Search Results for “Education of a corporate bond manager” – Page 2

The Education of a Corporate Bond Manager, Part II

Posted on 17 July 201018 July 2010 by David Merkel

For a new corporate bond manager with very little apprenticeship-type training, I had to learn some things on the fly.? Of my first tier brokers, roughly half of them took pity on me initially and explained to me the rules of the road.? That happened partly because I wanted to try some things that my old boss rarely did, and as I did that one of my brokers would explain to me, “If you’re going to do that, you have to do it this way…” which I would confirm with one or two of my major brokers.

If I wanted to buy a bond that was not presently being offered, I learned to find out who brought the deal and made a market in the bond issue, and told them, “If you find a few million bonds in a such and so spread context, I would be happy to pick some up.? Now, the less I knew about the price context, the more conservative I would be about price and size.? If I found a large amount offered to me at my level (rare), I would honor it by buying a small amount, and then backing up my price level to where I would not be offered so much, and try for more at better prices.

Price discovery is tough business, because some bonds trade rarely.? There are things to help you:

Comparable bonds in the same industry
Credit spreads across rating categories
Credit spreads across the maturity spectrum within rating categories
Spreads on credit default swaps on the same name.
Value of scarcity vs cost of illiquidity, and vice versa
Proper spread tradeoffs on premium vs discount bonds, call features, put features, off-the-run vs on-the-run issues, etc.
Calculating the spread on the last few trades, however dated, and then massaging the spread into what it is likely to be today.

My client was growing rapidly, and 30% of its liability structure was long because they wrote a lot of structured settlements.? [Geek note: structured settlements arise when a plaintiff wins a court case, and a stream of payments must be made by a defendant for the rest of the plaintiff’s life.? There are often inflation clauses, which makes the stream grow over time.? The defendant has insurance companies bid on paying the liabilities, and low bidder wins.]? I could buy a lot of long illiquid securities if my credit analysts liked the credit risk on the companies in question.

As such, I had a list of issues at various brokers that I wanted to buy if they became available.? Those ranged from moderately liquid to very illiquid.? I had a list that I sent out every now and then that I called the “Odd Duck” list; for fun, the last name on the list was the ultimate odd duck, AFLAC.? That got a few chuckles.

But with a rapidly growing client, much as I liked to source bonds that I fundamentally liked on the secondary market, I had to buy a lot of bonds in the new issue primary market.? Under normal conditions, the bond market has a lot of IPOs each day, as new bonds get issued, most often from companies that have issued before, but the characteristics of the new bond are different.

Now sometimes, when the corporate bond market is cold, or a deal is complex, it will take days for the deal to close, and sometimes a week or more.? But when things are hot, deals can close in seven minutes.? When I would see a new deal, the first thing I would do is analyze where we were in the speculation cycle for new deals.? As I said in my last piece, on average, new deals are brought a little cheap, because there is a price to gain liquidity that the issuer pays.

When deals were closing slowly, like say in half a day or more, I would send the deal terms to the analyst, and ask if she liked the credit.? If she said no, I would refuse the deal.? Otherwise I would put in for my normal allocation of bonds, subject to my limit for the company in question, and varying with the attractiveness of the deal, and how much cash I had to put to work.? When the market was rational, typically I would get good allocations, and deals would trade up a decent amount after issue.

But when the market was hot, and deals would close within an hour, I would work differently.? When the deal would come, I would put in for bonds, so that I would get some allocation.? I would ask for the high end of what I would normally ask for, knowing that I would get scaled back considerably.? Then I would send the details to my credit analyst, telling them that if they did not like the company, I would sell the bonds.

Eventually, most of my analysts during the times when the market was hot would come to me and say, “How can you put in for bonds without an opinion from us?”? First I would reassure them, and tell them that I valued their opinions, and that I would not hold onto a bond permanently unless they liked it.? I would sell all bonds they did not like, but when the technicals favored it, within a few months.

Second, I would tell them, “I do the one-minute drill,” which elicited the obvious question, “What’s the one minute drill?”? I then led them through a series of Bloomberg screens that would allow me to get a quick read on creditworthiness:

GPO – how has the stock price moved over the last year?? Down hard is a deal killer.
HIVG – how have option implied volatilities moves of late? Up considerably more than the market is a bad sign.
CH6 – how is operating cash flow doing?? If it is considerably worse than earnings, that ‘s a bad sign.
DES – what industry is it in?? Do I hate that industry?? If so, don’t play.
DES3 – all of the major financial ratios for the company.? What do the typical bond ratios look like?? Are they materially worse than those for the industry?
CH2 or ERN, are earnings declining?? If so beware.
CRPR – what are the credit ratings?

