Sunday, December 27, 2009

Boxing Day and Bond Funds

As members of this blog community know, my wife Ruth and I do our investment research by visiting the local high-end shopping mall near our home. We have commented on the density of the crowd of shoppers on “Black Friday,” (the day after Thanksgiving or the following day) in my blog this year and in 2008. This year, the mood at the mall on “Black Friday” was subdued, as evidenced by our ability to find a parking space close to our favorite second floor entrance. What a difference it was a month later!

“Boxing Day” is a term that comes from the time of Henry VIII, when presents were re-gifted, wrapped in boxes and given to the poor. In secular modern America, the day is one to return gifts of wrong size or wrong taste. On a rainy, cold 26th day of December this year, the car line to get into the mall spilled over to the adjacent highway, and could have been a mile long at one point. Both local police and mall security people were out in force to keep traffic crawling along in the anxious search for parking spaces. Walking in the mall, we encountered many more people than we encountered on any day during the shopping season. (Many of the habitu├ęs of this mall have at least a black belt in competitive shopping.) Clearly many people were returning gifts, but judging by the new shopping bags with the word ‘sale’ imprinted on them, they were also buying. Some may have been using their new gift cards with the perception that the cards contain a "decay mechanism," motivating people to use them quickly on what they might have believed to be favorable prices and available merchandise. In actuality, many bargains were scooped up already by Christmas/Chanukah gift buyers. The intensity of buying was high, with lengthy lines at cash registers to ring up new purchases. The well-dressed crowd was not only buying merchandise, they were also showing off their new forms, and were wearing full daytime makeup and assorted items of “bling.”

The analyst in me could not help seeing what I felt was unusual volume and participant vigor. My training suggests that when one sees these conditions, something of importance is happening. Here are my guesses. First, store visitors make a reconnaissance visit early in the season to determine price and availability, and think they can do better at the post-Christmas sales. Second, some shop the Internet and receive goods from the very same stores that pay the high rent for location in the mall. Their gifts are more easily exchanged in-person at the mall than by mail or express delivery. Third, there was significant growth in the purchase of gift cards this year. All three of these motivations drove people to the mall on Boxing Day 2009.

In last week’s blog I said I would discuss lessons from mutual funds this week. Throughout 2009, the volume of both gross and net sales of bond mutual funds has been higher than those for equity funds. In many historic ways, this is remarkable. Bear in mind that one of the steadiest inputs to fund assets are the monies from 401(k) salary savings plans for retirement. My experience as an adviser to a number of such plans at different income levels is that on average, about two thirds or more of 401(k) money goes into equity funds. Further, once most people set their initial asset allocation, they do not change it. Some may have shifted into bonds in 2009 as a reaction, perhaps an over-reaction, to the stock market performance in 2008. My guess is that the over-reaction is enough of an explanation for the high sales of taxable bond funds. In addition, retail taxable brokerage accounts do not appear to be increasing their trading of stocks at the firms that I monitor, and/or in which I invest. Fixed-income underwritings are strong, with both the public and institutions buying.

What is happening to cause this wide-scale interest in bonds and bond funds? As with most trends, there is both a long-term shift and a more current accelerator. For many years, the buyers of bonds looked to interest payments to fulfill specific spending needs, often retirement spending. (Remember the phrase that someone was “living on fixed-income?” For some, this included interest payments and slow moving pension plans.) The eventual repayment of principal was a significant event, either to cause a reinvestment or to make a significant purchase of an asset. (This could be to pay off a mortgage or to send a child to college or similar such expenditures.) Historically, once a high quality bond was issued at a currently acceptable interest rate, the vast majority of the issue would be held to maturity. Over time, some bonds would come back out on the market to meet estate needs or to meet the needs of a change of circumstances. With the recent rise of professional fixed-income managers, trading profits in addition to interest income were promised, and some delivered. Today fewer bond issues are locked up, and it is not unusual for bonds to have transaction turnover rates similar to stocks. They have become trading vehicles. Becoming trading vehicles changes some of the participants in the market place. In today’s low interest rate environment, trading can add or subtract much more than the coupon rate on the security.

What do bonds have to do with Boxing Day? To add to potential trading profits, traders look to find what they believe to be mis-priced issues, similar to the differences in pre- and post-holiday sale merchandise. Often the mis-priced securities are scarce. One of the reasons they are mis-priced is that the bonds may have been difficult to sell, which created a liquidity discount in terms of price, or a premium in terms of rate. Not dissimilar to post-holiday shoppers fighting over the one remaining great sweater in the right size. Inventory and liquidity are interrelated.

In taxable bond land, 2009 was in some respects three years in one. In the one year ending December 24th, the average non-money market fund had a total reinvested return of 19.53%, according to my old firm. The average income yield on high quality bond funds was in the range of 5%. In the long term funds, the average rates of return in 2009 rose from the Corporate “A” Rated Bond fund return of 15.95%, to Loan Participation funds returning 42.01%, and High Yield funds 50.82%. In my judgment, these are dangerous returns. To show the excess returns compared with the long-term trend for the five years ending on Christmas Eve, 2009, there were six different types of bond funds which had average annual reinvested compound returns between 4% and 5%, and two above 5%, (GNMA funds at 5.1% and Emerging Market Debt funds at 7.25%).

Next week we will look at the equity sides of the investment house, which did better in 2009 after such severe contraction in 2008 that the five year returns are below the fixed-income levels.

Nevertheless, just as the intensity of manic shoppers in the mall on Boxing Day is exhilarating, it sends a warning sign of an unbalanced activity. Translating that into bond land, I would prefer to be a supplier rather than a buyer of bonds. The summer sales are likely to have fewer buyers and more bargains.


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Anonymous said...

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Anonymous said...

I recently came across your blog and have been reading along. I thought I would leave my first comment. I don't know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.