High-Yield Bonds—Extra Income, But Added Risk

Friday, June 8th, 2012

by Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research

Key points:

• In a world of low interest rates, high-yield (or sub-investment-grade) bonds can be a source of added income in an individual investor’s portfolio. The yield on the Barclays U.S. Corporate High-Yield Bond Index is currently 8.2%—more than double the yield on the Barclays U.S. Intermediate Corporate (investment grade) Bond Index and more than 7.0 % greater than US Treasury bond yields of comparable maturity.¹
• Over the past few years, improving economic growth and easing strains on financial markets have resulted in strong returns in the high-yield market.
• With interest rates on Treasury bonds near 40-year lows, higher coupon-interest payments have been especially valuable during the past few years. When reinvested, the compounding of interest income can help reduce volatility in a portfolio.
• However, extra yield comes with added risk: Companies that issue high-yield bonds are, by definition, less credit-worthy than investment-grade companies and are therefore more likely to default. In addition, the market for high-yield bonds is less liquid than for other types of bonds, and high-yield bonds tend to be more correlated with the stock market than with Treasury bond prices, potentially changing the overall diversification of your portfolio.
• We advise limiting the amount of aggressive income investments in a fixed income portfolio to 20% to help reduce potential volatility and losses.

With the Federal Reserve holding US Treasury yields near 40-year lows, investors seeking income often expand their search for higher yields into riskier sectors of the bond market. One such sector is high-yield bonds, which are rated below investment-grade because companies issuing them are less credit-worthy. The issuers may have more balance-sheet debt and weaker earnings power, and/or they may do business in more-volatile sectors of the economy, making their earnings less predictable.

Lower Credit Quality Corresponds with Higher Default Rates

Source: Schwab Center for Financial Research, with data from Standard & Poor’s 2011 Global Corporate Default Study. The study analyzed the rating and default history of 14,654 US and non-US companies first rated by Standard & Poor’s between December 31, 1981 and December 31, 2010. The 15-year cumulative average default rate is calculated by weight-averaging the marginal default rates in all static pools. Past performance is no indication of future results.

Because of these risks, less-credit-worthy companies must offer higher yields than those offered on investment-grade bonds. As of May 31, the yield on the Barclays U.S. Corporate High Yield Bond Index—where the average maturity is four years—is 8.2%, compared to 2.8% for the Barclays U.S. Intermediate Corporate (investment grade) Bond Index, with an average maturity of 5.3 years.

Over the past 25 years, the average ratio of the high-yield index yield to investment-grade was 1.74 compared to the current ratio of 2.92. This higher-than-average ratio implies that the market is pricing in a higher degree of risk in high-yield bonds than the historical average despite the fact that default rates for high-yield issuers are currently below the long-term average.

Default rates among high-yield-bond issuers have declined since the peak of the financial crisis, and the ratio of upgrades to downgrades within the sector has improved. The most-recent figures from Moody’s indicate that average default rates are running at 2.2%, below the long-term average of 5.6% and significantly below the recent peak levels of 17.1% in 2009.

As the chart below illustrates, the high-yield market can be volatile. During times of financial distress such as the financial crisis in 2008-2009, or in the aftermath of the technology-stock bubble bursting in 2000-2001, yields spiked sharply higher—with prices declining steeply. When financial markets are under stress, liquidity can be scarce—both for companies seeking loans and in the high-yield market itself, as buyers retreat.

Recent improving financial conditions, as shown by the decline in the St. Louis Financial Stress Index, have been supportive of the high-yield bond market. (The St. Louis Fed’s index is comprised of indicators such as interest-rate yield spreads and volatility indexes that measure ups and downs in the financial sector of the economy.)

St. Louis Financial Stress Index Versus Barclays High Yield Index

Source: Barclays Database and St. Louis Federal Reserve Bank, monthly data as of April 2012.

To some extent, the high-yield bond market has been experiencing a positive cycle. As interest rates have fallen and economic conditions have improved, companies have been able to refinance debt at lower levels, which has improved the measures of their financial performance. As those measures improve, investors seek out the bonds, pushing yields lower, which in turn allows for more refinancing.

Income is important

A potential benefit of high-yield bonds in the current environment is the relatively high level of coupon income. It’s obviously helpful for investors looking to use that income to meet expenses, but it can also be beneficial when reinvested, because it can help dampen volatility in an overall portfolio when interest rates rise. In a rising-rate environment, higher-coupon bonds tend to decline less than bonds with lower coupons because the current income can be reinvested at higher interest rates, all else being equal.

