Archive for June, 2012
Hardball in Brussels (Grant)
Friday, June 29th, 2012
From Mark Grant, author of Out of the Box
Hardball in Brussels
In the last hour yesterday the equity markets rallied significantly on the basis of a 120 billion growth package for Europe that had been announced. The EU put out the headline like it was all new money but further investigation revealed that it was not. The growth package was mostly the amalgamation of schemes already in existence with the addition of some new money but not a significant amount. As the news behind the headlines was assessed the markets traded back down some in the after hour’s session. Then Europe’s leaders met and the evening got more interesting. The following is the basis of their decisions.
“We affirm that it is imperative to break the vicious circle between banks and sovereigns. The Commission will present Proposals on the basis of Article 127(6) for a single supervisory mechanism shortly. We ask the Council to consider these Proposals as a matter of urgency by the end of 2012. When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, following a regular decision, have the possibility to recapitalize banks directly. This would rely on appropriate conditionality, including compliance with state aid rules, which should be institution-specific, sector-specific or economy-wide and would be formalized in a Memorandum of Understanding. The Eurogroup will examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment program. Similar cases will be treated equally.
We urge the rapid conclusion of the Memorandum of Understanding attached to the financial support to Spain for recapitalization of its banking sector. We reaffirm that the financial assistance will be provided by the EFSF until the ESM becomes available, and that it will then be transferred to the ESM, without gaining seniority status.
We affirm our strong commitment to do what is necessary to ensure the financial stability of the euro area, in particular by using the existing EFSF/ESM instruments in a flexible and efficient manner in order to stabilize markets for Member States respecting their Country Specific Recommendations and their other commitments including their respective timelines, under the European Semester, the Stability and Growth Pact and the Macroeconomic Imbalances Procedure. These conditions should be reflected in a Memorandum of Understanding. We welcome that the ECB has agreed to serve as an agent to EFSF/ESM in conducting market operations in an effective and efficient manner.”
Behind the Headlines
Apparently Mr. Rompuy had jumped the gun in making the announcement about the growth package late yesterday afternoon as Italy and Spain had not yet agreed to it. No matter, the markets took Mr. Rompuy at his word and rallied away and it was not until after the close that the truth came out. In fact, in the evening negotiations, Italy and Spain threatened to veto the growth measures if certain other measures were not agreed to which were to their benefit. From all indications it was here that Ms. Merkel blinked and was willing to make certain adjustments that are significant. For us the most important change is that the loans from the new ESM fund will not be senior to private debt holders. That is definitely good news for bond investors and a decision that I can applaud.
The other news on that front was that the funds for the EFSF and the ESM were not increased and that while some firewall is a deception of sorts as it does nothing for the troubled nations at all it is indicative, though a contingent and unfunded commitment, of the size of the capital available should further needs arrive for the troubled nations, including Spain and perhaps Italy. If there was one eyes wide open part of the negotiations and discussion it was that Italy may also need some assistance soon because this was hinted at time and again. The ECB will be handling the distribution of bond buying in the secondary and perhaps primary markets for sovereign debt but, unlike the Fed, the printing presses are NOT available as the money allocated to the EFSF and the potential ESM is all of the money that can be used for any bond buying programs. This, then, is a significant negative for the program as there is not enough money to really help out Spain, much less Italy, if it is needed.
Another change is that money can be lent directly to the banks and does not have to go through the sovereign but this change will not take place until the end of 2012 when some sort of European banking supervisory authority is established and there are no details on what that will mean except that it will be located in Brussels. The statements seem to indicate that the money for the Spanish banks will now go the nation of Spain and then its banks and then the money will be transferred off of the Spanish books at a later date when the new banking authority is established.
Now all of this has to go back to various Parliaments, including Germanys, which may cause some consternation as the “seniority” of the ESM has been relinquished which may cause some problems in Finland, Austria, the Netherlands and perhaps even in Germany. It is interesting to note that all of the dictums that have been announced deal with funding and that none addressed the structural or solvency problems of a Europe that is mired in recession.
There is also some good news in today’s release for Ireland which indicates that troubled banks in various nations may now be funded by the EFSF/ESM and not just the nation in which the banks are domiciled. Europe is going to consider EU wide funding which is good for nations such as Ireland and Spain of course but it is bad then for the nations that must provide the bulk of the funding indicating more debt that has to be taken on by Germany, Austria, the Netherlands, Finland et al. It is not exactly Eurobonds because it is limited in scope but it is a definite blink by Germany as hardball was played by both Spain and Italy and Ms. Merkel was outflanked in the end.
