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.

Sinking Floaters

Economists estimate that three-month Libor will rise to a whopping 0.59% by the end of next year. If you own Libor floaters, or fixed-to-floats which will begin floating in the interim, the Street forecast should be somewhat troubling. As most Libor floaters have long maturities or are perpetual, they tend to trade off of the long end of the curve when the yield curve is steep. If the forecasts are even close to correct, Libor floater coupons will rise about 15 basis points. The yield of the long bond will rise about 70 basis points and the yield of the 10-year note is expected to rise by about 80 basis points by the end of 2013. Price drops of four or five points would be possible in such a scenario, while investors receive little in the way of increased income. Some fixed–to-float bonds could see their coupons decline, resulting in less income and more severe price declines. Many floating-rate instruments have had a good run, albeit for not necessarily the right reasons. One might consider taking profits now and re-entering the floater market after the curve has steepened. If you have invested in floaters for income purposes, you might wish to sell your floaters and include the proceeds in a bond ladder. We have found that there is no better hedge for changing rate and curve conditions than a well-constructed customized bond ladder.

Grand Fed Railroad

What happened to runaway interest rates? Pundits would have us believe that the smattering of relatively-positive economic data which have been released during the past few weeks were signs that Soft Patch 2012 (it seems like an annual event) was over and they economy was accelerating to escape velocity. Oh please, one cannot fly to the stars while tethered to a rock. That rock is fiscal policies, both domestic and foreign. The release of the Fed minutes indicate that, unless economic data exhibits sustained improvement, the Fed would act by injecting more stimulus into the economy. One would think that long-term rates might jump on the news that the Fed is poised to inject more stimulus, but the reasons for the need for more stimulus stated in the minutes (high joblessness, a faltering global economy, etc.)rattled the markets. It appears as though market participants were looking for hopeful comments from the Fed. Few were to be found. We have previously written that the past several weeks were not indicative of broader market sentiment and that many market participants were smoking "hopium." Market trends of the past three sessions seem to bear us out. We foresee a situation in which European and Asian economic concerns renew the capital flight into U.S. Treasuries. While we are not bold enough to call a bottom on the 10-year yield, we would not be surprised to see its yield in the neighborhood of 1.50% post Labor Day. The caveat is the Fed meeting in Jackson Hole, WY. If the Fed hints at more QE at next week's conference, we could see some upward pressure on long-term rates. The 10-year could approach 2.00% as the September FOMC meeting draws near, As with the two previous rounds of QE, the yield spike will probably be short-lived (and less dramatic this time around. As with a substance abuser, the economy builds up a tolerance to stimulus injections. The high is less each time. With the economy showing more railroad tracks than an East Village junkie, we do not put much hope in the stimulative effects of another round of QE. As we have previously stated, long-term rates will eventually be much higher, but not now. Also, rates could peak at lower levels during the next interest rate cycle than to what we have become accustomed. For now, it is on to Jackson Hole. 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.

Nothing Lasts Forever - Not even Libor

Libor is in the news again (still). U.K. regulators are working on plans to “improve” Libor to make it a more accurate representation of true interbank borrowing rates. At the present time, Libor is set via the honor system. Members of the British Bankers Association submit their financing rates, but there is no verification of whether or not a member bank was actually paying that rate to borrow from other banks. U.K. regulators are moving toward a system in which banks would continue to submit their rates as they do now, but could be asked to confirm those rates by presenting transaction data to regulators, so reports the Wall Street Journal. The Journal notes that Libor has infiltrated nearly every facet of our financial lives. Mortgages, credit cards and auto loans are often set off of Libor rates. The Journal opines that, because a great many financial contracts and securities are linked to Libor, it is unlikely that the Street will move to another benchmark. Although we agree that such a change would be difficult, it is not impossible. Those of you who have been in the industry long enough might remember when U.S. T-bill rates were benchmarks for loans, contracts and adjustable-rate securities. Gradually, over time, Libor supplanted T-bills as the benchmark of choice. It is not inconceivable that the industry could migrate to another benchmark (repo rate, etc.) gradually so as not to affect current securities, loans and contracts. Remember, nothing last forever.

