The Aleph Blog – Page 89 – Helping Institutions and Ordinary People Invest Better by Focusing on Risk Control

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 an Investment Risk Manager, Part VII

Posted on 1 October 2013 by David Merkel

In late 2007, I was unemployed, but had a line on a job with a minority broker-dealer who would allow me to work from home, something that I needed for family reasons at that point.? The fellow who would eventually be my boss called me and said he had a client? that needed valuation help with some trust preferred CDOs that they owned.

Wait, let’s unpack that:

CDO — Collateralized Debt Obligation.? Take a bunch of debts, throw them into a trust, and then sell participations which vary with respect to credit risk.? Risky classes get high returns if there are few losses, and lose it all if there are many losses.
Trust preferred securities are a type of junior debt.? For more information look here.

I got to work, and within four days, I had a working model, which I mentioned here.? It was:

A knockoff of the KMV model, using equity market-oriented variables to price credit.

Uncorrelated reduced discrepancy point sets for the random number generator.

A regime-switching boom-bust cycle for credit

Differing default intensities for trust preferred securities vs. CMBS vs. senior unsecured notes.

It was a total scrounge job, begging, borrowing, and grabbing resources to create a significant model.? I was really proud of it.

But will the client like the answer?? My job was to tell the truth.? The client had bought tranches originally rated single-A from three deals originated by one originator.? There had been losses in the collateral, and the rating agencies had downgraded the formerly BBB tranches, but had not touched the single-A tranches yet.? The junk classes were wiped out.

Thus they were shocked when I told them their securities were worth $20 per $100 of par.? They had them marked in the $80s.

Bank: “$20?! how can they be worth $20.? Moody’s tells us they are worth $85!”

Me: “Then sell them to Moody’s.? By the way, you do know what the last trade on these bonds was?”

B: “$5, but that was a tax-related sale.”

Me: “Yes, but it shows the desperation, and from what I have heard, Bear Stearns is having a hard time unloading it above $5.? Look, you have to get the idea that you are holding the equity in these deals now, and equity has to offer at least a 20% yield in order attract capital now.”

B: “20%?! Can’t you give us a schedule for bond is worth at varying discount rates, and let us decide what the right rate should be?”

Me: “I can do that, so long as you don’t say that I backed a return rate under 20% to the regulators.”

B: “Fine.? Produce the report.”

I wrote the report, and they chose an 11% discount rate, which corresponded to a $60 price.? As an aside, the report from Moody’s was garbage, taking prices from single-A securitizations generally, and not focusing on the long-duration junky collateral relevant to these deals.

In late 2008, amid the crisis, they came back to me and asked what I thought the bonds were worth.? Looking at the additional defaults, and that the bonds no longer paid interest to the single-A tranches, I told them $5.? There was a chance if the credit markets rallied that the bonds might be worth something, but the odds were remote — it would mean no more defaults, and in late 2008 with a lot of junior debt financial exposure, that wasn’t likely.

They never talked to me again.? The bonds never paid a dime again.? I didn’t get paid for running my models a second time.

The bank wrote down the losses one more time, and another time, etc.? How do you eat an elephant?? One bite at a time.? It did not comply well with GAAP, and eventually the bank sold itself to another bank in its area, for a considerably lower price than when they first talked to me.

So what are the lessons here?

Ethics matter.? Don’t sign off on an analysis to make a buck if the assumptions are wrong.
Run your bank in such a way that you can take the hit, rather than spreading the losses over time.? (Like P&C reinsurers did during the 1980s.)? But that’s not how GAAP works, and the CEO & CFO had to sign off on Sarbox.
A model is only as good as the client’s willingness to use it.? There are lots of charlatans willing to provide bogus analyses — but if you use them, you know that you are committing fraud.
Beware of firms that won’t accept bad news.

I don’t know.? Wait, yes, I do know — I just don’t like it.? This is a reason to be skeptical of companies that are flexible in their accounting, and that means most financials.? So be wary, particularly when financials are near or in the “bust” phase — when the credit markets sour.

The Education of an Investment Risk Manager, Part VI

Posted on 29 September 201329 September 2013 by David Merkel

My boss walked in and said that we needed to terminate our annuity reinsurance treaty with an entity that I will call Bigco (this happened in July).? Senior management had deemed that we should do it, and in days we visited Bigco, assuming that the actuary in question would approve a termination of the treaty where:

There was no termination provision.
There was a guaranteed minimum return to the reinsurer.
The reinsurer had participation in the upside of profits.

Who negotiated such a treaty?? Very one-sided, and Bigco needed to deploy capital, not contract it.

Could a negotiating position be worse?? Yes, it could, just wait.

When we got to Bigco, we talked with the actuary for a little while, and then he handed us over to the head of M&A.? Uh-oh, he sized up the situation perfectly, and denied our request, unless we were willing to pay considerably above book value to repatriate the assets.

We went home depressed, and a few months after that my boss was summarily fired.? In those days, September was the firing time.? You can imagine what that did for morale.? Personally, I expect my boss was fired because he was most similar the the CEO, and had done things well in managing his line of business.

One day the chief actuary came to me and said, “We have to terminate that treaty.”? I explained to him the backstory, that we had offered to buy it back at an ROE of 9%, and Bigco was demanding 6%.? I said to him, “I’ve already compromised the 10% ROE objective of our company, I don’t want to go further.? I’m free to walk away, right, if we can’t get a decent price?”? He said, “No, the deal must be done.? Under no circumstances can you walk away.”

