The Duration Station - Coupon Matters

Duration is a term thrown about quite carelessly by investment professionals when discussing fixed income investing. Duration is thought of as a measure of interest rate risk, but it is more involved than many investors realize. There are several components which go into determining the duration of a bond, maturity is only one factor. Cash flows play a major role in determining the duration of a bond. In fact, Macaulay’s Duration is defined as being the weighted average maturity of a bond’s cash flows. Modified Duration measures price sensitivity. However, when the duration of a bond is calculated using both Macaulay’s Duration and Modified Duration, the results are very similar. As an example, we will use the current 10-year U.S. Treasury Note (1.625% due 8/15/22). At a closing price of 99-6/32s (YTM: 1.716%) the Modified Duration of the 1.625% due 8/15/22 Treasury note is 8.97. The Macaulay’s Duration calculation gives us a duration calculation of 9.04. The results are fairly close. Now let’s compare this to the 7.25% due 8/15/22 government bond. The 7.25% due 8/15/22 government bond was issued in 1992 as a 30-year Government bond, but since it only has 10-years remaining and, other than its coupon, is identical to the current 10-year note, one would expect its duration to be similar to that of the current 10-year. However, when we run the duration calculations the results are quite different. At a closing price of 151-5/32s (YTM: 1.582%) the Modified Duration calculation gives us a result of 7.57. The Macaulay’s Duration calculation gives us a similar answer of 7.57. Why the big difference in the duration (almost 1.5 years) between two U.S. government securities of with the exact same maturities? The answer is simple: Cash flows. More money is being returned on a timely basis. The lower the coupon, the more a bond’s total return is paid at maturity. Some teachers of bond concepts use a fulcrum to describe this. With a zero coupon bond, the fulcrum is placed at maturity. The higher the coupon, the closer the fulcrum moves to the center of the hypothetical beam carrying the total return of principal and interest. A zero-coupon bond has a duration equal (or almost equal) to its maturity, therefore it is the most sensitive to interest rate moves than bonds which pay investors on a timely basis. A case in point is the U.S. Treasury Strip due 8/15/22. At a closing price of 83-26/32s (YTM: 1.814%), its Modified Duration is 9.77. Macaulay’s Duration gives us a result of 9.69. How does this translate into price movement? Let’s run the numbers. If let’s assume a 100 basis point rise in 10-year rates. The yield of the 1.625% due 8/15/22 Treasury note would rise to 2.716%. The price will have fallen to 90.685 from 99-6/32s. This is a drop of more than nine points. The price decline for the 7.25% due 8/15/22 is going to surprise you at first, but it will soon make sense. Moving its yield to 2.582% from 1.582% results in a price decline to 140.102 from 151-5/32s, by now you must be saying to yourself: “I thought the higher coupon was supposed to make a bond less volatile, but the price dropped more than 11 points versus just over nine points for the current 10-year. What investors must keep in mind is that fixed income investing is all about percentages. The 1.625% due 8/15/22 Treasury note experiences a price drop of about 8.6%. However, the 7.25% due 8/15/22 experienced a price decline of 7.4%. Do these numbers look familiar? They should as they are similar to the Modified Duration calculations of 8.97 and 7.57, respectively. This is where the percentage move in price comes into play when considering duration. What about our zero-coupon Treasury Strip due 8/15/22? Moving its yield up 100 basis points from 1.814% to 2.814% results in a price decline from 83-26/32s to 76.093, a decline of 9.3%, again similar to Modified Duration (9.69). The response to our analysis might be: I (or my client) only care about the price drop in dollar terms, not in terms of percentages. Alright, let’s discuss dollars. For this exercise, we will give or fictitious investor $100,000. Let’s see what happens in dollar terms. For $100,000 our investor can buy the following: 100m of the 1.625% due 8/15/22 65m of the 7.25% due 8/15/22 119m of the strips 0.00% due 8/15/22. Now let’s apply the price declines: T 1.625% due 8/15/22 = -9 points. 9 x 100m = $9,000. T 7.25% due 8/15/22 = -11 points. 11 x 65m = $7,150. S 0.00% due 8/15/22 = -7.75 points. 7.75 x 119m = $9,225.50. In dollar terms, the bonds with the lowest coupons and highest durations experienced the biggest dollar losses. One can make the case for the lower coupon bonds if one is willing to hold it until maturity. One will earn a higher rate of return for the lower coupon bonds 1.814% for the strips, 1.716% for the 1.625% due 8/15/22 and only 1.582% for the 7.25% due 8/15/22. However, the investors who own the 7.25% due 8/15/22 bonds will be able to reinvest cash flows on a timely basis. In a rising rate environment this can be most beneficial. This is why investors are willing to accept a lower yield for high-coupon bonds and/or demand higher yields for instruments with inferior timely cash flows. Interestingly, in retail-oriented securities, such as preferred stocks, often times we find the opposite to be true. In the preferred market, high-coupon preferreds often trade at higher yields as retail investors are often averse to paying premiums. This is the exact opposite of what happens in the institutionally-driven Treasury market, especially when the mostly likely path of interest rates is higher. Other factors can come into play in determining a security’s duration. Optionality is one. A call feature can lower the duration of a bond if a call becomes “in the money” (I.E. the security is likely to be called for economic reasons advantageous for the issuer). If a callable bond is likely to be called, its duration calculation would take that into account and its volatility would be less. However, if a call was out of the money (rates, at which the issuer could refinance, were equal to or higher than the coupon on the bond), the duration of the bond in question would be similar to that of a non-callable bond of a similar maturity from the same issuer. This leads us to the topic of convexity. As we are risking making this report too wordy and risk losing the attention of our readers, we will give a simple laymen’s explanation of convexity. Convexity compares the price movement of a bond when rates move up to when rates move down the same amount. A bond that experiences a greater downward price move when rates rise than it does upward price movement when rates decline is said to be “negatively convexed.” Callable bonds tend to be negatively convexed, especially as its first call date approaches, as the upward price movement due to falling rates is limited by its call price. If rates fall sufficiently for the issuer to call in the bond and refinance at a lower rate, it is likely to do so. Rather than the price of a callable bond rallying to where its similar non-callable brethren are trading, it will stop rising when it approaches its call price. However when rates rise and the call is “out of the money,” its price decline should be similar to similar non-callable bonds. Remember, call features on a bond are an embedded option designed to favor the issuer. This is not dissimilar to the advantage many home mortgage borrowers gain when they have the ability to refinance without penalty. We will leave off here for this week. Next week we will discuss how duration is works and is assessed within a portfolio. This discussion of duration and convexity and next week’s discussion of duration within a portfolio, as well as portfolio construction, was due intelligent questions asked by a Bond Squad subscriber. Whether building your own portfolios or having an outside manager doing that work for you, it is important that both investors and advisors understand how bonds work and how portfolios can and should be constructed (portfolio duration and bond fund duration must be looked upon differently than bond duration). The questions asked by our subscriber come at a fortuitous time for Bond Squad as we are in the final stages of negotiations to enter the fixed income portfolio management business. We will keep subscribers updated as to what is happening to that end. We do not foresee very many changes to how we serve or loyal customers. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

Credit Wasteland - Leveraged Loan Speculation Explained

When credit and interest rate concerns enter the scene, it is often a good time to look for value among quality fixed income investments. Instead, some market participants have advised investors to chase yields in even riskier areas of the market. We cannot help but see this as a recipe for potential disaster. One of the areas of the market investors have been told to chase yield is in the leveraged loan market. We have never suggested this asset class or equivalents because they carry more risk than typical fixed income investor desires or, frankly, should have. In spite of that fact that they are loans, leveraged loans are very risky investments. So as not to convey bias, here is Investopedia’s definition of a leveraged loan. “Leveraged loans for companies or individuals with debt tend to have higher interest rates than typical loans. These rates reflect the higher level of risk involved in issuing the loan. In business, leveraged loans are also used in the leveraged buy-outs (LBOs) of other companies.” It is the high interest rate which attracts investors. Salespeople will point out that loans are senior even to senior bonds. However, what many salespeople leave out is that these companies are so risky and have such poor debt coverage they cannot borrow in the unsecured corporate bond market. Instead, they issue loans to sophisticated investors who demand a high interest rate AND a claim on hard assets (equipment, buildings, inventory, etc.) That sounds encouraging until you realize that if the company failed and its assets liquidated, it is unlikely that creditors would receive “full value” for the assets during a distressed sale. However, sophisticated investors understand this. They may be willing to lend to a business at a rate of, let’s say, 13.00%. The investor does his due diligence and figures out that, if the company filed for bankruptcy, 50% of principal should be recovered. The investor might calculate that, by the time the company is likely to default the total return on the loan might be 8.00%, when the principal haircut is included. This might me alright for the sophisticated investors, but might surprise the heck of your average individual investors. For this reason, most individual investors cannot directly engage in leveraged lending. Wall Street, being what it is, has found a way around this. There are mutual funds and ETFs which invest in leveraged loans. Individuals can buy the fund shares. The funds, being sophisticated investors, buy the loans. Now borrowers with low credit qualities can tap a broader range of investment capital. This is a good solution, right? Maybe it is, maybe it isn’t. When investors purchase shares in ETFs and mutual funds which invest in leveraged loans, they are not investing in the loans themselves, only in the entity which is speculating in the loans. You, the investor, are not a creditor of record for those loans. If the leveraged loan market collapsed and a fund failed, you only have a claim in the fund as a shareholder. Although that is a frightening thought, it is not our biggest concern as it is fairly unlikely. Our bigger concern is one which is similar to our concerns about bond funds. When buying a leveraged loan fund, of any kind, you have no maturity. Because of investor capital flowing in and out of funds, the fund manager may not be able to hold loans to maturity or recovery. When and if the junk markets (and leveraged loans are very much junk) decline, investors may pull their money out of the leveraged loan fund. This means that the fund manager must sell some assets if he does not have a sufficient cash position. When market conditions change in this way, fund managers usually have to rebalance by selling assets. The result is that a fund manager may have to sell loans into weakness, whether or not he or she believes that to be a prudent move. The reverse is true in the current environment. Fund managers must purchase assets, even if they are richly-priced as new investor capital flows in. Do you think this cannot happen? Just look at what happened during the housing bubble. Investment managers, municipal fiduciaries, pension fund boards, etc. poured money into mortgage-backed vehicles. Few did their proper due diligence. Investors, managers and marketers relied on statistical models which told them that there was still value in these assets even late in the game. All the models said that mortgage assets were priced cheaply for their risk. This was not the case. It might not be the case with leveraged loans. We believe that there is little room for improvement in the junk fixed income markets. Investors, who purchase funds which speculate in this area of the market, could be locking themselves into a buy high/sell low scenario. However, this is just our opinion. It is an opinion formulated from decades of fixed income markets experience, but it is an opinion nonetheless. What is not an opinion is the very low quality of leveraged loans. Marketing professionals harp on the fact that these are loans and senior to bonds. It has become de rigueur for marketing types and even some sell-side strategists to point out that these loans are trading cheaply compared to junk bonds. Rather than seeing this as a “market inefficiency,” we see this as reflecting a very efficient market. In this time of great thirst for yield, asset value dislocations rarely happen on the cheap side. There is a reason that leveraged loans seem cheap to junk bonds. Although loans are senior to bonds within corporate capital structures, a leverage loan issued by a company with a poor credit rating can be more risky than a senior note issued by a company with a better credit rating. Let’s put this more bluntly. Buying leveraged loans could be akin to buying debt secure by real estate which is comprised of toxic waste dumps. If the company fails, the real estate is all yours, enjoy. Now, some of these toxic waste dumps may be worth something, but that is a speculation. Leveraged loans, whether or not they are inside funds, are total return speculations for aggressive and sophisticated risk takers. We are more than happy to discuss any and all fixed income securities, strategies and events with our subscribers. One need only give us a call or send us an e-mail. There are few matters with which we are unfamiliar. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

