Regularly I spend both formal and informal time with portfolio managers and other types of investment professionals, as well as talented amateurs. These conversations are part of my professional work as an investment manager and are also as a part of my volunteer activities for various non profit organizations.
This June, I am hearing two very different themes. The first theme, from successful managers, is that we are experiencing a “Beta or Junk” rally. Beta is that part of a securities performance that is market dependent, as distinct from independent. Stock managers are indicating that the stocks that are going up the most are being driven by improving margins due to cost cutting, with little (if any) sales growth. Inventory is being re-ordered after being allowed to fall to the point where it was hurting customer production. Few analysts however, are predicting long-term growth in demand, and many see the current enthusiasm waning in the near-term future. What appears to be happening on the bond side is that investors see a much wider spread between the interest rates of corporate bonds of all types compared to US Treasuries. However, this spread is currently narrowing. Unfortunately the yield spread, and therefore the price spread, is narrowing because the yields on treasuries are rising. This rise has more to do with the fears on the part of some buyers that treasury yields are not compensating their owners for the prospect of inflation, combined with the need of the US government to fund the rapidly increasing deficit.
The second theme I hear, is that stocks appear to be cheap, compared to earnings; not current earnings but “normalized” earnings. The concept of normalization of earnings was found in the early editions of Security Analysis by Graham and Dodd, which comes as close to being the analysts’ Bible as anything ever written. The way Professor Dodd taught me at Columbia in the late 1950s, was not to trust any given year’s results, but to average the reported earnings and margins over at least one business cycle. Dodd would also urge us to apply the valuation metrics to the normalized results in terms of both absolute and relative price/earnings ratios and yields. There have been a number of great, value-focused managers that have applied this thinking to their portfolios. One of the greatest was John Neff who purchased Citicorp stock when it collapsed into single digits during another loan crisis. Neff had the pleasure of holding the stock for many subsequent years at multiplies of his purchase price, which aided his Windsor Fund’s performance. An interesting side note is that when John Neff retired, his small retirement dinner in New York included only two non-insiders, John Reed (then the sole CEO of Citi), and me.
This is where the Scots come in; the case for normalization is based on the concept that at some point in the future, things will be like they were in the past. According to a legend turned into the wonderful Broadway musical “Brigadoon,” there was an ancient town in Scotland that would come back to life for one day each 100 years. My concern is that in a much more dynamic market than experienced in the fifties (when I was exposed to both Professor Dodd and Brigadoon), we will pass through the normalization phase very quickly, and be on to new crises and events. One example is the expected decline in the profitability of credit cards due to current legislation in the US and UK (including Scotland). However, the smart guys at card-issuing banks may find new ways to use their credit card relationships to make money, as well as to recoup some of the loans that have been written off. Nevertheless, when it comes, this day will not be an exact revival of Brigadoon.
What do you do with all this input and folklore? My first suggestion is to avoid buying and to perhaps practice some trimming of portfolio positions that have shown unsustainable price gains since March. We could experience a major mark-up of some prices as pension and hedge funds wish to show less cash on their June 30th statements. If this mark-up is extreme, one should react. July and early August, while tricky due to less than normal volume, may well be cautiously good entry points.
While you wait and contemplate, watch out for little signs of change and keep humming.
Showing posts with label bond spreads. Show all posts
Showing posts with label bond spreads. Show all posts
Sunday, June 14, 2009
Sunday, April 19, 2009
Should We Appreciate Bonds? Part II
Cocktail parties for charities often reveal more investment concerns than those expressed in an organization’s formal meetings with investment advisers or investment committee members. In this age of unusually high fixed income yields and low total returns from common stocks, taking advantage of spreads for capital appreciation, not primarily income and capital preservation, can be unnerving. The question of whether this new approach is a sound one for a fiduciary has been expressed by members of several charity boards and committees.
As many of our regular readers know “Monday Morning Musings” is written largely on Sunday evening. As some also may know, on Sundays I spend time with Barron’s, the oldest and (and in my view) the finest statistical package of data. I also use the weekend to peruse my old mutual fund analysis reports, now produced by Lipper, Inc. With these resources in hand I can more fully address the propriety of using credits, in this case corporate bonds, to make money for fiduciary accounts.
Each week Barron’s publishes a list of the 40 corporate bonds with highest estimated trading volume for the week. One of the most useful columns in this display is the estimated spread between the current yield and those of US Treasuries of similar maturities. As there are all kinds of buyers of bonds in the secondary market, these spreads vary widely from the lowest, 79 basis points (0.79% of 1.00%) to 1175 basis points. The suggested strategy is to buy investment quality corporate bonds whose spreads with treasuries are 300 to 400 basis points above a more “normal” spread of 100 basis points. In examining the April 17th list, I found there were seven bonds with a 400 point spread, and eight with a 500 point spread. The proposed strategy presumes a mini-portfolio of about four bonds, so there are a sufficient number of candidates in the most liquid of cases.
A more difficult question as to what is the “normal” spread, sent me to look up the data from the year-end Lipper Fixed Income Fund Performance Analysis Report Certificate Edition for 2006. The data is somewhat like comparing apples with oranges as to their weight and caloric content. Nevertheless, this was all that was available to me over the weekend. There are three distinct mutual fund peer groups which can be compared: General US Treasury Bond Funds, Corporate Bond Funds - A Rated and Corporate Bond Funds – BBB rated. As distinct from the proposed strategy that only includes four issues, each bond fund in the peer group may own more than 100 individual bonds. Each fund only has to assure the SEC and my old firm that the majority of its holdings meet the minimum credit rating in the title of the peer group assigned to them.
