Sunday, August 12, 2012

Manipulated Markets Thwart Wise Allocators

One of the insightful columns to read in each Weekend Edition of the Financial Times is written by Henny Sender. Her column is always well written and at times explores extreme positions which should be read to broaden one’s views. This past weekend’s column is entitled “This rapacious appetite for junk could yet result in indigestion.” The article describes the significant sales of below investment-grade bonds. Ms. Sender cites an example of a successful bond underwriting of an American utility whose common stock is viewed by many as worthless. Her view is that with high quality bonds yielding low rates (in most cases significantly below actuarial assumptions for pensions and less than the spending rates of trusts and tax-exempt institutions) investors are forced into extreme investments. At the opposite extreme, there are investors concerned about the value of their currencies; we have at least 15 countries with two-year bonds yielding below zero in terms of “real” rates (adjusted for inflation).

What has caused this behavior by so-called sophisticated institutional investors? This was not taught to them at their schools of supposed high learning. This bizarre condition occurred because at the urging of the politicians, central bankers have attempted to manage the supply of credit to support their faltering economies by making cheap credit available. In other words they have manipulated interest rates lower than they would have been under the present economic conditions. In non-manipulated markets the exact price of an investment is determined by the meeting of buying and selling forces. Normally, the market determines a rate of interest that is a reasonable gauge of the perceived risk of loss of an investment. In an administered market there is little in the way of risk discovery. Thus, all too often allocators will choose high interest rate paper for their portfolios to meet unrealistic demands for current income.

One of the misapplications of Newton’s First Law of Motion, (a body in motion tends to stay in motion) is that current market conditions will remain the same in the future. As is often the case, the best economic text, the Bible, has the early recognition of the seven feast years followed by seven lean years. Further as history shows, wweventually all manipulations become exhausted and then there is a return to freer markets. Currently those that pursue the high yield, or if you prefer junk markets, are not worried. The interest rate spread between their merchandise and US Treasuries of similar maturities is historically tight, showing the market’s acceptance of high-yield paper. I suggest that any appropriate analysis of the US government’s finances would suggest that the interest rate for US paper is too low as reflected in its credit rating downgrade. A more realistic interest rate on US paper should force higher rates on “junk” which will cause lower prices for these bonds.

The above views may appear contrary to the flow of money into high-yield bond funds and the issuance of new high-yield paper. This weekend some were suggesting that one way to take advantage of the current market is the purchase of high-yield municipal bond funds. The author of one article conceded that there could be an increase in defaults, but the current superior yields could absorb the defaults. (I do not believe that is the way the math will work out on the net asset values of these funds.) At this point I am unaware of any tax-exempt entity increasing its ratios of solvency. I am sure that there are some, but not many.

The job of an asset allocator

In my opinion and practice the sum total of a specific client’s assets should be arrayed to meet all the expected needs of the account, present and future. This belief and practice is very different than maximizing the disposition of current assets to meet current needs. Many allocators believe that in their infinite wisdom they will be able to shift allocations as the markets turn. There are a few that have the history of successful shifts to catch the big trends. In a review of mutual fund records I cannot find any significant number that has pulled off this feat three or four times in a row with large pools of capital. Thus, as portfolio allocator for most of our accounts, we rarely are all in or all out. (Or, if you prefer the current lexicon, risk on/risk off.)

The insatiable drive for income

Those allocators who get sucked into providing large amounts of current income are producing better current results than those of us who are using a more balanced approach. However the balanced approach appears to be working.  In a forthcoming review of a major account system for one of our clients, all forty-seven of the funds used are showing a positive result for the first seven months of the year. (A much longer period of perhaps ten or more years would be needed to demonstrate skill. But after some rough months in the second quarter, it is nice to momentarily see progress.) Remember that past performance is no guarantee of future results.

How much are you allocating to high-yield and at what yield will you exit these investments?
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