Then I would tell the credit analyst that if a company passes these tests, the odds of the company doing badly while I wait for the analysis of the credit analysts was slim.? Then I would get a smile from the analyst, who would go and do their analysis without fear of something going badly wrong while they do their analysis.

But there is one last complexity here.? When deals are running hyper-hot, and are closing in minutes, it is good to take a step back and ask on each deal if the yield spread is too tight. Bond syndicates price some deals too tight, and instead of the deals rising after issuance, something horrible happens.? I will bring that up, and other matters, in part III.

The Education of a Corporate Bond Manager, Part I

Posted on 16 July 201016 July 2010 by David Merkel

In 2001, I became a corporate bond manager by accident.? I had been the mortgage bond manager and risk manager of a unit managing the assets of a medium-to-large life insurer, when the boss left to take another job in the midst of a merger.

The staff and I got together, and the credit analysts told me that I should lead the organization during the merger.? When I asked why, they said they trusted me, appreciated my growing bond skills, that I was the only one who understood the client, and said that I had a better call on credit than the boss had.? I was surprised by that last comment, but upon meeting with the management of our parent company that was selling us, along with the life insurance company that we managed, they told me that yes, I should lead the unit until the merger closed, but rely on the high yield manager in our group to advise me for the duration, which was going to be three months.

The first thing that I did was a bond swap, trading away an older bond of a company for a new issue.? There was some hurry in the matter, so I entered into the swap before I could consult the high yield manager.? After I could talk with him, he pointed out that I had offered terms more favorable than I should have.? On a $5M swap, I ended up losing $20K.? We worked through the swap a number of different ways, which solidified my knowledge of corporate bond pricing.? I did not make that error again.

In the corporate bond market, new deals come frequently.? My former boss would do almost all of his bond buying on new deals, and almost never in the secondary market, because he knew that new deals almost always came cheap.? There is a price to be paid by corporations to gain liquidity.? The life company that I managed money for was growing like a weed (their products were perpetually underpriced), so I had a lot of money to put to work.

But, I already had a large portfolio of corporate names.? I was familiar with many of them to some degree because of my stock investing.? How could I go through the whole portfolio to look for bombs that might be lurking? Ask the credit analysts to give me a review on every name?? I did not want to kill them, or me for that matter.

I took the idea home , and thought about it, and then it struck me.? Thinking of bonds as having sold a put option to the equity, why not look at the amount that the stocks of the companies issuing the bonds had fallen in price since issuance of the bonds?? I set a threshold of 50%, and that gave me a list of about 30 names to hand to the analysts.? Manageble.? Cool.? (Oh, and tell me briefly about these 20 private bonds where there is no stock price.)

The analysts came back with their opinions, and surprisingly they advised selling half of the bonds and keeping the other half.? That was more than I expected.? But I started selling away, and began to learn the art of price discovery.? When you want to sell a bond, you first have to look at what investment banks ran the books of the deal.? There is an unwritten rule that if they play that large role in origination, they have to make a market in the bonds thereafter.? So, I consulted the various investment banks and inquired about levels, and then said something to the effect of, “If there is a reasonable bid (naming the spread over Treasuries) we would be interest in losing a few million bonds.? If there is an aggressive bid, we could be induced into selling a few more.? We might even be willing to sell the whole wad if they make us the offer that we can’t refuse.”

If there were multiple banks that traded the bond, I would set the above up with just one bank.? You never wanted to make it look like there were two sellers out there, or bids would vanish.? Beyond that, it was bad etiquette to employ two banks without telling them that they were in competition with each other.? If not. you could end up with two orders to buy your bonds, and you would have a moral obligation to meet both orders, even if that was against your interests.

Usually the broker would ask for the total size of the wad available for sale.? The idea was to get the buyers to think economically.? Yes, they could get a small amount of bonds if they met the spread, but was it worth it to bid for more?? Also, if they bought the wad, they would know that there were likely no more bonds on offer, the selling pressure would be gone, and the bonds would likely trade up from there.

I sold away a decent amount of the bonds that the analysts wanted gone, and then 9/11 hit.? What a day.? Since we worked inside the insurance company that we manager money for, and we had two TVs on the corners of our trading floor, all of a sudden our area was flooded with people staring at the spectacle.? I almost felt like Crocodile Dundee as I had to maneuver my way around and over them.

