What Now? And is There Anything New to Talk About? (Tchir)

Tuesday, May 15th, 2012

by Peter Tchir, TF Mar­ket Advisors

So now what?

Greece. Will they pay the bond due today or not? Will they form a new gov­ern­ment or not? Does any­one care? That is becom­ing the ques­tion. The mar­ket is grad­u­ally becom­ing numb to the news. I don’t think Greece can leave just yet. It would cause too much con­fu­sion, and no one within Greece or out­side has done enough to pre­pare. They will get some con­ces­sions. They will stick to the pro­gram for now. Europe needs an orga­nized exit. A lot comes down to the ECB. They could make a lot of con­ces­sions, at almost no cost in their fan­tasy world of account­ing, and take a lot of pres­sure off. With­out a gov­ern­ment, Papademos will con­tinue the exist­ing plan. The PSI bonds con­tinue to be weak and are trad­ing to epic dis­as­ter lev­els, but I guess they are about the only Greek thing out there that has enough value left to be worth shorting.

JPM has the share­holder meet­ing today. Never has there been so much noise over an announce­ment that isn’t even a full month’s worth of income. The other Mor­gan, MS lost money in Q3 and Q4 of last year and yet Gor­man isn’t being asked to resign? Which is worse, to have 6 months of losses, or 1 month of breakeven? The entire con­ver­sa­tion has become devoid of real­ity. The fact that it is CDS, Europe, Vol­cker, and Fortress involved has cre­ated a frenzy around the story that is blown all out of pro­por­tion. I have heard all the argu­ments about how the issue is big­ger than the money, but that is a fee­ble argu­ment. In a month, once the story has played out, peo­ple will look at the earn­ings, how lit­tle they play in the DVA game, how con­ser­v­a­tive their reserves seem, that they are buy­ing back stock, and get a nice div­i­dend yield, and like the stock. TFMkts Best Ideas took off the IG 9 10yr ver­sus IG18 short and is likely to leg out of the HY17 ver­sus HYG trade which at least in part had to do with JPM’s alleged position.

Spain and Italy are still real prob­lems. Their economies remain weak and their banks are a total mess. We didn’t need Moody’s to tell us that (I guess bet­ter late than never on the part of Moody’s, though more and more peo­ple would like to see Moody’s and Never be a used together a lot). In spite of how bad it is, we seem to have reached a crescendo for this round of sell­ing. With­out ECB inter­ven­tion in the bond mar­kets, I don’t see any cat­a­lyst for a big move tighter as there are no nat­ural buy­ers, but there are also few nat­ural sell­ers left, other than shorts, and cer­tainly Spain is get­ting to the point that fear of ECB inter­ven­tion makes pil­ing on a very dan­ger­ous propo­si­tion. A period of sta­bil­ity could cause a nice wave of CDS sell­ing as the short base has grown and the real­ity of how expen­sive it is to short these coun­tries kicks in. There was some talk about smash­ing together 4 bad banks and mak­ing one gigan­tic bad bank. I really have no clue what that would do, but it would be viewed as “tak­ing some action” and mar­kets like “action”. Although noth­ing is resolved, and I think most sce­nar­ios lead to another round of weak­ness, the cur­rent sell-off seems to have reached a peak and is likely to rally on any good news, no mat­ter how fee­ble. With Span­ish stocks being uni­ver­sally shunned, TFMkts Best Ideas has on IBEX ver­sus the DAX. TFMkts Best Ideas cov­ered Ital­ian short yes­ter­day and is now com­pletely out of Span­ish and Ital­ian bond shorts. It is short the 10 year bund, and really think­ing of sell­ing CDS on Spain.

China had mediocre data all last week that didn’t seem to come into play. China eased and no one seemed to care. As talk about JPM and Europe winds down, China could have a big influ­ence on the mar­ket again. Again, I doubt the rate cut will do much, but since that is recent, the mar­ket may grav­i­tate to that, espe­cially if they are able to con­jure up some data that the “soft land­ing” crowd can glom on to. I remain rel­a­tively neu­tral on what sort of land­ing China will have, but after the rate cuts, and last night’s bounce, China may help any rebound story.

The U.S. econ­omy, only a few weeks ago was at the core of the bull story. Now no one is talk­ing about it. For those of us who thought the 1^st quar­ter data was over­stated and wasn’t reflec­tive of the real econ­omy, it looks like we were right. The econ­omy is allegedly slow­ing down on many fronts. I use the term “allegedly” because I think it was never that strong, and might not be quite this weak, so the slow­ing is a func­tion of data adjust­ments. The econ­omy, I believe has been more sta­ble than that, and chug­ging along at a mediocre, but sta­ble pace. The data is weak enough to keep ZIRP in place even if not weak enough to war­rant QE3. But not so bad that com­pa­nies can’t gen­er­ate some prof­its. High Yield and Lever­aged Loans remain attrac­tive to me though expect a bit more volatil­ity as the JPM unwind con­tin­ues. While the IG9 long posi­tion has attracted the most atten­tion recently, there were posi­tions across a vari­ety of indices across the globe, includ­ing posi­tions in the high yield mar­ket. They may also have loans they choose to sell to mon­e­tize some gains and because they had to reduce the size of the hedge against them. TFMkts Best Ideas has longs in S&P, IG18, and a trea­sury short. If any­thing I will be look­ing to add risk here.

The morn­ing trad­ing is half hearted at best. Early rally, faded, re-rallied, re-faded. I think that descrip­tion applies to vir­tu­ally every “risk-on” asset out there. The mar­kets are still a lit­tle bet­ter across the board, but no enthu­si­asm. With all the uncer­tainty, and the weak­ness over the past week, that makes sense. I’m not sure the mar­ket is going to be squeezed higher with­out some real news or big liq­uid­ity injec­tion, but right now, it feels that a lot of the bad news has been absorbed to the point that a drift higher is the next direc­tion, though with some head­line induced gaps up and down.

Copy­right © TF Mar­ket Advisors

Tags: Bonds, Concessions, Confusion, Dividend Yield, Earnings, ECB, Fantasy World, Fortress, Frenzy, Gorman, Ig, Jpm, Losses, Proportion, Psi, Q3, Q4, Shareholder Meeting, Tf, Volcker
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The Axis of Weeble (Tchir)

Thursday, May 10th, 2012

by Peter Tchir, TF Mar­ket Advisors

Wee­bles wob­ble, but they don’t fall down. Europe, and the Euro in par­tic­u­lar might fall, but right now they are close to the bot­tom of this cur­rent wob­ble and are about to start another upswing (seri­ously, as I kid, you could make a Wee­ble fall down, but it was hard).

Greece is a bas­ket case. It may or may not have a gov­ern­ment. The even­tual gov­ern­ment may or may not want to stay in the Euro. That is all true, but will take time. Greece will and should attempt to rene­go­ti­ate the bailout pack­age. Our analy­sis yes­ter­day might be a good place for Greece to start. The results of the rene­go­ti­a­tion will deter­mine the tim­ing and neces­sity of Greece leav­ing the Euro. Until the Greek’s have had time to attempt to rene­go­ti­ate and have actu­ally planned for an exit back to the Drachma they will not risk a hard default where they really don’t know the con­se­quences. So look for more hard-line head­lines but expect May pay­ments to go smoothly. I think the post PSI bonds, down a touch again today, offer good risk/reward opportunities.

Spain may be less of a bas­ket case than Greece, but it is a far big­ger bas­ket. Spain nation­al­ized Bankia, the 4^th largest bank. So far the mar­ket is react­ing pos­i­tively. I think that this will turn out to be a “head fake” over time. While encour­ag­ing that Spain was will­ing to act a lot is left uncer­tain. Is this even enough to fix Bankia? Prob­lem banks have a ten­dency to be big­ger money pits than any­one at first real­izes. Look for doubts to creep back in about the suc­cess of this recap­i­tal­iza­tion. Then there is the ques­tion of how many other banks need how much money? The fig­ure will be stag­ger­ing. That brings us to the last ques­tion, how will Spain get all the money? Spain will be back to test the lows, but with the IBEX index at 9 year lows, a lot has been priced in and these lit­tle actions should be enough to pro­vide a decent pop. I rec­om­mended long IBEX vs short DAX into the Euro­pean close yes­ter­day.

Ger­many has its own set of prob­lems. The peo­ple voted and made it clear that the bailout pro­grams Ger­many is cre­at­ing don’t sit well with the peo­ple. So Merkel can­not eas­ily back down and make things eas­ier for Greece or Spain (or Italy, or Por­tu­gal, or Ire­land, for that mat­ter). She has to talk tough, but there is no way she has gone this far and will let it fail eas­ily. She is likely to insist on the same level of bud­get cuts, but may be less con­cerned about the tim­ing. She has to pan­der to her base, so look for dis­rup­tive state­ments from Ger­many, but their bark will be worse than their bite. Behind the scenes she will be a lit­tle more con­cil­ia­tory and flexible.

France has been sur­pris­ingly quiet since the elec­tions. Mr. Hol­lande is not forced to embrace the poli­cies of Merkozy and is free to carve his own role in Europe. The French elec­tions seemed to have less to do with bailouts and more to do with a renewed focus on France and a push for growth. So while he has to spend more time on domes­tic issues than the pre­vi­ous gov­ern­ment, he also has the abil­ity to push the growth agenda through­out Europe. He can be a leader in a “new” Euro­pean plan, one focused on “growth”. Since “growth” is just code for spend­ing, most of the politi­cians will get behind him. The equity mar­kets love growth and are always happy to drown out the screams and protests of the fixed income mar­kets. The fail­ure of the “growth” agenda will become appar­ent and mar­kets will sell off, but that could take some time. For­tu­nately for the bond mar­ket and the sov­er­eign debt cri­sis, the fal­lacy of the “growth” argu­ment will become appar­ent before more debt has been issued to fund elab­o­rate spend­ing projects. It does con­tinue to amaze me that “aus­ter­ity” is so hated and not an option, when in spite of all the votes, and approvals, very lit­tle actual aus­ter­ity has occurred.

Job­less Claims have the poten­tial to move the mar­kets. To me, the revi­sion is key to how the mar­ket will respond. If we get another upward revi­sion to last week’s data, the mar­ket will show lit­tle enthu­si­asm for the num­ber unless it is below 350k. If we get 365k and even a small down­ward revi­sion to last week we could see a sig­nif­i­cant pop. That’s because the mar­ket largely ignored last week’s num­ber with so much else going on, and because after Fri­day, the “we have jobs” por­tion of the rally took a seri­ous beat­ing. If we get a 365k print will another upward revi­sion, expect the mar­ket to be rather blasé about it. I like being a lit­tle long U.S. risk com­ing into the num­ber, but will take my read more from the revi­sion than the data itself.