Stop the Swap

We have received from subscribers who have been approached by fixed income marketers suggesting swaps out of seven-year high-coupon corporate senior bonds into 10-year subordinated bonds of the same issuer, often with lower coupons. The typical yield pick-up has been in the 60 basis point area. This kind of swap is unattractive and ill-advised for several reasons. A swap (senior-to-senior or sub-to-sub) should allow investors to pick up at least the slope of the Treasury yield curve within the maturities of the swap. Currently, the slope of the U.S. Treasury curve, from the 7-year note to the 10-year note is about 55 basis points. If one was picking up 60 basis points swapping 7-year senior debt for 10-year senior debt that would be alright, albeit lackluster. One should always desire to pick up somewhat more than the slope of the curve to account for the additional credit risk which comes with extending out on the curve in the credit markets. However, if one is extending out on the curve AND dropping down on the capital structure (senior to sub), we sure as heck need to get better than a five or even a ten basis point pickup over the slope of the curve. However, the yield pick-up was not the main crux of these swap ideas. The main “selling point” was that one could lock in a profit on the seven year bonds and use the proceeds to increase face amount when buying the new bond. We ran the numbers (as we are apt to do) on one swap which encouraged investors holding 7-year senior bonds issued by a large investment bank with a coupon of 5.625% to swap into a 10-year subordinated bond, issued by the same investment bank, with a coupon of 4.875%. The yield pick-up was about 60 bps (+5 to the curve). Because the swap involved selling the 7-year senior bond at a significant premium and buying the 10-year sub note near par, one could pick up about eight more sub notes for every 100m senior bonds sold. However, because of the large drop in coupon, the swap resulted in a drop income. If one swapped 100m of the 5.875% senior bond for 108m of the 4.875% sub note, one’s semi-annual interest payment declined from 2,812.50 to 2,632.50, a decline of 180 every six months. If one swapped 100m seniors for 100m subs and took out the cash, one’s semi-annual income drops from 2,812.50 to 2437.50. That is a $750 annual decline in income. In our view (based on 24 years of fixed income experience) this swap makes no sense. We encourage subscribers to run any and all swap and trade ideas by Bond Squad before pulling the trigger. That is what you are paying us for, not just this newsletter.

Going Down with High Yield

During this recovery, mutual fund marketing representatives have harped on the fact that credit profiles have improved among junk-rated issuers. Although some high yield issuers have been helped by low interest rates and investors’ thirst for yield, high yield borrowers might not be as “healthy” as some would like us to believe. The following are S&P credit upgrades and downgrades for both high grade and high yield credits: Year-To-Date 2012 Upgrades Downgrades Total 560 612 Investment Grade 211 139 High Yield 211 310 As can be plainly seen, high grade corporate issuers have been the biggest beneficiaries of current credit condition. The high yield market has actually experienced more downgrades than upgrades, in spite of the golden age for corporate borrowing. It is the job of product marketing people to paint the rosiest picture possible. It is the job of Bond Squad to paint the most accurate picture. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

Housing the "Multi-tudes"

Housing Starts and Building Permits data were very strong. However, much of the month-over-month increase was due to multi-family rental construction (up 25.1% MoM) we do not mean to downplay the strong housing data, but we would like to point out that rental property construction does not resultin the same kind of consumer spending as single-family primary residence home building. A good number of the single-family homes being built (up 11.0% MoM) are for rental/investment purposes. Today's data is very good news in that jobs are created from construction of any kind. We would just like to point out that home construction is unlikley to have the same follow-on effect as it had in the past. Even if most of the construction was for primary residences, the pace of constructions remains below levels seen during prior recessions, never mind recoveries. The lonng journey homes remains in the early stages.

Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad

Shadow (Bank) Dancing

Following the release of third-quarter earnings by JP Morgan and Wells Fargo, concerns that compressing net interest margins could be a problem for banks. We discussed this topic briefly in Friday’s “Making Sense” report. We explained that narrower net interest margins do not hurt banks as much as they did in the days when banks held most of the mortgages they wrote on their books. Securitization, where banks pool mortgages and sell to investors, either via the GSEs or directly via the so-called “private label” market, result in mortgages not being held on banks’ balance sheets. Instead, banks keep 25 or 50 basis points of the securitized mortgages for servicing the loans. They earn this whether net interest margins are 50 or 250 basis points. Smaller net interest margins hurt consumers because it discourages banks from writing loans which cannot be securitized. Narrow net interest margins do hurt bank profitability in the sense that they discourage banks from holding loans on their books because there is not enough reward to take on the risk. However, banks which are not lending, to not have to keep larger amounts of reserves on hand and they do not have to hire more employees (another down side of tight NIMs). Still its consumers which are hurt the most as banks will not commit much of their own capital for lending purposes. If they are securitizing loans, they are committing investors’ capital. Once the bank securitizes the mortgages, it gets its capital back. The lack of lending capital is slowing the U.S. recovery. However, it is not the lack of bank lending that is the biggest difference between 2012 and 2006 or even, 2003. It is the lack of the shadow banking system. The so-called shadow banking system was comprised of non-bank lenders, such as investment banks and SIVs which would provide mortgage capital. They often used mortgage brokers to facilitate these loans. The shadow banking system collapsed after investors realized (too late) that a vehicle securitized by subprime mortgages should not be rated AAA, no matter how senior one’s tranche and that, in many cases, the institutions which issued these mortgage vehicles has no obligation to pay investors a dime, if the mortgages contained within became delinquent of defaulted. This is how we arrived at today’s predicament in which most mortgages written today are GSE-qualifying and/or are for refinancing purposes or for the purposed of purchasing high-end properties. Those who could really make use of today’s low rates often cannot obtain financing. Of course, many consumers who could make use of today’s low rates probably should not be granted credit (or low-rate credit) and probably should not have received loans five years ago. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

Pay it Forward - The Recovery Rally in Junk has Already Happened

An article in the October 5th edition of the Wall Street Journal discusses that many investors are beginning to reduce their exposure to high yield debt. The article’s opening paragraph apprises readers to a situation of which we have cautioned our subscribers for quite some times. It states: “So much money has flooded into the junk-bond market from yield-hungry investors that weaker and weaker companies are able to sell bonds, they say. Credit ratings of many borrowers are lower and debt levels are higher, making defaults more likely. And with yields near record lows, they add, investors aren't being compensated for that risk.” This strikes to the heart of our argument that there are companies which could have defaulted if not for the Fed pushing investors to purchase their debt in an ever more difficult quest for yield. Still think there isn’t a bubble at the bottom at the corporate credit market? Consider this: Many investors, who would never consider lending money to a group of subprime home buyers as lending money to subprime corporation, many of which may find it difficult, if not impossible to refinance their debts once interest rates rise. Some investors who are pouring money into the junk bond market do not realize that they could be lending money to businesses that can only afford to service debt at today’s record-low rates and record tight spreads. If this does not sound almost like exactly what happened during the housing bubble, we don’t know what does. Supporters of the junk bond market point out that many high yield credits now have cleaner balance sheet than ever before. This is true of some corporate issuers, but if a corporation is rated B or CCC today, what will they be rated when their borrowing costs are several hundred basis points higher? Unfortunately, many of them could be rated D for defaulted. It is not unheard of for corporations to restructure debt, pay investors 50, 60 or 70 cents on the dollar (often in the form of new stock and new bonds) as part of a restructuring. All that needs to happen for such a restructuring to proceed as for the large institutional creditors to agree to the terms and for a bankruptcy judge to approve the deal. Smaller investors are forced to accept the terms of the restructuring/bankruptcy. Smaller investors may sue the issuer, but once the bankruptcy judge approves of the deal, suits by smaller investors are almost certainly doomed to failure. Why would large accept such haircuts? For one, they understand that if they don’t accept such a deal, the company in question could file for a traditional bankruptcy, which could take a year or more to complete. Meanwhile the situation could deteriorate further for the issuer meaning investor recovery could be less. Another important fact, one which escapes many retail investors and financial advisors, many (if not most) institutional investors do not buy B-rated and CCC-rated binds for income enhancement. They buy them for total return. Institutional investors hire credit analysts who pore over the books and balance sheets of distressed companies and come up with recovery value estimates (I.E. what investors might receive in a bankruptcy or restructuring. They use THIS recovery value, not par when assessing whether or not a junk bond is a worthwhile investment opportunity. Investors who have bought low-B-rated and CCC-rated debt and are expecting to receive par at maturity may be in for a rude surprise. That 6.00% bond for five years might turn into a 2.50% bond which finally pays investors, in the form of stock and new bonds, a year after the stated maturity. Because most individual investors are not credit analysts and cannot afford to hire one or subscribe to a credit research service, we have suggested that they should consider investing in high yield bond funds, if they wish to have exposure in high yield debt. Fund managers have credit analysts at their disposal and will take into account recovery value when considering junk bonds. However, this only solves one of the problems associated with high yield debt investing. In the past, we have suggested that investors consider high yield debt a total return asset class. In other words, high yield bonds are equities with a coupon. However, like equities, they are subject to both “fundamentals” and “technicals.” Fundamentals would be earnings, debt ratios, interest coverage, borrowing costs (both benchmark yields and credit spreads), etc. Technicals come from supply and demand. The hunger for yield, caused by low-rate monetary policy, have caused many junk bonds to trade richer (low yield and tight credit spread) than their fundamentals would suggest. Investing in a mutual fund can help protect you from not overpaying for a junk bond, based on recovery value. However, that only addressed the fundamental aspect of high yield investing. At the present time, it is difficult to find high yield bonds which are priced attractively. Many bonds are priced at levels at which fund managers are reluctant to buy them. However, as money pours into junk bond funds, they must continue to purchase securities which are consistent with the mission statement of the fund. Voilà, a bubble is born. A popular argument among mutual fund representatives, one which seems to be shared by fixed income strategists who have spent a relatively short-time in the industry, is that, as the economy improves, credit spreads will tighten among high yield debt and that should offset at least some of the effects of rising Treasury yields (when that day comes). Why do they espouse such views? Because history and historical models tell them that this usually happens. What appears to escape these strategists and fund reps is that Fed policy has already caused all the spread tightening that is likely to happen. As the Journal’s article reminds us; yields are near record lows. Credit spreads are also near record tights for some very-low rated credits. Instead of a traditional spread tightening scenario, the story in a few years could be one of spread widening. Where in the past, a 300 basis point rise of U.S. Treasury yields might have resulted in a 100 basis point move in the yields of many junk bonds, the story could be one of a 300 basis point rise of benchmark yields and 500 basis point increases in high yield borrowing costs. Fed policy has forced investors, many of whom are not aggressive by nature, into a very risky area of the fixed income markets. This has caused the spread tightening to occur BEFORE the recovery has gained momentum. The spread tightening investors are expecting to enjoy when the economy recovers has already occurred.

