Sunday, May 15, 2011

Are You the Smartest Person in the Room?

Have you ever noticed that most of the time sellers know more about a trade than the buyers? As retail consumers purchasing a product or service, we normally approach a salesperson and ask them specific questions about what is being offered. Rarely do we get an exhaustive disclosure. Even when negatives or blemishes are mentioned, their number and importance are less emphasized than the headlined advantages. At times we may get lucky and feel that the seller is more knowledgeable, perhaps even truly professional. We carry the same attitude, some might say naively, over to purchasing securities, particularly fixed income securities.

Seller’s advantage

This last week, according to Karatash Abdullah of Natixis, the following bonds were issued at what has to be considered historically, very low interest rates: IBM, Xerox, Wesfarmers (Australian), Philip Morris, General Mills, Prudential, BBVA (Spanish), Standard Chartered, Nordea (a Nordic bank), Banco Bades (Uruguay), Banco Safra (Brazil), Energy Transfer Partners, Pacific Gas & Electric, IPALCO – AES, Southern California Edison, DTE (formerly Detroit Edison), Delphi, and MIT. I found this list fascinating for its length, breadth of issuer, and the timing of the offering. However, what caught my specific attention were the first and last names on the list.

When I was a young analyst, many thought that IBM was the smartest big company in the world. The company was not only deemed to be very smart, but rather opaque in terms of disclosure. Though I wanted to be an equity analyst, I had a discussion with the bond side of the house of the insurance company that provided the exclusive funding for what I believe was $100 million+, for 100 years, and this was the key: at 2%. I had assumed that as a very large powerful buyer, the insurance company would get frequent detailed disclosures similar to its loans to private companies. When I learned that the insurance company only got the normal disclosures of a public company, I became much less interested in working for the insurance company. Later on it became clear that this loan was one of the competitive strengths of IBM in building its absolutely critical computer leasing business, particularly outside the US. While the insurance company did have a rather modest equity position in the stock, it was clear which side of the private placement was the smartest in that trade.

The last named issuer was MIT (Massachusetts Institute of Technology) a truly wonderful university (for those who can not get into Caltech where I am a Trustee). All kidding aside, not only is MIT a great engineering school, it has a world renowned Economics and Finance faculty. They are clearly very smart. What fascinated me is that MIT issued $750 million in 100 year bonds. This issue was so successful in scooping up money from insurance companies that they canceled a planned 30 year bond offering. The interest rate for the 100 year bond was 5.623% and was rated AAA. The life insurance companies that bought this issue were using it to offset their actuarial risk of issuing life policies to some portion of the population that will die 100 years from now. What I find fascinating is that the smart guys are betting, I believe, that during some portion of the term of the bond and perhaps cumulatively, inflation will be above the long term (since 1926) rate of 3%, and thus the real cost of having money over time is less than 2.623%. All of these back of envelope calculations ignore the real power of interest on interest that will be earned by the insurance companies. If interest rates go up, as I believe they will, the payments by MIT can be invested at higher rates than the 5.623% on the issue. That is not a dumb bet, but my guess that the MIT will prove to be the most prudent if not the smartest player in the trade.

Translating government debt personally

Periodically one of the rituals of personal financial life is to draw up a personal balance sheet. Most often this exercise is done in the connection of some credit extension to us. Far less frequently the exercise is part of financial goal management. This exercise should be done for our own use at least once every year. On the right side of the balance sheet we aggregate all the debt that is outstanding in our name. We may even footnote any contingent debt that could be the result of guaranteed borrowings by others. After conducting this exercise we feel pretty good about our financial condition, particularly if our net worth is the largest number on the right side of the balance sheet. In these days of fiscal problems in Greece, Ireland, Iceland, Portugal and probably Spain and Italy, our personal debt profile is not complete without adding our share of the US government’s debt in addition to state and local debt. In his latest blog, Frank Holmes of US Global Investors displayed a screen shot from On the bottom line of the display is an entry entitled “liability per taxpayer” which was shown as $1,021,775, that minute’s calculation of the collective US government debt divided by the number of American taxpayers. We live in a “progressive” tax country, where the wealthy pay higher taxes than the less well off (only about half of the taxpayers pay federal income taxes). Considering the way politicians think, I would suggest that those of above average wealth, in reality will pay one way or another, a greater proportion of the debts as they become due than the average earning taxpayer. For planning purposes, I would suggest that for each additional $ 1 million in net worth, some 50% of the average debt per taxpayer be added to our total liabilities. Now before one decides quickly to leave the repayment problems to our heirs, remember in all the discussion about the exploding debts of the federal and local governments, no attention is being paid to the ultimate value of the assets on the various governments balance sheets. Much of what the government owns could be sold to the private sector that just might be better managers and still act both prudently and socially responsibly.

I would be happy to discuss the construction of your own personal balance sheet; please use the email link below to reach me.

Investment implications

With smart guys selling bonds and government debt structure exploding, one wonders why it is prudent to own debt. When interest rates rise, (note that I said “when” not “if”), I think we will see significant liquidation of high quality bonds and a sharp rise in money market funds and instruments.

What do you think?


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