The final point that I would make today is that nothing is yet in place and is not even envisioned to be in place until the end of this year. In some sense it is a lot like discussing the ESM which is not yet in place either. All of the talk concerning removing the aid to the Spanish banks from the sovereign obligations of Spain will not happen unless this new banking authority is approved by the nations in Europe and there may well be some that don’t wish to turn over their sovereign banking powers to Brussels. What has been announced then is a plan, a scheme, that is some six months away from actualization if actualized at all. I would point out that there is a lot of risk between now and then and that Europe is quite good with coming up with all sorts of grand plans that somehow do not work out. In the meantime Ireland will still pay for her banks, Spain is going to get money but money lent to the country and not her banks, Greece now awaits the Troika and their report and then the decisions of the IMF and the EU on what if any changes might be made in their agreements and if any new money will be handed to Greece or if the funding will stop.
The EU has done a something I would say, made some progress, but what this something means is yet to be determined and it is one-half year away from implementation under the best case scenario and there will be plenty of challenges ahead in Europe during this timeline. The markets are rallying but the realization that nothing really was accomplished, meaning implemented, will drive the markets the other way soon I fear.
In Existence Now
In the final analysis Europe is quite exposed at this moment and may be for quite some time. The ESM, after the change in seniority status, must be re-affirmed in at least two countries that are the Netherlands and Finland and Germany has not yet approved it yet either. The EFSF has already spent $450 of its capacity on Greece, Ireland, Portugal and now $125 billion for Spain. The balance left in the fund is tissue paper thin and that is all that is in existence presently for any more problems in Europe. Plans and schemes aside, the amount of money that could actually be used today is a drop in the proverbial bucket.
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The Story That Got Bloomberg News Blocked In China
Friday, June 29th, 2012
Bloomberg News may be the most read news source in the world, but as of today, it is no longer available in China. Why? According to Bloomberg TV News Editor Denise Pellegrini, all it takes is for some investigative reporting exposing the dirty laundry, or in this case the even dirtier assets of one Xi Jinping – “the man in line to be China’s next president.” In “Xi Jinping Millionaire Relations Reveal Fortunes of Elite” Bloomberg writes: “Xi warned officials on a 2004 anti-graft conference call: “Rein in your spouses, children, relatives, friends and staff, and vow not to use power for personal gain.” As Xi climbed the Communist Party ranks, his extended family expanded their business interests to include minerals, real estate and mobile-phone equipment, according to public documents compiled by Bloomberg. Those interests include investments in companies with total assets of $376 million; an 18 percent indirect stake in a rare- earths company with $1.73 billion in assets; and a $20.2 million holding in a publicly traded technology company.” That a country’s will seek to block the internet when the wealth of its humble leaders is exposed is expected. However, what is unexpected is that the hidden assets of China’s president in waiting are rather easily discovered is troubling: it means Goldman has still much work to do in China, and much more advisory work to the country’s elite over how to best hide its assets in various non-extradition locations around the world under assorted HoldCos. Just like in the US. The good news, for GS shareholders, however, is that this indeed provides a huge new potential revenue stream.
More from Bloomberg:
Xi has risen through the party over the past three decades, holding leadership positions in several provinces and joining the ruling Politburo Standing Committee in 2007. Along the way, he built a reputation for clean government.
He led an anti-graft campaign in the rich coastal province of Zhejiang, where he issued the “rein in” warning to officials in 2004, according to a People’s Daily publication. In Shanghai, he was brought in as party chief after a 3.7 billion- yuan ($582 million) scandal.
A 2009 cable from the U.S. Embassy in Beijing cited an acquaintance of Xi’s saying he wasn’t corrupt or driven by money. Xi was “repulsed by the all-encompassing commercialization of Chinese society, with its attendant nouveau riche, official corruption, loss of values, dignity, and self- respect,” the cable disclosed by Wikileaks said, citing the friend. Wikileaks publishes secret government documents online.
A U.S. government spokesman declined to comment on the document.
…
While the investments are obscured from public view by multiple holding companies, government restrictions on access to company documents and in some cases online censorship, they are identified in thousands of pages of regulatory filings.
The trail also leads to a hillside villa overlooking the South China Sea in Hong Kong, with an estimated value of $31.5 million. The doorbell ringer dangles from its wires, and neighbors say the house has been empty for years. The family owns at least six other Hong Kong properties with a combined estimated value of $24.1 million.
Read the full article here.
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Focusing on Capital Preservation: Stable Value and Possible Alternatives
Friday, June 29th, 2012
by Brett Gorman, Henry Kao, Stacy Schaus, PIMCO
- Stable value, which combines an actively managed fixed income portfolio with a contract to help assure principal and income, offers capital preservation potential and historically higher risk-adjusted returns than money market and low duration strategies.
