Abandons Dividend Penchant to Save Telefonica http://t.co/AHhbFucX Now more interested in $TEF, good cashflow, div shld resume $$ Jul 26, 2012
  • Unilever Warns of Worsening Economy http://t.co/wscXplAV Global economy is weak, even for staple goods. $$ Jul 26, 2012
  • Zynga?s ?Draw Something? Isn?t a Pretty Picture http://t.co/nSrHWTG3 Always be wary of fads that have no balance sheet $$ Jul 26, 2012
  • Sanofi Dengue Vaccine Is Promising http://t.co/7EFL5ioC Good news. Perhaps Dengue Fever may be conquered for the good of mankind $$ Jul 26, 2012
  • Industrias Bachoco Announces Second Quarter 2012 Results http://t.co/n0amblWp Tough read, Q looks good, US acq prob paying off FD:+ $IBA $$ Jul 25, 2012
  • Assurant Reports Second Quarter 2012 Financial Results http://t.co/jdaB09Kh FIring on all cylinders, & shrinking share count FD: + $AIZ $$ Jul 25, 2012
  • Warren Buffett: Great Investor, Lousy Insurance Salesman? http://t.co/4KfZNNP3 Poor article; Buffett is very intelligent insurance exec $$ Jul 25, 2012
  • link 4 last tweet: http://t.co/sj75tC5q You could short the 2.6% bonds and go long default protection for an almost risk-free profit. $$ Jul 25, 2012
  • Someone Is Getting Really Nervous About HP?s Debt http://t.co/Zqj1xEhp If you look at bonds vs CDS, bonds aren’t panicking. FD: + $HPQ $$ Jul 25, 2012
  • Contra: Campbell Chases Millennials With Lentils Madras Curry http://t.co/MBdpXGsJ @ $3/pouch I don’t c a mkt 4 gourmet instant soup $$ Jul 24, 2012
  • Google buys Sparrow for ‘new Gmail project’ http://t.co/q0i3TfZv Sell your company 2 $GOOG 4 $$ . Get new tasks while old technology dies Jul 24, 2012
  • Iraq blacklists Chevron for Kurdish oil deals http://t.co/23opiYYs Not as big as it seems $CVX has no biz in Arab Iraq $$ FD: +CVX Jul 24, 2012

 

Rest of the World

 

  • North Korean Mystery Woman Is Leader Kim Jong Un?s Wife http://t.co/CK8seZPc I find it optimistic that he wants to live a normal life $$ Jul 26, 2012
  • Global economy?s cure is worse than the disease http://t.co/isJuL3rn Indirectly suggests the best policy would be benign neglect $$ Jul 25, 2012
  • Cyber Attacks on Activists Traced to FinFisher Spyware of Gamma http://t.co/ZITxw1bu Practice safe computing; scan for rogue processes $$ Jul 25, 2012

 

Public Radio

 

  • Public Radio International acquired by Boston public broadcaster WGBH http://t.co/Mck9Gx0n Interesting when a non-profit corp gets bought $$ Jul 26, 2012
  • If it is the same, could NPR or the Corporation 4 Public Broadcasting sell out also? Buffett could give them a good home. Or the Kochs 😉 $$ Jul 26, 2012
  • Grew up in the insurance world, so I’ve seen non-profit (mutuals) buy another mutual or stock company, but is it the same w/WBGH buying PRI? Jul 26, 2012
  • Renaming 2 Private Radio International 😉 RT @timjeby: Big Public Radio News: WGBH in Boston to acquire Public Radio International #pubmedia Jul 26, 2012

 

Municipal Bonds

 

  • For further reading consider: Some perspective on the recent California bankruptcies by @munilass aka Bond Girl $$ http://t.co/2jwUeNOX Jul 26, 2012
  • Muni Blues Worry Investors http://t.co/r4VvKP4g Municipalities aiming4 strategic default face challenges in courts; favor bondholders $$ Jul 26, 2012
  • Some perspective on the recent California bankruptcies http://t.co/RFAgUt5u @munilass on how unusual wud b4 muni bonds 2not pay principal $$ Jul 24, 2012