Credit is mixed this morn­ing, but by and large unchanged. Span­ish and Ital­ian bonds are trad­ing much bet­ter. There is still pres­sure on CDS, but even there I think it is less of a warn­ing sign than a mar­ket that is about to get squeezed badly. U.S. CDS is trad­ing a bit bet­ter with both IG18 and HY18 trad­ing frac­tion­ally tighter. Futures have man­aged to retrace back to almost ses­sion highs, and given how many peo­ple seemed to expect overnight prob­lems in Europe, expect buy­ing to con­tinue, espe­cially if job­less claims are good.

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E-mail: tchir@tfmarketadvisors.com

Twit­ter: @TFMkts

Tags: Axis, Bailout Package, Basket Case, Bonds, DAX, Doubts, Drachma, Last Question, Lows, Pits, Problem Banks, Psi, Recapitalization, Renegotiation, Risk Reward, Spain Money, Tendency, Tf, Upswing, Yest
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Europe Wasn't Destroyed in a Day

Monday, May 7th, 2012

by Peter Tchir, TF Mar­ket Advisors

Just like Rome wasn’t built in a day, the Euro­zone won’t be destroyed in a day, but it is on a path that leads to even­tual dis­man­tling. What day will his­to­ri­ans choose to pick as the day that the Euro died?

• The day Greece or some­one else first leaves the Euro
• The elec­tions of May 6^th
• The day Greece changed laws to retroac­tively add Col­lec­tive Action Clauses and cre­ated a new class of bonds for the ECB
• The day that Greek Pri­vate Sec­tor Involve­ment was fin­ished and new bonds traded at 20% of par

Per­son­ally, I think the Greek PSI was what proved the Euro­zone was doomed. Greece restruc­tured debt, made dif­fer­ent rules for dif­fer­ent hold­ers, and yet, the new bonds trade at 20% of par. It’s like drink non-alcoholic beer, why put up with the bet­ter taste with no use­ful result at the end. So these elec­tions, while impor­tant are merely another step on the path the Euro­zone has been headed for months, if not years.

The mar­kets will digest the elec­tions as we illus­trate in the weekly report. We are already see­ing it play out. After an ini­tial swoon in mar­kets, they have rebounded, and already threaten to take out some post elec­tion shorts. Ger­many has said they will play nice with France. Merkel seems to have the trick­i­est job as she and her sup­port­ers lost sup­port for their bailouts, and yet in Greece, the peo­ple who took the bailouts also lost power. It is funny that both the giver and receiver are viewed as hav­ing done the wrong thing. This will be impor­tant over time, but not this week.

This week we will see every­one play nice. Con­cil­ia­tory words will be spo­ken. Growth will become the topic de jour. The mar­kets will fall all over them­selves once again on news of bank bailouts. The head­lines we get in the early part of this week will once again be over­whelm­ingly designed to encour­age peo­ple and the mar­kets. Europe will have a new spirit of co-operation and will wel­come fresh insights into the process. Growth, growth pacts, plans to grow, infra­struc­ture growth, etc., will be talked about. There will be talk, and maybe even action on the bank recap­i­tal­iza­tion efforts. Good banks and bad banks will abound. Gov­ern­ments will promise money to banks at rates so low no sane investor would even con­sider. So I look for a con­tin­ued bounce and am a bit net long in the TFMkts Best Ideas™.

Ulti­mately these plans will fail, and we will see fresh lows on the year for stocks, with the U.S. and Ger­many hit hard­est (hav­ing out­per­formed by far too much already), because:

• Ger­many in par­tic­u­lar, but France and the Nether­lands will have trou­ble jus­ti­fy­ing their con­tri­bu­tions to the bail-out. They will be forced to turn to domes­tic issues to sat­isfy their elec­torate and this will become obvi­ous to the market.
• Growth isn’t easy to achieve. Once “growth” moves from a vague con­cept stage into some­thing resem­bled a plan, investors will likely laugh at the attempts. It will be clear that most of the plans are unlikely of achiev­ing long term growth above and beyond the cost of achiev­ing it. That will not help the bond mar­kets, and in turn will spill over into equi­ties as they real­ize they were fooled by head­lines and hype over real­ity, once again.
• The good bank/bad bank con­cept is a loser to start with. The bank recap­i­tal­iza­tions just enshrine zom­bie banks. By the time a bank is get­ting gov­ern­ment gifts, the prob­lems they have hid­den are likely as large as the obvi­ous ones. The man­agers don’t worry about lend­ing, they worry about pro­tect­ing their jobs and their income and hop­ing noth­ing else comes out. They hoard the new money in an effort to grow cap­i­tal and in the hopes that the prob­lems no one noticed go away before some­one notices. Start­ing fresh banks would be ideal. Or let­ting some bad banks fail and then start­ing them fresh would be okay. Let­ting the exist­ing banks get tax­payer money at uneco­nomic rates, does noth­ing for the cit­i­zens, or the coun­try, and ulti­mately if there is any “win­ner” it will be the banks, but even that may take years to play out.

I remain slightly long hav­ing been sig­nif­i­cantly short at the start of last week. I will look to add to some areas that should ben­e­fit the most from another short squeeze – with Span­ish stocks stick­ing out. I con­tinue to avoid Span­ish and Ital­ian bonds as I think the fixed income mar­kets will be less likely to be tricked by the head­lines, and there really is no nat­ural buyer. I am look­ing at adding Greek bonds now that the elec­tion is over and we have seen a bit of a sell-off. A trea­sury short looks appeal­ing, and the eco­nomic data in the U.S. con­tin­ues to sup­port the idea that high yield bonds should per­form decently (ie, pay­ing the coupon with­out much price volatil­ity in either direction).

E-mail: tchir@tfmarketadvisors.com

Twit­ter: @TFMkts

Copy­right © TF Mar­ket Advisors

Tags: Bonds, Collective Action Clauses, ECB, Elections, Euro, Eurozone, Greece, Headlines, Historians, Insights, Merkel, Nbsp, New Spirit, Non Alcoholic Beer, People, Private Sector Involvement, Psi, Rome, Swoon, Tf
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Asset Class Performance (April 2012): Another Good Month for Bonds

Friday, May 4th, 2012

The bar chart below, cour­tesy of Scott Bar­ber of Reuters, shows the monthly per­for­mances of the prin­ci­pal asset classes.

“The “risk on/risk off” barom­e­ter moved back in the direc­tion of “risk off” dur­ing April, as U.S. 10-year Trea­sury secu­ri­ties turned in the best invest­ment gains (in U.S. dol­lar terms) dur­ing the month,” said Bar­ber. “The 2.8% jump in the value of the Trea­sury secu­ri­ties came despite the almost uni­ver­sal per­spec­tive on the part of pro­fes­sional investors that the 30-year bull mar­ket for bonds is finally sput­ter­ing to a halt and that even­tu­ally inter­est rates will begin to climb. Investors dis­played a clear bias in favor of assets that not only gen­er­ated income but also offered them secu­rity – in other words, bonds of var­i­ous kinds were the only major asset classes to end the month in the black.”

Source: Scott Bar­ber, Reuters, May 2, 2012.

Tags: 10 Year Treasury, April, asset class, Asset Classes, Assets, Barometer, Bias, Bonds, Class Performance, Dollar Terms, interest rates, Investment Gains, Principal, Professional Investors, Reuters, risk, Scott Barber, Treasury Securities, Universal Perspective
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ECB, NFP, Don’t Hold Your Breath Waiting for Rotation into Equities (Tchir)

Thursday, May 3rd, 2012

by Peter Tchir, TF Mar­ket Advisors

Job­less claims bet­ter than expected and back to lev­els where we had been ear­lier this year (after they were revised upwards). This data has been so con­sis­tently revised higher, that the mar­ket is tak­ing it with a grain of salt.

Span­ish and Ital­ian bonds are hold­ing onto to most of their ear­lier gains on the back of more auc­tions and the ECB meet­ing. So far Draghi has had a very mea­sured tone. If the meet­ing ends with­out a change in his tone, I would expect weak­ness to resume. The mar­ket has come to expect, and in fact depend on, cen­tral bank inter­ven­tion. I don’t see a nat­ural buyer of the longer dated Span­ish and Ital­ian debt with­out real hope of an aggres­sive ECB.

We get ISM later this morn­ing, but the mar­ket is really going to focus on NFP tomor­row. That is the key. Most data points to the like­li­hood of a sig­nif­i­cant miss, though the employ­ment por­tion of Man­u­fac­tur­ing ISM and today’s job­less claims give hope to the bulls. I expect a miss as so much of the ear­lier gains were just pulling sea­sonal jobs for­ward. Con­struc­tion projects planned for April, were able to start in February.

MAIN, IG, and HY CDS indices all tried to stage minor ral­lies this morn­ing and have since drifted back to unchanged. Given the strength we have seen, par­tic­u­larly in IG, that is not sur­pris­ing, but may be a sign that once again the mar­ket has reverted from being too bear­ish to overly optimistic.

The belief that “every­thing” is priced in is over­whelm­ing. The only thing I hear more than that, is the view that decou­pling is occur­ring, and not just with the U.S. decou­pling from Europe, but with dif­fer­ent coun­tries within the EU decou­pling. That the­ory may or may not be cor­rect (I don’t think it is), but it cer­tainly seems fully priced in. The diver­gence of mar­kets in Spain and Italy com­pared to Ger­many and the U.S. is huge. Option pre­mi­ums also reflect that. I con­tinue to look at buy­ing the under­achiev­ers against short­ing the “decou­pled” markets.

Finally, on Bloomberg TV yes­ter­day we did a seg­ment look­ing at “fixed income” ETF flows. Within the ETF space, it was clear that high yield has been attract­ing money, over $6 bil­lion year to date, and trea­suries have had basi­cally $0 flows. The the­ory that investors who have piled into bonds will revert back to equi­ties seems wrong. They aren’t mov­ing into the “safety” of 2% 10 year trea­suries, they are mov­ing into junk bonds. That makes sense as mediocre domes­tic growth is enough for most of those com­pa­nies to avoid seri­ous prob­lems, and earn­ing 6.5% to 8% of income while being senior in the cap­i­tal struc­ture offers a lot of appeal, and I believe that appeal is longer last­ing than those wait­ing for the rota­tion back into equi­ties real­ize. It may be a sub­tle dif­fer­ence, but decid­ing to invest your “bond” money in high yield is very dif­fer­ent than invest­ing in trea­suries. I believe active man­age­ment is valu­able here and that flows into tra­di­tional mutual funds and sep­a­rate accounts are also strong, but focused on the ETF’s, at least in part because the flow data is so much eas­ier to get and to aggregate.

Copy­right © TF Mar­ket Advisors

Tags: Belief That, Bonds, Bulls, Central Bank Intervention, Construction Projects, Decoupling, Divergence, ECB, Grain Of Salt, Hy, Ig, Ism, Jobless Claims, Likelihood, Nbsp, Nfp, Premiums, Rallies, Seasonal Jobs, Tf
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Kathleen Gaffney: Bond Investor says Dividends Best Source of Income

Monday, April 30th, 2012

A bond investor who says stocks are the next best thing! Great Investor Kath­leen Gaffney, co-manager of the leg­endary Loomis Sayles Bond Fund explains why the great gen­er­a­tional bull mar­ket in bonds is com­ing to a close and why div­i­dends are becom­ing the best source of income.