- Plan sponsors that cannot obtain the wrap contracts or fixed income managers of their choice may want to consider a modified stable value solution, such as stable cash or stable interest.
- If stable value strategies do not offer meaningful benefits to a plan, PIMCO believes a short-term bond strategy specifically designed and managed for the plan’s unique return and volatility needs may be the best alternative.
Offering a strong, conservative capital preservation option is crucial for defined contribution (DC) plans, as volatility in the financial markets remains high and a growing number of investors approach retirement. In our view, stable value strategies, which combine an actively managed fixed income portfolio with a benefit-responsive contract, or “wrap,” that helps provide an assurance of principal and income, are perhaps the most attractive conservative investment option for DC plans. Despite continued challenges for some with gaining or retaining quality wrap capacity, stable value potentially offers capital preservation and attractive long-term risk-return characteristics, while its historically higher long-term returns versus lower-yielding money market alternatives can also help preserve purchasing power and help mitigate the effects of inflation.
Stable value is a significant asset class within the defined contribution space and, according to the 2012 PIMCO DC Consulting Support and Trends Survey (PIMCO DC Survey), most plan sponsors that offer stable value will likely stay with it but will evaluate their underlying investment managers. At PIMCO, we have developed what we believe are effective ways to assess stable value offerings and optimize exposure to this asset class in light of ongoing wrap capacity constraints. And for those plan sponsors that cannot fully maintain – or do not want to continue with – the stable value option, we have identified potentially attractive alternatives.
Assessing return and risk in stable value
Stable value is a fixed income investment typically used as a capital preservation option in DC plans. According to the Plan Sponsor Council of America’s 54th Annual Survey as of 31 Dec 2011, 61.5% of DC plans offer a stable value portfolio, including over three-quarters of plans with more than 5,000 participants, resulting in more than half a trillion dollars in stable value. There is little doubt that the prevalence of and significant assets invested in stable value portfolios have drawn increased interest from plan sponsors and consultants given the capacity constraints of the last few years.
Stable value seeks capital preservation, but with higher return potential compared with the main alternatives, money market and low duration strategies. Stable value has delivered better risk-adjusted returns over time than these alternatives, as shown in Figure 1, which uses Hueler Analytics Stable Value Pooled Fund Comparative Universe as a proxy for stable value risk and returns.
Over the last 10 years ending 31 Dec 2011, the Hueler Index returned 4.22% while the Lipper Money Market Index returned 1.72% and the Barclays 1-3 Year U.S. Government/Credit Index, a typical benchmark for low duration strategies, returned 3.63%. During this same period, as represented by standard deviation, the Hueler Universe exhibited about half the volatility of returns as the Lipper Index and less than one-sixth of the volatility of the Barclays 1-3 Year Index.
Going forward, absolute returns on stable value, as well as money market and low duration strategies, are likely to be lower given the Federal Reserve’s long-term near-zero interest rate policy.
Stable value’s historical performance relative to alternatives in the capital preservation space will likely come as no surprise to those familiar with the asset class. Unfortunately, the overall stable value market is still working through the wrap capacity challenges that resulted from the financial crisis in 2008, with some wrap providers – banks, especially – shrinking their outstanding book of business or exiting the wrap market entirely.
Wrap contracts are critical because, when combined with their associated fixed income assets, they help deliver the stability of principal and income characteristic of stable value portfolios. Additionally, while the risks to wrap providers have substantially decreased since 2008 due to recovering contract market value-to-book value ratios, many providers still seek to renegotiate wraps with more conservative guidelines and generally more restrictive terms for plan sponsors.
Despite those challenges, the PIMCO DC Survey shows that 78% of consultants believe plan sponsors are increasingly satisfied with their capital preservation plan options, up from 68% in 2011, and only 6% of consultants say plan sponsors will likely look to exit stable value for money market strategies, down from 11%. This change in attitude may result from indications that wrap providers are not as urgently seeking wrap contract changes in the last year and that the supply of wraps is improving, with much of the new capacity coming from insurance providers.
Nevertheless, the challenges in the stable value market in the last several years have caused a few plan sponsors to leave stable value, including several large, high profile plan sponsors. When asked in the PIMCO DC Survey what factors would cause plan sponsors to discontinue stable value, consultants’ top responses were generally consistent from 2011 to 2012: The top two remained “insufficient quality wrap capacity” followed closely by “wrap issuer restrictions on plan design.” A distant third was an “increase in wrap fees.”
