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.