I gathered my staff and told them to look at their portfolios, and e-mail me threat reports so that I could inform our client.? After that, take the rest of the day off, as there is nothing to do here; many of them wanted to mourn friends that might be dead (I lost two acquaintances).? I summarized the threat reports, and submitted them to the client by 4PM.? We repeated that process for the next eight business days, until the crisis was past.

I had worries over One Liberty Plaza, next to the former World Trade Center, which seemed to be leaning, and might fall.? We owned the AAA portion of the CMBS that contained the loan for that building.? As I scoured the web, I concluded there was no danger, the building only looked like it was leaning; the dark coloration was deceptive.

Eventually trading resumed.? If you remember Metcalfe’s Law, the value of a telecommunications network is proportional to the square of the number of connected users of the system.? Well, after 3 days, 2 of 12 major brokers were running, which meant that there was no trading.? After 4 days, 6 brokers were up, so I made an offer on some AA Manufactured Housing ABS, deeply below where there market was prior to the crisis.? I got hit, and I owned the bonds.? Some said to me, “Why not wait?? Why offer liquidity now?? I said that some had to make some bids to restart the market; my client had ample liquidity, and I was offering liquidity at a price; if someone was that desperate for liquidity, they could have it at my price.

After 5 days 8 of the 12 were up, and after 6, 10 of 12.? The last two took a while to re-emerge, but were back after 10 days.? Even so, things seemed sluggish.

I began to do the same with corporate bonds, doing a large auction offering liquidity, specifying bonds that I wanted at certain levels, and the amounts.? I ended up buying half of my list, and still my client had ample liquidity.? What a high quality problem to have.? More in my next segment.

Don’t Worry About Public Bond Market Illiquidity

Posted on 23 September 2015 by David Merkel

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

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

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

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

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

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

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

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

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

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

All Good/Bad Things Must Come to an End

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

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

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

The Shadows of the Bond Market’s Past, Part I

Posted on 12 August 2014 by David Merkel

Source: FRED

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

Date	T1	T3	T5	T7	T10	T20	T30	AAA	BAA	Spd	Note
3/1/71	3.69	4.50	5.00	5.42	5.70	5.94	6.01*	7.21	8.46	1.25	High
4/1/77	5.44	6.31	6.79	7.11	7.37	7.67	7.73	8.04	9.07	1.03	Med
12/1/91	4.38	5.39	6.19	6.69	7.09	7.66	7.70	8.31	9.26	0.95	Med
8/1/93	3.44	4.36	5.03	5.35	5.68	6.27	6.32	6.85	7.60	0.75	Med
10/1/01	2.33	3.14	3.91	4.31	4.57	5.34	5.32	7.03	7.91	0.88	Med
7/1/04	2.10	3.05	3.69	4.11	4.50	5.24	5.23	5.82	6.62	0.80	Med
6/1/10	0.32	1.17	2.00	2.66	3.20	3.95	4.13	4.88	6.23	1.35	High
8/1/14	0.13	0.94	1.67	2.16	2.52	3.03	3.29	4.18	4.75	0.57	Low

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

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

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

March 1971

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

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

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

April 1977

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

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

December 1991

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

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

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

August 1993

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

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

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

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

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

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

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

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

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

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

On Bond Risks in the Short-Run

Posted on 7 June 20148 June 2014 by David Merkel

From a letter from a reader:

Hi David,

I’ve been following your blog for the last few months and the articles are extremely insightful.

I’ve been working with fixed income credit trading the last few years but I feel that I have not been measuring risk well. I only look at cash bonds

Right now I’m only looking at DV01 and CR01, but my gut tells me that there’s a lot more to risk monitoring that can be done on a basic cash bond portfolio.

From your experience as a bond portfolio manager, what other risk metrics have you found useful?

I’d really appreciate if there were a few pointers you could give or just a trail that you could show me and I’ll follow it.

First, some definitions:

Basis Point [bp]: 0.01% — one one-hundredth of a percent. ?If you have $10,000 in a money-market fund, and they pay one basis point of interest per year, at the end of the year you will have $10,001. ?In this environment, that’s not uncommon.

DV01:?A?bond valuation?calculation?showing the?dollar?value?of a one?basis point?increase or?decrease?in?interest rates. It shows the?change?in a?bond’s?price?compared to a decrease in the bond’s?yield.