Rumors

My how the bond market reacted to the RUMOR that the ECB was going to cap interest rates. It rained on the very thin bond market when the ECB announced that there was no truth to the rumor. Rate caps and direct bond buying is unlikely to occur as long as Germany is opposed. Germany will continue to say "nein" until the periphery governments agree to conditions and reforms. Do not believe stories to the contrary. Much has been made of the damage to the German economy and the potential for higher interest rates should the eurozone fragment. The truth is that, if Germany has to support the periphery, its economy will be equally damaged and, as we have seen in recent weeks, its borrowing costs would probably rise. If Germany is going to experience pain either way, it might as well eliminate the source of the pain in the process. JPM is out with a new perpetual preferred. Price talk is in the 5.50% to 5.75% area. Will someone tell us why it is better than JPMprI? Please do not say: If the new preferred is called in five years you are better off. We will take the other side of that bet all day long. We would need to "out-Japan" Japan for that to happen. www.bond-squad.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.

Leading Indicators are Leading Us Where?

Leading Indicators were up 0.4% versus a Street consensus of 0.2% and a prior revised -0.4% (down from -0.3%). Headlines following the report decried that expansion is underway. Does not anyone look at the tables? The data components indicate that much of the cause for a positive reading of Leading Indicators was due to Stock Prices (0.10%), Interest Rate Spread (0.15%), Building Permits (0.18%)and Jobless Claims (0.18%). Readers are probably wondering: what is wrong with that? There is nothing wrong with having these positive components, but we do not believe that they tell the entire story. For one; higher stock prices only tell us that the demand for dividends and better earnings (until recently) have created investor demand. Building permits are encouraging, but they are centered at the upper end of the market and are centered on larger builders. New Home Construction also delays the price recovery of existing homes, keeping many home owners underwater. Jobless claims were juiced in July by a lack of seasonal auto plant closures. August data has seen more "normalized" figures in the mid-360,000 range. Although these are truly positive developments, they were nearly offset by some negative developments. For instance, the work week, which was up 0.7% in June was flat in July. If this persists, it would not be good for job creation. ISM New Orders were down .15%. Consumer Expectations and Economic Conditions was down 0.10%. The data indicates a modest recovery which is vulnerable to the fiscal cliff. It also indicates that, while the economy may not need QE3, it certainly cannot with stand the removal of policy accommodation. Notice how price of U.S. Treasuries are rallying today, in spite of the "good" leading indicators data? This is because of a few factors. 1) The numbers were better, but not fantastic. 2) The yields of long-dated Treasuries are reaching a point at which buyers might be attracted. 3) The prospects for QE in September have dimmed, somewhat. Remember, all easing, quantitative or traditional, is potentially inflationary and can put upward pressure on long-term interest rates (unless the Fed "twists" and buys long-dated securities to artificially hold down yields).' 4) It is the weekend. There is short covering underway. 5)Does anyone really believe that, with many market participants on the beach, this week's bond market action is truly indicative of broad market participant sentiment. Lastly, beware the Interest Rate Spread component of Leading Indicators. The component is reporting that the yield curve has steepened. Not good for curve-flattening strategies, such as some structured notes and Libor-floaters. Fear not, we believe that the curve will flatten, if only a bit, when market participants return in September. www.bond-squad.com 347-927-7823 Twitter: @Bond_Squad

Where do Rates Rate?

Ho-hum Jobless Claims data. Initial Claims were up 2,000 from to 366,000 from a prior revised 364,000 (up from 361,000). The Street had expected 365,000 new claims. Initial Claims appear to be settling in to a range of 360,000 to 370,000. This would indicate monthly job growth in the low 100,000s. Continuing Claims came in at 3,305,000. This was down from a prior revised 3,336,000 (up from 3,332,000). The Street forecast was for 3,300,000 Continuing Claims. This does not include 2.36 million people (down 63,900) receiving Emergency extended benefits. Housing Starts declined more than expected in July, coming in at -1.1% versus a Street consensus of -0.5%. This was not surprising as Building Permits had declined 3.1% in June. Building Permits are a proxy for future Housing Starts. July Building Permits increased 6.8% versus a Street consensus of 1.2%. This should translate to healthy August Housing Starts data. Encouraging was that of the 812,000 new building permits, 513,000 were for single-family homes. Recent earnings report indicate that large home builders have seen an increase in demand. However, demand appears to be the province of the large home builders, rather than broadly-based demand. Increased new home demand is a double-edged sword. On one hand, increased demand for new home sales usually results in job creation at the construction and supplier level. On the other hand, it combats overall real estate price recovery. This helps to keep consumers constrained and, in many cases, underwater in their current home. It appears that the economy continues to recover slowly and will continue to do so, unless policymakers undermine the recovery for political purposes. Improved economic data has some fixed income market participants thinking that QE3 is not the "sure thing" they once believed (we thought it was questionable all along). This is thought by some to be the cause of the recent spike of long-term Treasury yields. Although this may have been the genesis of higher long-term rates, the move has been exacerbated by thin markets and a reduced flight to safety from Europe as the continent is "on holiday." Do you doubt our analysis of rising rates? Consider that fact that German bunds (the other safe haven investment) have also seen a spike in yields. The 10-year bund has seen its yield rise from a recent low of 1.16% on 7/22/12 to a recent high of 1.56%. yesterday. Although some of the rise is due to concerns that a largely German-funded bailout of Spain would put upward pressure on German rates (it would likely do so as more debt without matching revenues often equals higher rates), the fact that rates began to Spike the last week of July and continued into August, when many Europeans are away from their posts is not a coincidence. We would not be surprised if the trend for rising rates stalls or reverses in September. The end of QE could mean the end of long-term asset purchases, but it could also mean the end of inflation-inducing monetary policy. Remember, long-term rates spiked at the times of QE1 and QE2. For information regarding Bond Squad subscriptions; go to: www.bond-squad.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.