 

Federal Reserve

 

  • Bernanke the unready http://t.co/6ppUDOMl Fed is impotent, but can’t admit it. Bernanke is wrong on monetary policy near 0%. $$ Jul 26, 2012
  • Fed strives to replenish depleted toolkit http://t.co/Yhy4pMy2 Doing the same thing, over & over again, but expecting different results $$ Jul 25, 2012
  • Fed Sees Action if Growth Doesn’t Pick Up Soon http://t.co/2TddWIZz Doing the same thing over&over again&expecting different results $$ Jul 24, 2012
  • Coming: The End of Fiat Money http://t.co/jHhnlPs0 Nice try. Lot of good stuff 2 read here, but no clincher 4 the return of gold $$ Jul 23, 2012

 

US Housing

 

  • By October of 2005 the prices of residential real estate peaked, which led to most of the leverage unwind that was about to happen. $$ Jul 25, 2012
  • Office of Financial Research Annual Report http://t.co/w9Xm4i9J Pp 8-9, first difficulty: by 2005 it was too late to stop the crisis $$ Jul 25, 2012
  • Is This What a Housing Bottom Looks Like? http://t.co/pSwtryX4 Lazy recovery, as people sell when they can avoid losses $$ Jul 27, 2012
  • Wrong: Reverse mortgages as popular as IRAs in 10 years http://t.co/pp7qoG63 Must have equity & creditworthy rev mtge lenders. Complex 2 $$ Jul 25, 2012
  • Home Values Post First Year-Over-Year Increase Since 2007 http://t.co/VHFnG83k Prices rising on the low end; higher priced problematic $$ Jul 24, 2012
  • Subprime Rally Building as Dealers Sop Up Supply http://t.co/s7BVK0v2 Combination of yield lust & rising housing prices drive up bonds $$ Jul 24, 2012

 

Miscellaneous

 

  • Pig Tissue Seen Fixing Injury That Sidelined Lin http://t.co/ys0kWDNb New tech uses pig tissue undoes painful damage from torn meniscus $$ Jul 27, 2012
  • Can a Food for Cows Make Healthier Snickerdoodles? http://t.co/o8vF4h5e Adding some DDG 2baked goods adds protein & fiber, good yes? $$ Jul 26, 2012
  • Closing In on a Cure for Vision Loss http://t.co/QCNZohN7 Testing “gene therapy, stem-cell therapy & a modified version of vitamin A” $$ Jul 24, 2012
  • Will the world’s greatest startup machine ever stall? http://t.co/R1wFzGsM Long interview w/President of Stanford re Silicon Valley ties $$ Jul 24, 2012
  • Breadbaskets of Last Resort See Once-in-a-Lifetime Prices http://t.co/A0AePuJx Focuses on upper Midwest; great time to have good corn $$ Jul 24, 2012
  • MIT Researchers’ `Cool’ Idea http://t.co/SMPitSjO Way cool, allowing 4 cheaper, better milk in rural areas where power is spotty. $$ Jul 24, 2012
  • Contra: The One Capitalism That Dare Not Speak Its Name http://t.co/jaZfeluf State Capitalism more prone 2 bubbles than laissez-faire $$ Jul 24, 2012
  • America’s Energy Situation In 15 Maps http://t.co/lw0vOwnc Refining, production, prices, intl concerns, natgas, crude, coal, solar, wind $$ Jul 23, 2012
  • THE DEFINING DECADE: Why You Can’t Afford To Waste Your Twenties http://t.co/8gl9RqGG Early success compounds; so does early failure $$ Jul 23, 2012
  • Lobbying Works! Big Spenders Reap Big Stock Gains Says Trennert http://t.co/2vsJyEXB But what happens if the US Government has to shrink $$ Jul 23, 2012
  • Who Really Invented the Internet? http://t.co/LkvW1xwM Many did, & they were standing on the shoulders of giants. $$ #ittakesavillage 😉 Jul 23, 2012