Tags: Barclays, Bond Market, Corporate Investment, ETF, ETFs, Extra Income, Fixed Income Portfolio, High Yield Bond, High Yield Bond Index, High Yield Bonds, Income Investments, Individual Investor, Interest Income, Interest Payments, Investment Grade Bonds, Low Interest Rates, Risk Companies, Sectors Of The Economy, Treasury Bond Prices, Treasury Bond Yields, Treasury Bonds, Treasury Yields
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Abnormal Returns: “There Has Never Been a Better Time to be an Individual Investor”

Thursday, February 23rd, 2012

Tadas Viskanta is the founder and editor of the finance blog Abnormal Returns. Tadas has over twenty years of professional experience in the financial markets. He is also the author of the forthcoming book, Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere.

~~~

There has never been a better time to be an individual investor.

Said another way one could argue that we are in the golden age of the individual investor.  That might seem like an odd thing to say coming off what some people call a ‘lost decade for stocks.’  However over that same time period the technological advancements that made Web 2.0, like Facebook, Twitter and LinkedIn, possible have also led to unprecedented opportunities for investors not previously seen.

We are for the moment leaving aside the state of the markets at the moment.  We could have written this same post a couple of months ago when the stock market was 20% lower.  We are also leaving aside the issue of whether the zero interest rate policy of the Federal Reserve represents a “war on savers” or is simply the byproduct of necessary policies.  The failure of MF Global and the systemtic risks it poses for all account holders are also outside the scope of this post.

This is not a novel theme for us.  Indeed one thing we note in our forthcoming book, Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere, is that investing has never been “cheaper or easier.”  Some of this has to do with the rise exchange traded funds.  In other respects it has to do with the blossoming of the options markets.  In large part, it has to do with technology.  In short, never before have investors had access to data, analysis, opinion and social tools that are commonplace today. Let’s take these points one by one.

1. Easier:  Investors today can with a brokerage account and a computer is now only a few mouse clicks away from a globally diversified portfolio of ETFs that in terms of expenses rivals what institutions paid a decade ago.  For all intents and purposes the expense ratio on the big ETFs is closer to 0.0% that 1.0%.  Many brokers now allow online trading of individual bonds and overseas securities.
2. Cheaper:  Brokerage commissions continue to get driven towards $0 over time.  In fact, many brokers today provide commission-free trading of a range of ETFs.  Options strategies that would have been cost-prohibitive a few years ago are now viable strategies today.  Do you remember when you used to have to pay extra for real-time quotes?  Today those are a commodity.
3. Richer:  The range of asset classes, sectors and strategies available via ETFs is truly dizzying.  It is even for interested parties hard to keep up.  Will most of these more exotic strategies fail?  Probably.  But sometimes a strategy, like low volatility investing, that is based in deep academic research, becomes available to investors.
4. More social:  Blogging and microbloggging (StockTwits & Twitter) has opened up the world of idea generation to the masses.  Anyone with a computer these days can put their ideas out there.  The blogosphere and Twittersphere is a meritocracy, albeit imperfect, where the smartest and most generous contributors rise to the top.  The social model is pushing into things like earnings estimates with Estimize and institutional-grade services like SumZero.  Many bloggers these days make fun of the raft of ‘free’ webinars that go on these days.  But if you think about it the software and Internet speeds were not there to make mass online seminars possible not all that long ago.
5. Smarter:  The raw material for investment analysis and trading is of course data.  Financial and price data is for the purposes of most individual investors is free these days.  Many firms are using data in interesting ways.  In the area of fundamental data some firms like Trefis and YCharts are making fundamental analysis easier.  A firm like AlphaClone allows you track the moves of (and invest) like the big hedge funds.  When it comes to portfolio level data firms like Wikinvest are aggregating account data making analysis easier for investors.

Most of the above discussion focuses on do-it-yourself investors.  However on the managed portfolio front things are changing for the better as well.

1. Brokers vs. RIAs:  The wirehouse brokerage model is going the way of the dodo bird.  Brokers and their clients now recognize in increasing numbers the conflicts inherent in that model.  Brokers are going independent as registered investment advisors in order to provide their clients with a conflict-free model.  That does not necessarily mean they are going to generate above-market returns, simply that these firms are no longer working at cross-purposes to their clients.
2. Online access to managers:  Not only is the fee-only model taking hold.  It is taking hold online in a big way.  If you can eliminate, to a degree, the human element inherent in portfolio management you can also reduce the end cost to the investor.  Some firms that are operating in this space include:  Wealthfront, Personal Capital, Covestor and Betterment.