The sad thing was that any termination of the treaty would positively affect management bonuses.? (That was the real target.)

I had a strong sense that I should always serve the ultimate owners of the firm — the dividend receiving policyholders.? But this was at variance from that.

So, with the weakest bargaining hand that I can imagine, I used the following strategy.? I did nothing.? Nothing. Nothing until early December, where I called the M&A guy at Bigco and and told him, “I’ve had a change of heart.? I’ll accept an ROE of 6.9%.? That’s my final offer!”? This was ticklish because I *had* to get the deal done.

He bit on the offer, and I pressed him saying that between this time and the closing, my market value adjustment formula would rule.? He agreed.? (He probably had a profit goal as well, which was what I was counting on.)

But, he didn’t look closely at the Market Value Adjustment formula.? I gave him one that was volatility-loving, that would adjust of the greater of the absolute value of the yield changes in 3-month T-bills or 30-year Treasury Bonds.? Don’t criticize the guy too much, the Federal Reserve fell for the same tactic on GICs they bought from us.

Before the deal closed, the Fed started tightening monetary policy, and the Market Value Adjustment got us out at an ROE of 9.1%.? What a win, and for the policyholders.? Management got more as well, and I got almost nothing.

I took risks trying to do the right thing, praying the God would help me, and in this case, it worked.? Can you be more righteous than your management team?? In most cases, no, but in this case I succeeded.

I would say to all, try to serve the interests of owners rather than management.? Act like an owner, not like a manager hauling down a fat salary.

Sorted Weekly Tweets

Posted on 28 September 2013 by David Merkel

China

Chinese Cities Hooked on Land Revenue Fuel Housing Costs http://t.co/8SXwubzUjk Ppl invest in what they think they ctrl; no alternatives $$ Sep 28, 2013
Amway Bankrolls Harvard Course?For Chinese Cadres http://t.co/XVk5MXV2eh May not b pyramid, but successful sellers mostly recruit sellers $$ Sep 26, 2013
Chanos Undeterred by China Growth as O?Neill Bullish http://t.co/xwvC9mOFHa China will become the biggest windshield bugsplat ever seen $$ Sep 25, 2013
Party Will Pay the Price for China?s Rebalancing http://t.co/inQ5BHYMdn The Day has arrived: Michael Pettis is on Bloomberg. Go Michael! $$ Sep 25, 2013
China?s Generation Winnebago Avoids Traffic in RVs http://t.co/Q8z41qGv1j New Chinese status symbol: RVs. Rest while your driver works $$ Sep 24, 2013
China + Gold = 9 Million iPhones Sold http://t.co/DfIAopLDLV Gold may do nothing, but it is beautiful, & beauty drives much marketing $$ Sep 24, 2013
Michael Pettis, in his current newsletter, reminds us that loan growth outstrips ability to repay in China, recent “growth” is a fake-out $$ Sep 24, 2013

Companies & Industries

Meet Hummingbird: Google Just Revamped Search To Answer Your Long Questions Better http://t.co/mtAf5pxGIA Improved Search Engine $$ $GOOG Sep 28, 2013
JC Penney Is on the Brink http://t.co/UtMX5sa3ZT Now $JCP has liquidity, @ a cost, but can they transform their business model? $$ #unlikely Sep 28, 2013
Penney’s Share Offering Prices at a Discount http://t.co/CWVp8dOKln $JCP Danger Will Robinson! Stock price does not hold secondary level $$ Sep 27, 2013
Kat Cole, Former Hooters Waitress, Runs Cinnabon’s $1B Empire http://t.co/sOe9WKUB1v Ppl go gaga 4 Classic Roll. 60% more cals vs Big Mac $$ Sep 27, 2013
Oaktree group to sell US foreclosed homes http://t.co/dUuGn768TI Too many investors chasing residential RE vs owner occupiers $$ #badsign Sep 24, 2013
Meet Prem Watsa: The Man Riding to BlackBerry?s Rescue http://t.co/flg4xn1MkX A case of regret, throwing good $$ after bad $BBRY Sep 24, 2013
Banks Prove Safer Than Industrials in Bond Rally http://t.co/B2t3pbaNGd I would b willing 2 overweight industrials now; they r safer $$ Sep 24, 2013
Do Amazon’s Lockers Help Retailers? Depends on What They Sell http://t.co/Pbd2cPK6zl Works if $AMZN doesn’t sell what u sell, &vice-versa $$ Sep 23, 2013
FireEye Takes Off as Shares Rise 80% in IPO Debut http://t.co/fnY1YkvvD1 Score processes on weirdness, share info globally 2 stop malware $$ Sep 23, 2013