Another complication is that funds have expenses which are deducted before the yield and total returns are calculated. By adding back the average total expense ratio to the reported yield, we get the average gross yield in the average portfolio. As of the end of March 2009, the adjusted yield spreads compared with treasuries were 246 basis points for the “A” rated Bond Funds, and 327 basis points for the “BBB” rated Funds. Using the same approach for year-end 2006, the spreads were 174 basis points for the “A” rated and 231 basis points for the “BBB” rated funds. Therefore there appears to be the historic possibility of a 96 basis point pick up using funds alone, which leaves no room for security selection skill.
While we professional investors fixate on relative performance and yields, our clients spend actual dollars, not basis points, so absolute return becomes critical to them.
At the time when one expects to use an investment, a decline in the absolute is extremely painful. So what can go wrong with the proposed strategy? The credit quality of the owned bonds can decline. (In theory, this is answered by the chosen manager following both the issued bond and the underlying stock on a day-to-day basis.) The next major risk, and one that I feel is much more likely, is that inflation and not deflation becomes the problem, causing investors to demand and get higher yields on new issues of US Treasuries. The higher yields on the new issues will drive the yields on existing bonds higher and therefore prices lower. While the spreads could questionably narrow, the prices of the bonds will decline under those circumstances. (One possible counter argument is that a balanced portfolio with a majority of equity investments, often drive equity prices higher initially.)
The fundamental question facing the fiduciary is whether the odds on tightening in the near term future far outweigh the longer term risk of specific credit problems and/or rapid inflation. My attitude is that the strategy could work well in the hands of a skilled active manager of selected bonds, but not a strategy to be recommended for individual investors or most institutional investors. The next cocktail party questions should be around demonstrable skills, not investment policies.
(This post is a follow up to my March 30, 2009 Blog entitled,
“Should We Appreciate Bonds?”)
As many of our regular readers know “Monday Morning Musings” is written largely on Sunday evening. As some also may know, on Sundays I spend time with Barron’s, the oldest and (and in my view) the finest statistical package of data. I also use the weekend to peruse my old mutual fund analysis reports, now produced by Lipper, Inc. With these resources in hand I can more fully address the propriety of using credits, in this case corporate bonds, to make money for fiduciary accounts.
Each week Barron’s publishes a list of the 40 corporate bonds with highest estimated trading volume for the week. One of the most useful columns in this display is the estimated spread between the current yield and those of US Treasuries of similar maturities. As there are all kinds of buyers of bonds in the secondary market, these spreads vary widely from the lowest, 79 basis points (0.79% of 1.00%) to 1175 basis points. The suggested strategy is to buy investment quality corporate bonds whose spreads with treasuries are 300 to 400 basis points above a more “normal” spread of 100 basis points. In examining the April 17th list, I found there were seven bonds with a 400 point spread, and eight with a 500 point spread. The proposed strategy presumes a mini-portfolio of about four bonds, so there are a sufficient number of candidates in the most liquid of cases.
A more difficult question as to what is the “normal” spread, sent me to look up the data from the year-end Lipper Fixed Income Fund Performance Analysis Report Certificate Edition for 2006. The data is somewhat like comparing apples with oranges as to their weight and caloric content. Nevertheless, this was all that was available to me over the weekend. There are three distinct mutual fund peer groups which can be compared: General US Treasury Bond Funds, Corporate Bond Funds - A Rated and Corporate Bond Funds – BBB rated. As distinct from the proposed strategy that only includes four issues, each bond fund in the peer group may own more than 100 individual bonds. Each fund only has to assure the SEC and my old firm that the majority of its holdings meet the minimum credit rating in the title of the peer group assigned to them.
Another complication is that funds have expenses which are deducted before the yield and total returns are calculated. By adding back the average total expense ratio to the reported yield, we get the average gross yield in the average portfolio. As of the end of March 2009, the adjusted yield spreads compared with treasuries were 246 basis points for the “A” rated Bond Funds, and 327 basis points for the “BBB” rated Funds. Using the same approach for year-end 2006, the spreads were 174 basis points for the “A” rated and 231 basis points for the “BBB” rated funds. Therefore there appears to be the historic possibility of a 96 basis point pick up using funds alone, which leaves no room for security selection skill.
While we professional investors fixate on relative performance and yields, our clients spend actual dollars, not basis points, so absolute return becomes critical to them.
At the time when one expects to use an investment, a decline in the absolute is extremely painful. So what can go wrong with the proposed strategy? The credit quality of the owned bonds can decline. (In theory, this is answered by the chosen manager following both the issued bond and the underlying stock on a day-to-day basis.) The next major risk, and one that I feel is much more likely, is that inflation and not deflation becomes the problem, causing investors to demand and get higher yields on new issues of US Treasuries. The higher yields on the new issues will drive the yields on existing bonds higher and therefore prices lower. While the spreads could questionably narrow, the prices of the bonds will decline under those circumstances. (One possible counter argument is that a balanced portfolio with a majority of equity investments, often drive equity prices higher initially.)
The fundamental question facing the fiduciary is whether the odds on tightening in the near term future far outweigh the longer term risk of specific credit problems and/or rapid inflation. My attitude is that the strategy could work well in the hands of a skilled active manager of selected bonds, but not a strategy to be recommended for individual investors or most institutional investors. The next cocktail party questions should be around demonstrable skills, not investment policies.
(This post is a follow up to my March 30, 2009 Blog entitled,
“Should We Appreciate Bonds?”)
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