Tags: Bonds, Dividends, Investor, Kathleen Gaffney, Loomis Sayles Bond, Loomis Sayles Bond Fund, Stocks
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The Intersection of Bonds and Equities

Tuesday, April 24th, 2012

by Guy Lerner, The Tech­ni­cal Take

Fig­ure 1 shows a weekly chart of the SP500. In the lower panel is an ana­logue chart of our bond trad­ing model. This bond model has been bull­ish for 3 weeks now.

Fig­ure 1. SP500 v. Bond Model/ weekly

Note how the bond model turned bull­ish back on March 26, 2010 and on March 11, 2011. Not only did these sig­nals coin­cide (more or less) with an equity mar­ket top, but these time peri­ods also sig­naled the end of active mon­e­tary inter­ven­tion by the Fed­eral Reserve. This was the end of QE1 and QE2, respec­tively. Now we have the lat­est incar­na­tion of QE end­ing — Oper­a­tion Twist. Inter­est­ingly enough, the equity mar­ket appears to be top­ping out once again as the bond model has turned positive.

So why is the bond model pos­i­tive? Despite the low yields, bonds could be viewed as a safe haven from a frag­ile macro envi­ron­ment. While this may be true to some extent, I believe the equity weak­ness or bond strength (in this case) is a reflec­tion and early sign of eco­nomic weak­ness. In par­tic­u­lar, the 2011 mar­ket top coin­cided with notice­able dete­ri­o­ra­tion in the eco­nomic data that was clearly point­ing towards reces­sion. Of course, the Fed came to the res­cue with Oper­a­tion Twist and the “dreaded” reces­sion was avoided.

So in sum­mary, a top­ping equity mar­ket appears to be a sign of an econ­omy that has peaked as well. This has been her­alded by strength in bonds. Most likely, this is sig­nal­ing fur­ther quan­ti­ta­tive eas­ing as the Fed­eral Reserve inter­venes in the bond mar­ket to prop up the econ­omy and the equity markets.

Tags: Analogue, Bond Market, Bond Strength, Bond Trading, Bonds, Deterioration, Economic Data, Economic Weakness, Federal Reserve, Figure 1, Guy Lerner, Incarnation, Macro Environment, March 11, Qe, Qe1, Recession, S&P500, Safe Haven, Time Periods
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The Day Austerity Died (Tchir)

Tuesday, April 24th, 2012

by Peter Tchir, TF Mar­ket Advisors

Aus­ter­ity is dead! Long live Spending!

Futures are up, Ital­ian and Span­ish bonds are up, CDS spreads on them are at least 10 bps tighter, and MAIN is 3 bps tighter on the day (though I have this feel­ing I bet­ter type fast as we are start­ing to fade off the best levels).

Lots of lit­tle things seem to be con­tribut­ing to the strength, TXU earn­ings, no eco­nomic data, auc­tions that raised the required money, etc., but there does also seem to be a belief that Ger­many finally “gets it”. That Ger­many is finally going to relent on their demands for austerity.

The first ques­tion is “what is defined as aus­ter­ity?” Pro­grams that are pro­vid­ing money today, that is quickly re-circulated into the econ­omy because it is pay­ing for peo­ple to live should not be cut – that is bad aus­ter­ity. Rais­ing taxes in gen­eral is prob­a­bly bad aus­ter­ity, but what about actu­ally col­lect­ing taxes on all those who have avoided pay­ing what they owe? Plans to reduce long term ben­e­fits must go for­ward, min­i­mal cur­rent cost to the econ­omy, but nec­es­sary for any long term solu­tion. So while “aus­ter­ity” hasn’t worked, it is not all bad, and some forms need to be main­tained to have any hope that the sit­u­a­tion can be turned around in the future.

The sec­ond, and more impor­tant ques­tion, is “why does any sane per­son think spend­ing for growth will work?” Just pause for 1 moment. How were these mas­sive deficits built up? Was all the spend­ing friv­o­lous? I don’t think so. A lot of spend­ing was meant to tar­get growth in cer­tain areas. It is just very dif­fi­cult to achieve. If spend­ing to get growth was so easy in a global econ­omy, the U.S., the cur­rent king of spend­ing, would have Chi­nese like GDP growth. It is not that easy to spend your way to growth. I’m sure at some level, Solyn­dra received money because there was a real belief some­where that it was a good invest­ment for growth. GM might be used as an exam­ple, but I’m not con­vinced that the gov­ern­ment spend­ing did any­thing more than pri­vate cap­i­tal would have done in the wake of a real bank­ruptcy. The excite­ment over “spend­ing for growth” is almost mind-boggling, because it basi­cally goes against a decade of his­tory show­ing the inabil­ity of gov­ern­ments to spend and achieve real growth. But, there is one part that does make sense, at least from a Wall Street perspective.

So the final ques­tion is, “who will finance all that spend­ing?” Ahhh, the real rea­son Wall Street is enthu­si­as­tic about spend­ing for growth. The only way a spend­ing for growth cam­paign can begin, is with another mas­sive round of bal­ance sheet expan­sion by cen­tral banks. That has been great for banks and wall street, while less clear what it has done for the econ­omy, or any­one with­out a sig­nif­i­cant por­tion of their wealth in stocks. If Spain announced a big new spend­ing cam­paign, would any­one really believe it would work? What would they do? Build more homes to get con­struc­tion going? How would that help when an unpopped real estate bub­ble is part of the prob­lem (actu­ally the bub­ble has burst, it just hasn’t been rec­og­nized on banks’ and cajas’ bal­ance sheets). Would investors who aren’t excited about lend­ing 5 year money at 4.75% sud­denly line up to buy all this debt think­ing the new spend­ing ini­tia­tives (which increase debt in the short term) will really work? I don’t think so. Buy­ing new debt in an envi­ron­ment where coun­tries feel free to spend and run deficits because aus­ter­ity doesn’t work, will only frighten pri­vate cap­i­tal. So the cen­tral banks of the world will have to step up again and pro­vide the fund­ing. I don’t think that is a good thing, but can see why some do, and can really see why some of those push­ing the most for a return to debt issuance and spend­ing and cen­tral bank inter­ven­tion would want it – because they ben­e­fit, not because it will work.

The real­ity is that spend­ing won’t solve any­thing. It will grow debt faster than the spend­ing can improve the econ­omy. Stop­ping longer term aus­ter­ity pro­grams will make the future debt to GDP ratios look even more hor­rific. There will ulti­mately need to restruc­tur­ing on a mas­sive scale.

It is no co-incidence that more and more sov­er­eign debt is being funded by insti­tu­tions in that coun­try. It is specif­i­cally to make leav­ing the Euro eas­ier. An Ital­ian pen­sion plan for exam­ple has both its assets and its lia­bil­i­ties in Italy. A con­ver­sion back to Lire is man­age­able in a sit­u­a­tion like that. Yes, the pen­sion plan’s rede­nom­i­nated Ital­ian Lire bonds may trade down because of the deval­u­a­tion, but their pen­sion oblig­a­tions would also be rede­nom­i­nated at the same time, off­set­ting a lot, if not all of the pain. The same is true in the bank­ing sec­tor. Cor­po­ra­tions won’t have that lux­ury as many are global, but it may explain why Ital­ian and Span­ish com­pa­nies have been busy issu­ing debt. So return­ing to tra­di­tional cur­ren­cies has the least impact on the coun­try and the Euro­zone if the debt is largely held inter­nally. That is the direc­tion the coun­tries and the ECB have been mov­ing, so don’t ignore this as a more likely real solution.

Debt restruc­tur­ing in terms of coupon reduc­tion, notional reduc­tion, and matu­rity exten­sion are all real pos­si­bil­i­ties too. If coun­tries learned any­thing from Greece, it is that by wait­ing too long, and accept­ing more Troika money than the pri­vate sec­tor wrote-off, the prob­lem doesn’t go away. Restruc­tur­ing early and harshly is far bet­ter than wait­ing and doing it in bits and pieces, and it has to affect ALL cred­i­tors. One rea­son that the ECB hasn’t resumed its SMP just yet is that coun­tries aren’t sure how much they want to owe the ECB. The ECB has proven itself to be an unhelp­ful part­ner in restruc­tur­ing. Watch what the ECB does (or doesn’t do) and ask your­self why.

So “Aus­ter­ity Now” may be over, but killing some­thing that didn’t work, isn’t the same as solv­ing the prob­lem. Going back to the norm that caused the prob­lem in the first place, hardly seems like a solu­tion either. Cur­rency rever­sion and/or debt restruc­tur­ing will be the ulti­mate end-game.

We get a del­uge of hous­ing data out this morn­ing. I expect it to dis­ap­point, but at this stage I’m not sure another hous­ing dis­ap­point­ment does any­thing for the mar­ket. It would merely con­firm what is becom­ing a con­sen­sus view – that the actual weather actu­ally played a role in mak­ing the win­ter num­bers look bet­ter than they might oth­er­wise have been.

Good luck with the rest of the day, though I sus­pect that once Europe goes home we will do noth­ing but watch every move in AAPL like we did yes­ter­day after­noon. In the mean­time I hope I can get the Don Maclean Amer­i­can Pie song out of my head on “the day aus­ter­ity died”….

Copy­right © TF Mar­ket Advisors

Tags: Auctions, Austerity Programs, Belief That, Bonds, Bps, Current, Earnings, Economic Data, Futures, GDP, GDP Growth, Global Economy, Gm, Long Term Solution, Money, Nbsp, Sane Person, Taxes, Tf, Txu
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Reading the Tea Leaves When There is No Tea (Tchir)

Tuesday, April 17th, 2012

by Peter Tchir, TF Mar­ket Advisors

Every­one is try­ing to fig­ure out what is going to hap­pen next. Investors are look­ing clues and sig­nals as to the next big move. The prob­lem is that liq­uid­ity is so poor, moves that might nor­mally sig­nal a shift in sen­ti­ment or risk, are now just noise.

We can look at 10 year Span­ish yields. Def­i­nitely a use­ful sig­nal, but back to exag­ger­ated moves on lit­tle vol­ume. Liq­uid­ity is abysmal.

Things like the EUR/USD basis swap was once an indi­ca­tor, but how use­ful is some­thing when the Fed has pro­vided unlim­ited swap lines and banks are encour­aged to use them. Hardly an indi­ca­tor of any­thing, though I would argue any weak­ness in the face of all that cen­tral bank effort is more mean­ing­ful than signs of strength.