In the New York Times this past weekend there was an article talking about the many changes we are seeing through the analysis of “big data.”  The applications of big data has taken hold faster in the world of personal finance, like BillGuard, than it has in investing.  However one can easily see how access to data on individual trading decisions could make for an interesting recommendation engine.  In the end, more algorithmic investment tools and services coming one way or another.  The fact is that a simple, well-designed algorithm can do a better job of managing in real-time a portfolio than the vast majority of investors or investment advisors.

In many ways the automation of much of what constitutes investing today will be a godsend for investors.  The majority of investors really don’t want to manage their own portfolios.  Not do they a hyper-personalize portfolio.  An algorithmic service that managed in a low-cost fashion portfolios it would allow those investors to focus on the things over which they have some control.  The stuff of truly personal finance like:  savings rate, lifestyle choices and retirement options.

Sometimes in the midst of volatile markets we can forget just how far things have come.  Just a few years ago who thought you could trade a leveraged on $VIX futures.  But today you can.  Who would have thought you could buy an ETF for the Egyptian market, but you can.  However this example points out the double-edged sword that is today’s markets.  Now we do have access to all manner of investment and trading vehicles.  However like any tool these vehicles need to be used responsibly.  The vast majority of investors should likely take a pass.

The reason is that despite the many technological advancements we have seen in investing our brains are still largely hardwired for an age of scarcity.  That is why so many of the behavioral biases we have accumulated over time work against us when it comes to investing.  That is why we consistently buy high and sell low, i.e. the behavior gap.  That is why we oftentimes only seek out (and recognize) that information that conforms to our long held beliefs, i.e. confirmation bias.  In the end the most difficult hurdle to investment success is not the market environment or the range of investment vehicles, it is us.

So despite the advances we have seen, most investors would be well-served in investing in a low cost, globally diversified portfolio which they systematically rebalance and occasionally revisit.  The upside is that this sort of investment process is, as we said, now cheaper and easier than before. In the end no one knows what the markets will do, but the vast majority of investors can do more by doing less.

The full application of technology to the investment world will simultaneously open up novel areas of investment for adventurous investors and simplify the mechanics of portfolio management for the average investor.  Investors have to choose which path they will follow.  They simply need to recognize that their own, somewhat flawed brains, are coming along for the ride.

*I know I have likely omitted some very cool startups in the investing and personal finance space.  This is not meant to be a comprehensive accounting of the field.  Feel free to include in comments any interesting firms in this space.

(H/t: Barry Ritholtz)

Tags: Abnormal Returns, Access To Data, Better Time, Blogosphere, Brokerage Account, Byproduct, Exchange Traded Funds, Forthcoming Book, Frontlines, Individual Investor, Interest Rate Policy, Mf Global, Necessary Policies, Options Markets, Professional Experience, Same Time Period, Technological Advancements, Twitter, Unprecedented Opportunities, Zero Interest
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Investor Sentiment: It Cuts Both Ways

Wednesday, December 28th, 2011

The article below is a guest contribution by Guy Lerner, writer of the Technical Take blog.

Most market participants use investor sentiment as a contrary tool. Gauge which direction the majority of investors are leaning and bet against them. But there are times when it doesn’t pay to bet against the herd. There are times when too many bulls is a good thing as in “it takes bulls to make a bull market”. So here we have the SP500 closing above the much watched 40 week moving average, and I am sure many an investor is trying to gauge the significance of such a milestone in this seasonally positive time of year when trading volumes have shrunk. So this technical event must mean something?

Yes, it means that the SP500 has now been above the 40 week moving average only twice in the past 20 weeks. Does it mean that the market is on the cusp of an explosive move higher? If the market is, don’t tell investors because they haven’t gotten the message yet. And that is really the trouble with this market – there are neither bears or bulls out there. If the market is really going to move higher in a meaningful way, I would think that we would begin to see the “it takes bulls to make a bull market” scenario (i.e, too many bulls) unfold as prices move higher. This is how new trends start, but instead we are just seeing ehhh.

So if this price move is for real and if the pending recession (see here) is going to be thwarted, then I would expect to see buyers. Sentiment cuts both ways sometimes; having a lot of bulls could be a good thing. For now, I remain bearish, and I gave my reasons nearly 4 weeks ago. Despite the passing of time and the expected holiday rally, little has happened to change that opinion.

The “Dumb Money” indicator (see figure 1) looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investors Intelligence; 2) MarketVane; 3) American Association of Individual Investors; and 4) the put call ratio. This indicator shows neutral sentiment.

Figure 1. “Dumb Money”/ weekly

Figure 2 is a weekly chart of the SP500 with the InsiderScore “entire market” value in the lower panel. From the InsiderScore weekly report: “As of 12/21/11 – Sentiment moved from a Sell Bias to Neutral as buyers outnumbered sellers – albeit by the slimmest of margins – for the first time in three weeks. The main sentiment driver was a decrease in selling, as the number of sellers fell nearly -23% week-over-week versus a 7% increase in the number of buyers. The Consumer Discretionary and Energy sectors showed the greatest improvement in sentiment, with a drop in selling again being the main cause. There continues to be a fair amount of actionable buying and actionable selling and with no sector showing a particularly strong signal in either direction we find company-level activity most compelling.”