CR01: Credit Sensitivity ? Credit Default Swap [CDS] price change for 1bp shift in Credit par spread — same as DV01, but applied to CDS instead of a bond.

Now, onto the advice: when you manage bonds, the first thing you have to do is understand your time horizon. ?Is it days, weeks, months, or years? ?When I managed bonds for a life insurer 1998-2003, the answer was years. ?Many years, because the liabilities were long. ?That gave me a lot of room to maneuver. ?You sound like you are on a short leash. ?Maybe you have a month as your time horizon.

When the time horizon is short, the possibilities for easy profits are few, and here are a few ideas:

1) Momentum: yes, it works in the bond market also. ?Own bonds that are rising, and sell those that are falling. ?Be sensitive to turning points, and review the relative strength index.

2) Stick with sectors that are outperforming. ?Neglect those that underperform.

3) If you have significant research that has a differential insight on a bond, pursue it with a small amount of money if it may take a while. ?If the change might happen soon, increase the position.

4) Try to understand when CDS is rich or cheap vs cash bonds by issuer. ?Look at the price history, and commit capital when pricing is significantly in your favor.

5) Set spread?targets for your investing. ?Decide on levels where you would commit minimum, normal, and maximum funds. ?Be generous with the maximum level, because markets are more volatile than most imagine.

6) Look at the criteria for my one-minute drill:?http://alephblog.com/2010/07/17/the-education-of-a-corporate-bond-manager-part-ii/

(and look at the end of the piece, but the whole piece/series has value.)

7) Analyze common factors in your portfolio, and ask whether those are risks you want to take:

Industry risks
Duration risks
Counterparty risks

8 ) Look at the stock. ?If it is behaving well, the bonds will follow.

Maybe your best bet is to trade CDS versus cash bonds, if the spread is thick enough to do so. ?If not, I would encourage you to talk with more senior ?traders to ask them how they survive. ?Trading is a tough game, and I do not envy being a trader.

The Education of an Investment Risk Manager, Part IX (The End)

Posted on 3 October 2013 by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

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

4-9 against creating the guaranty fund.

The moderator looked shocked.

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

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

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

In Closing

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

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

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

The Education of an Investment Risk Manager, Part VIII

Posted on 2 October 2013 by David Merkel

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

“Yes, I am,” I said.

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

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

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

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

CA: “When can you have it to me?”

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

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

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

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

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

Here were the main findings:

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

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

But what happened to the five companies?

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

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

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

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

What are the lessons here?

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

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

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

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

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

Posted on 14 February 2013 by David Merkel

Personally, I did not have an outline when I began this series.? If I had decided to create a “story arc” it would ended with part six, which led to my becoming the corporate bond manager, but I will end this series on a different note, and with different lessons.

1)? After the merger, post 9/11, we decided on heresy.? We were going to sell a large amount of the CMBS I had acquired? over the prior three years for a large capital gain, and redeploy it into the bonds of hotels, airline EETCs, and every other area negatively affected by 9/11.? We did a huge down in credit trade.? Some of the tale is told here.

As far as mortgage bonds went, the sale was a stunning success.? The execution levels for the sales were great, and what we reinvested in were areas of the market that were dramatically oversold.? What could be better?? (A client who knew how use the results would be better.)

2) One day in 2000, the client came to me and said, “We’d like to do a bond indexed annuity.”? After reviewing product design, which allowed holders a one time option to increase their rate over the term of the annuity, and doing a little bit of game theory work, I said, “Here’s the good news: given what we know about policyholder behavior and what we know about bonds, this is a cinch to hedge.”? As I explained the dynamics to them they realized the risks were minimal, and they decided to proceed ahead.? Sadly, the product was not attractive enough, and it was killed.? Equity products got attention in that era, not income products.

3) In 2002, when I was a corporate bond manager, I had to do what a mortgage bond manager does on occasion: read thick prospectuses.? Bear markets in credit often offer the most interesting deals — as an example, the Prudential “C” bonds.? In this case I had to read through the prospectus of a Dominion subsidiary that had an Enron-like financing structure post-Enron.? If Dominion’s credit was downgraded, and its stock traded below a certain level for a certain number of days, the bonds would have to be redeemed at par-plus through an issuance of preferred stock.

We became one of the larger holders of those bonds. Enron-like structures are good for bondholders if they are a small part of the capital structure.? They are bad if they are big, because you can’t protect everything.