It was easy when the EUR/USD rate itself was a key indi­ca­tor. Some­times it still is, some­times it isn’t. It is flow dri­ven, but the flows are con­fus­ing as some money is just being shifted from one Euro­zone country’s bonds to another’s, and there is grow­ing con­fu­sion over what it means that each country’s debt is being held in an ever greater pro­por­tion by its own banks.

For myself, I’m look­ing more at yield curves than any par­tic­u­lar bond. The curve flat­ten­ing is still a bear­ish indi­ca­tor, though Spain is a weird one today, where cur­rently the 2 year yield is higher, the 5 year yield is bet­ter, but the 10 year is higher, though all have rebounded significantly.

CDS seems to remain a bet­ter indi­ca­tor of the true state of the credit mar­ket, though the tech­ni­cals from any poten­tial “whale” trade unwind are hard to account for. I am see­ing bid/offer spreads nor­mal­ize in the U.S. which is a good sign, but they are still wider than nor­mal in Europe. IG18 is basi­cally unchanged on the day, in spite of the moves in stocks, another sign that the rally isn’t very deep yet.

The size of the moves in all mar­kets is get­ting scary. We have now seen stock futures move more than 1% today from their overnight lows. Were the retail sales data really that good? Some of it looked strong, but the “core” num­bers were less com­pelling. Empire man­u­fac­tur­ing was bad. We are quickly head­ing back to a period where you need to have small posi­tions, because news that would have caused a 0. 5% move in the mar­ket a cou­ple of weeks ago, is now mov­ing it 1%. Maybe today is some­how a turn­ing point, but I don’t think it is, so we will see sell­ing pres­sure into every rally as total return play­ers have to “right­size” their posi­tions for the increased volatil­ity. This is the real intra­day volatil­ity that investors expe­ri­ence as they do their intra­day P&L esti­mates, not VIX or any other form of implied vol.

With no liq­uid­ity be care­ful read­ing too much into any move (pos­i­tive or neg­a­tive) but expect some weak­ness as these moves will force investors (hedge funds in par­tic­u­lar) to make smaller bets.

Twit­ter: @TFMkts

Tags: Basis Swap, Bonds, Confusion, Curve, Eurozone, liquidity, Nbsp, Proportion, Rally, Sentiment, Signals, Spite, Stock Futures, Tea Leaves, Technicals, Tf, True State, Weird One, Whale Trade, Yield Curves
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The Importance of Being Earnest (Columbia)

Thursday, April 12th, 2012

Tags: 100 Years, Bias, Bonds, Bulls, Columbia Management, Corporate Pension Funds, Dividends, Great Depression, Inclination, Market Gyrations, Maxim, Meltdown, Nasdaq, Oil Crisis, Portfolio Managers, Portfolios, Rich Rosen, Spite, stagflation, Trough
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The Danger of HY ETF’s Trading at Discounts to NAV

Wednesday, April 11th, 2012

by Peter Tchir, TF Mar­ket Advisors

Alcoa helped the mar­kets bounce back after the close, and some indi­ca­tions that the ECB may start buy­ing bonds again helped the mar­ket even more. One company’s earn­ings don’t make a trend, and I am still con­cerned that earn­ings will be mediocre at best. Span­ish bonds are already off their highs, and CDS never really moved on the back of the ECB sto­ries. I remain skep­ti­cal that any­thing mean­ing­ful will be done, and now that we have the “ECB” rally out of the way, I expect to see the weak­ness resume. In the TFMkts Best Ideas which went out ear­lier, we liked adding to shorts this morning.

The fact that the High Yield ETF’s are trad­ing at a dis­count should be a big con­cern to any­one in the high yield mar­ket, not just those who own the ETF. There is a real risk that this dis­count can trans­late into arb activ­ity which leads to fur­ther declines.

With the ETF’s trad­ing at a dis­count, the trade would be to sell bonds in the mar­ket and to buy shares. They would then deliver the shares to the ETF providers as a “redemp­tion” and take the bonds to cover the ones they shorted. Although this has the appear­ance of being risk neu­tral, my expe­ri­ence is that it can become a big dri­ver. I also don’t think many HY bond traders or ETF desks have seen this sce­nario play out in the credit mar­kets. We saw a bit of it on the way up, many of the shares the ETF’s “cre­ated” were for ETF arb clients, but on the way up, where those par­tic­i­pants were buy­ing bonds, no one seemed to care much. In a down­side sce­nario it can be far worse.

I will walk through a rough exam­ple of what used to hap­pen in CDS with “index” arb, and I don’t see what it wouldn’t apply to the ETF’s if they remain at a discount.

Assume there are two vir­tu­ally iden­ti­cal com­pa­nies and most of the time their CDS trades roughly in line. Then one day you notice that over the past week, both went from trad­ing at about 90, to one trad­ing at 100, and the one that is in the index trad­ing at 110. Many accounts will look at this and deter­mine that it doesn’t make sense. They may sell pro­tec­tion on the name at 110 think­ing the mar­ket has moved “too far too fast”. They may put a “pairs” trade on and buy the one at 100 and sell the other at 110. Nei­ther are bad trades, but what they have missed, is the over­all weak­ness in the mar­ket (that saw even the non index name to move 10 bps wider) has been priced into the CDX indices. They are say trad­ing at 115, in spite of fair value being 110 for exam­ple. They tend to trade “rich” or “cheap” to fair value based on mar­ket sen­ti­ment. Hedgers in par­tic­u­lar like to be “tem­porar­ily” short the liq­uid index, while retain­ing spe­cific (and usu­ally less liq­uid) credit bets.

The “index arb” clients will come in and pay 110 for the “index” name, while sell­ing the index at 115 (it is more com­pli­cated than that, but that is the basic premise). The “arb” trader doesn’t care if 110 is a “good” or “fair” price for that CDS, they only care that they can buy all the names in the index at a spread tighter than where they can sell the index. That is it. They have no inter­est in buy­ing the name that trades at 100. They only care about the rich­ness or cheap­ness of the index ver­sus the sin­gle names.

What tends to hap­pen next, is hard to explain, but seems to hap­pen all the time. The sin­gle name traders who sold pro­tec­tion feel­ing it had gone too far, start hav­ing dif­fi­culty find­ing sell­ers to take the other side. They are get­ting long credit risk. What do they do? They buy pro­tec­tion on the index because some­how it makes them feel bet­ter than just clos­ing out their posi­tion. Effec­tively sin­gle name desks put on the oppo­site trade as the arbs. Doesn’t make sense, but hap­pens all the time. So by buy­ing the index as a hedge, they ensure that it con­tin­ues to trade cheap, mean­ing that the index arbs will be back to buy more of the sin­gle name.

But why won’t oth­ers sell that name or put on the pairs trade? The prob­lem here is that the spread between the index and non index name con­tin­ues to widen. So after some decent sized arbs go through, the names now trade at 105 and 120. Any­one who sold at 110, think­ing to make 10 to 20 bps, just lost 10 bps. What is the prob­a­bil­ity that a) they add more, b) they sit tight, or c) they get stopped out on some? I can almost guar­an­tee that option a is the low­est prob­a­bil­ity. Sim­i­larly, any­one who put on the “pairs” trade at 10 bps, is now down 5 bps since the spread is 15 (and that ignores bid/offer). These peo­ple are more likely to add to the posi­tion, but even there, peo­ple start get­ting ner­vous that there is some­thing really wrong with the one com­pany. That fear creeps in. In credit, being wrong means instead of earn­ing 1.1% per annum you lose 60%. That fear, whether ratio­nal or not, makes it dif­fi­cult to find sell­ers of protection.

So the “cheap­ness” of the index feeds on itself and cre­ates a feed­back loop that dri­ves all spreads wider. The index names get hit the worst, but every­thing moves. It doesn’t end usu­ally until the index is at a level that new entrants come into the mar­ket to sell the index, which is not only at a good level, but very cheap to fair value.

I am very con­cerned that this same process can occur in the HY bond mar­ket and liq­uid­ity, as bad as it is in a strong mar­ket, is far worse in a down mar­ket. As of yet there is no sign that this is hap­pen­ing in a mean­ing­ful way, but JNK has seen out­flows for a few days and HYG saw out­flows yes­ter­day.

Copy­right © TF Mar­ket Advisors

Tags: Alcoa, Appearance, Arb, Bond Traders, Bonds, Credit Markets, Declines, Desks, Downside, Earnings, ECB, ETF, high yield, Hy, Participants, Rally, Redemption, S Trading, Tf, Trades
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Has the Bear Market for Bonds Begun? (Schwab)

Monday, April 9th, 2012

April 5, 2012

by Rob Williams, Direc­tor of Income Plan­ning, Schwab Cen­ter for Finan­cial Research, and

Has the Bear Mar­ket for Bonds Begun?

Why are inter­est rates still so low? The econ­omy is recov­er­ing, unem­ploy­ment is falling, gaso­line prices are ris­ing and the stock mar­ket has dou­bled in value in the last three years. We’ve noted the com­men­tary lately about an end to a 30-year bull mar­ket in bonds, and whether investors are at sig­nif­i­cant risk for losses if rates rise. The ten­dency, as we’ve seen it, is to worry about these broad con­cerns with a mix of skep­ti­cism and fear. While we think that inter­est rates will con­tinue a mod­est increase over the rest of this year, we’re less con­vinced that we’ll see a sharp, uncon­trolled spike in rates or decline in investor demand. We see other long-term struc­tural sup­ports, with a few of the larger ones high­lighted here.

• De-risking sup­ports demand for bonds. The sim­plest expla­na­tion for why rates are so low is that investors—individual and institutions—are still ‘de-risking.' For indi­vid­ual investors, the expla­na­tion for the propen­sity to favor bonds over stocks is pretty straight­for­ward. Since 2000, indi­vid­ual investors, in aggre­gate, have gone from prince to pau­per one too many times. After a period of low volatil­ity dur­ing the 1990s, we’ve moved to a period of excep­tion­ally high volatil­ity. Not only have returns from the stock mar­ket been volatile, but net worth has been volatile as well thanks to the drop in home prices. Aging investors may sim­ply want to hold on to more of what they have, sup­port­ing demand for bonds.
• More impor­tantly, insti­tu­tional investors are de-risking as well. We focus on indi­vid­ual investors, of course, but the U.S. bond mar­ket has been dri­ven, by-and-large, by large insti­tu­tions such as pen­sion funds, insur­ance com­pa­nies, global banks and inter­na­tional sov­er­eigns. This is an enor­mous mar­ket, and they are de-risking as well. In our view, pen­sion funds, insur­ance com­pa­nies and oth­ers with lia­bil­i­ties to fund have been, and will likely con­tinue, to reduce expo­sure to riskier assets in favor of bonds. Here are a few statistics:

1. Accord­ing to Ned Davis and the Fed­eral Reserve, in 1953 bonds accounted for 84% of assets invested in U.S. insur­ance and pen­sion funds. The per­cent­age has fallen steadily since then, to 40% of $15.7 tril­lion in global assets as of the end of 2011. (Yes, tril­lion.) Over the same period, the allo­ca­tion to stocks rose from under 8% in 1953 to peaks of over 42% in the late 1990s and mid-2000s before falling back to under 34% today with the rest allo­cated to bonds and other investments.
2. Accord­ing to Mil­li­man, a pen­sion fund con­sult­ing com­pany, cor­po­rate pen­sion funds are under-funded by $372 bil­lion. Munic­i­pal pen­sions are under-funded by tril­lions more. After dis­ap­point­ing returns from equi­ties, many are shift­ing slowly back to a more tra­di­tional method of match­ing fixed assets with future lia­bil­i­ties. On the mar­gins of this multi-trillion dol­lar mar­ket, a one-percentage point move is a big deal.
3. Insur­ance com­pa­nies face sim­i­lar met­rics. Many will need to add more fixed income to match future lia­bil­i­ties. Accord­ing to Mer­cer, an insur­ance con­sul­tant, demand for fixed income secu­ri­ties from insur­ance com­pa­nies could run in the range for $500 to $600 bil­lion annually.