Underinflation

CPI (2.1% YoY, 0.0% MoM)was milder than PPI (2.5% YoY, 0.3% MoM), indicating that Businesses are reluctant to pass higher costs onto consumers. This resumes a trend which has persisted for the past decade, having taken a hiatus as fuel prices fell during the past year. This could be a sign that businesses are seeking to grab market share. This makes sense to us as it has been large, dominant, players in various sectors of the economy which have reported the best earnings numbers. Home building has improved, but has been centered among the large homebuilders. Retailing has picked up, but it is the so-called "big box" stores which have reported the most impressive results. The demand pie is smaller so the bigger companies are using economies of scale to garner a bigger slice of the smaller pie. Foreign Purchases of U.S. Securities rose by only $16.7B versus a prior revised $121.3 billion. Purchases of Treasuries increased by $32.5 billion, but corporate bond purchases declined by $24 billion. Judging by rising treasury yields and tighter credit spreads, that trend may be reversing in August. However, August is a poor month to use to judge sea changes. Liquidity is usually poor in August and markets appear to be thinner than usual this August. Empire Manufacturing data indicate that manufacturing in the New York Region contracted in August, after rising a modestly-good 7.39 last month. Slow consumer demand during the first half of the year reduced the need for inventory replenishment. However, June Empire Manufacturing was 2.29 (not much inventory replacement there either). May was the month for inventory replacement with Empire Manufacturing coming in at 17.09. We also believe that the auto plant phenomenon also influenced the July report of 7.39 (pushing it higher than it might have been otherwise). Industrial Production and Capacity Utilization trended higher in July. Auto manufacturer activity influenced the data. Prices of U.S. Treasuries are higher on thin volume. The yield of the 10-year Treasury stands at 1.76%. If we get to 1.80%, sales and shorts could enter the markets. Even if that does not happen at 1.80%, it could happen when the market participants return in September (or following the Fed's Jackson Hole conference.) Meanwhile, credit spreads in the investment grade market and the upper-end of the high yield market continue to grind tighter. To subscribe or receive a free trial go to www.bond-squad.com

What Is Inflation? High Yield: We told you so!