Seeking to optimize fixed income management
In our view, choosing the fixed income manager for a stable value option is one of the most important decisions a plan sponsor makes – especially in such a low rate environment where index yields are anemic. The 2012 PIMCO DC Survey showed that many consultants think a clear majority of plan sponsors are inclined to evaluate the underlying investment management of their stable value option in the coming year. PIMCO believes this is especially important given that much of the new wrap capacity entering the stable value market is offered by insurance providers, many of whom are only issuing contracts in a bundled arrangement with provider-affiliated fixed income managers.
By smoothing the performance of associated fixed income portfolios, wrap contracts can also inadvertently, and for extended periods of time, mask poor fixed income performance by the manager; that underperformance will be eventually reflected in reduced crediting rates for participants. Unfortunately, with the wide differences in fixed income manager performance during and after the 2008 market crisis, many plan sponsors have experienced this directly.
Indeed, the 31 Dec 2011 Hueler Analytics Universe data show a return differential of 183 basis points (bps) between the three-year crediting rate of the top decile stable value portfolios at 3.84% and bottom decile portfolios at 2.01%. Historically, this difference was much smaller on average, but the underperformance of many fixed income managers in 2008 is only fully reflected in the crediting rates over time given the smoothing mechanism of the wraps. For comparison, note the difference in the 10-year crediting rate between the top and bottom deciles is 64 bps, including the most recent three-year period. In our view, many stable value options underperformed not only because of the broader market dislocations but also because some stable value managers have generally weak fixed income investment and risk management processes.
The 1.83% return advantage of the top-decile-performing stable value funds of the Hueler Universe is significant. This is why PIMCO believes fixed income management in a stable value option is such a crucial decision. Additionally, with the current year-over-year U.S. inflation rate as measured by the consumer price index in excess of 3%, those top-performing stable value portfolios did a better job of providing a real return for participants than poorly performing stable value portfolios.
Focusing on good capacity from good partners
We also recommend considering assessing the wrap contracts and wrap providers. First, we suggest assessing whether the wrap contracts in the stable value option are what PIMCO would call “good capacity” – that is, determine if the contract terms are fair and equitable, with investment guidelines that are not overly restrictive. This is important because the wrap contract’s terms will govern participants’ coverage when they need it most.
Unfortunately, we believe some wrap providers have taken advantage of the supply-demand imbalance of the last few years to push risk back onto plan sponsors and participants. Gaining access to new capacity should not be at the cost of accepting excessive contract risk through unfavorable terms or overly constrained guidelines.
We also prefer wrap providers that are good partners. Specifically, we prefer issuers committed to the stable value business and flexible enough to work with plan sponsors as their plans and the DC market evolve. Plan sponsors are under ongoing pressure to offer competitive benefits packages, which often means more choice and transparency, as well as increasing legal and regulatory scrutiny. It is therefore important that the wrap providers are relatively easy to work with, responsive to plan sponsor needs and committed to developing long-lasting relationships.
Stable value: all or none?
Some plan sponsors may feel they do not have access to 100% good capacity, all good partners or the fixed income managers of their choice. Yet these plans sponsors may not have to exit stable value entirely. There are alternatives, specifically two modified stable value solutions, which we call “stable cash” and “stable interest,” as shown in Figure 2.
Stable cash
“Stable cash” is a partially wrapped stable value solution with no expected principal volatility that aims for higher returns over time than a money market strategy. The goal is to obtain as much good stable value capacity from good partners as possible, using preferred fixed income managers, but the balance of the portfolio’s assets are then allocated to a money market strategy. The money market allocation sits ahead of the wrapped assets in the portfolio’s withdrawal order; this can help reduce wrap provider risk and, potentially, reduce provider contract constraints. It can also possibly increase the plan sponsor’s flexibility during employer-initiated events or increase the likelihood of gaining wrap provider approval for plan changes.
If a plan sponsor prefers, the stable cash structure can be designed to maintain a $1 net asset value (NAV), similar to a money market strategy. Figure 3 illustrates three blended hypothetical stable cash strategies, using historical returns of both the Hueler Universe as a proxy for stable value and the Lipper Index as a proxy for money market returns.
The end result for a plan that increased the targeted cash amount in a stable cash portfolio to 15%, 25% or even 50% could have been returns over the last 10 years that exceeded money markets but with less volatility.
Of note, a stable cash structure of 75% stable value and 25% money markets resulted in a hypothetical return of 3.59%, just a few basis points less than the Barclays 1-3 Year U.S. Government/Credit Index return of 3.63% over the same time period (as shown in Figure 1), but with about one-sixth of the volatility.