• Demo­graph­ics are also chang­ing. It's no secret that the U.S. pop­u­la­tion is aging and that the first wave of "baby boomers" is retir­ing. Some have been pushed into early retire­ment while oth­ers have cho­sen to stop work­ing. It’s our sense that many investors may remain less inclined toward extra risk with the money they have to live on for the next few decades, for a grow­ing por­tion of their port­fo­lios. Return of cap­i­tal, in nom­i­nal terms, may be as impor­tant as return on it, at least for money that doesn't have as much time to recover from volatil­ity in other markets.
• And then there's the Fed. The other big fac­tor hold­ing down yields, of course, is the Fed. Over the past year, the Fed has pur­chased 61% of new Trea­sury issuance, keep­ing a cap on rates. With the fed funds rate at zero and the Fed buy­ing long-term bonds, yields are likely to remain low as long as those poli­cies are in place. Right now, the Fed is indi­cat­ing that the pol­icy is expected to last another year or more. We’ll know more when they meet next in late April to see if they com­mu­ni­cate any change in tone. But for now, state­ments from Fed Chair­man Bernanke and oth­ers show that the Fed remains cau­tious about the strength of recent eco­nomic num­bers, still wor­ried about slow­ing growth in Europe and China, and believes that unem­ploy­ment needs to be lower before they are close to ful­fill­ing their mandate.
• This analy­sis is not meant to say that inter­est rates will stay low for­ever or that long-term Trea­sury bonds are attrac­tively val­ued. At some point, when the econ­omy appears to be on firmer foot­ing and/or infla­tion expec­ta­tions rise sub­stan­tially, the Fed is expected to begin to unwind its pro­grams and inter­est rates are likely to move higher. We've already seen a mod­est rise in rates off lows in late March, and we'd expect to see a slowly ris­ing trend through the rest of the year. We look for­ward to the time when rates begin to move up a bit, actu­ally, because it’ll mean that the econ­omy is health­ier and investors face addi­tional options for return on their sav­ings. How­ever, we don't know when that time will arrive, and we're not in the camp that sees rates ris­ing dra­mat­i­cally any­time soon for many of the rea­sons we've cited above. Still, we think it’s a good time to look at your allo­ca­tion to dif­fer­ent types of bonds, by credit risk and matu­rity. It's dif­fi­cult to pre­dict inter­est rates, and you can’t con­trol them. But you can con­trol what you hold in your portfolio.

Q1 2012 Sec­tor Performance

The wide range of per­for­mance between dif­fer­ent sec­tors of the global bond mar­ket, by matu­rity and level of credit risk, reminds us that the bond mar­ket defies easy gen­er­al­iza­tion. Not all bonds are cre­ated equal. Dur­ing the quar­ter, there was a sharp price-driven appre­ci­a­tion in ‘riskier' assets, such as cor­po­rate, high yield and emerg­ing mar­ket bonds, while long-term Trea­sury bonds fell as yields rose. Over­all, we expect we'll see sim­i­lar per­for­mance by sec­tors through much of the rest of 2012, with yields ris­ing mod­estly for Trea­suries on improved eco­nomic data, with peri­ods of volatil­ity and re-trenching if we see weaker data or con­cerns about global growth.

• Flat line on returns for the tax­able bond index. The Bar­clays US Aggre­gate Bond Index turned in a mea­ger per­for­mance over the first quar­ter, deliv­er­ing 0.3% in total return on the com­bi­na­tion of coupons and a mod­est drop the price of the index as yields for gov­ern­ment bonds rose sharply in March. For those focused on income, the index is now yield­ing north of 2.2% with an aver­age dura­tion (i.e. the weighted aver­age tim­ing of inter­est and prin­ci­pal pay­ments, and a mea­sure of inter­est rate risk) of just under 5 years. We expect that income will drive returns for much of the rest of this year, with a range on inter­est rate risk most likely through year-end.
• Invest­ment grade cor­po­rate bonds, includ­ing finan­cials, out­per­formed. High-grade cor­po­rate bonds were the pri­mary ben­e­fi­ciary of increased risk-appetites and yield-chasing, a theme that's con­tin­ued from late 2011 into 2012. But per­for­mance was not spread out evenly across asset classes. The finan­cial and bank­ing sec­tor, a lag­gard as recently as Q3 2011, beat util­i­ties and indus­tri­als over the last three months. This is thanks in part to improv­ing mar­ket con­di­tions and no real neg­a­tive sur­prises in the Fed's recent bank stress tests. Few investment-grade sec­tors look cheap now, a con­cern for investors who have been look­ing for yield and pour­ing money into cor­po­rate bonds. We're more cau­tious at the moment, given the strong recent run. It may make sense to look for oppor­tu­ni­ties when they present them­selves at more attrac­tive lev­els. The cycle, to us, still favors credit.

Q1 2012 Sec­tor Performance

Source: Bar­clays, as of March 30, 2012. Shown above are total returns for cor­re­spond­ing Bar­clays indices. Past per­for­mance is not indica­tive of future results.

• High-yield returns show the shift in sen­ti­ment toward yield and risk. More return poten­tial means more risk, of course. We think the cycle still favors credit, as we've said, with high yield beat­ing the pack with a 5.3% return for the quar­ter plus a 5+% yield pre­mium over Trea­suries. With cor­po­rate bal­ance sheets gen­er­ally appear­ing strong, it looks like investors are being ade­quately com­pen­sated for risk, rel­a­tive to the alter­na­tives. An impor­tant con­sid­er­a­tion, as always, is not to push the invest­ment the­sis too far, tilt­ing too far away from the more con­ser­v­a­tively invested core bond port­fo­lio in the search for yield.
• Euro-zone risk eases, boost­ing inter­na­tional per­for­mance. Euro­zone trou­bles are far from over, but two rounds of liq­uid­ity injec­tions and orderly Greek ‘restruc­tur­ing' did help to tem­per uncer­tainty so far in Q1. For­eign bonds ben­e­fited, while emerg­ing mar­kets ben­e­fited more, due pri­mar­ily to the improved appetite for risk assets. Emerg­ing mar­ket debt mir­rored U.S. high yield for a 5.9% total return. In the cur­rent low-rate cli­mate, a com­bi­na­tion of emerg­ing mar­ket and U.S. high yield bonds may still make sense for the more ‘aggres­sive' sleeve of a more risk-seeking portfolio.

Mea­sur­ing Inter­est Rate Risk

We started the con­ver­sa­tion in this newslet­ter with thoughts on the bull mar­ket for bonds. Is it over? More impor­tantly, is the bear mar­ket for bonds under­way? If rates rise, what risks do you face? Mea­sur­ing risk is bet­ter than guess­ing, in our view. Duration—the weighted aver­age time until pay­ment of inter­est and prin­ci­pal on bonds—is one measure.

• The U.S. tax­able bond mar­ket has a dura­tion today of 5 years. The aver­age matu­rity is around 7 years. The ten­dency is to look at and refer to the 10-year or 30-year Trea­sury as a bench­mark or bell-weather for the larger mar­ket for bonds. But it's worth remem­ber­ing that the mar­ket as a whole has shorter matu­ri­ties on aver­age. Longer-term bonds are riskier, if rates rise. But long-term bonds are part, not all, of the entire mar­ket. If you hold a port­fo­lio with a mix of short– to intermediate-term bonds, you may not have much expo­sure to long-term bonds. A port­fo­lio focused on short– to intermediate-term bonds, with matu­ri­ties between 1 and ten years, is good place to start, in our view, for most investors.
• A tax­able bond mar­ket with dura­tion of 5 would be expected to fall roughly 5% in value if rates rise 1%. This esti­mate is a rule of thumb, using dura­tion as a mea­sure of risk. It assumes a 1% increase in rates across the yield ‘curve'—meaning at every matu­rity, and for every bond. If rates across the curve rise 2%, from 2.2% to 4.2% on the 10-year Trea­sury, for exam­ple, and at every other matu­rity from one out to 30 years or more, the value should fall 10%. This is rough, but gives a sense of how much dam­age an investor might feel if invested in a broadly diver­si­fied port­fo­lio of short– and intermediate-term bonds or funds. Shorter-maturities are less sen­si­tive, gen­er­ally, if rates rise, than longer-maturity bonds. Bonds with higher coupons are gen­er­ally less sen­si­tive also, com­pared to bonds (Trea­suries, for exam­ple) where coupons tend to be lower. The income paid by bonds in the form of coupons off­set a por­tion of these price changes, espe­cially if inter­est is rein­vested at higher yields and com­pounded over time.
• The cur­rent bench­mark dura­tion of 5 is also around the aver­age dura­tion for the aver­age intermediate-term bond fund. Intermediate-term bond funds have dura­tions of 3.5 to 6 years (or, if dura­tion is unavail­able, aver­age effec­tive matu­ri­ties of four to ten years), using the def­i­n­i­tion that Morn­ingstar uses to define mutual fund cat­e­gories. “These port­fo­lios are less sen­si­tive to inter­est rates, and there­fore less volatile, than port­fo­lios with longer dura­tions,” says Morningstar.
• Short-term bond funds have a dura­tion of one to 3.5 years, on aver­age, accord­ing to Morn­ingstar. So if short-term rates rose 1%, short-term funds would be expected to fall in value by 1% to 3.5%. We gen­er­ally sug­gest short-term bonds or funds for money needed within 1 to 3 years, with cash invest­ments or bonds that are near­ing matu­rity for money needed sooner. Short-term rates will rise, ulti­mately. But it seems less likely that they will until the Fed changes poli­cies and says that they will, to us. The Fed can gen­er­ally drive short-term rates more directly than they can long-term rates using tra­di­tional mon­e­tary pol­icy includ­ing the Fed funds rate.
• In con­trast, long-term bond funds, espe­cially those with heavy Trea­sury expo­sure, involve the high­est risk if rates rise. Dura­tions for long-term funds are gen­er­ally 6 years or longer, often con­sid­er­ably longer. This is where investors who have ben­e­fited from strong cap­i­tal appre­ci­a­tion in long-term bonds or funds can look to take some ‘dura­tion' off the table, re-positioning a por­tion of strong gains by short­en­ing dura­tion back to bench­mark. It may not be the most attrac­tive place, in our view, for most investors to think about adding money now.
• You can tar­get dura­tion, using lad­ders or funds. As a place to start, we think investors should con­sider a mix of short– and intermediate-term bond funds, for a mix of lower inter­est rate sen­si­tiv­ity (in short-term funds) and income poten­tial with mod­er­ate risk (intermediate-term funds). It may sound like a bro­ken record, we know, but we still like bond lad­ders with a mix of matu­ri­ties from ready-to-mature out to around 10 years. When inter­est rates rise, there will be short-term bonds matur­ing to rein­vest for higher yields. And lad­ders can help reduce the over­all volatil­ity in the bond port­fo­lio. This kind of port­fo­lio helps with a plan to man­age inter­est rate risk proactively.