We bought the bonds at a significant discount to par for a 3-year bond.? Our research showed that Dominion the parent company was on the hook.? The larger holders negotiated (we were in the top 10), and eventually the bonds were tendered for a 10%+ gain, plus 7% of carry over the less than one year period.? I ended up sharing the the experience in real time with Cramer, who wrote a post about it in the midst of the furor.? Yes, bond markets can affect stock markets, and vice-versa.

4) There was a large debate in that era over what to do about Qwest / US West.? Amid corporate troubles, there was one easy play — buy long-dated US West bonds.? We all agreed on that.? But should we own Qwest bonds?? That was harder.

But then one day, because of our high yield contacts, we came into contact with the offering documents of a Qwest subsidiary, which had done badly.? It was a private placement, so when we inquired about it they asked for our documents, and we faxed a copy to them, though we had not been on the original deal (good thing).

As it was the debt was trading at under 50 cents on the dollar.? As I read through the prospectus, I realized that the debt was guaranteed by Qwest.? Given the short term of the debt, it made sense to trade our lower yielding Qwest positions for it.

And what did we do?? Nothing.? What happened to the debt two years later?? It was paid off at par.? To misphrase Mr T., “I hate it when a plan doesn’t come together!” (I am certain that comment dates me.)

5) (the end of the end) While I was the less-restricted manager of bond assets, both corporate and mortgage, for my client, I would sometimes meet with my former boss for lunch.? I would tell him what I was doing, and he would say, “Don’t you realize the risks you are taking?”? I would tell him, “Yes, but I have to evaluate risk and return relative to the other risks and returns available elsewhere in the market.? You have to pick the best of them.”

One thing I do know, I was far more willing to accept bond market risk than my boss, who had a strong teaching in the 90s, prior to hiring me, a neophyte.

There are two odd things here: why should an actuary turned bond manager take risk to make money amid panic?? Because he learned to be contrarian — this is something that must be experienced in order to teach it.? Second, why should I do far better than the guy who taught me?? I was more willing to take risk when it seemed to be rewarded.? Don’t get me wrong, when spreads and yields are narrow, I am not there.? I don’t take uncompensated risks.

There is wisdom in trying to understand the credit cycle.? It is one of the few constants in terms of economics.? If you follow credit, you will understand the economy in the short run.? If you follow the credit cycle, you will invest better than most.

The Education of a Mortgage Bond Manager, Part IX

Posted on 13 February 2013 by David Merkel

The Negative Convexity Project

Me: We can’t buy the majority of Residential Mortgage Backed Securities [RMBS] anymore.

Boss: What! That is a staple asset class of ours.? There’s nothing illegal about life companies owning RMBS.

Me: nothing illegal, yes, but because of new cash flow testing rules which our client is subject to, the negative convexity of RMBS will force our client to put up more risk-based capital than they would otherwise have to.? Most RMBS will require so much additional capital that the additional yield is uneconomic, and that assumes we get the yield when we want it, ignoring prepayment and extension risks.

Boss: I can’t believe that we can’t buy any RMBS… are there any exceptions?

Me: There are a few.? You know about the odd RMBS classes that have positive convexity, but little yield?

Boss: Yes, Yes… but why would we want to buy that?? Our client needs yield!

Me: I know that.? Would that they could do something other than need yield to sell yield.? There is one type of RMBS that still fits, and it is the NAS bond [Non-accelerating security], last cash flow structure.? Also, some of the credit-sensitive RMBS bonds rated less than AAA don’t affect the convexity issue, but we might not want to buy them, because the additional yield per unit risk is not compelling.

Boss: So what do we do?

Me: Buy NAS bonds when they are attractive, and buy CMBS that is attractive, after that look to corporates that our analysts like.

Boss: You are right, but I hate to lose a staple asset class.

=–=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==–=-=-=-==-=-=–=-=-=-=-=-=-=

What I wrote there took longer than a single conversation, and involved contact with the client as well.? The client was very conservative with capital, because they levered up more than most life insurers.? The results of detailed cash flow testing would affect large annuity writers like my client, and negative convexity would make them put up more capital, constraining the amount of business they could write.

Wait: negative convexity simply means your bond portfolio hates interest rate volatility — it does better when things are calm.? That is certainly true with residential mortgages, where people refinance easily when rates fall, and in that era, no one faced falling property prices.

It took some effort, but I made my case to the client and my boss, and we stopped buying most RMBS.? As an aside, it made asset-liability management tighter.