Stable interest
Like stable cash, “stable interest” is a modified stable value structure that seeks to maximize its allocation to good capacity with good partners. But instead of an allocation to a money market strategy, stable interest has an allocation to unwrapped bonds – generally a short or low duration bond strategy.
The unwrapped, marked-to-market allocation within the portfolio results in a NAV that may fluctuate, both up or down, on a daily basis. The type and amount of the unwrapped assets determine the portfolio’s overall volatility. The unwrapped fixed income allocation also sits ahead of the wrapped portion of the portfolio, providing many of the same potential benefits as the money market allocation in stable cash. One additional advantage to stable interest is more flexibility for the plan sponsor to keep the unwrapped assets with their preferred fixed income managers.
Figure 4 compares returns and risk for blended hypothetical stable interest strategies, using historical returns of the Hueler Universe as the proxy for stable value and historical returns of the Barclays 1-3 Year U.S. Government Credit Index as the unwrapped fixed income proxy.
Even with a surprisingly large allocation of 50% to the unwrapped fixed income strategy, only eight negative monthly periodic returns occured over the 10-year period ending 31 Dec 2011. Of the eight months with negative periodic returns, only one was lower than -0.25%, which was a monthly return of -0.34%.
In general, the hypothetical returns of the stable interest structure were higher than those of the stable cash structure, with the trade-off being a small amount of ongoing volatility in the portfolio’s NAV. Moreover, with a lower allocation of 25% to unwrapped assets in the stable interest portfolio, the hypothetical total return was 4.07%, significantly higher than the Lipper Index return of 1.72% over that same period but with slightly lower volatility of 0.46% vs. 0.49%.
In our opinion, either stable cash or stable interest strategies may be superior to accepting suboptimal contract terms, wrap providers or fixed income managers. Any of the blended allocations could likely have been achieved with fewer wrap providers than might be needed for full stable value implementations.
Beyond stable value: other DC conservative options
We recognize, however, that stable value is not for every plan. Some plan sponsors may find it does not offer meaningful benefits for participants, or the plan sponsor may decide to exit the asset class for other reasons. What, then, are the best alternatives?
In the past, plan sponsors have looked to money market strategies or low duration options. In the 2012 PIMCO DC Survey, most consultants said that plan sponsors looking to replace the stable value option would likely consider money market strategies. Today, however, money market strategies present a fundamental challenge as a true capital preservation option in a DC plan. Specifically, participants are facing a form of “financial repression,” meaning they are being forced to accept near-zero returns on short-term investments for a long period of time due to the Federal Reserve’s commitment to low short-term interest rates; with the CPI in excess of 3% recently, many participants may actually be losing purchasing power on an inflation-adjusted basis by investing in money markets. As for low duration strategies, they may provide a better alternative in terms of after-inflation expected return potential, but their additional volatility may be unappealing.
PIMCO believes a short-term bond strategy specifically designed and managed for the unique return and volatility demands of a DC plan may be a better solution because it can appropriately balance the short-term need for capital preservation and the long-term demand for real returns to maintain purchasing power. This is particularly true if the short-term strategy is tailored to meet the low-risk needs of DC participants. In fact, we believe short-term strategies modified for DC participants will play an increasingly important role in the future of capital preservation strategies within DC plans.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Stable value wrap contracts are subject to credit and management risk. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Diversification does not ensure against loss. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax questions and concerns.
This material contains hypothetical example for illustrative purposes only. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results.
The Barclays 1-3 Year Global Credit Index consists of publicly issued global corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. The Barclays 1-3 Year Government Credit Index is a market capitalization-weighted index including all U.S. government bonds with maturities greater than or equal to one year and less than three years. Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The Hueler Analytics Stable Value Pooled Fund Comparative Universe is a 23-year historical return series and is produced on a monthly basis. The Lipper Money Market Fund Index is comprised of funds that invest in high-quality financial instruments rated in the top two grades with dollar-weighted average maturities of less than 90 days. Lipper Fund indices are calculated using a weighted aggregative composite index formula that equal-weights the constituent funds and reinvests capital gains distributions and income dividends. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
©2012, PIMCO.
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The Buyers Have Left The House (Grant)
Friday, June 29th, 2012
Via Mark J. Grant, Author of Out of the Box,
“We are on strike against the morality of cannibals.”