Please visit www.schwab.com/onbonds for more fixed income per­spec­tive from the Schwab Cen­ter for Finan­cial Research. If you have ques­tions or con­cerns about the issues raised in this pub­li­ca­tion, please speak to your Schwab representative.

Impor­tant Disclosures

Tags: Bear Market, Bond Market, Bond Markets, Bonds, Fixed Income, Gasoline Prices, Global Bond, Individual Investors, Interest Rate Risk, Investor Demand, Net Worth, Pauper, Propensity, Schwab, Skepticism, Stock Market, Strategist, Structural Supports, Volatility, Well Thanks
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The End of the 30-year Bond Bull Market?

Thursday, March 29th, 2012

Is the great 30-year bull mar­ket in bonds com­ing to an end? Yes, per­haps — or maybe not: It depends on whom you ask and how flex­i­ble your tim­ing is.

While many peo­ple think of bonds as con­ser­v­a­tive hold­ings, they have pro­duced stel­lar returns for decades, thanks to the tam­ing of infla­tion and other fac­tors. A bas­ket of stocks would have returned a mere 19% from the start of 2000 through 2011, for exam­ple, while a bas­ket of bonds would have returned about 113% through a com­bi­na­tion of ris­ing prices and inter­est earnings.

But many experts say eco­nomic recov­ery could now reverse the process by dri­ving inter­est rates higher, caus­ing bond prices to fall. Yield on the 10-year U.S. Trea­sury rose to around 2.25% in March, after hov­er­ing around 2% for four months. "I think bonds are less attrac­tive than they have been for a long time," says Scott Richard, Whar­ton prac­tice pro­fes­sor of finance.

But ris­ing rates and falling prices are not nec­es­sar­ily com­ing so soon, accord­ing to Whar­ton finance pro­fes­sor Franklin Allen, who notes that short-term rates in Japan have stayed extra­or­di­nar­ily low for many years. Though the odds favor a rise in rates, strong demand for high-quality bonds, par­tic­u­larly U.S. Trea­suries, could per­sist for some time, he says, keep­ing prices high and yields low. "I think [Trea­suries] are still very much a safe haven, and that's why inter­est rates are so low, even though there are many things to worry about." He adds that there is a chance they will stay low "for a very long time."

How­ever, accord­ing to Whar­ton finance pro­fes­sor Krista Schwarz, "It's vir­tu­ally impos­si­ble to fore­cast future yields. One can talk about risks to the upside and risks to the down­side, but both risks always exist."

From Bull to Bear

Clearly, the U.S. econ­omy is gain­ing steam, though slowly. Typ­i­cally, that causes inter­est rates to rise, which dri­ves bond prices down — turn­ing a bull mar­ket into a bear. But the econ­omy has had false starts in the past. Signs were good early in 2011, but progress stalled amid the Euro­pean debt cri­sis and the tsunami and earth­quake in Japan. Most experts agree that eco­nomic signs are even stronger this year, but many warn that progress could be derailed by gov­ern­ment debt prob­lems in the U.S. and Europe, ris­ing oil prices and rip­ple effects from a slow­down in China and other emerg­ing mar­kets. In the U.S., the trou­bled hous­ing mar­ket con­tin­ues to dampen recovery.

Uncer­tainty dri­ves investors to pur­sue safety, which pushes busi­nesses, indi­vid­u­als and for­eign gov­ern­ments to stock up on U.S. Trea­sury secu­ri­ties, the mod­ern world's safe haven. The Trea­sury mar­ket is big enough to soak up world­wide demand, and safe because it is backed by the government's power to tax. High demand has dri­ven bond prices up and forced yields to extra­or­di­nary lows.

Still, bond mar­ket experts point to a sim­ple, undis­puted fact: Yields on Trea­suries and other highly rated bonds are so low they can­not go much lower. His­tor­i­cally, they have been much higher, and the law of aver­ages says they should rise again. Cur­rently, the 10-year U.S. Trea­sury note yields a mea­ger 2.25%, down from around 5.25% before the finan­cial cri­sis struck in 2008. It has not been lower since the 1940s, and has spent most of the past seven decades in the 4% to 8% range, peak­ing at more than 14% in the early 1980s.

Low inter­est rates are won­der­ful for bor­row­ers but tough on indi­vid­u­als who count on inter­est income from bank accounts and bonds, such as retirees. Ris­ing inter­est rates can be very hard on investors who already own bonds or bond mutual funds, because they drive down the value of older bonds that pay less, poten­tially caus­ing sub­stan­tial losses. A 30-year bond can lose 10% of its value for every one-percentage-point rise in pre­vail­ing rates.

Ris­ing rates would also be hard on U.S. tax­pay­ers, who would have to pay more to finance the government's $15 tril­lion debt. "When rates rise, the bor­row­ing costs on our deficits are going to rise sub­stan­tially, and that's going to restrain the abil­ity of future admin­is­tra­tions to do things," Richard warns. The major­ity of fed­eral debt matures in less than five years, mean­ing the gov­ern­ment must con­stantly sell new bonds to pay off old ones, shoul­der­ing higher inter­est costs as rates rise.

The Fed's Influence

The bond mar­ket is extra­or­di­nar­ily diverse and com­plex, includ­ing cor­po­rate and munic­i­pal bonds as well as Trea­suries issued by the U.S. gov­ern­ment. But all bonds are loans from the investor to the issuer. Buy a $1,000 bond yield­ing 4% for 10 years, and you will receive $40 a year in inter­est and get your $1,000 back after a decade.

Before that matu­rity date, how­ever, the bond price can fluc­tu­ate as mar­ket con­di­tions change. If newer bonds yielded only 2%, investors would pay a pre­mium for the older bond that paid 4%. In other words, the older bond's price would rise until the $40 in annual inter­est earn­ings equaled the 2% yield offered by newer bonds — so the bond's price would rise from $1,000 to $2,000. Price changes due to rate changes are more extreme for bonds with more time to matu­rity, because the investor would expe­ri­ence the effects longer. Of course, the process also works the other way, with ris­ing rates dri­ving prices down.

While the process is more com­pli­cated in real life, and the price changes are gen­er­ally less extreme than in the above exam­ple, this is the prin­ci­ple that pro­duced the great bull mar­ket in bonds. Begin­ning in the early 1980s, the Fed­eral Reserve — first under Paul Vol­cker and then Alan Greenspan — worked suc­cess­fully to reduce the annual infla­tion rate, which peaked at nearly 15% in 1980 and now stands below 3%. The Fed tack­led infla­tion by rais­ing short-term inter­est rates. That raised bor­row­ing costs, which reduced spend­ing. The result­ing drop in demand helped restrict price increases, and infla­tion fell. Grad­u­ally, inter­est rates were ratch­eted down, boost­ing bond prices.

The Fed's main tool is its strong influ­ence over short-term inter­est rates, such as the Fed funds rate that banks charge each other for overnight loans. The Fed does not have as much direct con­trol over long-term rates, which usu­ally are higher because investors demand a pre­mium for the risks they face, such as higher infla­tion, when they tie their money up for longer peri­ods. But long-term rates are in part a bet on what short-term rates will be in the future, so the Fed's down­ward pres­sure on short-term rates puts down­ward pres­sure on long-term ones as well.

Other mar­ket forces, such as the demand from investors seek­ing "safe" hold­ings, have a strong role in gov­ern­ing long-term rates. And because the mar­ket for Trea­suries is so large, Trea­sury yields influ­ence other inter­est rates, such as those charged by mort­gages and cor­po­rate and munic­i­pal bonds. "Every­thing moves rel­a­tive to Trea­sury rates," says Richard.

Many experts have crit­i­cized Greenspan for con­tin­u­ing the Fed's low-rate pol­icy early in the 2000s, when he was try­ing to encour­age lend­ing to stim­u­late the econ­omy after the Internet-stock bub­ble burst. Low rates, crit­ics say, fueled the lend­ing binge that caused the hous­ing bub­ble, which burst in 2008, caus­ing the Great Reces­sion. The Fed has main­tained its low-rate pol­icy under chair­man Ben Bernanke, who took office in 2006. His goal was to encour­age lend­ing to spur eco­nomic growth. Cur­rently, the Fed funds rate is zero, down from more than 5% before the reces­sion. "This is the first time in the post-war period that we have had the Fed funds rate at zero," Richard notes.

Other Trea­sury yields are also at near-record lows. Even the 30-year U.S. Trea­sury bond yields only 3.3%, despite the pre­mium that investors demand for tying their money up for so long. Low-rate pol­icy has dri­ven the stan­dard 30-year fixed-rate mort­gage down to about 4%, from over 6% before the reces­sion. Inter­est earn­ings on bank sav­ings are near zero.

To fur­ther stim­u­late the econ­omy, the Fed has resorted to try­ing to reduce long-term rates by pur­chas­ing long-term bonds, which increases demand and raises prices, but this is only mod­er­ately effec­tive, Richard says. "I believe Bernanke kept us from going into a deeper reces­sion, or even a depres­sion," he adds. "The Fed acted in an excel­lent way, in my opin­ion.... [Bernanke] has responded with every bit of artillery that he has, and he just doesn't have any more. Another round of eas­ing won't do any good."

The Fed's prob­lem — run­ning out of ways to stim­u­late the econ­omy — means Trea­sury yields have effec­tively hit bot­tom, or come so close that, in the long run, the odds of drop­ping fur­ther appear to be vastly out­weighed by the odds of going up. "Math­e­mat­i­cally, you would expect that they would go up, since they are at all-time lows," Allen notes.

When Rates Rise

If the econ­omy strength­ens, the Fed may some­day become more con­cerned about infla­tion and start nudg­ing inter­est rates up to cool growth. Bernanke has said this will not hap­pen until late 2014 at the ear­li­est, but some experts think the econ­omy will start grow­ing fast enough to force his hand sooner.

