The Bipolar Express

It was not supposed to be like this. 2014 was supposed to be the year when the U.S. economy reached escape velocity, the Eurozone was expected to throw off the shackles of a sovereign debt crisis on the periphery, China was supposed to fulfill its destiny and South America was expected to rival its neighbors to the north. With the exception of the U.S. economy printing 4.6% GDP in the second quarter and probably on its way to a 3.0% plus print in Q3, 2014 has been somewhat disappointing. Still some of the U.S. economic data has been encouraging. The best way we can describe economic conditions is, bipolar. (5) The Bipolar Express Economic conditions have a manic feel about them. The Unemployment Rates is now down at 5.9%, but wage growth is only about 2.0% and 0.0% in real terms (vs. CPI of about 2.0%). Some industries complain of worker shortages, but with rare exceptions, wage growth remains lackluster. Even the kind of hiring we are seeing is Bipolar. Much of the hiring seen during the current expansion has occurred at the low and high end of the wage scale. Relatively little hiring has taken place in the middle-income semi-skilled area of the economy. Jobs in this sector have been largely replaced by technology. It seems that each and every year, economists predict that this will be the year that wage growth picks up. Thus far, economists have been disappointed. It might be that economic bipolarism is permanent, or at least semi-permanent. Technology and a global competition for labor are working to keep a lid on wage growth (but not necessarily wages). As we do not envision the pace of technological advancement slowing or the desire for employment to dissipate around the globe, conditions for modest wage growth could be with us for a long time. If the global economy is viewed as one entity, it demonstrates a split personality. On the cheerier side there is the U.S. economy. It is growing in spite of little help on the fiscal side, households which still have fairly high levels of debt and headwinds blowing in from overseas. What is the key to U.S. economic growth? The answer is: business flexibility. In the United States, business can more easily adjust staffing levels. They can reduce, add or move production to different locales. U.S. businesses tend to be more nimble and responsive to changing consumer tastes than many of their foreign counterparts. The Eurozone economy might be the polar opposite of the U.S. economy. Businesses cannot easily adjust staffing or shutdown plants without running afoul of government regulations. There is little dynamism in the Eurozone economy. As last week’s IMF report intimated, it is too easy to remain unemployed in the Eurozone. What incentives are there for small business creation if unemployment benefits are nearly endless and government regulations make starting a business difficult? Since the European sovereign debt crisis of 2012, it was hoped that Germany (the Eurozone’s largest and most flexible economy) would pull the economic bloc out of the depths of despair. Instead, the Eurozone periphery (and France) has become a kind of economic quicksand, pulling the German economy lower. Capital markets participants, accustomed to the success of the Fed’s extraordinary monetary policy stimulus, are optimistic that aggressive monetary policy stimulus will restore growth to the Eurozone. Thus far market participants have been disappointed on two points: 1) Aggressive monetary policy stimulus implemented by the ECB thus far has not been able to restore economic growth to the Eurozone. 2) Monetary policy will not be enough to reverse the Eurozone’s fortunes going forward. Last week, ECB president, Mario Draghi said that governments must act “urgently” to enact fiscal reforms, adding: “I am uncertain there will be very good times ahead if we do not reform now.” At the present time, it appears that most Eurozone governments are unwilling to make the much needed fiscal reforms and the Eurozone constituency appears unwilling to accept such changes. We agree with Mr. Draghi. All the monetary stimulus in the world is not going to restore sustained growth to the Eurozone without significant fiscal reforms. We hold little hope that China and the South American economies can live up to their potentials unless structural reforms are implemented as well. The problem here is that the respective governments do not appear to want their economies to fire on all cylinders, not at least in the truest sense. Our concern is that asset prices have built in economic rebounds in Europe, Asia and South America which might not materialize as was hoped.

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Coincidence?

We have discussed several times how corporations are using debt to facilitate share repurchases and how higher interest rates might not only bring an end to the share buyback trend, but could, eventually, result in corporations selling shares in the future (to pay for maturing debt if interest rates are too high to make debt refinancing economically feasible). Some readers have expressed doubt as to the relationship between debt issuance and share repurchases. Thus, when MetLife announced it was repurchasing $1 billion worth of common shares, we decided to look at MET’s 2014 debt issuance. The last U.S. dollar-denominated bond issued by MetLife was the 3.60% due 4/10/24. The bonds are dated 4/10/14. The size of the bond issue was $1 billion. What was the stated use of the proceeds? According to MetLife, the proceeds are to be used for “General Corporate Purpose.” Maybe the fact that MetLife issued $1billion of debt and two months later it buys back $1 billion of common shares was a coincidence. Then again… Using debt to repurchase shares is not necessarily a bad thing. When interest rates are low, debt-fueled common stock buybacks might make sense for corporations and can be positive events for stockholders. However, just as corporations might use debt sale proceeds to repurchase shares when rates are low, they can re-issue common shares to pay off maturing debt when borrowing costs are higher. Investors who own stocks which have benefitted from share repurchases should be mindful of this when interest rates begin to climb.