Suspicious Minds (What Happened to Payrolls Data?)

The employment data were not out for more than 30 seconds before conspiracy theorists were crying foul. The economy added only 114,000 jobs, according to the establishment survey, but the unemployment rate dropped 3/10ths to 7.8%, a move more consistent with 250,000 job growth. The truth is that the drop was mostly due to part-time employment, probably due to holiday season hiring by retailers. The Challenger and ADP data, released earlier this week, support this theory. The only part of today's data which was "odd" was the expansion of government hiring for July, August and September. We believe that government jobs were created. Our question is: Why were they created. We expect hiring to stay in the low-to-mid 100,000s (unless we fall off the Fiscal Cliff. Unemployment could stay below 8.00%, but that might require further shrinking of the work force. In the end, the numbers were not manipulated, but certain phenomena happened at the right time. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

In the Trenches

Our In the Trenches report dated 9/23 received rave reviews from subscribers. We are making it available to the public. Just click on the following link to view: www.bond-squad.com/articles.htm To subscribe to Bond Squad click here:

Is the Economy's Number(s) Up?

The second-quarter GDP data indicate that the economy grew at a paltry 1.3%. The data was probably heavily influenced by the so-called “snap-back” from the mild winter which padded first-quarter numbers. However, economists were figuring the snap-back into their estimates which resulted in a Street consensus forecast of 1.7% Q2 GDP. Some pundits criticized this gloomy outlook. Upon the release of the 1.3% final reading of Q2 GDP, they promptly pointed to the better retail sales and consumer sentiment seen during the third quarter. Admittedly, Q3 data might look a bit better than the Q2 data (the Street consensus forecast calls for 1.8% GDP in the third quarter), but the September data is casting doubt on that outcome. Most disturbing are the Durable Goods and Personal Income data. Household incomes barely budged, but prices, particularly prices of goods which consumers cannot easily reduce consumption (such as food and energy), edged higher. It is true that fuel prices have dropped during the past two weeks, but that is due to demand destruction and the fear or more demand destruction. In other words, the markets fear a broad global slowdown thereby reducing energy consumption. At best, consumers may be able to tread water. However, if the slowdown intensifies, we could see the moderate gains in job creation and the meager wage growth we have thus far experienced in 2012 turn flat or even negative. However, we should note that, versus inflation (as measured by PCE), household incomes actually fell by 0.3% in August. Remember, August was supposed to be the (latest) month that the economy finally turned. Durable Goods Orders were most troubling. We usually do not focus much on the headline number due to the volatility of the transportation component (particularly commercial aircraft), but Durable Goods Orders fell off the table last month. It was reported that Boeing received an order for just one aircraft in August. The Street consensus forecast of -5.0% had built in downturn in transportation orders. To have a drop of 13.2% is reflective or recessionary data. Apologists for the economy had not legs on which to stand when the core number also turned negative, coming in at -1.6%. Following the poor August Durable Goods data, supporters of a sustained recovery waited with great anticipation for Friday’s release of the Chicago Purchasing Manager report. This report is considered a good bellwether for manufacturing throughout the U.S. and is greatly influenced by the automotive industry. Surely, it was thought, that the Chicago Purchasing Manager data would indicate that the economy remains on a path (albeit a bumpy one) to recovery. Their hearts sunk when the report indicated that manufacturing activity contracted for the first time since September 2009. There are times when an index, such as the Chicago PMI, can trend negative due to drops in components which are considered less critical than others. However, the drop was precipitated by a decline in the New Orders component, which fell from a relatively good 54.8 to a troubling 47.4. In fact, all components fell with the exception of Supplier Deliveries (52.1 versus a prior 49.9) and Prices Paid (63.2 versus a prior 57.0). However, all that meant was that businesses may have over-ordered raw materials and components from suppliers and they paid more to do so. The results could be fewer components and materials ordered in October and a pause in hiring. We do not see much impetus for the economy to gain momentum the last three months of the year. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

The people are revolting! They stink on ice.

Alright, this caption is somewhat gratuitous, but it isn’t often that we can work in Mel Brooks’ material. We are, of course, referring to the demonstrations in Spain and Greece which have turned violent. The basis for the protests is opposition to budget cuts and regulations changes. The protests began peacefully, but our old friends, the anarchists, arrived on the scene and made their presence known by instilling violence and, in Greece, throwing Molotov Cocktails. These developments are casting doubt on whether or not the eurozone can remain intact. In response, the vigilantes pushed the yield of Spain’s 10-year note to over 6.00%. This is the first time since September 6th, when ECB President, Mario Draghi, announced that the ECB’s plan to engage in unlimited bond buying, if conditions are met and formal bailouts are requested. Spain’s’ Prime Minister Mariano Rajoy told the Wall Street Journal that Spain will “100 percent” seek a rescue if borrowing costs stayed “too high.” The question is: Will the people stand idly by and allow Mr. Rajoy to agree to austerity, reforms and a dilution of Spanish sovereignty? The markets are, once again, becoming concerned that things might end badly for the eurozone. However, although U.S. equity prices a trending lower and the prices of long-dated U.S. Treasuries are rallying, the price action we have seen this morning appears to be underreacting to overnight developments in Europe. In truth they are not underreacting. They are merely continuing the trend which began last week. The market began to lose faith in the ability of the money-printing crowd (A.K.A. central bankers) to engineer economic recoveries on their own. This is a good thing because central bankers cannot do it alone. Fiscal policy makers will have to react, sooner or later. This is the two-month anniversary of Mario Draghi’s promise to do whatever it takes to keep the eurozone together. The color from the market participants and pundits is quite telling as to where allegiances lie (or lay). Most U.S.-based market participants, strategists and commentators have cast doubt on the ability of European leaders to successfully engineer a true periphery restructuring and solution. Their European counterparts fire back stating that; U.S. market participants do not truly understand the situation in Europe. This disagreement is most evident in their outlooks for the euro versus the dollar. European and Europhile market participants continue to point to Fed policy as the reason the value of the U.S. dollar must decline and why U.S. interest rates have to rise. U.S. market participants point to the fact that, what the ECB is proposing is exactly the same thing. Whether the ECB buys bonds or the eurozone fragments, the result is a bad outcome for Europe. If can kicking becomes the overarching strategy, how could the euro not decline? In times of trouble, capital will gravitate to the currency of country which is best able to weather a storm and which has the most comparative advantages over its peers. Please do not point to China as having a comparative advantage over the U.S. Yes, it can produce “widgets” more cost-effectively, but that is where the advantages end. Property rights and the free flow of capital are fairly important advantages which China just does not have at this time. This could be good news for investors in U.S. assets and anyone who owns and spends dollars. For in spite of the Fed’s desire to ease monetary conditions, the U.S. dollar refuses to weaken. This is good for consumers looking to spend, but bad for export-driven businesses. What does it mean for jobs? Probably not much as increased exports may not translate into mass hiring. With the global economy sputtering and China’s “landing” being somewhat harder than many had anticipated, the U.S. will not be able to export its way out of the doldrums. Foreign central banks will see to that as well. We will know more about the direction of Europe this later this week when Spain and France announce their new budgets. Is it just us or does France seem like not only the periphery’s enable, but a periphery “wanna be?” So much for the bubble in Treasuries. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

Bubble Gum - What CDS is Telling Us

Are junk bonds mispriced? Money began to flow into the nether regions of the credit markets from income-oriented investors and from speculators who have left the equity market and are choosing to speculate in, what we like to call, equities with a coupon (and some recovery potential). Many investors who have acquired junk bonds try to convince us (and themselves) that they are not really speculating. They espouse the belief that the new reality is one of lower defaults and easier access to credit (at lower rates) than in the past. If you replace “junk-rated corporation” with “subprime mortgage borrower” and the today’s junk bond argument is similar to the Housing Bubble’s subprime argument. The thirst for yield and desire to speculate for total return purposes has created a junk bond market with valuations which cannot be justified by corporate credit health. The expected compression between yields found on junk bonds and U.S. Treasuries has, largely, already taken place. We should note that bonds at the very bottom of the credit ratings scale often trade on a dollar-price basis, rather than on a spreads basis. This means that sophisticated market participants are trading them on a perceived recovery value basis. When bonds trade on a dollar price basis, it is an indication that market participants are not expecting to receive par at maturity. We have just gone through optimal years for junk bonds. Much retail money has flowed into junk. If there is a bubble in the fixed income markets, we believe it lies in the nether regions of the junk market. What about the idea that these bonds could rally further on an improving economy? Fed policy has brought the rally forward. I. E. Much, if not all, of it has already occurred. One way to see if there is a bubble brewing in junk bonds is to compare bid side credit spread on cash bonds versus bid side CDS for the same issuer. Let’s use JC Penney as an example. The bid side spread for the JCP 7.95% due 4/1/17 is about 617 basis points over the 5-year Treasury. The institutionally driven CDS market is setting the cost to buy protection for 5-year JCP at about 765 basis points. If we are to believe that institutional market participants are better equipped to judge risk (and Bond Squad firmly believes this to be true), the cash bond market is under estimating JCP’s risk of default. If an institution wanted five-year exposure in JCP, it would be better off selling protection at 765 basis points in the CDS market, rather than buying JCP 5-year debt. One can simulate (even synthesize) A JCP bond by selling 10mm JCP CDS and buying 10mm 5-year Treasury strips. Notice that we used a size of 10mm notional. That is the typical quoted size in the CDS market. The high grade market may be getting rich as well. Let’s look at Alcoa. The AA 5.55 due 2/1/2017 are being bid around a spread of 195 basis points over the 5-year Treasury. Five-year AA CDS is spread around 295 basis points. Again we have a 100 basis point disconnect. Although the Alcoa bond offers an attractive yield for an investment grade credit, it appears rich versus CDS. Let’s look at CVS: The CVS 5.75% due 6/1/17 are being bid at +.70 to the five year. Five-year CVS CDS is at 45 basis points. It appears that, with CVS, investors are over estimating risk versus the CDS market. That JCP and AA bonds are trading at narrower spreads than their respective CDS tells us that it could be the thirst for yield is inflating the prices of bonds offering relatively high yields. This alludes to an underestimation of risk by investors. Consider CVS. The CDS spread for CVS is less than that for CVS bonds. This tells us that retail investors (or funds which must buy bonds instead of derivatives) are avoiding CVS bonds due to their 1.30%-ish yield. Relatively speaking, CVS credit spreads are overestimating credit risk versus what the CDS market believes. Using CDS spreads as a guide is not fool proof. As we have seen in the past, CDS market participants can also misread a situation. However, they have rarely got it more wrong than the bond market, especially when smaller investors are active in the respective cash bond market. We believe that CDS spreads give us a guide as to where risk should be priced. It is not fool proof, but it offers a good guide. Taking that into consideration, it appears that riskier credit market assets are getting a bit rich, with some in a full-blown bubble. The CDS geeks have formulas which they use to gauge default probabilities. It is possible to ascertain the market’s default probability estimates via CDS spreads. Buy running the CDS spreads for CVS, AA and JCP through the International Swaps and Derivatives Association’s Fair Value Model, we get the following default projections for our three aforementioned companies, five years out. CVS: 4.00% AA: 24.00% JCP: 49.00% Whether or not these estimates correctly estimate default probability is a subject of debate, however, they are used when pricing risk. We would not want to be the one facing angry investors should the nearly 50/50 default probability of JCP come up tails when we were betting heads. Bond Squad never simply goes with gut feelings, nor do we blindly run with the herd. We are always looking more deeply into market valuations to see what might be “cheap” and what might be a trap. Bond Squad Subscription Info: http://www.bond-squad.com/subscription.htm Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