-Ayn Rand
Slowly, surely the largest investors in the world are no longer buying the debt of Europe. Recently the Chinese sovereign wealth fund, China Investment Corp., said that they were done and would no longer be buying European debt. The institutional readers of “Out of the Box” number somewhat more than 5,000 money managers and I can report that one after another they are either seriously pairing back on their holdings or exiting Europe. The risks are just too great and the way Europe does business is also having a serious effect. You see, Europe does not count any contingent liabilities, sovereign guaranteed debt, derivatives, bank guaranteed debt, regional guaranteed debt or promises to pay for various entities as part of their calculation for their debt to GDP ratios. The CEO, CFO and the Board of Directors of an American corporation would go to jail for Fraud for operating in this manner but this is the devised scheme in Europe. This is also why it sets my teeth on edge each and every time I see some country brandishing their debt to GDP ratio in the press; it is just factually inaccurate or to be more succinct—it is a lie.
Let us consider what is happening with Bankia in Spain. The Spanish government’s bank fund has $7.40 billion left in its coffers according to the government. Bankia will require about $23 billion in recapitalization. Spain is floating the idea of guaranteeing Bankia’s debt so that Bankia can then pledge it to the ECB and get cash and since it is a guarantee and not a direct issuance of sovereign debt then Spain is waving the banner, and proudly, that it will not affect their debt to GDP ratio. There is a certain kind of madness about all of this and it is taking place in Spain, Portugal, Ireland, Italy, Greece, Belgium et al. What can clearly be said then is that the numbers we are given, the data that is flouted day in and day out as accurate is nothing short of a con game built on a Ponzi scheme that rests on the back of a financial system that has been purposefully designed to distort the truth.
Regardless of your opinion about all of this there are consequences to this type of manipulation that are in the process of becoming realized. Eventually, when hopes and prayers give way to reality, losses are taken and I submit that we are just at the beginning, just at the start, of seeing realized losses begin to hit balance sheets. A case in point would be Credit Agricole who reported that they had suffered a $3.4 billion loss because of their exposure to Greece, eliminated their dividend and watched the price of their stock sink to an all-time low which is down 72% on the year. Then with the new European bank scheme where regulators, not the judicial system, will decide just who will get what in the case of any bank impairment you can be sure, 100% positive, that the regulators will decide for the benefit of the State and the investor can go hang. While it is certainly true that many European institutions are coerced, forced may be more accurate, to buy the sovereign debt of their country or other European countries the sugar rush from the LTRO is waning while the rest of the non-coerced world is fleeing from European sovereign and bank debt like Floridians from a hurricane. To be sure markets have been gamed before but this is one bubble that will make the American financial crisis or the dot.com debacle seem insignificant in size when the moment comes that it is pushed past the point of redemption. The European nations and banks have performed a neat new trick, nailing themselves to the Cross, and it is now only for Pontius Pilate to pick up the spear and begin.
“He who created us without our help will not save us without our consent.”
-St. Augustine
Copyright © Mark Grant
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On Bond Ladders (Merkel)
Friday, June 29th, 2012
by David Merkel, Aleph Blog
I received the following from a reader:
My primary motivation for writing to you is this post by Jeff Miller:
In my mind, you are the foremost expert blogger when it comes to bonds so I wanted to get your take. It’s been a long time since my bond class getting my MBA and I haven’t dealt with bond math in quite awhile.
I’m wondering about this whole individual bond ladder versus bond fund issue. Maybe I am wrong so I wanted to ask you. Duration is duration. Whether one owns an individual bond ladder or a bond fund, if the duration is the same, the price sensitivity to an increase in interest rates is the same? If a person owns an individual bond ladder and rates move up, those bonds will be marked to market and show a capital loss even if they pay off at par at maturity, and you’ve locked in your cashflow. With a bond fund, you take a price hit to the fund, but those cashflows from the fund get reinvested in the fund at lower prices and higher yields?
I guess I am just wondering if someone is going to buy and hold and sit tight for say 5-7 years whether they construct a bond ladder or buy a bond fund if the duration is the same, they are going to end up pretty much in the same place 5 years later.
Anyways, I hope maybe you will do a post on the ins and outs of bond math vis a vis interest rate changes and the pros and cons of bond funds versus a bond ladder from the perspective of duration. Thanks.
From 1995-2001, I spent a lot of time doing interest rate modeling. With the growth in computer power and modeling techniques, we finally hit the barrier of the “Turing test” as far as interest rates went in 1995 with my modeling. As a part of our regular weekly meeting with the investment department, I brought examples of full yield curve interest rate modeling for a 30-year horizon. When I showed what the future yield curves looked like, the bond managers said to me, “This is the first time we have ever seen a random model produce interest rate scenarios that look reasonable.”
For a brief period, my model was the best that I knew of. By 2002 the actuarial profession as a whole came up with a better model, which they still use today for asset/liability management calculations. Once I used it, I accepted it as better than my model, and used it for other processes beyond regulatory compliance.