Figure 2. InsiderScore “Entire Market” value/ weekly

Figure 3 is a weekly chart of the SP500. The indicator in the lower panel measures all the assets in the Rydex bullish oriented equity funds divided by the sum of assets in the bullish oriented equity funds plus the assets in the bearish oriented equity funds. When the indicator is green, the value is low and there is fear in the market; this is where market bottoms are forged. When the indicator is red, there is complacency in the market. There are too many bulls and this is when market advances stall. Currently, the value of the indicator is 58.72%. Values less than 50% are associated with market bottoms. Values greater than 58% are associated with market tops.

Figure 3. Rydex Total Bull v. Total Bear/ weekly

Let me also remind readers that we are offering a one-month free trial to our Daily Sentiment Report, which focuses on daily market sentiment and the Rydex asset data. This is excellent data based upon real assets and not opinions.

Source: Guy Lerner, Technical Take, December 25, 2011.

Tags: Bulls, Cusp, Dumb Money, Explosive Move, Extremes, Figure 1, Guy Lerner, Individual Investor, Investor Sentiment, Market 1, Market Participants, Market Scenario, Market Sentiment, Marketvane, Moving Average, New Trends, Passing Of Time, Price Move, Recession, Time Of Year
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What a (Cash) Drag: Institutional Investors and ETF Cash Equitization

Thursday, July 28th, 2011

By Kevin Feldman, CFP, iShares

How institutional investors handle “cash drag”- and how you can, too.

I recently blogged about a report from Greenwich Associates that showed institutional ETF usage is on the rise.  One of the primary ETF strategies in that space?  Cash equitization, an approach that’s little-used (and perhaps even little-known) in the individual investor realm.  Reading through the report and all the subsequent media coverage got me thinking – why aren’t more retail investors using ETFs to equitize their cash?

At first glance, cash equitization using an ETF is pretty straightforward.  As opposed to carrying a significant cash position, an investor simply selects an ETF that closely approximates their target risk and asset class exposure to remain invested in the market. Typically institutional investors will implement a cash equitization strategy when cash is on the sidelines and waiting to be put to work. For example, at times large institutional clients are transitioning between managers or doing a search for a new manager in a particular asset class.  Rather than risking underperformance through “cash drag” (deviation of returns from a benchmark’s returns due to cash holdings), the institution will invest in an ETF with similar asset class exposure as an interim solution.

Institutions have been using ETFs for cash equitization since, well, the beginning.  In fact, when ETFs first came on the scene, they were mostly perceived as institutional products – and some of those institutions were getting their feet wet with the products by using them for cash equitization.  The largest and most liquid ETFs lend themselves to this practice because there’s now a wide variety to choose from, total costs are generally very low for short holding periods, and typically they’re easily traded throughout the day.

So why do institutions want to avoid cash drag, and how does their reasoning apply to individual investors?  Likely one of the biggest reasons an institution would choose equitization over holding cash is that they believe market returns will be positive over time (that’s why we invest, right?).  Both equities and bonds have experienced strong performance as of late (the S&P 500 Index was up 30% over the past year as of 6/30/2011).  Conversely, interest rates on many cash vehicles are near 0% at the moment, so portfolio cash may actually be earning negative real returns after inflation is taken into account.  And although cash holdings can reduce risk in the form of portfolio volatility, they can “drag” on returns in up markets.

In addition, the case for cash equitization can be even stronger in an institutional bond portfolio than in its equity counterpart.  For one thing, income from bond holdings naturally increases cash levels more than in an equity portfolio, making the portfolio more susceptible to cash drag.  And since a key component of a fixed income portfolio is often to invest in income-generating securities, the low yields on cash can work against that strategy.  When an institutional bond fund wishes to reduce its cash holdings and employ a cash equitization strategy, ETFs offer a compelling solution with an assortment of criteria to choose from such as yield, maturity, credit quality, and sector in order to match specific investment objectives and risk tolerance levels.

How does this apply to individual investors?  Well, they might have a certain amount in cash that they already know is eventually destined for the market, but that they just haven’t gotten around to investing yet (this is obviously much different than cash that’s been earmarked for savings or expenditures).  The “institutional approach” might be to consider using an ETF to get that cash off the sidelines and out of its zero- or near-zero-yielding account and into the market (if that’s where it’s headed eventually) to manage your own personal cash drag.  Keep in mind that investing in an ETF has much higher risks associated with it than investing in cash, so investors should consider their own risk tolerance and return objectives before entering the market.  Additionally, investors should work with their financial advisor and tax planner to determine if the costs of moving in and out of an ETF position and possible tax consequences outweigh the overall cash drag on their portfolio.