Rest of the World

Irish Billionaire Has ?Boatload? of Customers for Spanish http://t.co/GhyDzrhkhk Get your own Spanish Villa while supplies last! $$ Sep 27, 2013
Debt Disaster Seen Unless VAT Rises to 20% by 2020 http://t.co/fXyeptRNJZ Japan is a bug in search of a windshield; 20% would kill econ $$ Sep 26, 2013
Merkel?s Cold Embrace Leaves SPD Wary of Coalition Talks http://t.co/6pCmU9KgCf If SPD doesn’t compromise, cud a minority government form $$ Sep 24, 2013
Believing Data Not Required W/GDP Warrants http://t.co/36SKEKLcha Do u think Argentina is fudging GDP #s up? Buy Argentine GDP Warrants $$ Sep 23, 2013
For Migrants, New Land of Opportunity Is Mexico http://t.co/jy3XaZeRCA Immigrants r moving to Mexico as the economy deregulates a little $$ Sep 23, 2013
Czechs Yearning for Growth Set to Abandon Merkel Path http://t.co/sU8mxocTL7 No natural political coalition 4 austerity, even when right $$ Sep 23, 2013
Greece Plans Foreclosures to Meet Bailout Demands http://t.co/W7Ryxvv6J6 Inability 2 foreclose gums up Greece’s financial system $$ Sep 23, 2013

Central Banking

Richard Koo says ‘vicious cycle’ taking hold as Fed faces ‘QE trap’ http://t.co/se3uPY5eP1 Similar to my arguments in Easy in, Hard out $$ Sep 27, 2013
Constitutional Money by Richard Timberlake http://t.co/iipZBfnFqm “Treaties may become inapplicable because of changes in circumstances” $$ Sep 25, 2013
US Fed Shouldn’t Give Forward Guidance, Former Bank of Israel Head Fischer Says http://t.co/ZzbTLqTEU9 Correct. Fischer 4 Fed Chair $$ Sep 24, 2013
Why we listen to former FOMC members who r partisans of the Fed, rather than skeptics of central banking, like James Grant, amazes me $$ Sep 24, 2013
Yellen Would Bring Tougher Tone to Fed http://t.co/xoNY2kKWqa Academic economists, like Yellen, do not understand how the economy works $$ Sep 24, 2013

Housing/Mortgages

Mortgage Bonds Without Government Backing Face Tough Time http://t.co/MrtGxmynes Tough 2 mkt private label RMBS, not enough excess spread $$ Sep 28, 2013
Subprime bond bounces back, leaving behind a subprime borrower http://t.co/x7KRB8Rp9n Long article about a deadbeat & his subprime loan $$ Sep 27, 2013
There have been a scad of articles like this, but the guy did not do “due diligence” on the loan, and did not have to buy the house $$ Sep 27, 2013
Home gold rush is over http://t.co/AASXbe14zc Too many investors vs owner occupiers creates an imbalance as smarter players start 2 sell $$ Sep 26, 2013
FHA, Facing Losses, Likely to Tap Treasury http://t.co/Hdpqqdplri Shortfall for Fiscal Year Could b at Least $1B, Early Projection Shows $$ Sep 26, 2013

Financial Sector

BATS Prepares to Take On Big Bell Ringers http://t.co/x8PjU05xE9 NYSE + Arca > BATS + Direct Edge > NASDAQ $$ Graph: http://t.co/rDV3hY7uzf Sep 28, 2013
Shine a Light on Repo http://t.co/KrF4MtaA7Y Did u know that repos r 96 years old? Learn about obscure corner of the fixed income market $$ Sep 27, 2013
The bank that rejects the most mortgages http://t.co/JxD3xhvlY4 $JPM highest rejection rate, $STI lowest, $WFC biggest lender, avg 20.6% $$ Sep 27, 2013
Covenant-Lite Loans Need Uniform Definition http://t.co/RbEywreAEC It would help, but there is always nonstandard data in securitizations $$ Sep 26, 2013
Wells Fargo: New CLO Regulations May Lead to Issuance Slump http://t.co/FcK5NLQvba Forcing securitizers 2 take first losses ruins profits $$ Sep 24, 2013
The VC Secret: 3 Out of 4 Start-Ups Fail http://t.co/jjFrQc9JNP Ratio sounds high, but when VC-backed firm wins, it pays 4a lot of losers $$ Sep 24, 2013
That’s the way 2 manage pension assets if u r big enough. In-source, build up expertise, & keep adding smart people 2 addl asset classes $$ Sep 23, 2013
In-Sourced, Fully Funded, Public, and American http://t.co/ISUDgDvGhC! South Dakota Retirement System manages 65%-70% of assets in-house $$ Sep 23, 2013
America’s latest financial crisis? It’s incredibly personal. http://t.co/yHLcIm7xuR People do NOT understand how to save or handle cash $$ Sep 23, 2013
Value Investor Charles de Vaulx On China, Gold, Apple And Berkshire Hathaway http://t.co/4LgwGyzI7g Longish good interview. $$ $STUDY $BRK.B Sep 23, 2013
Fidelity sued by employees over its own 401(k) plan http://t.co/yo5h32QQD6 Biting hand that feeds them, they object 2 high fees 4 funds $$ Sep 23, 2013
Inside Nasdaq’s succession planning process http://t.co/6uOUsgrpuQ $NDAQ trades at a discount 2 peers; it needs a merger or better mgmt $$ Sep 22, 2013

