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.

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.