Past performance does not guarantee future results.

Buying and selling shares of ETFs will result in brokerage commissions.  There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

Bonds and bond funds will decrease in value as interest rates rise.

Copyright © iShares Blog

Tags: asset class, Benchmark, Cash Equitization, Cash Position, Cfp, ETFs, First Glance, Greenwich Associates, Holding Periods, Individual Investor, Institutional Clients, Institutional Investors, Institutional Products, Institutions, Interim Solution, Ishares, Media Coverage, Retail Investors, Sidelines, Target Risk
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Bonds and Bond ETFs: Related But Different

Monday, July 4th, 2011

by Vikash Jain, ArcherETF

Exchange-traded funds holding bonds offer cheap, efficient access to bond markets that, for individual investors, can be illiquid and expensive to trade. No surprise then that they are among the most favored of all ETFs in Canada. However, bond ETFs are not bonds. They behave differently and that has implications – good and bad – for investors.

Three of Canada’s biggest ETFs – by assets under management – hold bonds. All three are from the iShares family: the DEX Short Term Bond Index Fund (XSB-TO) with nearly $2 billion in assets; the DEX Universe Bond Index Fund (XBB-TO) with about $1.5 billion and the DEX All Corporate Bond Index Fund (XCB-TO) with about $1.3 billion.

The first difference between single bonds and bond ETFs is credit risk, better known these days as “Sino-Forest”. The typical bond ETF has hundreds of holdings. XCB, for example, has 148 individual issuers, with the big five banks accounting for about 25% of its allocation. XBB and XSB, with government bond allocations of more than 60%, offer even better credit quality, though at the expense of yield.

Sino-Forest aside, generally, when you buy a quality bond you can reasonably expect to get your principal back plus interest, as long as you hold it to maturity. While you hold it, the bond gradually ages and, every day, its price moves in response to changing interest rates. But, as an individual investor holding to maturity, you can ignore all that.

Not so on a bond ETF. You cannot hold a bond ETF to maturity because they do not age (I’m envious!). XSB is always about 2½ years from maturity, XCB and XBB are about 5 and 6 years away. The ETF manager regularly refreshes the portfolio by selling bonds as their time to maturity moves out of the target range. As they refresh, the ETF price moves with interest rates, rising as they fall and vice versa.

On the flipside, unlike a bond’s locked in coupon yield, the yield on the bond ETF moves roughly in step with market interest rates. Your expectation of where interest rates are going will determine which bond or bond ETF you buy.

After Wednesday’s 3.7% inflation reading, the chances are a rate hike will come sooner rather than later. However, at archerETF, we believe that a hike will impact prices of mid-term – that is 5 to 8 year – bonds more than it will shorter and much longer dated bonds. In other words, the yield curve will flatten out, with short and mid-term rates rising more than longer-term rates.

Interest rate changes affect bonds with longer term more. Another metric for evaluating bonds is something called duration: it is simply the term adjusted by the present value of the bond’s coupons. A bond with 10 years to maturity paying a 5% coupon would have a duration of about 8 years. An interest rate increase of 1 percentage point would cause the price of that 10-year bond to fall about 7.5%. An equivalent 5-year bond would fall about 4.25% and a 2-year by about 1.86%.

Based on our view, our bias is to hold short-term and long-term maturities so we hold XSB but avoid the mid-term XBB and XCB for now. For the long-term exposure, we use other instruments.

If the short-term rate rises significantly, as we believe, the shorter duration will lessen the price impact on the ETF. As for the longer maturities, though they have a longer duration, we expect their smaller increase in rates will keep prices from falling too much. In the meantime, we will benefit from their higher yield.

XSB is well diversified and highly liquid. The only complaint is its fee: at 0.27%, it seems a tad rich for an indexed bond ETF but still much less than the mutual fund equivalents. Even then, I hope, as more ETF competitors arrive in Canada, we’ll see this price come down.

The archerETF Global Tactical Portfolio

archerETF offers Global Tactical Portfolio Management.

Our outlook is Global: we invest across countries, sectors, commodities and other asset classes to improve returns. Our management is Tactical: we strive to select the right opportunities at the right times in response to changing market conditions to manage and minimize portfolio risk.

Please call us at TF 1-866-469-7990 for more information.

Tags: Assets Under Management, Bond Index, Bond Markets, Canada Bonds, Canadian Market, Commodities, Corporate Bond, Credit Quality, Credit Risk, Etfs In Canada, Exchange Traded Funds, Flipside, Government Bond, Index Fund, Individual Investor, Individual Investors, Price Moves, Quality Bond, Single Bonds, Sino Forest, Target Range, Term Bond
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The Fear and the Flight of the Individual Investor

Tuesday, August 17th, 2010

This article is a guest contribution by Dr. Charles Lieberman, Chief Investment Officer, Advisors Capital Management.

Date:  8/16/2010