Other

Billionaires Battle as Bezos-Musk Companies Vie for Launch Pad http://t.co/jEOhw4xXac Fight over a launchpad @ Kennedy Space Center $$ Sep 28, 2013
Supersonic Drones Can Outmaneuver Humans. So Why Do We Still Need Pilots? http://t.co/J5N9FhDVbH Pilots fly better in complex situations $$ Sep 28, 2013
Postal rate hike proposal faces Senate scrutiny http://t.co/aq7gKcDnm1 First Class would go to 49 cents, as internet slowly eats USPS $$ Sep 26, 2013
This Year’s SAT Scores Are Out, and They’re Grim http://t.co/04jtzUJMtL <50% of 2013 graduating seniors got “college-ready” SAT scores $$ Sep 26, 2013
Little GAAP Could Drive Accounting Simplification http://t.co/Ti24zRMFY2 If the acctg is 2 complex, biz is probably 2 complex as well $$ Sep 26, 2013
Work is not waiting for a job. If you don’t have a job, start your own business. http://t.co/pkUXupCOJg Sep 25, 2013
Investors Are Buying High, Yet Again http://t.co/PaTcowZvk8 Opportunities are fewer now, listen to Buffett & Klarman & trim back risk $$ Sep 25, 2013
Tweet tips: Most effective calls to action on Twitter http://t.co/PrcHMiNDMc! U could also ask them to favorite your tweet $$ $TWTR Sep 24, 2013
Death Dinners at Baby Boomers? Tables Take on Dying Taboo http://t.co/68nxd534eB Good 2 talk about death, but r u ready 4 the afterlife? $$ Sep 24, 2013
Here Are The Best Fundamental Investors To Follow On StockTwits http://t.co/a72aV98KUo A good list of resources & teachers; I’m listed #5 $$ Sep 23, 2013
A Backdoor Roth IRA for a High-Income Couple http://t.co/79fYNIF5d6 Invest in regular IRA, convert 2 Roth, repeat process annually $$ Sep 23, 2013

PPACA / Obamacare

Will Obamacare hurt job creation and marriage? http://t.co/n7h7BEkrXK Belief in Obamacare is akin 2 belief in magic; resources r free $$ Sep 27, 2013
Prices Set for New Health-Care Exchanges http://t.co/J4VFjvF5HR Younger Buyers May Face Higher Insurance Premiums $$ Obamacare #FTL Sep 26, 2013
Best of the Web Today: The Young and the Clueless http://t.co/3GbWYOqipM ObamaCare may work, provided no one responds to its incentives. $$ Sep 26, 2013
Young Invincibles Caught in Crossfire Over Obamacare Cost http://t.co/hgyCGtZMaj Note how Obama packs the gallery w/young people $$ Sep 24, 2013

Municipal Debt / Detroit

Stockton to Unveil Plan Including Cuts for Creditors http://t.co/zBj3ngCXMz Trying to preserve pensions may draw lawsuit from bondholders $$ Sep 28, 2013
Detroit spent billions extra from pensions http://t.co/UBdb3GaqtI That’s what u get 4 having 1-party rule, w/no 1 to look over shoulder $$ Sep 27, 2013
Orr proposes freeze for Detroit pension funds http://t.co/sSFtqADV23 Unions don’t get that they destroyed the finances of Detroit $$ Sep 27, 2013
Judge Rules Retiree Health Protected Like Pension http://t.co/xg7bcR28oM! Loopy ruling sets Los Angeles on a course 2 bankruptcy $$ Sep 25, 2013
Hands off DIA, pensions, Detroiters say in poll http://t.co/dHmp2qjc5n! Detroit is an example of a complex system self-destructing $$ #dying Sep 23, 2013

Energy

Pipeline Billionaire Ready for Next Round of Deal Making http://t.co/KhTwsdBDRs $ETP CEO thinks there is room to consolidate pipelines $$ Sep 28, 2013
Six Myths About Renewable Energy http://t.co/G0dB1SJ2aU Balanced article. 3 myths pro, 3 myths con. It will b a minority of total energy $$ Sep 23, 2013

The Economic views of Ray Dalio

One more note, this slideshow put together from BI moves a lot faster than Dalio’s video or the… http://t.co/ytGIHQEaxP Sep 24, 2013
And for those that want to read Ray Dalio’s economic template book, it is free here: http://bwater… http://t.co/f1AVlDufxo Sep 24, 2013

US Politics & Policy

Texas Counties Lead in Job Growth, Lag in Wage Gains http://t.co/XdyNF4ZEJt No surprise, but biz leaves CA & there is high unemployment 2 $$ Sep 27, 2013
CHRISTIE KEEPS PENSION PROBE RECORDS FROM PUBLIC VIEW AS GOVERNOR EYES 2ND TERM http://t.co/NmnbLRxRwd! Running mate has pension scandal $$ Sep 24, 2013
Open-Government Laws Fuel Hedge-Fund Profits http://t.co/P5vZBpkiDq Hedge funds file FOIA requests 2get FDA reports on drugs, etc. $$ Sep 23, 2013
At 77 He Prepares Burgers Earning in Week His Former Hourly Wage http://t.co/jQJaWTiQd3 Example of “failed 2 save” Don’t let it happen 2u $$ Sep 23, 2013
Self-Driving Vehicles Progress Faster Than Rules of Road http://t.co/1lFAmdlJKz Regulations, laws, insurance all need 2b revised 4 this $$ Sep 23, 2013
The Hidden Classified Briefing Most of Congress Missed http://t.co/eSBnz0uPxd How intelligence gets disseminated w/o getting disseminated $$ Sep 23, 2013
How the NFL Fleeces Taxpayers http://t.co/OeG5kRTM2O Longish article on how they get free stadiums, pay no federal or state taxes, etc. $$ Sep 23, 2013
Facebook ?Likes? Are Now Legally Protected Speech http://t.co/Oi7XQkYVlB Political speech is protected by the 1st Amendment even “like” $$ Sep 22, 2013