"The key fac­tor that could cause Trea­sury yields to rise is an improv­ing eco­nomic out­look," Schwarz says. "This would work in two ways. First, it would bring for­ward the time of pos­si­ble tight­en­ing of mon­e­tary pol­icy by the Fed. Second, investors would be will­ing to buy riskier assets, push­ing Trea­sury yields higher as investors shift out of Trea­suries and into these other assets. Indeed, this is pre­cisely what has been hap­pen­ing so far this spring." But eco­nomic prob­lems, or a dip in infla­tion below the Fed's 2% tar­get rate, could put the Fed back into a rate-cutting mode, Schwarz adds. "And if things in Europe take another turn for the worse, or there are some other strains on global mar­kets, then this would cause safe haven flows into Trea­suries, sup­port­ing prices and bring­ing yields lower."

What would the world look like if rates did start to rise? Bor­row­ing costs would prob­a­bly go up, mak­ing it more expen­sive to buy things like homes, cars and appli­ances. Yields would prob­a­bly rise on interest-bearing accounts, such as bank sav­ings and money-market funds. That would be good for savers, assum­ing the gains were not devoured by higher infla­tion. But bond investors could be hit hard, ana­lysts note, as higher yields on new bonds would drive down val­ues of older, stingier bonds already in investors' port­fo­lios. The great bull mar­ket could turn into a great bear market.

If this hap­pened, an investor who owned an indi­vid­ual bond would face an unpleas­ant choice: sell at a loss to rein­vest for a higher yield, or con­tinue receiv­ing a below-market yield by keep­ing the bond to matu­rity, when the bond would be redeemed at full face value. Either way, the investor who owns a bond when yields rise would be worse off than one who had stayed in cash. The cash holder, hav­ing avoided the price drop, could then buy a new bond with a higher yield.

The prob­lem is par­tic­u­larly dif­fi­cult for peo­ple who invest in bonds through mutual funds. Because funds con­stantly replace the bonds they hold to main­tain the aver­age matu­rity promised to investors, the fund itself has no fixed matu­rity date — matu­rity is always five years from the present, for exam­ple. If rates rise, the fund will likely sell some bonds at a loss, and see the ones it retains fall in price, caus­ing a drop in the fund's share price. Over time, the higher yields earned by newer bonds added to the fund will help repair the dam­age, but there's no escap­ing the fact that a sharp rise in inter­est rates could cause deep losses for many bond fund investors. Unlike own­ers of indi­vid­ual bonds, fund investors can­not sim­ply wait for the matu­rity date to redeem at full value.

Many experts are warn­ing that bonds — and bond funds — are riskier than they have been in recent decades. The risk can be reduced by own­ing bonds and funds with shorter matu­ri­ties, since those hold­ings would suf­fer less from ris­ing rates: Even if rates were to dou­ble or triple overnight, a $1,000 bond matur­ing the next day would still be worth $1,000, while a bond that wouldn't mature for 10, 20 or 30 years would col­lapse in value.

Unfor­tu­nately, bonds and funds with shorter matu­ri­ties, while mit­i­gat­ing the prob­lem of interest-rate risk, cur­rently offer very low yields. An investor who took the short-maturity route would regret it if yields did not rise. And that does remain a pos­si­bil­ity, Allen says, argu­ing that per­sis­tent eco­nomic prob­lems around the world could fuel high demand for Trea­suries and other highly rated bonds for years, keep­ing rates low.

Flock to Stocks?

If eco­nomic con­di­tions improve and bonds seem too risky, investors may turn to stocks, which have done well in recent years. Prince­ton econ­o­mist Bur­ton G. Malkiel, author of A Ran­dom Walk Down Wall Street, argued in a recent edi­to­r­ial piece in The Wall Street Jour­nal that stocks are a safer choice now than bonds. "Bonds are the worst asset class for investors," he wrote. "Usu­ally thought of as the safest of invest­ments, they are any­thing but safe today. At a yield of 2.25%, the 10-year U.S. Trea­sury note is a sure loser." After infla­tion took its share, that bond would effec­tively yield noth­ing, he added.

If investors fol­low Malkiel's advice, a flood of money to stocks from bonds would under­mine bond prices by reduc­ing demand.

For small investors, bonds could con­tinue to pro­vide diver­si­fi­ca­tion in the port­fo­lio, one of the chief rea­sons for own­ing them, and bond losses, if there were any, could be off­set by stock gains. Many experts say ner­vous investors can reduce their bond hold­ings, but elim­i­nat­ing them entirely could actu­ally add risk by putting more eggs in the bas­ket of stocks.

Allen points out that there are many poten­tial eco­nomic prob­lems that could under­mine stocks and make bonds a safe haven. "I think [bonds] are still a good place to have a chunk" of the port­fo­lio, he says.

Tags: Bond Prices, Bonds, Downside, Economic Recovery, Finance Professor, Four Months, Franklin Allen, inflation, Interest Earnings, interest rates, Krista, Many Things, Odds, Practice Professor, Professor Franklin, Safe Haven, Steam, Treasuries, U S Treasury, Wharton
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Bianco and Biderman on Bonds and Debasement

Thursday, March 29th, 2012

James Bianco plays straight-man to Charles Bider­man in this extended (and admit­tedly audio-challenged) dis­cus­sion of the real­ity behind money print­ing, infla­tion, and the US Trea­sury mar­ket. Fol­low­ing our dis­cus­sion of the deficit ear­lier, it seemed appro­pri­ate to lis­ten to this back-and-forth as Bianco addresses who is really buy­ing US Trea­suries, how 'money' is cre­ated by the Fed for the banks, and where infla­tion is leak­ing into the sys­tem. "The day the Fed admits there is an infla­tion prob­lem is the day they are too late" is how they sum­ma­rize the temporary/transitory ver­biage that the Fed needs to keep using to pla­cate the masses. Gold (and TIPS) remain their pre­ferred strat­egy as Bianco argues that putting the 'infla­tion' threat in con­text is crit­i­cal — this is not about 14/15% com­par­isons, this is about investor expec­ta­tion that we get 3% infla­tion with the Fed at ZIRP and intend­ing to keep print­ing money — which is just as toxic. The two end with an inter­est­ing con­ver­sa­tion on the simul­ta­ne­ous debt defla­tion and price infla­tion and the impor­tance of not com­par­ing either to their extremes by way of shrug­ging off concerns.

Tags: Banks, Bonds, Debasement, Deflation, Expectation, Extremes, Gold, Inflation Problem, Inflation Threat, Investor, James Bianco, Money Printing, Preferred Strategy, Price Inflation, Printing Money, Straight Man, Treasuries, Treasury Market, Us Treasury, Verbiage
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Is Needing EU Help a Good Thing? I Really Cannot Remember.

Wednesday, March 28th, 2012

by Peter Tchir, TF Advi­sors

Mar­kets are up a lit­tle this morn­ing, basi­cally get­ting back the late day fade.  S&P Futures up 4.  IG18 is ¾ of a bp tighter.

In Europe, bonds in Spain and Italy are bet­ter after an ini­tial round of weak­ness.  As far as I can tell, they both bounced on rumors that the EU was going to help out the Span­ish banks.  Maybe it’s too early today, but I’m begin­ning to have trou­ble see­ing the logic of ral­ly­ing sov­er­eign debt on a story that the banks need help.  I con­tinue to be a lit­tle sur­prised that Italy is back to mov­ing up and down in lock-step with Spain, as I think Spain is doing a lot to dis­tin­guish itself – and not in a good way.  Ital­ian 5 yr CDS is actu­ally 4 bps wider on the day at 371 while Span­ish 5 yr CDS is 2 tighter at 423.

I will dig into the Span­ish debt issuance and bud­get issues in more detail, but yesterday’s news should scare investors.  The deficit in the first two months of the year was worse than expected, and worse than last year because they trans­ferred money to var­i­ous regions and munic­i­pal­i­ties.  Now they will just guar­an­tee debt of those regions, so no trans­fer, and improved deficit.  All fixed?  Hardly, just account­ing games and another sign that some­how Europe does not under­stand that guar­an­tees count.

Yes­ter­day in fixed income ETF’s, we saw gains across the board, but with trea­sury related assets out­per­form­ing credit assets.  Junk bond ETF’s had the small­est gains, but that was a bit of catch up from the prior day, and the real­ity is that they are run­ning out of room for any sig­nif­i­cant upside, which is why we still like HY17 vs HYG.  HY17 is back to 99 and does seem to be ben­e­fit­ting from the roll.  We are also finally see­ing some “com­pres­sion” as HY out­per­formed IG.  That trade has been hurt­ing peo­ple as the “com­pres­sion” story has been com­pelling, but the mar­ket hasn’t played nice with that trade.  Look­ing at it now, but not yet in it.  IG18 still seems like a rea­son­able short.  Even with creep­ing back into 88.75 this morn­ing, it feels like the mar­ket is under­hedged and even a bit long and it has failed to come back to its tights of 85.5 in spite of a spir­ited stock market.

Durable goods orders have a chance to break the trend of weak data, but that series is so volatile, I’m not sure a pos­i­tive read­ing does much.  My guess is that we miss this num­ber as well, but in this day and age of cen­tral banks dom­i­nat­ing mar­ket moves, that miss might not do much.

VIX and TVIX (trad­ing with almost no pre­mium again) both bounced.  Stocks leaked, but the real­ity is that every­one is still digest­ing Monday’s move and really try­ing to fig­ure out if all that mat­ters is cen­tral bank liq­uid­ity.  I think that has its lim­its, and we have had sell-offs with big cen­tral bank poli­cies in place, but even my faith was shaken on Mon­day as Ben seemed almost single-minded in his pur­suit of more ways to “accom­mo­date” the mar­ket, in spite of our con­cerns that he may be doing more harm than good to the econ­omy, both in the short run and in the long run.

Copy­right © TF Advi­sors

Tags: Accounting, Amp, Assets, Bonds, Bp, Bps, Budget Issues, Debt Issuance, Fixed Income, Futures, Guarantees, Ig, Junk Bond, Logic, Months Of The Year, Municipalities, Sovereign Debt, Spanish Banks, Tf, Treasury
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Homer Simpson’s Financial Markets and “Fixed Income” Products (Tchir)

Sunday, March 25th, 2012

by Peter Tchir, TF Mar­ket Advisors

Stop tomorrow’s prob­lems today.

Just this week we had:

TVIX – an ETN that pro­vides dou­ble the daily change in the vix futures.  Who is smart enough to be able to take big bets on VIX futures that doesn’t have a futures account?  Who is this designed for?

MF Global & “cus­tomer money” – months after the prob­lem, no good expla­na­tion of where the money went, and even more scary, is that the it remains unclear whether MF did any­thing ille­gal with cus­tomer money.  Our under­stand­ing of how our money should be treated, and the legal rights we have signed away don’t nec­es­sar­ily match up.