Jobless Claims Make No Claim on an Improving Economy

Initial Jobless Claims came in at 382,000. This was down from last week’s prior revised 385,000, but was unchanged from last week’s initial read. The Street had expected a decline to 375,000. Continuing Claims continue their downward trend coming in at 3,272,000 down from a prior revised 3,304,000 (up from an initial read of 3,283,000). The Street had forecast 3,300,000 continuing claims. The prevailing sentiment is that the majority of American’s who left the unemployment benefits rolls simply exhausted benefits. The number of Americans receiving emergency extended benefits fell by about 60,700 to 2.16 million. Again, the prevailing view is that many of the people who fell off the extended benefit rolls simply exhausted benefits. Ryan Sweet, a senior economist at Moody’s Analytics Inc., weighed on the data: “The problems are more on the hiring side than the layoffs side. If they panic and start cutting workers that would raise an immediate red flag because layoffs would be a recipe for another recession.” A positive development is that retailer, Kohl’s, announced that it plans on hiring 52,700 temporary holiday season workers. This is ten percent more than last year. A not-quite-so-good development is that Bank of America will cut 16,000 jobs by year end. Of course most of the 52,700 workers hire by Kohl’s will be laid off as well, following the holidays. If there are truly positive developments in the job market, will someone please point them out to us? Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

Sugar, Sugar: Has the Fed's sweetness run out already?

Man, we thought the sugar-rush effects of QE would be temporary, but we did not believe that they would fade this quickly. Since yesterday, we have commodity prices decline and prices of U.S. Treasuries rise. In fact, oil prices fell so sharply yesterday that there were concerns that a so-called “fat-finger” erroneous trade was placed. Word is that the price decline was due to the flattening of a large long position in oil. This caused other market participants to sell oil futures and the bearish sentiment spread throughout commodities. It could be that, market participants believe that the struggling global economy could reduce the demand for crude oil and the dollar (along with gold, which is another $10.00 an ounce) will remain the global reserve and safe haven currency. We believe that the Fed will do everything it can to fight deflation (which is a real possibility of the global economy continues to slow). However, we do not see rampant inflation or sky-rocketing oil prices at the present time. The situation could change down the road, if the Fed is not vigilant. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

How Temporary is Temporary

Monetary stimulus is supposed to be temporary in nature, both in terms of how long it is kept in place, and in how long it provides benefits to the markets and economy. With the Fed's decision to keep policy accommodative ad ifinitum, will the effects of Fed policy last as long? There is evidence that the benefits of Fed policy wanes over time. We believe that QE3 will be largely ineffectual in terms of job creation. Even if the Fed could lower mortgage rates 50 basis points, it would do little to spur new borrowing or more refinancing. Consumers who can refinance would probably use the newfound cash to pay down other debts. This might benefit the economy down the road, but not immediately. However, the most likely result would be to keep many households, which are now struggling to get by, from imploding financially. As we demonstrated with several charts this past week, households have a long way to go just to reach a sustainable debt to income ratio. We expect the rally in commodities and decline in the value of the dollar to be temporary. Why? Because governments around the world are also trying to devalue their currencies. Once foreign central banks work their magic, we believe that we will see long-term yields settle in and the dollar slide to halt or, even, reverse. Here are some interesting charts: U.S. 10-year since 2009 (source: Bloomberg):

As you can see, the yield of the 10-year rose during the times surrounding QE1 (2009) and QE2 (late 2010). Each time the 10-year yield reset back to or below the levels seen prior to QE (admittedly helped by the “twist,” which is not going away). During 2012, the 10-year yield has been influenced by a slowing global economy. This has caused a flight to safety among investors. As we mentioned previously, foreign central banks have also done their share to keep a lid on long-term U.S. interest rates. We expect this to continue. A similar pattern exists in the value of the euro versus the dollar:

Notice that the biggest spikes were around the times of QE1 and Qe2 (2009 and 2010). We expect Europe to remain dysfunctional is looking to engage in open-ended money printing of its own. If history repeats itself, currency speculators may be singing “there’s no place like home for the holidays” by year end. Oil prices demonstrate somewhat different, but not altogether dissimilar pattern:

Oil prices began to rise on 2009 with the discussion and eventual launch of QE1. It spiked with the launch of QE2. It fell with the soft patch in mid-2011 and spiked on the mild winter, which provided market participants with false hope that the economy was gaining traction. Oil fell again with yet another soft patch before spiking following Fed (and ECB) comments that more easing is on the way). We believe oil prices could remain elevated heading into the winter. The weaker dollar (albeit probably temporary) and, what many meteorologists are forecasting to be, a harsh winter in the Northeastern United States (the region which carries most of the nation’s demand for home heating oil) maintain upward price pressures for crude oil. However, unless our elected officials can make real progress on fiscal policies, we could see another soft patch begin to materialize in the second quarter of 2013. If we fall off the so-called “Fiscal Cliff,” the soft patch could coincide with the 2013 calendar. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

End of Days

The Fed let the markets have it with both barrels. Although the shots will be largely ineffectual for economic growth, they could prove damaging for certain fixed income vechicles, Libor Floaters. Why Libor floaters you ask? Because the yield curve will steepen. What the Fed is doing is potentially inflationary. Although continued twisting will buffer the rise of long-term rates, there could be upward pressure on long-term rates. However, the Fed will ensure that short-term rates are anchored at very low levels. Since Libor is sensitive to the Fed Funds rate, it, and coupons which adjust off of Libor, will also be low. Investors who believe that higher Fed rates are not too far off had better read the text of the Fed statement which read: “To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.” This means that, unless the economy gains traction more quickly than anticipated and/or a more hawkish Fed Chairman succeeds Mr. Bernanke in 2014, Fed Funds and Libor will remain low for a long time. The same might not be true for longer-term rates if the Fed is willing to keep policy accommodative even as the economy gains traction “for a considerable time.” To make a long story short: Libor Floaters have had their day in the sun.

A Taste of Honey

The following is an excerpt from our daily commentary. Subcrivers get this and much more: The economy is constantly evolving. Although there are some traits common to economies which have existed during the 236 years of U.S. history, there have also been great differences. “Things” don’t just happen. This is why we are critical of technical analysis over the long term. Although data and patterns can be used to great effect in the near term, once there are structural changes to the economy and secular changes to markets, technical analysis (without considering the context of the times) is much less useful. With this in mind, we believe that the FOMC will extend its guidance for extraordinary policy accommodation until, at least, 2015 and could announce open ended bond purchases (probably focused on MBS). The first actual Fed Funds rate hike might not come to a year or more after that. However, that assumes that domestic fiscal policies remain dysfunctional and global economic conditions remain impaired. Although this is our base case scenario, we are not so audacious to state with certainty that, economic conditions will remain impaired for the next three to five years. It is also not a certainty that the Fed will do anything more than jawbone today. We believe that the best way to position for the next several years is to ladder portfolios, focus investments on the five-year to seven-year area of the curve, but having an adequate portion of one’s portfolio in the in the two-year to four-year area of the curve, as well as on the 10-year to 15-year area of the curve. What percentage of one’s fixed income portfolio should be place on specific areas of the curve? That depends on investors’ goals, objectives and risk tolerance. We like the so-called belly of the curve (intermediate portion). We would tend to underweight the short end of the curve, overweight the intermediate portion and have moderate exposure out to 15 years, but this is gross generalization. Portfolios should be constructed to match investors’ needs. As we speak with market participants and investors, we pay close attention to their fears. Investors tend to fear inflation and rising rates. This is mostly due to concerns that the Fed will be slow to react to a strengthening economy or that Fed money printing will lead to devaluation-related inflation. However, market participants fear that the Fed will run out of options to fuel the liquidity-related strength in risk assets and to keep the economy above water before fiscal policy makers adjust policies to reflect new realities. We are in the market participants’ camp. We would be thrilled if the biggest problem we faced was repositioning portfolios to reflect strong growth and related inflation pressures. However, we believe that to be an unlikely scenario for the near future. We do not put much credence in a weak currency inflation scenario. The rest of the word is in the same boat. The worst thing for many export-driven economies is for their home currencies to weaken versus the dollar (listen to the noise emanating from Japan). They will do what they can to support the dollar. The U.S. dollar could exhibit some weakness in the near-term, but as with QE1 and QE2, the dollar will find support rather quickly. It is for this reason that we believe that Fed policies are creating trading opportunities, rather than investment opportunities, in risk assets, such as equities, high yield debt and metals. These trading opportunities may perform well for six months, a year, maybe longer, but we do not see the foundations for long-term secular bull markets in these asset classes. Even if the “Fiscal Cliff” is avoided, necessary spending cuts (and probably some tax increases) will place a drag on the economy. A shrinking labor force and less affluent retirees could result in less consumer spending than in the past. The U.S. economy will continue to evolve and adapt. This could feel painful at times, but it is a necessary process. As the Theory of Evolution teaches us; it is adapt or die. Follow us on LinkedIn by joiningg the Bond Squad group. It is open to everyone. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

A Seariver Runs Dry

I cannot believe I failed to mention thiis, especially since I once made a market in this bond and my best friend and former bond partner reminded me last week. The much misunderstood Seariver Maritume 0.00% due 09/1/12 has matured. What makes this passing special was that it was one of three tax-deferred corporate "zero" in the markets. The beneficiary of an IRS loophole in the 1980s and grandfathered by the courts the former Exxon Shipping bond was misunderstood by many market participants and investors. As a tax-deferred bond, investors did not pay tax on accretion (phantom income) annually, as with traditiional corporate zeros. Instead, tax was paid on the entire accretion at maturity. This made it an oustanding bond for minors and retirement accounts. The only other tax-deferred zeros are the Ally (GMAC) Units (of $10,000) 0.00% due 12/1/12 and the Ally 0.00% due 6/15/15. Thanks to tax law changes, no such tax-deferred corproate bonds will be issued again. The Ally 0.00% of 6/15/15 are offered at a yield-to-worst in the neigborhood of 4.87%. Both Ally bonds are currently callable at their accreted value, but since the accreted value of the 15s is about 93.961, a call isn't likely. The main problem with these (besides being obligations of Ally) is that they trade rather infrequently.