Wrong

Over the Top: Jordan R. VanOort Earns Prestigious CFA Designation http://t.co/jRMcdyRq1R CFA designation is good, but prestigious? $$ Sep 28, 2013
& really, when there are over 100,000 of us, does receiving your CFA Charter really rate a press release? Tougher to become an Actuary $$ Sep 28, 2013
Wrong:Pimco shook hands with Fed – & made a killing http://t.co/gBlELQ6U7p 2 notes: agency MBS r easy 2 understand, & TBA mkt not obscure $$ Sep 27, 2013
Point: Fed could have easily done this internally. What! They can’t find any among their 1000s of Ph.D. economists to get simple mkts? $$ Sep 27, 2013
It is probable that enough data on what the Fed would do escaped over the transom 2 give PIMCO & the other firms insider info. $$ Sep 27, 2013
Wrong: New idiots, same as the? actually these idiots might be worse http://t.co/Xa5jGmbQII US economy grew faster under balanced budgets $$ Sep 27, 2013
Wrong: Reduce working week to 30 hours, say economists http://t.co/HiI7Zmhimo More work means more production means more GDP, Consumption $$ Sep 27, 2013
Loony: Detroit Union Seeks 2 Revive `13th’ Pension Check Policy http://t.co/Lf5YMVBKxW Practice that continues 4 28Y is a tacit agreement $$ Sep 27, 2013
Wishful thinking: Let ObamaCare Collapse http://t.co/n3yNizNAfP Until the US itself fails, no entitlement has ever been eliminated $$ Sep 26, 2013
Wrong:Shinzo Abe: Unleashing the Power of ‘Womenomics’ http://t.co/R00AN5pUEH This comes from nation w/a shrinking population. Ridiculous $$ Sep 26, 2013
Wrong: How Sensitive Is Public Pension Funding to Investment Returns? http://t.co/hSeoOLsvrc! Should use mkt-based assmptns not historic $$ Sep 25, 2013
Wrong: US city, county public pension levels sank in 2012 http://t.co/o2JUwsi5JF! 2 optimistic, b/c risk assets bottomed in late 2002 $$ Sep 25, 2013
Wrong: Don?t Be Alarmed by Obamacare?s Failures http://t.co/fS63xQpaaP PPACA doesn’t make actuarial sense, young people won’t participate $$ Sep 24, 2013
Wrong: Yellen Isn?t a ?Knee-Jerk Dove,? Kroszner Says http://t.co/0aeTM6BIiB Favoring negative interest rates == ?Knee-Jerk Dove? $$ Sep 24, 2013

Replies, Retweets & Comments

Thanks @TightTalk @BabyFreshNuggz @X9T_Trading for being top new followers in my community this week (insight via http://t.co/sern3wLA13) Sep 27, 2013
“Here is part of my solution: accounting for repos should be bifurcated, so that is not treated ?” ? David_Merkel http://t.co/caWGlbe3eL $$ Sep 27, 2013
Loonies, Detroit is dead MT @ToddSullivan: RT @AmyResnick: just wow. Detroit Union Seeks to Revive `13th’ #Pension http://t.co/u3XJAER0bi $$ Sep 27, 2013
Believe MT @ReformedBroker: You’re not gonna believe this – but Detroit’s pension doled billions left and right http://t.co/9i5MinpGAX $$ Sep 27, 2013
RT @ezraklein: Perhaps if President Obama makes the House GOP 300 sandwiches, they’ll agree to lift the debt ceiling. Sep 27, 2013
#FollowFriday Thanks @ReformedBroker @pelias01 @researchpuzzler for being top influencers in my community this week 🙂 Sep 27, 2013
‘ @allstarcharts @jfahmy The 1st discipline of investing/trading is humility; even if you know more, the timing/environment can be tough $$ Sep 27, 2013
Commented on StockTwits: I think Watsa can be trusted. Aside from financials in the old days that were dodgy, I th… http://t.co/dJ8g2rVKmK Sep 27, 2013
Thanks @abnormalreturns @dpinsen for being top engaged members in my community this week (insight via http://t.co/sern3wLA13) Sep 26, 2013
“I never directly pay for research… most of it is freely available on the web. What is not, I?” ? David_Merkel http://t.co/EAk37XXNdJ $$ Sep 26, 2013
“This is already known by those that study the statistics. Look at year over year figures, you ?” ? David_Merkel http://t.co/5J46Rm19vo $$ Sep 26, 2013
I just left a comment in “We’ve got bubbles, we’ve got troubles – MarketWatch” http://t.co/P11awJw1KQ Sep 26, 2013
‘ @Reddy Cummings is my gerrymandered rep. He is by far one of the most intellectually underpowered members of the House, & that says a lot Sep 25, 2013
@moorehn @ReformedBroker @SimoneFoxman @SallyPancakes @kensweet @jennablan They r favorites of mine. $$ Sep 25, 2013
Entitlements will have to be reduced; it is only a question of how and when. Druckenmiller’s presentation:… http://t.co/BsA9S78RTI Sep 24, 2013
Thanks @MarshaCollier @EdmundSLee @rwohlner for being top new followers in my community this week (insight via http://t.co/sern3wLA13) Sep 24, 2013
Thanks @researchpuzzler @pelias01 for being top engaged members in my community this week (insight via http://t.co/sern3wLA13) Sep 23, 2013