Alternative Investments

I was not totally hidebound with respect to derivatives.? I bought our first asset-swapped convertibles, and synthetic corporates.? If the risks associated with getting additional yield were small, I would take those risks.? In both cases, they converted other asset into straight corporate debt (plus counterparty risk).

But I wouldn’t do anything.? I grew to hate CDOs, as I saw how perverse the structure was. I remember one weird CMBS deal structure that added a note that combined the AAA, BBB & BB CMBS of the deal.? What a nice yield, but the riskiness was greater than my models would allow for the incremental yield.

Finally, for this piece, the “piece of work” broker that I have previously described pitched me a private placement debt deal for a power producer affiliated with his firm.? After hearing the initial spiel, I said, “Okay, soft-circle me for $25 million, subject to due diligence; send me all of the hard data via email and paper.”

My request should not have obligated me to buy the deal.? Indeed, when I got the hard data, and began estimating the counterparty risks, I thought the deal was a loser, so I contacted the “piece of work,” and said, “Sorry, but we are dropping out of the deal — it just doesn’t offer enough value for the yield.”? After some arguing, he eventually said, “Look, stay in the deal, and I promise you that I will get you out at par at minimum on deal day.? Okay?”

Sigh, even though he was number eight with us, he served an important firm that could potentially do a lot for us, so I agreed.? The day of the deal came, and indeed, he got us out at a teensy premium (I would have accepted par, maybe even a slight scrape).? The deal did horribly, at least initially, though I have no idea of what the eventual credit result was.

As my boss who taught me bonds would say, “On Wall Street, if you want a friend, get a dog.”? There are some honorable people on Wall Street, but the economics of Wall Street often leads to suboptimal results for clients, and indeed, the salesmen may be sweet enough, but they live to distribute paper; they don’t live to be your friend in any true sense.? Professional duty to company trumps friendship.

The Education of a Mortgage Bond Manager, Part VI

Posted on 9 February 2013 by David Merkel

1) One thing that impressed me about working in a life insurance investment department is how many ideas we kicked around and abandoned.? I did not experience that to the same degree working at a hedge fund.? I think that is true for two reasons: 1) we have a significant balance sheet, and can take on illiquidity. 2) we are conservative, and aren’t going to take on marginal risks.

2) Another thing that impressed me was how well the money was managed, and how poorly the liability writers thought it was managed.? I did a big study to analyze what we had earned for F&G Life over the prior seven years.? We beat single-A bond yields by more than 0.7%/year.? That’s huge.? That said, they kept asking for more.? I shake my head and wish that we were running a mutual fund; we would have gotten a lot of respect.

3) When I came, the client held no CMBS, after three years 25% of the assets were CMBS.? It made so much sense given the 10-year duration of the EIAs that were growing so rapidly.? Given my models, and the lack of yield from corporates, this was a big improvement.

CMBS, because it is noncallable, makes a lot more sense for longer-dated liabilities.? Hey, I was not only the mortgage bond manager, I was the interest rate risk manager.? I would not knowingly take bad risks.

4) When the merger happened, the boss decided to jump to another firm.? Unintentionally, I may have encouraged that, because when he asked me, ‘What would I do in this new organization?”? I said, “Let me draw it out for you,” showing that he would be CIO of insurance asset management.? He was crestfallen, and sought other avenues of employment.? When he announced his new job, there was a big change.

First, the St. Paul talked with me and the High Yield manager, and gave me authority to manage things, so long as the high yield manager agreed.? Basically, they trusted me, but knew I was inexperienced, so they wanted the high yield manager, who was far more experienced than me, to guide me.? There was an economic incentive here: the better we did, the less cash the St. Paul had to transfer to Old Mutual at the closing.

But after that, the analysts came to me and said “you be our leader.”? The high yield manager agreed.? When I asked why, they said, “We trust you. You have always had a better call on credit than the prior boss, and you understand our client better than anyone else!”

That led to something hard.? I called a meeting of the analysts and managers, but told the old boss, who was still with us, that he was not invited.? I almost cried.? He was our leader for so long, and a good one, but I had to take control.

Once I did so, I asked the analysts for reports on all companies where the stock price had fallen by more than 50% since bond purchase.? We began selling those bonds where it made sense.? Those sells were almost always good sells, and I wish I had not been countermanded by my new bosses on Enron (the greatest company in the world.)

I have more to say but that will have to wait for the next part.