Come a Little Bit Closer

Do you think that U.S. Consumers are near the end of the delebveraging process? Think again. We have been asked: How much deleveraging must U.S. households complete before the economy begins to pick up speed? We are of the opinion that U.S. household debt to income must go back, at least, to levels seen prior to the housing bubble, if not prior to the tech bubble. The following chart displays U.S. household debt as compiled by the Fed: U.S. Household Dept (SAAR) since 1980 (source: Bloomberg & Fed):

As you can see, just to get to levels seen prior to the housing bubble (2000 to 2004), debt would need to be slashed nearly in half. Either household debt falls to come more in line with incomes or income rise to service the debt. Even more telling is the chart which displays household disposable income after debt service: Federal Reserve US Financial Obligations Household Debt Service Ratio Total:

If we want to see the economy experience trend or above-trend growth, we need to get the Household debt service ratio in line with past periods of robust growth. Again, this can be done by shedding debt or increasing incomes. Neither appears to be happening at a rapid pace. To subscribe to Bond Squad go to: http://www.bond-squad.com/subscription.htm Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

Free Sample

We have decided to make this week's "In the Trenches" report available to everyone. In this week's edition, we discuss Jobs, the ECB, the Fed and we dig deep into a popular bond fund. We hope you find this as valuable as the hundreds of financial professionals and and investors who subscribe to Bond Squad. http://www.bond-squad.com/articles.htm

Where have all the workers gone?

Nonfarm Payrolls data indicate that the economy added 96,000 (seasonally-adjusted) jobs in August. This number threw Bond Squad and the street a curveball. The Street revised its forecast for job growth higher (to 130,000) following a better-than-expected ADP report. We front ran the Street by forecasting 130,000 jobs last week, due to strong July data. ADP often throws curveballs and we were not about to swing. However, the so-called “establishment survey” threw us a curveball when the BLS revised July data lower. July Nonfarm Payrolls were revised lower by 22,000 to 141,000 from an initial read of 163,000. Although we did not believe that the stronger economic data observed in July would be sustainable at this time, we did not believe we would see downward revisions. We also believed that there would be some spillover from the phenomenon of automotive factories remaining open in July. Auto sales were strong and we believed that hiring would creep higher in August. What has apparently occurred is that workers were not recalled in August because they were not laid off in July. This is seasonality wreaking havoc on the numbers. Seasonal adjustments account for layoffs in July and call backs in August. Neither has occurred this year. The result was good July data and a payback in August. Even though seasonality can cause volatility in the data, taking the average of the July and August data probably paints a good picture of job growth for the past two months. The resulting average Nonfarm Payrolls data for July and August is 118,500. Nearly every economist on the Street has stated that recent economic data is consistent with job growth in the low 100,000s. No Time to Wallow in the Mire The economy appears to be mired in the low-to-mid-100,000s. Nonfarm Payrolls has averaged 73,000 jobs per month since the recession ended in July 2009, but it has averaged 146,000 since December 2010 (the first full month after QE1). Goldman Sachs Chief Economist, Jan Hatzius, pointed out that Nonfarm Payrolls averaged 153,000 in 2011, but only 139,000 in 2012, thus far. What this comparison leaves out is that the average for the first eight months of 2011 yielded average job growth of 143,000, closer to this year’s average. Calendar year 2011 benefitted, not only from a spike in job growth at the beginning of the year (as did 2012), but a spike in hiring heading into the holiday season. Nonfarm Payrolls since January 2011 (Source: Bloomberg): Though not precisely correlated, the patterns of 2011 and 2012 are similar. Could we see a spike in hiring heading into this holiday season? It is possible, but gains in holiday hiring could be offset by a reduction or stagnation in the workforce among export driven companies. Due to a faltering global economy and the “Fiscal Cliff” fast approaching, companies' incentive to hire in the fourth-quarter of 2012 could be less than it was a year ago. Surrender, Surrender Today’s depressing data goes beyond the disappointing Nonfarm Payrolls data. It even goes beyond the 15,000 jobs lost in manufacturing (in spite of strong automotive industry data). The household data tells a troubling story. The headlines report that the Unemployment Rate declined from 8.3% (actually 8.25%) to 8.1% (actually 8.111%). However, the “household survey” reports that the decline came not from workers finding jobs, but from workers leaving the workforce. The size of the workforce contracted. The labor force participation rate fell to 63.5%, the lowest since 1981. The number of people in the labor force (Americans who are working or looking for work) fell by 368,000. To put this into perspective, the data indicates that more than three-times the number of people left the labor force than found jobs! Temporary workers declined by 5,000. Increased hiring of temporary workers is believed to indicate an improving job market. Ergo, a decline in the number of temporary workers does not bode well for job seekers. Why the big discrepancy between the BLS data and the ADP data? ADP measures job growth among companies for which it provides payrolls services. Among these companies are many retailers, restaurants and healthcare –related firms. The data from these sectors were fairly strong. According to the data; Retailers added 6,000 jobs, restaurants hired 28,000 workers, and the healthcare industry added nearly 17,000 jobs. Of these, only healthcare is likely to continue expanding at a robust pace. Other than in healthcare, jobs created do not appear to be what one might consider well-paying. That 80s Show Today’s data are filled with interesting tidbits. One is that, if the labor force was the same size as it was in the beginning of 2009, the unemployment rate would be over 11%. How about wage growth? What wage growth? On a month-over-month basis, wage growth was flat. On a year-over-year basis, wage growth maintained its pace of 1.7%. This is just keeping up with the pace of inflation. However, the rate of inflation (as per headline CPI) has declined during the past year from 3.8% in August 2011 to 1.4% in August 2012. Core inflation increased to 2.2% in August 2012 from 2.0% in August 2011. This indicates that a good portion of the increase in consumer spending might have been from lower food and energy prices. Average Weekly Hours for July was revised to 34.4 from 34.5. This figure was repeated in August. Not only is job growth problematic, those who have jobs are not seeing their hours increase. Typically, rising hours worked data is a precursor for increased hiring. Instead, they have trended slightly lower from a 2012 peak of 34.6 (during the warm winter). U.S. Labor Participation since 1980 (source: Bloomberg): Judging by the recent run-up in energy prices and the probable effects from the drought in the Mid-west, the consumer will experience what is, in effect, a tax increase heading into the all-important holiday season. Add to the equation a potentially harsh winter for the Northeast and winter 2012-2013 could be a drag on growth, just in time for the “Fiscal Cliff.” Déjà vu All Over Again Enough of crunching the data and opining on their causes, readers want to know what this means for Fed policy, interest rates and the fixed income markets. Today’s data dramatically increase the chances that the Fed does something at next week’s FOMC meeting (9/12-9/13). Whether or not it engages in asset purchases (and to what degree) remains to be seen. The markets have reacted to the increased probability of Fed intervention by sending Treasury yields lower and commodity prices higher. Usually easing, whether it is traditional or quantitative, results in rising long-term rates. After all, easing is designed to promote growth which generates inflation. However, the market is assuming that the Fed is incentivized with keeping long-term borrowing costs low. Helping that scenario along is that higher food and energy prices could put the brakes on consumption and core inflation. It seems that we have discussed this before. We do not believe that QE3 will do much to boost hiring. However, the Fed has a mandate of full employment (in addition to price stability). It will do whatever it can to add however many jobs QE can generate, as long as inflation remains under control. Those who do not like the Fed’s course of action should cease blaming the Fed and blame the fiscal policy makers who are really responsible for forcing the Fed’s hand. The prospect for low rates for an extended period of time should be good for high grade corporate bonds, high yield bonds, municipal bonds, preferreds and dividend paying equities. We would consider high grade corporate bonds, the upper-tier of high yield, municipal bonds and dividend paying equities as investment opportunities. The remaining asset classes may present trading opportunities, but investors tend to become complacent and overlook the true risk present in these volatile asset classes. In reality, high-risk assets remain high-risk assets. High-volatility assets remain high-volatility assets. We are temporarily in an environment which benefits these assets. When the world “normalizes” investors could be “whip-sawed” when the market reassesses risk in a more traditional fashion

Draghi Net

Word out of Europe is that the ECB will launch a “sterilized” bond buying scheme by purchasing short-term sovereign debt in the secondary market. “Sterilized” means that the ECB would absorb the money set loose in the markets from bond buying. It could accomplish this by borrowing the money back at a yet-to-be-determined interest rate. By going the sterilized route, the ECB could counteract the potential inflationary and currency-devaluating effects of monetary easing. What a minute, isn’t monetary policy supposed to add to the money supply? Isn’t some measure of currency devaluation desirable to boost exports, etc.? You can stop rubbing your eyes, ECB President, Mario Draghi, has not gone mad. He has a different objective than the pro-bailout speculators. The pro-bailout camp desires money printing, some currency devaluation and a continuation of the status quo on the periphery. Mr. Draghi simply wishes to keep the eurozone intact while structural reforms can be gradually implemented. This is clearly a rescue of the eurozone, rather than a growth stimulus program. Germany is exercising influence over the ECB as it has been the Germans who have expressed fears about inflation. Strings are attached to this bond buying. There will be criteria attached to the bond buying scheme. There will likely be memoranda of understanding and fiscal criteria for any country involved in the bond buying program. This includes asking for an official bailout and opening up its economic books. As of now, the only countries which would qualify for such bond buying are Greece, Portugal and Ireland. Spain and Italy have not asked for bailouts. The prospects for Italian and Spanish bond buying tomorrow (following the ECB meeting) are very slim. As such, the markets reacted and corrected back to pre-rumor levels. The days of money throwing are over. Strings will be (and should be) attached, if only because the Germans are the grownups in the room. Even if the ECB would rather broaden the scope of the bond buying program, unlimited bond buying is a difficult proposition. It is difficult because the ECB cannot print money. It has not ability to print euros. The printing of currency has to come via a unanimous agreement by eurozone members. We do not see the Germans agreeing to wanton money printing. Let’s Make a Deal What lies ahead for the eurozone? There are basically three scenarios: 1) The eurozone moves closer to the French/periphery economic model. 2) The eurozone moves closer to the German model. 3) The eurozone fragments. Our view is that, unless there are dramatic culture shifts, scenario number three seems the most likely outcome. Like a Surgeon Investors and speculators looking for a magic cure for Europe are likely to be disappointed. Sometimes the herbal cures don’t work and surgery is necessary. The only question is: Where will the cutting occur? Will it be sovereign governments restructuring their economies or cutting free of the eurozone. Tom subscribe to Bond Squad please got to: http://www.bond-squad.com/subscription.htm Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad

Inflation Hedging? Oh Lord!