Individual investors are gone from the equity market more so than any time in decades, pushed out by poor returns, unfathomable volatility, and concern and disillusion with the political and economic environment. Instead, investors have turned to bonds, as they seek safety and the return of their capital ahead of investment returns. This search for safety will prove counterproductive and investors will get hurt down the road once the economy recovers. Their flight from stocks has made the equity market the place to be for the foreseeable future, although only those with some staying power will reap these benefits.

The flight to safety is demonstrated most clearly by the flow of investor funds into bond funds and bonds. IBM recently issued a $1.5 billion 3-year note to yield 1.0%, one-half the yield on its common stock. This contrast indicates in the starkest terms that many investors prefer that they get their capital back in three years, even if they earn almost nothing on that investment, rather than risk capital loss by buying the common stock. U.S. Treasury TIPs, which protect investors from inflation, yield zero in the 5-year maturity range. So, some investors are forgoing all return, if they can keep their capital inoculated against inflation over this term. Just as impressive is last week’s Johnson & Johnson issue of 10-year notes at 3.15% in contrast with the 3.7% yield on its common. It is very likely that the stock investor will earn a return that is a multiple of the return earned on these bonds over a ten year horizon.

This preference for bonds over stocks is not restricted to just high quality borrowers. High yield bond issuance so far this year has already exceeded $155 billion, versus a record $163.6 raised in calendar year 2009. So, last year’s record level of issuance will be exceeded by a considerable margin. August issuance is normally quite light, but $21.1 billion has already been brought to market. In fact, when we speak to bond dealers in our effort to buy bonds for our clients, finding attractive paper is hard and we have been forced to become very selective in our picks. In contrast, we can easily sell anything we own. We have also heard that bond funds have had to sacrifice their ability to be selective, because so much cash is pouring in, they must buy almost anything available to avoid sitting on mounds of uninvested cash. How did we arrive at this point?

Investors are clearly seeking safety. Their concerns may be motivated by fear that economic growth might lapse, that the Washington political process is so polarized that good policy is hard to win approval, while foreign policy is also fraught with unusual dangers. In truth, I can think of any period in my entire investment career when the outlook has ever been clear and there werent major concerns. Uncertainty has always been high.

The economic outlook is “unusually uncertain”, as suggested by Fed Chairman Bernanke, a rhetorical flourish that supports current apprehension. Looking back, I recall forecasts of a double dip recession in every single recovery I have lived through, even though not one ever flamed out. People are always nervous that bad times will come back. That history notwithstanding, a double dip recession forecast has become fashionable, once again. However, the data suggest that growth has slowed in 2010, not that a second recession has started or is even likely. Companies have refinanced themselves with enormous volumes of debt and equity issuance. Public companies are sitting on about $1.7 trillion in cash, S&P 500 companies are sitting on about $1trillion, profit margins have widened very sharply and profits and cash flow are quite robust. Analysts have been caught up in this atmosphere of caution and companies keep exceeding and raising their profit forecasts above that of analysts. The typical company has too much cash and needs to figure out how to use this asset more productively than earning a few basis points. Companies have been investing in new equipment and technology in their effort to improve competitiveness, but despite this sizeable rise in capital investment, retained profits exceed investment, so the cash hoard keeps getting larger. So, acquisition activity has picked up and most firms have used cash to finance these deals. It is hard to see the basis for a significant retrenchment in the corporate sector under these conditions.

The health of the banking system is also greatly improved. Late in 2008 and early in 2009, there were reasons to fear that the entire financial system might unravel, severely damaging the overall economy. After the failure or near failure of Lehman, Bear Stearns, AIG, Fannie Mae and Freddie Mac, a financial collapse was not a farfetched possibility. Instead, the banking system was recapitalized, bad loans were written off, and government loans have been largely repaid. Yes, borrowers are not borrowing, but this has as much to do with the flush condition of the corporate sector as it does with the caution of bankers to lend. Good projects can get financing, as is easily demonstrated by the extraordinary low rates available in the bond market.

Tags: Bond Funds, Bond Issuance, Capital Management, Chief Investment Officer, Common Stock, Disillusion, Dr Charles, Economic Environment, Foreseeable Future, High Yield Bond, Individual Investor, Individual Investors, Investment Returns, Investor Funds, Lieberman, Maturity Range, Risk Capital, Staying Power, Stock Investor, U S Treasury
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Not All Oil and Gas ETFs are the Same

Wednesday, August 4th, 2010

While there are numerous compelling reasons to invest in natural gas and crude oil exchange traded funds (ETFs), for buy and hold investors, returns can be diminished in a market environment known as contango. Contango exists when the price of future delivery is higher than the spot price. For an investor using futures there is no way to eliminate the impact of contago on returns, however using ETFs that track a deferred futures contract can reduce this structural decay.