 

Market Dynamics

 

  • Fidelity Targets Securities Lending http://t.co/stEvATII The buyside is beginning to fight back against the trust & investment banks $$ Jul 27, 2012
  • Study: High-Speed Trading Hurts Long-term Investors http://t.co/ZhMhkiCG This probably affects those w/higher turnover more $$ Jul 27, 2012
  • Currencies: from Nullifying to Negative http://t.co/lxqwZZKw What is the game? To make money, or avoid losing a lot? Neg int rates a pain $$ Jul 25, 2012
  • Bond Trading Loses Some Swagger Amid Upheaval http://t.co/l93Vp7xL Except 4 the most liquid corporates, need broker2find liquidity/bonds $$ Jul 25, 2012

 

Comments

 

  • Our Olympic Gold in Wit $$ RT @TheLondonWhale: RT take a bow @ReformedBroker: Switzerland tough to beat in gold vaulting Jul 28, 2012
  • “Cultural change cannot be achieved by outsiders, in 1 generation, no matter how much $$ gets spent.” ? David_Merkel http://t.co/5eBdsBlO Jul 27, 2012
  • @brettsimonson Think the direction I would have headed was public policy, which involves a finer view of asset/liab mgmt, run avoidance etc Jul 27, 2012
  • @brettsimonson Hi Brett, no part 2 from what I can see. Very disorganized that week — no power for a week Jul 27, 2012
  • Ditto, well-deserved $$ RT @ReformedBroker: we love you, simone RT @SimoneFoxman: Yay, 5K! Thanks for following, everyone!! Jul 27, 2012
  • @munilass Also, if a kid was disconsolate for a while, before 2AM it was mine. After, it was hers. Jul 27, 2012
  • @munilass When the family was young, my wife & I had a deal. I took midnight feedings, she took the early morning feedings. Jul 27, 2012
  • @munilass My house works like this: I work late b/c it is quiet. My wife who homeschools the kids gets up early b/c it is quiet. Jul 27, 2012
  • @munilass I know many classes of bonds and other fixed income instruments. But I only know enough about munis to be dangerous. Thus I ask. Jul 27, 2012
  • @munilass Decided to review the book “Investing in the High Yield Municipal Market” by Triet Nguyen. If I have Qs, can I ask you? Jul 27, 2012
  • @e_d_sanders Both parties stand for different shades of nothing. They give rhetoric to their bases, do little, and cling to power. $$ Jul 27, 2012
  • RT @Convertbond: Sell the US equity rally hard when Spain’s 2s \ 10s curve starts to re-flatten #Government #Bonds 2 year & 10 year … Jul 26, 2012
  • “”Of course this food is organic. We used Organic Chemistry to create it.”” ? David_Merkel http://t.co/CvYhIQ7p $$ $DF Jul 26, 2012
  • Happy 2b your 1st subscriber $$ RT @SNLFinancial: Follow SNL Financial reporters so you?re always in the know: http://t.co/Rbwi9Jn3 Jul 26, 2012
  • “Why we need to dismantle the Democrat & Republican parties: the national budget slaves for local interests” Merkel http://t.co/gllFMcec $$ Jul 26, 2012
  • A weather forecaster for either WBAL or WTOP said that Maryland gets a derecho once every 5-10 years. Two in one year? Hope not. $$ Jul 26, 2012
  • Just what we need, another derecho $$ RT @BloombergNews: Severe storms, possible derecho forecast for Northeast US http://t.co/XPGdJQoC Jul 26, 2012
  • RE: @bloombergview Not worthy to be read $$ http://t.co/TsRQZdTI Jul 26, 2012
  • RE: Loads of 12% coming out mean that only 88% of the money is going to work for the investor.? Doesn’t matter where ? http://t.co/hJgSPGrT Jul 26, 2012