Last week, a subscriber (a very knowledgeable subscriber) asked us about the Lord Abbett Inflation Focused Fund. As a bond-oriented firm, we have not delved too deeply into funds. We understand how they work (maybe that is why we have not focused on them), but we understand that they do make sense for many investors. With this is mind, we gave the Lord Abbett Inflation Focused Fund a good going over. Our reader’s question centered on the use of inflation-related swaps (CPI swaps, if you will), along with various fixed income instruments to, as the fund’s mission statement proclaims: “The Fund's objective is to seek to outperform the Consumer Price Index over full economic cycles. The Fund invests in a portfolio of fixed-income securities and using a combination of inflation-indexed securities and inflation-linked derivatives to seek to maximize inflation-adjusted returns. “ After reading that, investors might expect to find a veritable cornucopia if inflation linked bonds, sitting there just waiting to reap the rewards of rising inflation. However, a quick look at the fund’s top holdings tells a different story. Top Holdings (MHD) Position % Net GP 8 ¼ 05/01/16 3.05k 1.080% JPM 3.45 03/01/16 1.95k .671% FHMS K019 A1 2.00k .662% FH 848738 1.86k .622% FH 848703 1.80k .592% FH 1Q1355 1.83k .581% DBUBS 2011-LC1A A1 1.52k .521% C 5 ½ 04/11/13 1.53k .511% FH 1Q1358 1.69k .507% HPQ 4 ½ 03/01/13 1.50k .499% There is not a single inflation-indexed bond among the top ten holdings. In fact, the only adjustable-rate securities are the four Freddie Mac MBS structures (all beginning with “FH.” The FHMS is a fixed-coupon MBS) and they float off of Libor, not CPI. If we dig down through the next 10 holdings, we find a similar story. One also might be excused for believing that the fund would have performed poorly as inflation fell during the past year, but the data says otherwise (see the following chart): Comparison of fund LIFFX and U.S. CPI YoY (Source: Bloomberg): Contrary to what investors might have believed, the fund performed fairly well, even as inflation declined. By now, some readers are probably scratching their heads, but the answer to this paradox can be found right in the fund’s mission statement, which says: “The Fund's objective is to seek to outperform the Consumer Price Index over full economic cycles.” Nowhere does the fund state that its goal is to provide long exposure to rising inflation. It merely states a goal of “outperforming CPI over full economic cycles.” During the past year, if one took a disinflationary or even a neutral inflation stance, one would have outperformed CPI! Although we cannot see in which derivatives, such as swaps the manager has invested (derivatives markets are very opaque), but judging by the performance of the fund, the manager has probably has engaged in an inflation-neutral strategy (a strategy we have advocated for several years). What if the environment changes and inflation begins to heat up? Although rampant inflation is not yet on the horizon, it could pose a threat someday. What would the manager do? When we look at the fund, most of the top holdings have short or intermediate maturities or average lives. The manager has positioned the fund so to be nimble should the inflation environment change. When income is desired, we nearly always choose a portfolio of bonds over a bond fund, if for nothing else but bonds having final maturities and predictable income streams, whereas funds do not. However, where speculation, total return and, as in the case of inflation, hedging is desired, a well-constructed and well managed fund can provide the diversification (many of the MBS structures in the fund would not be available to retail investors) and discipline most investors cannot obtain on their own. Discipline is a very important word in this discussion. All too often, when an investor asks his or her financial advisor for inflation protection, the investor believes that a position which benefits from rising inflation is needed. Most investors are not qualified to make inflation projections and could be misled by price certain price fluctuations in their daily lives which might not show up as an increase in the year-over-year change of the rate of inflation which is necessary for most CPI-linked bonds to outperform. A fund, such as this (one with which we have no connection whatsoever), can provide some inflation protection, with the discipline of trained professionals reducing the possibilities that one might be looking in the wrong direction, inflation wise. If you would like to discuss inflation, hedging or derivatives, drop us a line. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

Voodoo Fed – Bernanke was standing next to the mountains.

Meanwhile back in the Grand Tetons, Fed Chairman Bernanke gave his long awaited speech on the economy and Fed policy. Mr. Bernanke stated that further policy accommodation remains a possibility as lackluster growth and high unemployment remain a “grave concern.” He mentioned that there has been little improvement to unemployment since January and told the audience: “Unless the economy begins to grow more quickly than it has recently, the unemployment rate is likely to remain far above levels consistent with maximum employment for some time.” Mr. Bernanke stated that the problems facing the economy were largely cyclical and then described several structural causes for the tepid recovery. He finished his speech with oft-stated promise: “Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.” This has led many market participants, including fixed income media darling, Bill Gross, to opine that not only is QE3 likely, it is imminent. We all due apologies to the intrepid Mr. Gross, we do not believe that Mr. Bernanke was telling that markets that QE3 at the next meeting was a done deal. For one thing, we have employment data due out next Friday. Secondly, if he fires off all of his bullets now, what will he do when and if the U.S. economy falls off of the “Fiscal Cliff” in January? Barring terrible employment data (unemployment rate at 8.3 or higher and/or Nonfarm Payrolls below 100,000), we believe that the most aggressive actions we could see from the Fed at its two-day meeting, schedule for 9/12 and 9/13, are an extension of the policy accommodation timeline into 2013 and/or a lowering of the Fed deposit rate. The Fed has its final meeting of 2012 on December 12th. Unless conditions worsen before then, we believe that the Fed will hold off until after the election to implement QE3. This would avoid a politicizing of the Fed and give Fed officials a better feel if our elected officials will permit the economy from plunging into the fiscal abyss.

Are Best Buy Bonds Best Buys?

Many investors are equity oriented. They see an LBO announced for a company which stock they own and they are cheered. After all, the private equity group has probably announced it will pay above current market price for the shares. But to do this, the new private owners must barrow to complete the purchase. This is not good news for bondholders. Best Buy has been in the news not only because of its poor earnings, but because its founder, Richard Schulze, wishes to take the company private. This was the subject of our Making Sense report: Best Buy has been a company in the news in recent weeks. We have not covered the story because BBY has only three bonds issues outstanding. However, what could play out with BBY presents us with the opportunity to discuss how creditors might be affected when a company is taken private. Founder, Richard Schulze, is considering a takeover bid for Best Buy and taking the company private. Doing so would trigger a “poison put” on bonds. A poison put requires a company to buy back bonds from investors, usually at a premium (101 in this case) upon change of control of the company. Why would investors want to put back their bonds just because a company goes private? When a company is taken private, it is usually done via a leveraged buy-out. The new owners borrow money, usually via bank loans, to purchase the company. Bank loans are usually secured by specific assets. Secured loans are senior to even senior debt as senior debt is unsecured (they are general obligations). Another concern is that, a private company does not have to report earnings. Investors have no idea what its balance sheet looks like. By owning bonds of a company which has been taken over via an LBO, you are now a creditor of a company which just had a ton of debt loaded on its balance sheet and you are now subordinate to all of this debt. To make matters worse, because there is no financial reporting, it is impossible for bondholders to assess their risk. Since LBOs can be considered negative consequences for fixed income investors, many bonds are issued with poison puts. If the company in question is taken over (via a leveraged deal or otherwise), investors can put the bonds back to the company at the stated put price. A poison put can also help investors assess the street consensus opinion of the likelihood of a takeover of a company. Let’s look at BBY’s three bonds and where they are trading: Best Buy (BBY) 6.75% due 7/15/13 Bid: 102.75 Offer: None offered. Best Buy (BBY) 3.75% due 3/15/16 Bid: 92.956 Offer: 93.450 Best Buy (BBY) 5.50% due 3/15/21 Bid: 90.052 Offer: 90.625. Obviously the market is not pricing the bonds as if a takeover would occur. If it was, the prices would be much closer to the 101 poison put price. This means investors have to ask themselves a question: Do I feel lucky? Why lucky? If one buys BBY 2016 and 2021 bonds, one actually wants a Schulze takeover to occur, as one could put bonds back at $101. If the deal does not happen, one owns bonds, not due to mature for a number of years, with a faltering business model. What about the 6.76% due 7/15/13? When last we looked, there were no bonds offered at any price, but let’s assume an offering materialized at 103.25. That would give as yield of 2.578%. Prices of the 2013 BBY paper indicates that market participants a deal will occur and/or that, even if a deal occurs 2013 bonds will mature on schedule. The way we see it is: The 2013 BBY bonds might be good for aggressive investors to pick up short-term yield. Apparently other market participants share our view as no one was willing to sell bonds when we last looked. The longer-dated bonds might be offer an opportunity to speculate on a possible takeover, but if it does not occur, you be hitching your wagon to a falling star. The market is forecasting the latter. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

Just One More Thin Commentary

Draghi cancels his plans to attend the Jackson Hole Fed conference. Immeidately, the chatter in the equity markets is that he has a bond buying plan to announce and does not wish to upstage Fed Chairman Bernanke. Here is how we see it: He had nothing constructive to say. If one has nothing constructive to say, it is better to say nothing. He also might be running home to deal with Spain. Today’s Spanish GDP report for Q2 2012 indicated the recession deepened. Spain’s GDP contracted, coming in at -1.3%. This follows a Q1 2012 read of -0.6%. Martin van Vliet, economist at ING Bank in Amsterdam, stated: “We fear that things are likely to get worse before they get better. With much more fiscal austerity in the pipeline and unemployment at astronomic highs, the risks are clearly tilted toward a more protracted recession.” Adding to Spain’s troubles, Spain’s bank deposits fell by 74.2 billion euros ($93 billion), or 4.7 percent, to 1.51 trillion euros as capital seeks safer harbors. Also, Catalonia has requested $5 billion of assistance, almost one-third of the current assistance fund. It appears as if the entire eurozone will fall into recession. Making policy decisions in Europe is difficult because, monetary policy decisions which help the periphery (in the near-term) could cause unwanted inflation in core countries while doing little (if anything) to solve the real problems afflicting the eurozone. The problem is that the periphery does not believe there is a problem, other than core nations not agreeing to policies which would permit the periphery to continue on as it has in the past. With sub-par growth in the U.S. and economic contraction in Europe, we have argued that it would be virtually impossible for China to avoid a slowdown and, possibly, a so-called “hard landing.” Last week’s HSBC PMI report, which measures manufacturing in China, indicated that manufacturing activity contracted further, falling to 47.8 fro, 49.3 (a reading below 50 indicated contraction). HSBC data is seen by some market participants as being more reliable than official Chinese Government data. China’s Industrial Profits index declined to -2.7% from -2.2%. Many investors had pinned their hopes on China carrying the world on its back. It is China which has been carried by exports to the U.S. and Europe. Hard laning for China? We are waiting for the "thud."