On Leveraged Municipal Bond Closed-End Funds

Posted on 26 September 2013 by David Merkel

I’ve received two notes recently on Closed-end Leveraged Muni Bond Funds.? Here’s one:

David,

I have been asked several times about the Blackrock Target Term Municipal Bond Trust (“BTT”).? The appeal is obvious:? at $17, it offers a 7% tax free yield.? A theoretical $25 redemption price in about 15 years adds roughly 2.5% per year to the total return (not tax free, but at least tax deferred).

All wonderful stuff.? What I do not understand is the leverage via Tender Option Bonds.? I realize TOB’s equate to borrow short/lend long, which has obvious risks, but the range of outcomes and probabilities is beyond me.

Can you shed some light on this?

And here is the other:

What about the closed end funds of Eaton Vance that are trading at a discount to their nav? I?m thinking specifically of the muni one EIV?

Also do you know the statistics of how many munis go to maturity vs getting called in 10 years?

Thank you for all you do to educate your reader!

I responded to the latter:

http://funds.eatonvance.com/Municipal-Bond-Fund-II-EIV.php

With CEFs, I look at the fund?s website, which I note above. This funds has a lot interest rate sensitivity, and a lot of oddball credits, many of which are insured to AA. Remember that many guarantors failed in the last crisis. The question is economic necessity of existence for each creditor, which would take a lot more work to determine.

I don?t have any data on calls, but given the falling rate environment, most healthy credits that could call, did call. It would be stupid not to call.

But with respect to the former:

You can get the basic data on BTT here:

https://www2.blackrock.com/webcore/litService/search/getDocument.seam?contentId=1111182509&Venue=PUB_IND&Source=WSOD

The levered fund duration is astounding at 17.5 years.? A 30-year Treasury does not have that level of interest rate sensitivity.? The question to you is what is your time horizon?? Can you buy and hold, and if you do, will inflation and defaults eat you up?

I am not inclined to buy either EIV or BTT.? Municipal finance is not what it used to be, and players should recognize the weakened position of municipal borrowers.? The rating agencies are looking through the rear-view mirror to rate munis.

No, things are not as bad as Meredith Whitney posited, but they are bad, and the understatement of employee benefit liabilities are significant.

On tender option bonds, you have it basically right, and there is not much more to it than what you said, but here is the full treatment from Nuveen.

Here’s the trouble with muni bond portfolios: to get a great yield you have to take a lot of the following risks:

Liquidity
Credit
Guarantor
Leverage
Duration

These are not trivial risks, and so I am unlikely to invest in high yielding municipal bond Closed End Funds.

Quiet Companies Are Better

Posted on 26 September 2013 by David Merkel

I appreciate the companies in my portfolio that don’t say much.? They just do their work, and don’t advertise it.

There is a bias among promotional companies, that one must promote the company in every press release.? I disagree.

Just be honest.? If you don’t have anything significant to say, don’t say it.? Spend your time on growing the business, rather than advertising accomplishments.

Truth: I would prefer that companies simply issue a 10-Q or 10-K, and do not hold a conference call for analysts.? Just give us the data, and let us analyze it.

Let the analysts do their work, and don’t answer their phone calls.? Create a genuine level playing field where no one gets to talk with management unless everyone is invited to listen.

I realize this is radical, but I am trying to be genuinely fair, which does not happen often on Wall Street.

Classic: How to Size Your Portfolio to Fit

Posted on 26 September 201326 September 2013 by David Merkel

I wrote the following at RealMoney on 4/10/2007

I’ve written two columns already about “spring cleaning” a portfolio, walking you first through the criteria I use when reshaping my holdings and then through the stocks and decisions those criteria pointed to. But there’s one aspect I didn’t cover: What’s the best way to size positions for a long-only equity portfolio?

In order to answer this question, I use the Kelly criterion (popularized in the excellent book Fortune’s Formula), which says that a position size should be equal to (edge/odds). Edge is the excess return that you expect to earn on average. Odds describes the likelihood of winning. A 50/50 bet makes odds equal to 1.

There is added complexity in applying this to stocks, because in gambling, each game is (mostly) uncorrelated with the last one. In investing, if you have a number of investments going at the same time, they are to some degree correlated with one another.

That’s particularly true for me, because I concentrate sectors. I believe that my portfolio acts more like a portfolio with half the number of positions because of the correlatedness of the various names in the portfolio. Thus, the 35 names in my portfolio behave more like 18 uncorrelated names.

The Kelly criterion applied to stock investing would recommend a fixed-weight portfolio. Optimally, you would rebalance daily to those fixed weights. But two factors interfere: First, there are costs to trading, and second, momentum tends to persist in the short run.

To me, those realities mean that you can have fixed weights, but that you set a band around those fixed weights for rebalancing. I use a 20% band, but the more I think about it, the band should be smaller, maybe 10%. My portfolio has gotten bigger over the past few years, and trading costs are a smaller-percentage cost factor. I’ll stick with 20% for now. It has served me well, but I will re-evaluate this.