  • Commented on The Economist | Monetary policy: Bernanke the unready http://t.co/rsqLZm7A Jul 26, 2012
  • “Marriage civilizes, & gives us some hope that he will normalize N. Korea. He lived outside NK 4?” ? David_Merkel http://t.co/uxDl62iM $$ Jul 26, 2012
  • RT @ReformedBroker: RT @jamielissette: *MOODY’S CHANGES OUTLOOK ON 17 GERMAN BANKING GROUPS TO NEGATIVE Jul 25, 2012
  • “For what it is worth, that’s the way Canada does it. Income taxed @ FMV @ death. No estate tax.” ? David_Merkel http://t.co/lQx4RjYN $$ Jul 25, 2012
  • RE: @CSMonitor The book “Hungry Ghosts” documents The Great Leap Forward very well. Worth a read. $$ http://t.co/LQ5dChjQ Jul 25, 2012
  • “It would be cleaner to tax unrealized capital gains at death, and eliminate the estate tax.” ? David_Merkel http://t.co/GqPiMZ5r $$ Jul 25, 2012
  • “Rating agencies are supposed to be behind the curve. They rate over the full credit cycle?” ? David_Merkel http://t.co/z80RTQCv $$ Jul 25, 2012
  • @e_d_sanders He could have included 1 or 2 more words & it would have been crystal clear. I think the ambiguity was deliberate. I cud bwrong Jul 25, 2012
  • “Don’t open suspicious attachments. Use procexp to review processes. Disable processes you can’t?” ? David_Merkel http://t.co/PUaCZKOf $$ Jul 25, 2012
  • “When computers screen applicants, a skills shortage emerges. Computers seek current perfection, not?” David_Merkel http://t.co/HVRm6HOP $$ Jul 25, 2012
  • “A case where so many things went wrong, it is amazing that they almost won. Really, they were?” ? David_Merkel http://t.co/hJcw4tCX $$ Jul 25, 2012
  • @e_d_sanders I’m voting third party; I don’t like the GOP either; it’s obvious that no one man builds infrastructure; not a point 2 make Jul 25, 2012
  • @e_d_sanders It’s not a misquote. Read the two paragraphs in context; he is downplaying individual initiative. Jul 25, 2012
  • @havocp I copied the quote from the WH website. Given what O said in the above that, both interpretations are legitimate. Could b clearer. Jul 25, 2012
  • @havocp and I appreciate your comment. I like those that comment, and even those that disagree with me highly. Jul 25, 2012
  • @havocp Doesn’t matter to me. Concentrating effort is significant and deserves a reward, not condescension. $$ Jul 25, 2012
  • RT @pdacosta: Crisis contained, to inhabited areas. RT @SJosephBurns: “The Subprime Crisis will not affect the economy overall.” – Ben B … Jul 25, 2012
  • RT @ritholtz: WSJ reporting ?Federal Reserve moving closer to action to spur growth” Bond buying, rate guidance, lower reserve rate amon … Jul 24, 2012
  • RE: @bloombergview You’re still going to need LIBOR, however calculated, for existing contracts. Replacement will be ? http://t.co/smOdgXbd Jul 24, 2012
  • “Ethics comes before competence. Doesn’t matter how good you are, if you are unethical. The?” ? David_Merkel http://t.co/6bgcT6nT $$ Jul 23, 2012
  • RT @AmityShlaes: “The post office ought to be self supporting. At present business men are deluged with useless mail.” — Calvin Coolidg … Jul 22, 2012
  • @niubi No, b/c many babies do not sleep through the night @ 3 months Jul 21, 2012
  • If I could ship the rain in Maryland 2 the Midwest, I would. But Maryland farmers r having a good year. Corn looks normal & prices r high $$ Jul 21, 2012
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.