Regardless, I did tests using my model and the more advanced model to see what the best strategy was for individual investors in bonds. The only consistent result was that the ladder strategy was the second best strategy. Never best. Never worst. Reliable.
And I spent some time thinking about it. Structurally, ladders work well when you don’t know what is going to happen. If you are really, really smart, and you can consistently predict changes in yield curve steepness and levels, yes, you can do far better.
Ladders make sense from a cash flow standpoint because they are a sustainable strategy. Maturing proceeds are invested in the longest bonds that the ladder accepts. That keeps the interest rate risk even, and with a positively sloped yield curve, offers a relatively high yield.
I agree with the concept of ladders. But ladders are not incompatible with mutual funds. Over the years, I have run into mutual funds that embed a ladder concept into their interest rate management strategy, but it is far enough back in time that I can’t name any that do that now. In general, I think most bond mutual funds would be better off if they used some form of ladder to implement their interest rate strategy.
But to your question, yes, there is little difference, aside from fees, whether one owns a mutual fund with the same duration profile as a laddered portfolio. When you deal with short portfolios, the duration statistic is very descriptive of the interest rate risk.
If someone is looking to invest for many years, in the present environment, stocks may be the better choice, but if limited to bonds, choose a portfio that replicates the time horizon on average. Then as the horizon draws nearer, adjust to reflect the need for cash paid out.
That’s my best answer for now, though I am more than willing to answer other questions related to this.
Copyright © David Merkel
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Profit Margins (Bradley)
Friday, June 29th, 2012
by Tom Bradley, Steadyhand Investment Funds
There is lots to worry about these days. Rob Arnott, of fundamental indexing fame, talks about the 3D hurricane – debt, deficits and demographics.
As part of the hurricane, I’ve been questioning how sustainable U.S. corporate profit margins are, given that they’re near or at record highs. Relative to history, the shareholders are getting a disproportionate share of the spoils (in the form of profits) compared to company employees. (Note: Margins in Europe have recovered since 2009, but not nearly as much as in the U.S. Japan is … well … at the bottom of the heap.)
As a contrarian, I’m inclined to think the worm will turn one day and margins will come back to more normal levels, but I’m not so sure now. A recession would give revenues and margins a cyclical hit, but from a longer-term perspective, higher overall profitability may be here for a while.
Larry Lunn and the strategy team at Connor, Clark & Lunn Investment Management captured this theme in a recent research note: “… profit margins should hold up (new norm) because labour has little bargaining power (excess capacity), productivity is high due to technological innovation, and companies are globally mobile and they remain very cost conscious.”
In addition, I think continued industry consolidation will help maintain higher margins. As industries get down to a few leading players, there’s a greater chance of pricing discipline. The Canadian banks are a good example of this.
By definition, healthy profits bring with them new competition, but of all the things to worry about, margins have moved down my list. Quality companies will continue to get paid well for their goods and services.
Copyright © Steadyhand Investment Funds
Tags: Index Investing, Indexing
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Signposts to Rising Rates (Tucker)
Friday, June 29th, 2012
As interest rates continue to hit record lows, investors may get the feeling that they’ll never go back up again. In this short video, iShares Head of Fixed Income Strategy Matt Tucker outlines three of the factors keeping rates at rock bottom – and what it will take for them to finally begin to rise.
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What the Most Successful People Do Before Breakfast, and other Weekend Reads
Friday, June 29th, 2012
Happy Canada Day!
Here are this week’s reading diversions for your personal enlightenment. Have an awesome Canada Day weekend!
Foods Before Working Out: 10 Carbs To Eat Before And Post-Workout
Exercising on an empty stomach never quite feels right. When it comes to helping our bodies feel good before and after workouts, most of us would agree we should start with a healthy plate of food.
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What The Most Successful People Do Before Breakfast | Fast Company
Mornings are a great time for getting things done. You’re less likely to be interrupted than you are later in the day. Your supply of willpower is fresh after a good night’s sleep. That makes it possible to turn personal priorities like exercise or strategic thinking into reality.
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Tall women are more likely to develop ovarian cancer than their shorter friends, research suggests.
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Could caffeine transform the average nan into supergran? | Mail Online
Their study on mice revealed that caffeine boosted power in two different muscles in elderly adults – an effect that was not seen in developing youngsters.
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Foods For Vision: 6 Top Picks For Your Eyes
Here are six of the best foods for promoting eye health. Any favorites we forgot? Let us know!
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Having Your Coffee and Enjoying It Too – NYTimes.com
Coffee drinkers who were relatively healthy when the study began were less likely than nondrinkers to die of heart disease, respiratory disease, stroke, diabetes, infections, injuries and accidents.