• PPI was higher than expected on price increases for drugs, tobacco and vehicles. • Lower fuel prices are beginning to lift consumer spending. Are lower fuel prices inflationary? • JPM prices a new five-year note at +135 to the five-year Treasury. Spread tightening is in full swing. • Bloomberg reports that high yield investors and fund managers move up the quality and liquidity scale. Bond Squad suggested such a strategy many months ago. • Is Bond Squad really on vacation? Which data set tells the real inflation story, the headline data or the core data? Headline PPI indicates that inflation is a non-event. However, the core data indicate that inflation is beginning to heat up. The answer to the question of why there is a big discrepancy between the headline and core PPI readings lies in gasoline prices. On a year-over-year basis, gasoline prices are down 7.9%! The price decline in a good (commodity) which has a very inelastic demand curve has resulted in more free cash for with consumers can use to spend. We have argued that higher fuel prices can have a deflationary and sales-sapping effect on the overall economy. Other than the Fed and supply-side economists, we have had few advocates in our corner. For the past decade, the trend has been one of higher fuel prices. In spite of the fact that the higher headline inflation data clearly constrained consumers (requiring extraordinary Fed accommodation in 2003 to spark consumer spending, helping to inflate the housing bubble), many pundits held the belief that inflation is inflation and that the Fed should tighten regardless of from whence it comes. Simple theories for simple minds we guess. The evidence points to the fact that lower fuel prices (and lower prices of necessities with inelastic demand curves) can spark inflation in the broader economy as consumers begin to spend their newly-found surplus income in sectors of the economy which are far more influential on economic growth. However, for our theory to be proved correct, lower prices for goods with inelastic demand curve would need to translate into better retail sales data. Voila, retail sales increased last month as fuel prices fell. To be fair, fuel prices fell in May (-8.9% MoM) April (-1.7%) and March (-2.0%) while Retail Sales (ex-autos and gasoline) increase only in March, but consumers are cautious. During those months, the savings rate increased. Consumers finally began spending their surplus cash in July. The high yield bond game may be entering the fourth quarter. Bloomberg News is reporting that high yield fund managers are moving into more liquid high yield bonds. The article states: “High-yield fund managers investing a record $44.9 billion of deposits this year are selecting bonds they can sell more easily if investors start withdrawing the money. Even as the Standard & Poor’s 500 index returned 3.4 percent since the end of June, typically a benefit to the riskiest debt, the highest- rated junk bonds have outperformed the lowest-ranked by 0.4 percentage point, Bank of America Merrill Lynch index data show.” Barclays credit strategist, Michael Kessler, stated: “Investors are right to be nervous about holding less- liquid paper. What’s different now is that it’s happening during a pretty significant rally.” What today’s article states, Bond Squad has been saying for many months. This is yet another instance where Bond Squad subscribers have been ahead of the curve. If anyone would like a copy of the article, drop us a line. For complete reports and much more, subscribe to Bond Squad. The following packages are available: Subscribe for 1-year and receive "Making Sense" Full Access (daily e-newsletter and phone access to Tom directly during business hours of 8am EST- 4pm EST) at the discounted price of $250. If you prefer to receive the Reports Only (with no access to Tom directly), the rate is just $150 per year. www.bond-squad.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.

Bond Squad Makes Sense

We have re-started our blog. This was Bicycle Repairman's (a friend of Bond Squad and knower of all things fixed income) fixed income blog for years. This blog will give Bond Squad Subscribers and potential clients an opportunity to interact with Bond Squad and the greater fixed income community. Although we are on vacation this week, we would like to post a few items. Preferreds: CNBC's Jim Cramer says that the performance of preferreds, especially Dutch preferreds is good indicators of market sentiment. Sorry Jim, preferreds are among the worst indicators. They are primarily retail products and purchased without a good understanding of their risks (primarily duration risk). Many retail investors buy them believing that they will be called in five years (or at their first call dates). That happened during the three decades of rate declines (corporations were able to refinance at lower rates), but those days are gone. This should be painfully obvious!!! Preferreds will do "ok" as long as long-term rates remain low. Move the 10-year yield up 200 basis points and watch preferreds lose a few points of their price. Bond Funds: Investors have been plowing money into bond funds. Much of this has been due to their performance since 2009. What many investors may not realize is that bond funds have outperformed largely because of Fed policies low rates, tighter spreads, etc.)This reminds us when we were young traders and the Fed was easing. It seemed that every day, we would simply profit by marking to market. We would adjust our hedges accordingly and simply rake in the cash. The next year, when the Fed was tightening, we discovered that we had to work for a living. Investors could find themselves "working for a living" in a few years. Those who have laddered their portfolios will probably just need to roll maturing assets. Where on the curve they should invest will depend on rates, spreads and the shape of the yield curve. Bond Squad can help. Sprint: We have long been fans of Sprint bonds. With the fastest network in the industry and management which is now focusing on shedding dead (or nearly dead) businesses, Sprint is an interesting company which could find itself as an acquirer or acquiree. Smith Barney: SB we hardly knew you! Next month, Morgan Stanley will permanently retire the Smith Barney name. This is an inglorious end to an iconic Wall Street name. We enjoyed our time as part of the Smith Barney family. Smith Barney Financial Advisors were among the best trained, most knowledgeable and client-oriented professionals on the retail side of the business. We will not let the traditions of Smith Barney fade away. We will carry on the ethics and focus on customer service which was hallmarks of Smith Barney. We consider ourselves to be a little slice of SB in a Mad, Mad, Mad, Mad World. We will post from time to time during our vacation week. If the response from the field is favorable, we will continue to post snippets. However, Bond Squad subscribers will continue to get in-depth coverage. The blog is good, but it is no substitute for the real thing.