 

What to do on Bonds?

What to do on Bonds?

Posted on by David Merkel

I’ve had good returns on bonds over the last year, largely because I invested in long deflation investment grade bonds.? I took on a lot of duration risk by investing long, and it paid off.? I’ve reduced the size of my duration bet, but it is still large relative to the consensus.? That said, momentum tends to persist.

But what to do now?? Yes, rates could still go lower on the long end.? Credit spreads could still tighten on the long end and elsewhere.? Most of my credit related positions have done well, including preferred stocks of banks.

I have a positive view on conforming mortgages, though I have no position there now.

On illiquidity I have a negative view because things are volatile enough that you need flexibility.

On FX, I am long the Swiss Franc, and it has been a loser.? I suspect that with weakness in the euro, the Swissie will not break its link with the Euro.? At present, the US Dollar seems ascendant.? What can stand in its way?

I am tempted to put money into emerging markets debt, because their economies are run in a more orthodox manner than the developed economies, but not by much.

Really, I am scratching my head over all the various risks, and thinking that short-term investment grade credit is the only thing that I like.? Beyond that, I am open to suggestions.

New Highs, New Lows, Yield Greed

New Highs, New Lows, Yield Greed

Posted on by David Merkel

When I read this post by Ivan Hoff, I decided to look at the new high and new lows lists, which I never do now, but used to do regularly back in the days when I read a paper Wall Street Journal every day.? Now our philosophies for doing so differ.? He is looking for buy high, sell higher, and I am looking for misunderstood companies that are first safe, then cheap.

So after the close, I copied the new highs and new lows for the NYSE, NASDAQ, and Amex as a group.? There were 203 highs and 89 lows.

But then I noticed something funny: a large number (53) of the new highs came from preferred stock, hybrid debt, and bonds — yieldy stuff.? With the lows, there was some weird stuff, but 7 companies had rights and warrants, hitting new lows, and one new muni bond fund, NKGD, which was just noise.

Then I looked at the industries that they were in, mostly to separate out the ETPs and CEFs from everything else.? Here are the tables:

New Highs

Values
Row Labels Sum of mktcap Count of ticker
0715 – Insurance (Property & Casualty)

205,242

2
0524 – Tobacco

97,162

2
0803 – Biotechnology & Drugs

62,010

8
0521 – Personal & Household Products

40,837

2
0963 – Retail (Specialty Non-Apparel)

38,396

1
1203 – Electric Utilities

20,944

7
0515 – Food Processing

17,571

1
0721 – Misc. Financial Services

15,158

57
0115 – Forestry & Wood Products

11,980

1
0727 – Regional Banks

6,434

22
0806 – Healthcare Facilities

5,358

3
1209 – Water Utilities

4,356

2
1106 – Airline

3,595

2
1206 – Natural Gas Utilities

3,363

2
0812 – Medical Equipment & Supplies

3,209

4
0957 – Retail (Grocery)

2,472

3
0951 – Retail (Department & Discount)

2,356

1
1018 – Computer Services

2,039

1
1024 – Electronic Instruments & Controls

1,790

1
0612 – Oil Well Services & Equipment

1,335

1
0730 – S&Ls/Savings Banks

1,290

9
0915 – Communications Services

1,007

2
1036 – Software & Programming

832

2
0718 – Investment Services

548

2
0209 – Construction – Supplies and Fixtures

494

2
0712 – Insurance (Miscellaneous)

347

1
0942 – Restaurants

333

1
0703 – Consumer Financial Services

322

2
1033 – Semiconductors

316

1
0421 – Furniture & Fixtures

120

1
0909 – Business Services

33

1
1003 – Communications Equipment

31

1
0133 – Paper & Paper Products

17

1
0912 – Casinos & Gaming

0

1
Grand Total

551,295

150
Exclude Misc Fin Svcs

536,137

93

New Lows

Values
Row Labels Sum of mktcap Count of ticker
0118 – Gold & Silver

41,488

9
1036 – Software & Programming

16,268

7
1003 – Communications Equipment

14,856

7
0515 – Food Processing

12,732

2
1033 – Semiconductors

10,351

2
1109 – Misc. Transportation

8,131

1
0206 – Construction & Agricultural Machinery

5,849

1
0948 – Retail (Catalog & Mail Order)