On the Dark Side

On the Dark Side Risk assets have had an impressive run during the past few years. In fact, risk asset performance has been more robust than economic data. A popular selling pitch among wholesalers was that risk assets are attractive because they were performing well and they tend to do well when the economy gains momentum. The reality is; the capital markets tend to get ahead of the economy. When there is a glimmer of a recovery, sophisticated investors tend to act proactively. By the time economic data appears to justify risk asset valuations, the best (if not all) opportunities are in the rearview mirror. The process was accelerated because of extreme monetary policy accommodation (resulting in very low interest rates) which forced investors into risk assets well before fundamental data justified such valuations. The second wave was that of investors who believed that the Fed would be successful. The third wave of investors into risk assets consisted mainly of those who missed the best opportunities and have finally capitulated and are pouring money into risk assets, often using the idea that risk assets should outperform as the economy improves. It is our opinion that the best days of risk assets are probably behind us for now. This is evidenced by the fact that higher-quality fixed income investments have performed as well (if not better) than their high-risk brethren. We are not unique in this view (although we have been among the first to suggest moving up in quality and to shorten duration on the long end of bond portfolios). During the past month we have witnessed an increasing number of fixed income market participants and portfolio managers move toward our position. We have read articles in various publications which featured interviews with fixed income money managers who believe: • Low foreign sovereign yields could hold down long-dated U.S. Treasury note and bond yields. • It is time to take on some duration. • It is time to reduce exposure in junk bonds and banks loans, particularly in the CCC and lower area of the credit spectrum. If one searches the Wall Street Journal, Barron’s or Bloomberg News, one can find multiple articles speaking to this. It is our opinion that further price appreciation in junk debt (bonds or loans) could be problematic. Interest income should be the prime drivers of returns among lower-rated fixed income securities. As such, we believe that it is in the best interest of our readers and asset management clients, for whom high yield investments are appropriate, to focus on BB-rated high yield credits. This is not to say that values cannot be had in B-rated bonds, but in this environment, the lower you reach, the more selective you need to be. Into the Great Wide Libor Spread For the past five years, we have preferred step-up notes over floating-rating rate securities. The notable exception has been fixed-to-float securities with attractive fixed coupons, a long fixed period and a floating spread over their typical Three-month Libor benchmark of at least 300 basis points. We advised readers to avoid fixed-to-float securities with low fixed coupons and, particularly, those with very narrow floating-rate spreads. Our thinking has been that the Fed might not raise short-term rates for a long-time and, when it does, rate increases could be moderate and gradual. Thus far, this strategy has worked out well. We continue to favor this strategy when building out the long end of a fixed income ladder or barbell. Our long-time readers (especially those who followed us at Citigroup) should recall that we were calling for a long-period of low Fed Funds Rates and a lower-than normal equilibrium rate as far back as 2010. Not much has changed in our outlook, except that we are probably about a year away from the start of Fed Funds Rate hikes. Our advice to readers considering floating-rate or fixed-to-float securities is to not be drawn in by the lower prices typically found with securities offering narrow floating spreads. The reason they are trading at lower prices than their wider-spread brethren is because narrow coupon spreads might not offer much interest rate (or asset price) protection in a rising rate environment. Subscribers are encouraged to run any and all fixed income investment ideas by us prior to purchasing. All that Glitters is Gone Emerging markets debt has made an impressive comeback since bottoming in early February. Supporters of EM debt have bloviated about how EM fear was overdone. We are not so certain. Remember, it was rising U.S. interest rates which put EM economies under pressure, particularly EM economies running high current account deficits. The decline in U.S. Treasury yields has taken the pressure off many troubled EM economies. However, few of these economies have begun the structural changes necessary to withstand rising interest rates in the U.S. As our base case is for long-term U.S. interest rates to creep higher over time, we view the rally in EM debt as an opportunity to reduce exposure in emerging market sovereign debt, if one is overexposed based on their goals, objectives and risk tolerances. In the EM space, we are most positive on South Korea, Mexico and Poland and are cautiously optimistic on India. We prefer corporate bonds over sovereign debt, particularly among export-driven businesses. Yesterday, EM market participants pointed to Exports data as a sign that China’s economy is healing. China’s Exports surged 7.0% in May versus 0.9% in April. There is little doubt that the PBOC’s weakening of the yuan has helped drive Chinese exports. However, it might have hurt Imports which came in -1.6% in May. Yesterday, the PBOC began shoring-up the yuan. It might be that the Chinese economy could be leveling off, but whether or not it will begin accelerating soon remains unanswered. China continues to combat trouble in its banking system and is dealing with domestic demand which has disappointed. News out of China is that banks are moving to secure metal stores at warehouses as concerns about collateral fraud increase. Readers might be aware of reports earlier this year regarding the wide use of metals (such as copper) for loan collateral. As metals prices declined during the past year, the collateral backing some loans became insufficient. Concerns are mounting that the same metals collateral might have been pledged for multiple loans. It might be that some loans have little or no collateral backing them. The Wall Street Journal reports that some foreign banks are conducting investigations pertaining to loan collateral and have ceased lending to some Chinese-based commodities traders. Our view on investing in China is to look for opportunities elsewhere. There is much work to be done in the Middle Kingdom before its financial system can be seen as legitimate in terms of western standards.

Reward with moderate risk

Why are investors buying CCC garbage bonds, when one can purchase $25-par senior debt issued by institutions with solid balance sheets? Think: BANCL HCJ JMPB TVE TVC

Back in Black

I have been away for awhile building my newsletter/consulting business and launching my fixed income portfolio management business. Since I have been away, long-term interest rates, such as the 10-year UST yield, plummeted, spiked (to over 3.00% in the case of the 10-year)and plunged again. The loan market became the darling of investors and began to falter earlier this year. Fed policies have cause investors to reach for yield and become desensitized to risk. Fund marketers have jumped from strategy to strategy in an attempt to keep investors engaged. Meanwhile, if you built a diverse (laddered) portfolio of bonds and bought quality bonds on weakness (often as ill-advised and panicked investors threw babies out with the bathwater), you have performed as well as the exotic strategies in the near term without the credit and/or duration risk associated with more aggressive fixed income strategies. We will post here from time to time, but to get the real story in a timely manner (and to engage in professional portfolio management), visit our site at www.bond-squad.com. Until later, This is Bicycle Repairman signing off.

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.