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Heart Disease – 8 Surprisingly Bad Foods for Your Heart – MedHelp
Women who eat a lot of foods rich in refined carbohydrate like white bread, pizza and rice are twice as likely to develop heart disease as women who eat few of those foods, according to a recent study from Italy. The increased risk seems to be associated with carbs that are quickly absorbed into the bloodstream rather than carbohydrates on the whole, say the researchers.
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New Steps in Europe Lead to “Risk On” Again – How Long Will it Last?
Friday, June 29th, 2012
by Mark Hanna, Market Montage
Deep in the European night, some additional steps were agreed to in the multi year European crisis. While I’ll leave the heavy analysis to other sites, the big picture is there was an incremental win for the “Club Med” countries with a rescue fund (the ESM) being authorized to essentially be a “bad bank” if you will, in that it will inject money into troubled banks in return for shares. By being a shareholder rather than a bondholder it gets poor treatment in the capital structure in case said banks go belly up – hence takes on much more risk. In a way this sounds “TARP-ish”. The other bonus is that by using this method it bypasses the state government and puts the liability onto the ESM rather than say Spain or Italy itself – a big advancement. The ESM will also be able to buy sovereign debt directly.
It appears Spain and Italy banded together in negotiations and refused to go along with the 120B euro “stimulus” package until they got their way on this new form of bailout. As for said stimulus package the more I read about it, the less impressive it seems as all but 10% of the money has apparently already been committed – it sounds mostly like repackaging. Going back to the ESM situation, of course that rescue fund does not have unlimited resources like a central bank does, so in many ways it’s just a reshuffling of the debts with a finite amount of firepower but that’s good enough (for now) in these crazy headline driven markets.
Well telegraphed ahead of the meeting, was a move to a ‘banking union’ – in this case a central regulator for the continent’s banking system. This was also announced last night.
Via Reuters:
- Responding to pleas from Spanish and Italian leaders, a midnight summit of the 17-nation currency area agreed that euro area rescue funds could be used to stabilize bond markets without forcing countries that comply with EU budget rules to adopt extra austerity measures or economic reforms.
- After hours of argument, they also agreed that the bloc’s future permanent bailout fund, the European Stability Mechanism, would be able to lend directly to recapitalize banks without increasing a country’s budget deficit, and without preferential seniority status.
- Countries that requested bond support from the rescue fund would have to sign a memorandum of understanding setting out their existing policy commitments and agreeing a timetable. But they would not face the intrusive oversight of a “troika” of international lenders.
- European Council chairman Herman Van Rompuy said the aim was to create a supervisory mechanism for euro zone banks involving the European Central Bank to break the “vicious circle” of dependence between banks and sovereign governments.
- Euro zone leaders will return on Friday to discuss longer-term plans to build a much closer fiscal and banking union, on which they asked Van Rompuy and the heads of the European Commission, ECB and Eurogroup finance ministers to present detailed proposals by October.
Not surprisingly, once announced, world markets went into a tizzy as they do each time these grand events happen. Of course as we’ve seen over the past few years, each announcement seems to have less and less effect so we need to see how ‘lasting’ this one has. Do Spanish and Italian bond yields fall substantially and on a permanent basis? Or after the knee jerk reaction – however long it is (hours/days/weeks) are we back to a new leg of the Euromess. With trillions in sovereign debt and a rescue bucket that “only” has hundreds of billions (500B euros) there appears to be a mismatch in demand v supply, but we’ll see how it plays out in the coming weeks. Market participants want the ECB to go all the (Ponzi) way and turn into the Fed with unlimited buying power behind the EU debt market – Europe is not there yet. The other option is turning the ESM into a “bank” (banking license) and hence allowing it to lever up, borrow from the ECB, and then do all the buying – which is essentially nothing more than the ECB going full monty as a buyer of debt but by using the ESM as the middleman.
As for the market from the lows around 2:30 PM yesterday to the opening print this morning will be a head spinning reversal. The S&P should be back into the 1340s and we’ll be in the upper third of the recent range. As long as today’s move holds I believe this will be a third follow through day during this 3 month correction (and second in a few weeks!). If it happens, psychologically it will be easy to doubt this one since there is recency bias and the last one failed so quickly, so maybe it will be the one which sticks. Ironically, as I wrote yesterday, this is happening just as almost every group has now been washed out as the last holdouts (high growth consumer discretionary) were pulverized this week. Hence we have broken charts everywhere – but to be fair that was the case in late 2011 as well.
Outside of Euromess, we’re still left with all the macro economic weakness and corporate earning issues – and a holiday week of trading coming around the bend. Never a dull moment.
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