I firmly believe that my eight rules tilt the odds in my favor. What are they?

Industries are under-analyzed relative to the market on the whole and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries where the trends are not fully discounted.
Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean a low price-to-earnings ratio, low price-to-book value ratio, low price-to-sales ratio, low price-to-cash flow from operating activities, low price-to-free cash flow or low enterprise value-to-EBITDA.
Stick with higher-quality companies for a given industry.
Purchase companies appropriately sized to serve their market niches.
Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.
Analyze the use of cash flow by management to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.
Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.
Make changes to the portfolio three or four times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

I need to calculate what I think my edge is. My procedure will be messy and somewhat ad hoc, but I would rather be approximately right than precisely wrong. How much is each rule worth?

The offensive rules are 1, 2, 7 and 8. Each of those generates roughly 2% of alpha annually. The defensive rules are 3, 4, 5 and 6. Each of those generates roughly 0.5% of alpha annually. Now, that would be an alpha of 10% annually for a portfolio that followed all those rules perfectly. My alpha over the last six years and seven months has been greater than that, but I will chalk up the overage to happenstance. Maybe more should go to happenstance, but I will discuss that below.

If my edge is 10% per year, what are my odds? I have long maintained that the idea I believe is best probably is as good as my 35th idea. Too many portfolio managers naively believe that they can identify their best ideas, when there are so many unknowns to an outside, passive, minority investor. My methods work on average, over the intermediate term. Most of my investments work if I give them two to three years to develop. Time is usually on my side with my methods. That would imply that my odds might be 50/50, or 1:1. That’s a coin flip, but one that, repeated often enough, leads to an extra 10% per year. Using the straight Kelly formula, that would mean I should have 10 positions; 10% divided by 1 is 10%, and for each position to be 10% of my portfolio, that would mean 10 positions. But I own 35 positions. What do I do?

As I mentioned above, because I concentrate industries, my 35 stocks behave more like 18. An equal-weight 18-stock portfolio has weights of 5.5%, and that’s still not 10%. Again, what do I do?

Good investing is based on humility, a willingness to accept that there are many things that you don’t know and that many successes may not be due to skill. Many who use the Kelly criterion decide to go “half Kelly” and cut position size in half because it also cuts volatility in half — but it also diminishes the expected returns by 25%. It’s a humble way to go.

Another way to think about it is that with quantitative investing, when you find a good strategy and have vetted it though back-testing, typically the alpha achieved when the strategy goes live is half of what the model would have predicted.? Though I have already given my edge a haircut, perhaps more of the success needs to be attributed to happenstance.

Whether due to happenstance or conservatism on my part, cutting the 5.5% in half leads to positions of 2.8% in size. How many equal-weighted positions is that? 36. That’s about what I have, and when conditions are bullish, I contract the number down to 30. When conditions are bearish, I hold up to 40 positions. Most of the time, I keep it at 35. That keeps me disciplined, which is a virtue that yields dividends in its own right.

That’s what I do. But what should you, my reader, do?

I encourage you to calculate your edge.

Look at your annualized returns over the past few years, and compare them with the index that you want to beat. Take the? excess (assuming there is one), and cut it in half. Some things went well for you that are not attributable to your skill.

I encourage you to calculate yours odds.

Look at your trading. Divide it into two categories, winners and losers. How often do you win (relative to the index)? When you win (vs. the index), how much do you win on average? When you lose (vs. the index), how much do you lose on average? (Make sure you use your annualized results for this exercise.)

If you consistently lose vs. the index, I’d buy the index instead of continuing to lose capital trying to do it myself. If you beat the index, then work out the calculation that I went through for my portfolio. Take into account your conservatism, but even if you are aggressive, I strongly discourage you from using portfolio weights higher than the full Kelly criterion; it’s too dangerous.

In general, I believe skilled investors with moderately sized portfolios are best served by diversification equal to what I use.? On the raw Kelly criterion, it’s equivalent to saying that one has an alpha between 2.5% and 3.3%. Hey, that’s hot stuff!? Most mutual fund managers would kill for those returns.

In summary, size your positions inversely to your expected alpha. To the extent that you are less certain of your skills, expand the number of your positions.

Classic: Take the Easy Road With Bonds

Posted on 24 September 2013 by David Merkel

I really enjoyed answering the “Ask Our Pros” questions at RealMoney.? I answered the following on May 11th, 2005, and would add in Jeff Gundlach and Ed Meigs as active managers:

Ask Our Pros is a service we provide to RealMoney subscribers that enables them to get answers to their investment questions from our contributors. To ask a question, you must be a RealMoney subscriber.? Please click here for information about a free trial.

Reader:

Can someone explain bonds, tax-free vs. taxable? What are some of the strategies that you use to purchase bonds, and what percentage of your portfolio typically should be in bond funds?

— A.A.

David Merkel:

Here is my simple advice for retail bond buyers:

Bonds are promises, from various entities, to pay back the money that you lent, plus interest. Most bonds are taxable. A few, like U.S. Treasury bonds, are exempt from state taxes, while many of the bonds of municipalities are exempt from federal taxes, state taxes (usually if the municipality is in your state) and city taxes (usually if it’s the city you live in).