In order to avoid taking actual delivery of crude oil or natural gas, many ETFs that track these important commodities need to roll over their contracts on a regular basis. If you’re an investor in oil for example, while the price of spot crude oil may increase, it will generally have to increase by more than the premium paid on the next month’s futures contract (the rollover contract) in order for the ETF to increase in value at the time the contracts roll over.

It is almost impossible for an individual investor in the futures market to eliminate the effects of contango – there is no free lunch in commodity investing. Contango takes into account several factors including, where applicable, storage costs for the physical commodity. Any mispricing between the spot price of a physically held asset and a futures contract is generally eliminated by market arbitrage.

ETFs that track the price of crude oil futures are designed to be a convenient and cost effective means to access the futures market for investors, limiting risk to the amount invested and not subjecting investors to margin calls.

Minimizing contango with deferred futures contracts

As an example, the following chart shows that at end-of-day trading on June 25, 2010, investors would have to pay roughly a 57 cent premium to buy the next month futures contract in crude oil. As the chart shows this is quite a low premium based on recent trading activity. Earlier this year, the premium to roll over into the next month’s contract was nearly $5.00.

Historical premiums for 1 month crude oil contract

Compare that to the premium paid to rollover the Winter-Term NYMEX® Crude Oil Contract which is tracked by the Horizons BetaPro Winter-Term NYMEX® Crude Oil ETF (TSX: HUC). HUC provides exposure to the Winter-Term NYMEX® Crude Oil con­tract which expires in December of each year. HUC rolls its posi­tions in this contract every June over several days. This annual roll can greatly diminish the premium the investor pays to have long term exposure to crude oil prices.

The chart from Bloomberg below highlights the premium that would have been paid to roll into the December 2011 crude oil contract. An investor would have been required to pay a pre­mium of $2.86 – a substantially higher premium than the near month contract rollover, however this is a one-time charge. HUC will not pay any premiums to roll over to another contract for 12 months. The investor could take that $2.86 premium and divide it by 12 to determine the monthly premium paid through the course of the contract.

Tags: Arbitrage, Canadian Market, Commodities, Crude Oil Futures, Day Trading, ETF, ETFs, Exchange Traded Funds, Futures Contract, Futures Contracts, Futures Market, Individual Investor, Market Environment, Natural Gas, oil, Oil and Gas, Oil Exchange, Physical Commodity, Price Of Crude Oil, Price Of Crude Oil Futures, Several Factors, Storage Costs, There Is No Free Lunch
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Technical Talk: Buying Power Argues for Contained Correction

Friday, January 29th, 2010

The comments below were provided by Kevin Lane of Fusion IQ.

As seen in the chart below, individual investor allocations to equities have only recently moved back above its 21-year mean allocation of 60%. The massive under-allocation to equities in late 2008 into the 2009 low was one of the major reasons we became so bullish on stocks since it suggested that selling was washed out of the market and massive liquidity (aka – buying power) was built up ready to buy back into stocks.

That said we have seen assets rotate back to equities over the last 10 months and the market, being a liquidity driven animal, has responded accordingly. Currently investors have only a slight overweight to equities at 4.0% above the 21-year mean or stated another way investors are now 64.0% allocated to equities versus the 21-year mean of 60.0%. This is one reason why we continue to believe that after a bit of a correction stocks can move higher as investor liquidity is not tapped out yet.

While not as ample as near the lows buying power remains adequate to power/move stocks higher and keep corrections fairly well contained.

Source: Kevin Lane, Fusion IQ, January 28, 2009.

Tags: Allocations, Assets, Fusion, Individual Investor, Investors, Iq, Kevin Lane, liquidity, Lows, Market Driven, Move Stocks, Overweight, Power Move
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Technical talk: Sentiment review

Friday, April 10th, 2009

The comments below were provided by Kevin Lane of Fusion IQ.

Secular liquidity, a.k.a. buying power, as seen through the eyes of current individual investor allocations relative to historical norms, shows ample liquidity on the sidelines and in cash. Current levels approximate liquidity seen at the 1990 and 2002 lows, which continues to suggest that there is probably enough liquidity to keep moving stocks higher in this snapback/bounce.

When combined with incredibly negative investor expectations, no alternative for return in fixed income, and the principles of mean reversion at work and moving higher with some volatility, pullbacks (possible retest of lows) and consolidation are a reasonable expectation still. Remember, continue to watch how stocks act on bad news. When they rally on bad news, not only does it suggest investors are looking over the valley, but it also suggests liquidity is more than sufficient to absorb the selling.

Granted, after a 25% rally off the lows and stiff resistance in front of us near 850 (S&P 500), it won’t be an easy climb. The reason it is never an easy climb off the lows is because at every level higher on an index, pockets of under-water investors (i.e. losing money positions) can sell at break-even prices. Nonetheless these indicators suggest we can move higher over time. We will continue to monitor for changes that would suggest this argument no longer holds true.

Shorter-term sentiment measures such as Put/Call ratios and AAII Bearish Sentiment Survey, which were decidedly bullish for the market several weeks ago via their bearish readings, have moderated but are not yet at levels that would be construed as a negative.