5,451

1
0951 – Retail (Department & Discount)

4,837

1
0603 – Coal

4,479

2
0424 – Jewelry & Silverware

4,243

1
0103 – Chemical Manufacturing

3,933

3
0203 – Aerospace and Defense

2,995

1
1018 – Computer Services

2,851

3
0218 – Misc. Capital Goods

2,300

2
0924 – Personal Services

2,292

1
0927 – Printing & Publishing

2,043

1
0124 – Metal Mining

2,024

2
0721 – Misc. Financial Services

1,903

2
0215 – Construction Services

1,802

1
0939 – Rental & Leasing

1,760

1
0915 – Communications Services

1,616

1
0418 – Footwear

1,439

1
1024 – Electronic Instruments & Controls

1,384

2
0909 – Business Services

1,223

1
0812 – Medical Equipment & Supplies

1,077

5
0612 – Oil Well Services & Equipment

1,075

1
0918 – Hotels & Motels

937

1
0969 – Schools

836

1
0609 – Oil & Gas Operations

820

1
0933 – Real Estate Operations

731

1
0415 – Auto & Truck Parts

703

2
0127 – Misc. Fabricated Products

693

2
1021 – Computer Storage Devices

512

2
0966 – Retail (Technology)

418

1
0703 – Consumer Financial Services

195

1
0806 – Healthcare Facilities

64

1
0727 – Regional Banks

61

1
0803 – Biotechnology & Drugs

54

2
0930 – Printing Services

6

1
0942 – Restaurants

5

1
0421 – Furniture & Fixtures

4

1
Grand Total

166,437

81
Exclude Misc Fin Svcs

164,534

79

By the time you are done separating out the passive vehicles, because one is miscategorized in the new highs, you have for regular stocks 92 highs versus 79 lows.? The market cap spread favors the highs because of Berkshire Hathaway, Altria, Amgen, Target, Kimberly Clark, Reynolds American, and H.J. Heinz.? The only large company among the lows was Barrick Gold.

I should add that all of the ETPs and CEFs making new highs were all fixed income funds.? ALL!

Then I looked at the yields of the common stocks that were making new highs and new lows.? For new highs, 35 out of 92 (38%) have yields over 2%.? For new lows, 10 out of 79 (13%) have yields over 2%.

This is a market that is driven by yield and safety/non-cyclicality.? The new highs are predominantly in stable industries, and the new lows in cyclical industries.

I’ve said it before, but I’ll say it again, yield is not real.? It is a residual of a larger economic process.? If you own a bond, preferred stock, or common stock that pays dividends, your future well-being relies on the economic success of that company.? With stocks, that connection is direct, with bonds it means avoiding default.? Other securities face similar limits.? Yields cease to exist when companies fail; chasing yield as a main strategy will fail, because fund shareholders will give up during the hard times when capital gets marked down, and sell.

Though the portfolio that I manage for clients has an above average dividend yield, I do not look for dividend yields; I look for solid companies, and the dividend yields find me.? (Buybacks too.)? I do not reach for yield.? There are many investors that are reaching for yield in this environment, and I think they will eventually get burned.

So be wary over yield.? It may not pop for a year or two; it might pop tomorrow.? I identify risks, and risks typically don’t come with dates.? Just be wary.? When everyone is scrambling for yield, it is probably best to not aim for a yieldy portfolio.

PS — note all the banks and S&Ls on the new highs list, and they are almost all small firms.

Full Disclosure: long AMGN

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