With respect to taxability, what is best to buy depends on your marginal tax bracket. The higher your tax bracket, in general, the more municipal bonds can help. Beyond that, it is worthwhile to compare the after-tax yields on taxable and nontaxable bonds with equivalent risk. (As always, please be sure to check with a qualified tax professional for advice on your specific information.)

Now for the controversial bits. In general, I don’t recommend that individuals buy individual bonds, unless you are buying Treasury bonds and are following a simple strategy like a ladder.

A ladder is a set of bonds that mature sequentially. Say the ladder is five years long; each fifth of the bond money would be invested one, two, three, four and five years out. Each year, you would take the money from the maturing bond and buy a new bond five years out. Many bond managers pooh-pooh ladders because they think they can beat the performance of a ladder. But a ladder is the most robust bond strategy out there, period. I believe it gives the best return for the risk, particularly given the possibility of shifts in inflation, yield-curve twists, etc. But a bond manager can’t get paid for running a ladder.

There are other reasons for avoiding individual bonds: Bond dealers often rip off retail investors. I have stories, but they’ll have to wait for another day. Liquidity for retail investors is generally poor. Most of the bonds pitched to retail investors will be new issues, which aren’t necessarily the best bonds to buy; they just happen to be the bonds most available at a given moment. This is particularly true of municipal bonds. If you don’t believe me, read Joe Mysak’s column on Bloomberg for a while. The municipal market is a place you don’t want to go without an adviser.

Another reason you don’t want to buy bonds, single-issuer bond trusts or preferred stocks on your own is that many of them have funny features that make the yield look really good, but the bonds can be called away in low interest rate environments, leaving you to reinvest in that low interest rate environment. One dirty secret of bonds is that the excess yield inherent in callable bonds and residential mortgage-backed securities on average does not compensate for the call risk. Only a few experts win that game, and you likely are not one of them.

Finally, my word on bond funds: There are very few managers worth paying up for. Maybe Dan Fuss at Loomis Sayles, Bill Gross at Pimco and a few other, more obscure managers that I am less certain are worth paying up for. The only guarantee in bond funds is that low expenses win in the long run, so I’d go to Vanguard. Performance advantages are fleeting, and tend to revert to the mean, but expense advantages are permanent. Vanguard’s bond funds usually are in the top half each year; repeating that for 10 years makes them top decile.

So don’t take the hard road. I’d go to Vanguard and use their Total Bond Market index fund. Utterly unsexy, but a winner. The only place where Vanguard lacks is international bond funds; it has none. For that, if I want diversity, I go to T. Rowe Price, or buy a closed-end fund that doesn’t hedge currencies at a discount.

How much to invest in bonds? Consult your financial planner. This factor varies so much, it’s all over the map. The right proportion of bond investment depends on market conditions, investment horizon, your personal life factors, wealth level, risk aversion, etc. My experience is that most people are unbalanced in their asset mixes — too much is in stocks or too much is in bonds. The best default mix might be Ben Graham’s 50/50, or the pension mix of 60% stocks, 40% bonds. These are both very robust strategies, but again, what is best for you depends on your personal situation.

I have to say, from the business side of the desk, I really loved managing a multibillion-dollar bond portfolio. I really did well at it, but the best part about it was interacting with my brokers, who all were stupendous to work with. I find that running equities is antiseptic, particularly as an analyst who has an exceptionally competent trader to execute his decisions. Running bonds is colorful because of the human interaction and all of the games that can arise from that. I learned how to haggle in the bond market, and for a nerd like me, becoming good at that was a surprise. Would I want to manage bonds again? Yes. It was fun.

Classic: Two Ways to Analyze Corporate Bonds

Posted on 24 September 2013 by David Merkel

This was written on July 16, 2004. I republish it now because it cannot be found on RealMoney’s website.? If you subscribe to RealMoney, demand that you can see my old posts.

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==-==-=-=-=-=-==-==—
Tighter corporate spreads imply stronger profits and free cash flow at debt-issuing corporations. But there is another factor at play here that is less known outside of the corporate market.

There are two distinctly different ways to analyze corporate bonds. The first way is the old standard, which relies on fundamental analysis of a company’s financial statements. The second way relies on contingent claims theory (options theory, Merton’s model) and relies primarily on market-oriented variables, such as stock prices and option volatility.

The basic idea behind the latter method is that the unsecured debt of a firm can be viewed as having sold a put option to the equity owners. In an insolvency, the most the equity owners can lose is their investment. The unsecured bondholders (in a simple two asset class capital structure) are the new “de facto” equity holders of the firm. That equity interest is most often worth far less than the original debt. Recoveries are usually 40% or so of the original principal.

Under contingent claims theory, spreads should narrow when equity prices rise, and when implied volatility of equity options falls. Both of these make the implied put option of the equity holders less valuable. Equity holders do not want to give the bondholders a firm that is worth more, or more stable.

So what’s the point? Over the last seven years, more and more managers of corporate credit risk use contingent claims models. Some use them exclusively, others use them in tandem with traditional models. They have a big enough influence on the corporate bond market that they often drive the level of spreads. Because of this, the decline in implied volatility for the indices and individual companies has been a major factor in the spread compression that has gone on. I would say that the decline in implied volatility, and deleveraging, has had a larger impact than improving profitability on spreads.