Click on the graphs for larger images.

Source: Kevin Lane, Fusion IQ, April 9, 2009.

Tags: Allocations, Bad News, Bearish Sentiment, Expectation, Fixed Income, Individual Investor, Investor Expectations, Iq, liquidity, Lows, Mean Reversion, Norms, Pockets, Pullbacks, Ratios, Retest, Sidelines, Snapback, Stiff Resistance, Volatility
Posted in Markets | 1 Comment »

David Swensen: How to Sleep Soundly

Monday, March 16th, 2009

Yale’s Alumni Magazine for March/April 2009, features Marc Gunther’s interview with Yale Endowment’s Super-Investor, David Swensen, and details some of Swensen’s key advice to investors about portfolio management. It is a must read. Here is an excerpt.

In just under a quarter-century as Yale’s chief investment officer, David Swensen ’80PhD has generated Bernard Madoff-like returns — except that Swensen made his money honestly. Under his leadership, Yale’s endowment has generated an astonishing 20 consecutive years of positive returns, from 1988 to 2008.

Yale Alumni Magazine: Has it been a difficult time for you?

Swensen: In some ways, yes. I absolutely love the idea of producing ever-increasing levels of support for Yale. Looking ahead to the next few years, that’s not going to be in the cards. That’s a difficult reality to deal with.

But in terms of the day-to-day work, managing through this economic and financial crisis is absolutely fascinating. It’s exhausting, but fascinating.

Y: It may be fascinating to you, but it’s discouraging for those of us who have watched our 401(k) values plummet. Given all the turmoil and uncertainty, what should individual investors do?

S: If an individual investor followed the program I outlined in Unconventional Success [see box], they probably did reasonably well, through the crisis, thus far. They’d have 15 percent of their assets in U.S. Treasury bonds. They’d have another 15 percent in U.S. Treasury inflation-protected securities. Those two asset classes have performed well.

Of course, the other 70 percent of assets are in equities, which have not done well. With all assets, I recommend that people invest in index funds because they’re transparent, understandable, and low-cost. So, the equity holdings have gone down step-by-step with the declines in the market.

I recommend that investors rebalance.

But I also recommend that investors rebalance. Rebalancing is even more important amidst these huge declines in the stock market because it presents a great opportunity. People can sell the Treasury securities that have appreciated dramatically to bring their allocation to the 15 percent target, and they can redeploy those funds into domestic equities and foreign equities and emerging market equities and real estate investment trusts, all of which are now much cheaper, and therefore have higher prospective returns.

Y: Explain this idea of asset allocation, please.

S: Asset allocation is the tool that you use to determine the risk and return characteristics of your portfolio. It’s overwhelmingly important in terms of the results you achieve. In fact, studies show that asset allocation is responsible for more than 100 percent of the positive returns generated by investors.

Y: How can that be?

S: It’s because the other two factors, security selection and market timing, are a net negative. That’s not surprising. They’re what economists would call zero-sum games. If somebody wins by buying Microsoft, then there has to be a loser on the other side who sold Microsoft. If it were free to trade Microsoft, the amount by which the winner wins would equal the amount by which the loser loses. But it’s not free. It costs money. It costs money in the form of market impact and commissions if you’re trading for your own account, and it costs money in terms of paying fancy fees if you are relying upon an investment advisor or mutual fund to make these security-specific decisions. For the community as a whole, all those fees are a drag on returns.

That’s why the most sensible approach is to come up with specific asset allocation targets that you can implement with low-cost, passively managed index funds and rebalance regularly. You’ll end up beating the overwhelming majority of participants in the financial markets.

Y: So people should not be afraid of stocks now?

S: Not only should they not be afraid, they should be enthusiastic. One of the great ironies is that if you had talked to the average investor 18 months ago, he or she would have thought it was a pretty good idea to buy stocks. In recent months, the same investors despair about their portfolio and are fearful about putting money into the equity market.

That’s 180 degrees wrong. They should have been cautious 18 months ago, when prices were much higher than they are now. They should be enthusiastic today.

Y: That runs counter to human nature.

S: That’s one of the really tricky things about the investment world. It’s very different from a lot of things we deal with, day in and day out. If you talk to a businessman, a businessman is going to feed the winners and kill the losers. But in the investment world, when you’ve got a winner you should be suspicious about what’s next. And if you’ve got a loser, you should be hopeful — although not naively hopeful.

To read the whole interview, plus the additional material, click here. (make sure you read the items highlighted in blue on the right hand side)

Tags: Asset Classes, Bernard Madoff, Chief Investment Officer, David Swensen, Equity Holdings, Index Funds, Individual Investor, Individual Investors, Inflation Protected Securities, Marc Gunther, Portfolio Management, Quarter Century, Rebalance, Rebalancing, Treasury Inflation Protected Securities, U S Treasury, U S Treasury Bonds, Unconventional Success, Yale Alumni Magazine, Yale Endowment
Posted in Bonds, Emerging Markets, Energy & Natural Resources, Markets, Oil and Gas | Comments Off