The Post Hoc Junk Bond Fallacy

CNBC correspondent, Bob Pisani (a noted eternal bull), provided some interesting data this morning. Mr. Pisani noted that pension funds have reduced their equity holdings from 60% in 2006 to 38% today. In that same time period endowments reduced their equity holdings from 48% to 33%. According to his sources, the reason is for the reallocation is aging baby-boomers. Much of the assets have been reallocated to fixed income. If this sounds familiar, it should. We have mentioned asset reallocation many times in this space. We believes that, as the population ages, the reallocation will increase. At some point, this reallocation will cease. After all, no one, not even baby-boomers, live forever. For now though, we expect to see more capital flowing into bonds and bond funds. Bond funds were also included in Mr. Pisani's report. He mentioned that the amount of money in high yield bond funds has risen to $212 billion from $102 billion in 2008. Mr. Pisani also stated that buying high yield bond funds is more akin to buying equities than buying bonds. He used ETF JNK as an example. For much of its existence JNK (created in December 2007) has tracked very closely with the Dow Jones Industrial Average and the S&P 500 (see following chart). Notice how JNK followed equities, that is, until 2012. Many investors have been sold a bill of goods that high yield bonds are not all that susceptible to interest rates and interest rate forecast and do well when the economy does well. What is (conveniently) left out of this theory is that, high yield companies need to refinance maturing debt and often desire to issue new debt in order to expand their businesses. If junk bonds typically follow equities, why did the disconnect between JNK and equities begin during the winter months of 2011 and 2012, when the economy appeared (to some) to be recovering more rapidly? An equity bull might opine that money was leaving high yield bonds and moving into stocks, but fund flow data debunks that theory. Let's look at the same chart, but with LQD (high grade bonds added). Lo and behold, it has been a high grade bond ETF, and not a high yield bond ETF which has tracked equities, Why has this been so? Contrary to what many high yield mutual fund wholesalers might tell you, high yield bonds are sensitive to higher rates. Although interest rates are not expected to skyrocket, they are unlikely to trend much lower. Couple that with the fact that the move to high yield debt by investors might be a bit overdone, and a leveling off of high yield bond prices, due to slackened demand, and the disconnect between JNK and equities is quite logical. Investors need to understand that much of the capital which flowed into junk bonds should not be there and would not be there if not for the very low interest rate environment. It appears as though many investors are taking their money out of junk and moving into assets which should be better able to ride out both the waves caused by higher rates or a recessionary storm cause by the upcoming Fiscal Cliff. We have stated for many months that we had been living in a golden age for junk bonds. All golden ages must come to an end. The bottom end of high yield has the potential to enter the dark ages, while some high grade bonds (and upper-tier high yield bonds) are experiencing a renaissance. A question which should be asked by investors and financial advisors alike is: "Which would I rather own, junk bonds or high-dividend common equities of strong, blue chip companies?" Many readers may expect Bond Squad to favor junk bonds. After all, we are a fixed-income-focused concern. However, we are also very candid and frank. We would rather own an un-notarized I.O.U. from T, PG, JNJ and similar corporations than senior bonds issued by Rite Aid, American General Finance or Office Depot. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad

The Truth about Bonds

This weekend's post is an excerpt from my weekly "In the Trenches" report. Everything contained in this post is correct and accureate. I hope you enjoy it. It all started when we reached out to about 50 former readers whom I asked to consider giving Bond Squad a try. These were not just names off a marketing list, but people who had sung our praises (in print) during our former professional lives. The reasons they gave us for not subscribing to Bond Squad startled us. We expected to see responses which questioned the cost of a subscription or that fixed income is no longer a focus in their practices. The most common responses were: “I don’t have time to read” and “I just listen to the idea of the day. We admit that these responses left us somewhat dismayed. We spent more than a decade writing fixed income market commentary, which was accurate, honest, straightforward and went far beyond suggesting bonds because they were “cheap” or, in the case of preferreds, “affordable.” That being said, this edition will be direct, frank and maybe a bit brash. However, it will provide information which is not generally available to retail financial advisors and their clients. “Clients” is the key word here. Although individual investors make up a portion of our readership, the vast majority of subscribers are financial advisors (along with about a dozen or so traders and strategists). We will be shifting our marketing efforts to focus on investors. We plan to expose suspect strategies, bonds and other securities for what they really are. We will also sing the praises of those which we find of value. Don’t be surprised if a client, colleague or acquaintance questions a popular investment idea and informs you that they heard about it from Bond Squad. The investment world is a very small place and Bond Squad is everywhere. Now that we have this boring, but necessary, bit of housekeeping out of the way, let’s get down to business. Did anyone notice that the yield of the 10-year Treasury dipped below 1.70% this week, ending the week at 1.687% from a recent high close of 1.8355% on August 16th? What happened to precipitate such a rally on the long end of the curve? Was it some technical pattern which simply had to play out? Has a war begun in some part of the world? Did some economist find a piece of economic data missed by his or her peers? No, none of those events occurred this past week. What did happen was that European officials and some market participants came home from the beach. We are not surprised that the sentiments of European officials and market participants have not changed for the better. After all, what has changed for the better in Europe or in the global economy? Let’s discuss some hard facts: • Greece is a basket case. If it was a horse, it would have been shot already. Even the most ardent PETA member would be for putting Greece out of its misery. In the case of Greece, that means putting it out of the eurozone. In keeping with political traditions, European officials, both inside and outside of the European periphery have done their level best to kick the can down the road. The latest scheme being bandied about is a “temporary” Greek exit from the eurozone. The thinking here is that, Greece will leave long enough to devalue its currency, get its economy in order and re-enters the eurozone. Pay no attention to the fact that, if Greece does not completely restructure its economy its death spiral starts anew the moment that Greece re-enters the eurozone. Why go the temporary route? The idea here is that, if Greece’s exit is only temporary, the contagion will not spread to Spain and Italy. Good luck with that plan. Neither Italians and Spaniards, nor market participants (vigilantes) are that stupid. • The global economy is slowing. Europe is heading into a recession, if it is not there already. China’s landing, once thought to be soft, appears to be harder than originally anticipated. China’s more dramatic slowdown does not surprise us. With its two largest export customers, Europe (probably in a recession) and the U.S. (experiencing sluggish growth), how in the world was China supposed to keep its economy chugging along? Oh that’s right, internal consumer demand. That had about as much chance of happening as Argentina beating the U.S. in Olympic Men’s basketball. The only economy which might be able to disconnect, at least temporarily, is the U.S. economy. The U.S. economy is the only large economy which can swim against the global tide and pull the rest of the world along with it. However, the U.S. is swimming with an anchor around its neck (household deleveraging) and an anvil on its chest (the upcoming “Fiscal Cliff”). These realities have many investors (and equity market participants) looking to the Fed to save the day. After all, Fed Chairman, Bernanke, says the Fed has tools remaining which could help the economy. Let’s put this in perspective. Let’s say that the Bond Squad team is in a small boat (the S.S. Bond Squad if you will). Unfortunately, our craft has sprung a leak. We are out at sea and cannot repair the leak, but we do have three tools; a one-gallon bucket, a 16 ounce cup and a teaspoon. As the water begins to pour in we begin bailing with our one-gallon bucket. This helps, but it cannot keep up with the volume of water coming in the boat. We have another team member join in with the 16 ounce cup. This helps, but not to the extent of the one-gallon bucket. However, the water is still coming in faster than we can bail. Now we are left with the teaspoon. Having no other tools, we press another team member into bailing with the teaspoon. The teaspoon removes water alright, but its benefits are negligible. What is really needed is a structural repair of our boat. This accurately describes the current condition of the U.S. economy. This is what media pundits, equity market participants and purveyors of “creative” fixed income instruments have yet to understand. We have grown weary of explaining the truth about various non-traditional fixed income investments. We used to enjoy blowing holes through faulty investment strategies and suspect trade ideas. However, many investors and advisors seem hell-bent on blowing themselves up. We have seen investors latch onto some real screwy ideas. Others were not so absurd, just misunderstood. What we have found over the years is that many investors and advisors want to believe the marketing story and ignore warnings to the contrary. Let’s review some of the more “interesting ideas” we have seen during the past decade: Icelandic Bonds: About six or seven years ago; a newsletter made its way through the investor community hawking Icelandic sovereign debt. The newsletter suggested opening an account at a brokerage in Copenhagen, Denmark to buy sovereign bonds. After all, what could happen to bonds issued by a sovereign nation which can print its own currency? Investors found out that they can and do default (has anyone heard of Argentina?). Also, the bonds could not be delivered outside the Scandinavian countries, hence the required account in Denmark. We spent two years explaining the facts of life to financial advisors and their clients. Many did not believe us. All found out that we were correct. Corporate Inflation-Protected Bonds (IPIs): These beauties were marketed as having coupons which float at a specified number of basis points over CPI. Hold on there Sparky, that it is not how they work. In actuality, they float as a specified number of basis points over the year-over-year change in the CPI Urban Consumer Index; Non-Seasonally-Adjusted (got that?). This not-so-small nuance meant that if inflation ran at 3.00% one year and 3.00% the following year, and your coupon spread 200 basis points over the year-over-year change, your coupon was 2.00%. If it went from 3.00% to 2.50%, your coupon fell 50 basis points to 1.50%. What is the floor coupon you ask? The floor was 0.00%. If the year-over-year change in the rate of inflation matched or exceeded your coupon spread, your coupon was 0.00%. Many investors discovered this the hard way in 2009. How could there be so much misunderstanding of a product which we explained in a paragraph? We believe is that people wanted to believe what they wanted to believe. We experienced situations where we would correctly explain bond and the caller would call back and ask for another fixed income specialist in hope of getting the answer they wanted to hear. Sometimes they were successful, unfortunately. ‘ Preferreds: Where do we begin with this product? Somewhere along the line, both investors and advisors got it into their heads that preferreds were “five-year securities.” To be fair, for about 15 years they had worked out that way. The problem was with the cause and effect perception (post hoc, ergo propter hoc). Many preferreds were called after five years (their first scheduled call date) because long-term rates were falling. They fell for approximately 25 years. However, many investors and advisors seemed to miss the cause and effect relationship between long-rates and preferred callability. Over the years we heard some wild theories. Theories we heard ranged from, “companies call preferreds because they like to come to the market to keep investors interested in their securities,” to a crazy theory which compared the coupon of the preferred to Libor. What many investors and advisors seemingly failed to grasp was that preferred securities were long-term financing vehicles for which the company was advantaged by being able to refinance at a lower rates. Investors loved the fact that they were getting these great returns for five years, but when a call occurred, they would simply reinvest in the newly issued replacement. Investors were effectively buying step-down securities. Every five years, investors where having their income stream cut. Oh yeah, great investment idea. During the 1990s and early 2000s, many individuals refinanced their mortgages, taking advantage of falling interest rates. Why would it be different for corporations? It wasn’t. In the primarily retail-driven preferred market, it was fairly easy for corporations to issue long-term securities with relatively-low coupons (when subordination was considered) with an option to call them in if interest rate and credit spreads conditions favored the issuer. That’s right folks, call features always favors issuers. Just like the ability to refinance a mortgage without penalty favors borrowers. What investors should have been doing is building ladders with bullets (non-callable bonds) with a bias in to the seven-year to ten-year area of the curve. They would have kept higher income streams longer. Also, preferreds are very subordinate securities, in most instances; investors were not being sufficiently rewarded, in terms of yield, for accepting such subordination. Because preferreds had been so popular among retail investors, some investment banks created synthetic preferreds (with names such as Corts, CBCTS, Saturns, Preferred Plus, etc.) which were not issued by the reference companies, but were trusts containing securities issued by the reference company. At first, senior notes were placed in trusts and shares of the trusts were sold to investors. Later on, $1,000-par trust preferreds (called junior-subordinated debt to make them seem more bond like than they were) were placed in trusts. Since investors liked the call feature, a five year first call date was included, but that call option was often sold to speculators. Very few investors realized what they were buying. Surprisingly-few financial advisors knew what they were recommending. Even more surprising was that many fixed income marketing specialists were not quite sure what “corporate trust securities” actually were. All they knew was that they had a new preferred to sell. This was a source of frustration for us. We actually had a colleague tell us once: “Our job is not to understand bonds, it is to sell bonds.” Never in our long career have we ever taken that approach to our jobs. Preferreds continued to be a source of misunderstanding as the Collins Amendment to the Dodd-Frank financial regulation legislation took effect. Immediately upon the announcement that trust prefererreds (Trups) and enhanced trust preferreds (E-Trups) would lose their Tier-1 eligibility (they only had partial Tier-1 eligibility to begin with), fixed income markets, mutual funds and their wholesalers went out with their “strategies” on how to play the situation. Many (seemingly the most popular) hypotheses were flawed. Some were just plain incorrect. One popular theory that, because the Collins amendment triggers capital event clauses embedded in most debt/equity hybrids (the most accurate description of Trups, E-Trups and junior subs), banks affected by the new financial regulations would call in most or all of their trust securities. The counter strategy was that banks would not wish to anger investors and would not call their trust preferreds prior to their first call dates, or at least until the Collins Tier-1 haircuts (one-third each year beginning 2013) took effect. Our take on the situation was that banks would do what was economically advantageous for them. If banks would call in any preferreds early, they would likely begin with their highest coupons first. This is exactly what has happened during the past two years. That some of the lower-coupon Trups and E-Trups are now getting called in is more a function of Fed policy keeping rates extremely low across the yield curve than any Collins-related phenomenon. In fact, most of the preferreds being called in now have reached their firsts stated call date. Those investors who purchased deeply-discounted low-coupon preferreds in 2010 and early 2011 in hopes of a short-term windfall had better kiss the ground and thank the almighty for creating Ben Bernanke (or those who caused the housing bubble and financial crisis). If not for the extraordinary policy accommodation set forth by the Fed and the crises which were the impetus for extraordinarily accommodative monetary policy, these low coupon preferreds (with coupons below 7.00%) would probably be trading in the low $20 area (or lower). Sometimes it is better to be lucky than good. Investors who were not so lucky were those who purchased trust preferreds with high coupons with the belief that they were unlikely to be called prior to 2013 or were unaware that the new Collins regulations enabled banks to call in many of their trust preferreds early. Some investors purchased preferreds at significant premiums only to have them called in at par, days or weeks later. The situation was not helped by wholesalers and fixed income product marketers proactively soliciting trades based on flawed strategies. We actually listened in to a call conducted by a competitor of our former firm advocate buying trust preferreds at discounts because nearly all would be called in shortly. Only a few months later, this same firm marketed the idea that few, if any, would be called in prior to Collins. We do not believe that there was any intent to harm investors. They simply misunderstood the tenets of the Collins amendment and how the fixed income markets operate. Not to be self-congratulation, but the desk on which the Bond Squad team worked did not go out with such flawed strategies. To a person, our desk knew the story correctly and conveyed accurate information. Unfortunately, the truth is often not “sexy” and investors and advisors chose the get-rich-quick approach. Fixed income marketers spewed forth flawed strategies regarding Libor floaters and fixed to floaters. Many of the floaters strategies were based on two incorrect beliefs 1) As “rates” rise, floaters outperform, protecting investors from a rising rate environment. 2) Floaters always trade at or near par. If one would sit and ponder this for a few minutes, the flaws in these lines of thinking become painfully apparent. Why would a corporation issue a bond which removed interest rate risk from investors and heap it on themselves? The answer is they wouldn’t. Oh sure, they can hedge with options, swaps, etc., but hedges are risks unto themselves. It is better for a corporation to issue floaters which are a little more “creative.” Enter long-dated and perpetual Libor floaters. With rates very low, corporate issuers came to two realizations: 1) With rates low, they would like to issue long-term debt with fairly low coupons, but investors might be resistant to extending far out on the curve while earning lackluster yields. 2) Investors desire income streams which would increase with “rising rates.” How can corporations obtain long-term financing at fairly low interest rates while attracting investors seeking the potential for rising income streams? The answer was the Libor floater. It is not by accident or whim that corporations issue long-term or perpetual securities which float off of Libor, nor is it because Libor is the standard benchmark. The Fed maintains Constant Maturity Treasury rates for the various points on the curve (which are updated every day). Bonds can be created (and have been created) using CMT rates which closely match the maturity, but where would be the advantage for the issuer in doing that. This is why most CMT floaters offer no coupon spread over CMT. This permits corporations to finance at the same rate as the U.S. Treasury. Any time a corporation embeds optionality into a bond, it is always done in a manner which favors the issuer in most circumstances. U.S. Constant Maturity Rates as of 8/24/12: Description Cur. Rates Curr Dt Treas Const Mat 1 Month .10 08/24 Treas Const Mat 3 Month .10 08/24 Treas Const Mat 6 Month .13 08/24 Treas Const Mat 1 Year .19 08/24 Treas Const Mat 2 Year .28 08/24 Treas Const Mat 3 Year .37 08/24 Treas Const Mat 5 Year .72 08/24 Treas Const Mat 7 Year 1.14 08/24 Treas Const Mat 10 Year 1.68 08/24 Treas Const Mat 20 Year 2.41 08/24 Treas Const Mat 30 Year 2.79 08/24 Note: CMT rates are set daily by the Federal Reserve Bank to reflect a specified amount of time from a given date by interpolating the yield curve. How does issuing a long-dated security linked to Libor benefit an issuer? As long as the yield curve is positively-sloped (which it is about nine out of every ten years), the issuer is financing for the long-term at interest rates which are below prevailing rates for long-term securities. This is why we saw a spate of new issuance of Libor floaters in 2003, 2004 and 2005, as well as in the period from 2010 to 2012. Corporations tend to issue such floaters when the yield curve is steep, particularly when policy rates are historically low. As long as the curve is positively sloped, it is “advantage issuer. “ Do you disagree with this assessment of Libor floaters? Ask yourself this question: Where would a Libor floater which spreads its coupon 300 basis points over Libor trade when Libor is at 3.00%, the ten-year note is at 6.00% and the 30-year is at 7.00%. It is not inconceivable for non-cumulative preferreds or so-called “junior subs (the most common structures for Libor floaters) to trade at 250 basis points above the 30-year U.S. Government bond yield. This would result in a trading yield of 9.50%. However, your coupon would only be 6.00%. Yes, your coupon has held up from what was available when the security was issued (many Libor Floaters offer a fixed coupon for the first five years), but your trading yield is 350 basis points higher than your coupon. The result would be a trading price around $70.00. This has happened in the past. If your floater of choice is perpetual, it does not even roll in on the curve. What happens if the curve flattens? That is when Libor floater performs best. However, the par-call feature embedded on these securities limit price appreciation, especially as the call date approaches. The best scenario for Libor floaters is the one in which we are in. The curve has flattened, with long-term rates coming down. That, combined with robust investor demand, has pushed prices of some, but not all (see GSprA, GSprC and GSprD) Libor floaters higher. Our advice is to take any profits now and get out. What about CMT linked floaters? Such floaters do better when the curve is steep (the opposite of a Libor floater). However, because that it’s the most typical shape of the yield curve, issuers need to protect themselves. They do so by offering zero spread over CMT. Usually, as with Libor floaters, CMT floaters have a call feature which allows issuers to call them in, should conditions become adverse for themselves. The bottom line is that there are no magic bullets in fixed income. There is no one single product which is advantageous for investors in nearly any market or economic environment. Every kind of adjustable and variable instrument performs well under specific conditions and poorly under others. Issuers structure securities manners which favor them under the most likely scenarios. Wouldn’t you if you could? Another misconception among investors and some advisors is that bond funds and ETFs are just as good as a portfolio of bonds. Although both bonds and bond funds can be useful for many investors, they are not the same. Bonds should be viewed as income-generating vehicles. At some point (if the issuer doesn’t default and the creek don’t rise), bonds will mature and investors will not only enjoy a return on investment, but return of investment as well. Bond funds offer no such guarantee of return of investment. Bond funds, both mutual funds and ETFs, turn bonds into an equity-like investment. By that we mean; investors are rewarded for total return and, possibly, the performance of the fund manager. Investors looking for income and a greater degree of certainty should probably build a bond ladder. Where bond funds offer advantages is in the high yield bond arena. Most investors who consider high yield bonds do so for potential total return opportunities (or they should be). This is especially true of the very low end of the junk bond ratings scale where relatively few bonds mature at par. Recovery value is what is most important. Most individual investors do not have the financial resources to build a sufficiently diverse junk bond portfolio which can protect against negative outcomes among issuers. Mutual funds and ETFs can be useful vehicles for equity-like speculations in the bond market (Bond Squad has invested in funds such as, HYG (high yield bonds) and LQD (high grade bonds) for total return speculations on the bond market (always invest in something you understand). Another, perhaps the best, use for funds is equity investing. Equity funds offer the kind of diversification beyond what most individual investors are able to obtain by purchasing individual stocks. It also takes stock picking out of the hands of amateurs. During the past two years, we have seen a trend in which some traditional fixed income investors have ventured into high-dividend –paying stocks in search of income. Although we also see the merits of high-dividend stocks (we have owned HDV in the past), they cannot be considered direct surrogate for bonds. Why? They have no maturity! Because equities do not have the same degree of principal return certainty offered by bonds, investors seeking dividend income may wish to consider a dividend income fund. At the very least, investors should attempt to build a portfolio of high-quality, non-cyclical dividend-paying stocks. Investors must be able to accept the reality that they might not be able to get 100 percent of their invested principal on a given date, if ever. This concludes the “gloves-off” portion of “In the Trenches.” We will begin offering an investor-centric subscription package. Although we are still working out the details, the package will be priced in the $100 to $150 range and provide weekly commentary and support to fixed income-oriented investors. If their advisors do not have time to read the truth about fixed income, we will make it possible for investors to know the real story behind the products and strategies being marketed to them. We will spread the truth, one investor at a time, if necessary.