CPDO – the legal bat­tle in Aus­tralia over this dis­as­ter con­tin­ues.  In the top 3 of mis-rated prod­uct of all time.  You take some­thing that is BBB+ on aver­age, LEVERAGE it, and get AAA.  It relied on “self-insurance” the thing partly respon­si­ble for the equity crash in 1987.

Greek CDS auc­tion – finally a Credit Event occurred and set­tled this week.  Very few peo­ple still seem to under­stand how lucky CDS hold­ers were that the auc­tion on New bonds deliv­ered a real pay­out.  The sys­tem didn’t fall apart as some had wor­ried, but no rea­son that CDS can­not be at least 90% cleared, or bet­ter yet, traded on an exchange.

BATS – “Mak­ing Mar­kets Bet­ter” accord­ing to their web­site had to pull their own IPO.  Maybe they didn’t real­ize algo’s don’t pro­vide actual liq­uid­ity, all they do is take real liq­uid­ity from exchange and run around the elec­tronic world try­ing to scalp a few frac­tional cents not avail­able to indi­vid­ual investors any­ways.  If they have to list on a proper exchange, peo­ple really should ques­tion the need for these other exchanges, sub-penny trad­ing, etc.

I’m all for some com­plex­ity and inno­va­tion, but it does seem after a week like this, that the finan­cial mar­kets have become too com­plex, and some real effort should be made to sim­plify things and put every­one on an even play­ing field.

Which brings me to a story I’m just get­ting up to speed on.  It seems like banks and invest­ment banks are work­ing on ways to sat­isfy their customer’s demand for yield.  They should come with a  warn­ing that “yields in hind­sight may be smaller than they appear”.  I haven’t been able to con­firm that this is being sold to retail or how much has been done, but I decided to poke around in some bonds listed by Citibank – mostly because some­how they seemed to have needed more sup­port from the tax­pay­ers than any other bank (except for BAC which I have picked on too often).

So let’s take a look at what appears to be a Citibank NA Cer­tifi­cate of Deposit – how dan­ger­ous could that be?

It seems a bit long for a CD – 2032 final matu­rity, espe­cially since it is callable at any time.  Accord­ing to this it hasn’t been issued yet, so maybe this is all a bad dream, but since I was able to find it on Bloomberg, it prob­a­bly is some­thing they are try­ing to sell.

So on any “fixed income” prod­uct, the big ques­tion is what is the coupon?  It pays 6%!

Ok.  I could buy Cit­i­group Inc 5.85% bonds with a 2034 final matu­rity.  They are non-call and priced around 103.5 to give a yield of 5.57%.  So stop right there.  The CD may be mar­gin­ally higher in the cap­i­tal struc­ture and slightly safer, but for 20 years I would much rather have 5.57% non callable bond rather than a 6% bond callable at any time.  I would spend more time work­ing out the value of the call and if the trade-off is even remotely fair, but there is no point, because the coupon isn’t “fixed” it resets annually.

So after 1 year, the coupon will be 5% minus 6 month LIBOR at the time.  If today was a “set­ting” date, the coupon would be only 4.25%.  So as short term rates rise in the future, this coupon on this Inverse Floater will go do.  If 6 month Libor is ever at 4% or above on a set­ting date, then this bond will have the “floored” coupon of 1%.  So if the Fed starts rais­ing rates or LIBOR goes up because bank credit risk dete­ri­o­rates, you own a low coupon bond in either a high rate envi­ron­ment, or weak bank credit environment.

But this “Cer­tifi­cate of Deposit” looks tame com­pared to another they seem to be mar­ket­ing at the same time.  Again, I don’t know for cer­tain that they are mar­ket­ing this, but it does show up on Bloomberg under a list of Citi bonds, so I have to assume it isn’t there by accident.

So this one is a “dual range accrual”.  So it look like you have to track the num­ber of days in a period where 3 month Libor is between 0% and 5% and the Rus­sell 2000 is above 75 (maybe they mean 750?).  If both con­di­tions are met for the entire period, you get a 4.25% coupon.  So a Citibank CD that is callable at any time, has a best case coupon of 4.25%, and could be 0% in either a high rate envi­ron­ment (libor above 5% or in a weak stock mar­ket the RTY is below the thresh­old).  Retail investors are sell­ing options hand over fist with the promise of some decent yield in the first year.  I find it hard to believe they under­stand the options they are sell­ing, and I find it impos­si­ble to believe that  they are sell­ing the options at any­thing close to fair value.

Stop tomorrow’s prob­lems today, but if you are show a “fixed income” prod­uct where the coupon is too good to be true, it is too good to be true!

Copy­right © TF Mar­ket Advisors

Tags: Bats, Bbb, Bets, Bonds, Complexity, Electronic World, Etn, Financial Markets, Fixed Income Products, Greek Cds, Homer Simpson, Individual Investors, Ipo, Leverage, Mf Global, Nbsp, Proper Exchange, Real Liquidity, Self Insurance, Tf, Vix Futures
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Those Catchy Spanish (Yield) Curves (Tchir)

Thursday, March 22nd, 2012

From Peter Tchir of TF Mar­ket Advisors

Span­ish Yield Curve

With ZIRP and LTRO it is hard to get a good read on the Span­ish yield curve and what any­thing means.

Span­ish 10 year yields have risen 9 days in a row, 5 year yields have moved higher 8 out of 9 days, and the 2 year has been much more mixed, until recently.

The 2 year yield is out 19 bps in those 9 days, but 18 bps of that move has occurred the last 2 days.  The 2 year bond fits the sweet spot of LTRO, is likely to be held by banks in non mark to mar­ket accounts, so it has been sta­ble, but it has even started to leak a lit­tle.  The move is small, almost triv­ial, yet with all the things work­ing to sup­port 2 year bonds, it is curi­ous that it is able to widen at all, let alone 18 bps in 2 days.

The 10 year yield is 48 bps higher, but the 5 year yield is 54 bps higher.  The curve is still steep, but we are start­ing to see yields mov­ing faster in the 5 year than in the 10 year.  In the past 5 days, the 5 year yields have under­per­formed the 10 year by 7 bps.  At the risk of mak­ing a moun­tain out of a mole-hill, this is worth watch­ing.  The move started with the entire curve steep­en­ing.  So the move was bear­ish, but more iso­lated to the long end.  The move is start­ing to impact the “belly” of the curve more.  In a nor­mal world, this small “flat­ten­ing” of 5’s/10’s would be easy to ignore, but in a world where the curves are influ­enced (manip­u­lated) by gov­ern­ment poli­cies that do every­thing pos­si­ble to keep the front end anchored, this move may mean far more than it nor­mally would.

We have been watch­ing Spain for almost 2 weeks as a poten­tial canary in the coalmine, and it seems in the past 2 days it has hit everyone’s radar.  I wouldn’t be sur­prised to see some ECB buy­ing to keep the move in check, but with a pretty bloated bal­ance sheet and a lot of dis­agree­ment over the abil­ity of the ECB to shield its bond hold­ing from restruc­tur­ing, they might not be so willing.

In an effort to dig deeper into Spain, while the 10 year will still be a focus, the “flat­ten­ing” and “front end” will be the next canaries as to just how bad this can get.  Small moves there are far more impor­tant than they seem because it means they are mov­ing in spite of low rates, ECB pur­chases, LTRO, t-bill auc­tions, etc.   It seems strange that small moves there could be the most impor­tant clue for how bad this can get, but when we first started notic­ing that Span­ish 10 year yields couldn’t hold onto gains on any day, it also seemed far-fetched to a lot of peo­ple that Span­ish yields would be in the spot­light again.

Pain in Spain is very neg­a­tive for the Euro.

Expect talk of PSI and debt restruc­tur­ing to increase.  There is only one way for sov­er­eigns to get their debt down quickly.  That is to pull a PSI and make banks and insur­ance com­pa­nies take the hit.  I would avoid Euro­pean bank shares here, as their equity mar­ket cap and abil­ity to absorb losses will be a tempt­ing tar­get for politi­cians who want to reduce debt and don’t want to waste a year mak­ing things worse, like Greece did.  This is espe­cially true with LTRO reduc­ing fund­ing concerns.

Tags: Balance Sheet, Banks, Bonds, Bps, Coalmine, Disagreement, ECB, Government Policies, Market Accounts, Mole Hill, Radar, Restructuring, risk, Spain, Spanish, Sweet Spot, Yield Curve, Yield Curves, Zirp
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Moment of PSI Truth (BofA)

Thursday, March 8th, 2012

Today is sup­pos­edly the day. The ini­tial dead­line for Greek PSI will occur later today (unless of course it is extended some­how — but will be released here) and while CAC acti­va­tion (and hence 90% par­tic­i­pa­tion) is the con­sen­sus most likely out­come for bonds under Greek law (but not for all bonds under Eng­lish law) — which the mar­ket appears to be very com­fort­able with given overnight trad­ing — there are still risks, as BofA notes, that a num­ber of low risk but high impact events unfold with extremely neg­a­tive con­no­ta­tions. Clar­i­fy­ing expec­ta­tions and mar­ket impli­ca­tions, it does seem that while BofA is a lit­tle more san­guine than us on this ini­tial dead­line, that the market's com­pla­cency is extremely high.

BofA: PSI participation

The Greek PSI par­tic­i­pa­tion is sup­posed to be announced tomor­row, at 8am Athens time, on greekbonds.gr. Sum­ma­riz­ing views that we have dis­cussed in recent reports:

• The most likely sce­nario is acti­va­tion of Col­lec­tive Action Clauses (CACs) for all bonds under Greek law – about 87% of the total. We expect that PSI con­sent for these bonds to be above the 66% thresh­old required to acti­vate CACs. Assum­ing total PSI par­tic­i­pa­tion is below 90%, we do not expect the IMF-ECB-EU Troika to increase the total size of the new Greek pack­age in order to avoid acti­vat­ing CACs. Note that CACs will be acti­vated for all bonds under Greek law together, as the acti­va­tion thresh­old does not have to be reached sep­a­rately for each bond.
• How­ever, CACs may not be acti­vated for all bonds under British law – about 10% of the total. Acti­va­tion of CACs in this case will be decided on a bond by bond basis, dur­ing bond-holder meet­ings for each bond at the end of March and early April. As PSI par­tic­i­pa­tion for some of these bonds may not reach the thresh­old to acti­vate bond-specific CACs (in some cases as high as 75%), some of them may be repaid in full.
• A small PSI par­tic­i­pa­tion for the bonds under British law is not a prob­lem for the suc­cess of the PSI, even in the case that CACs can­not be acti­vated for some of these bonds. Acti­va­tion of CACs for the bonds under Greek law and a small par­tic­i­pa­tion for the bonds under British should be enough to bring the over­all PSI par­tic­i­pa­tion to the tar­get of above 90%.
• About 3% of the PSI eli­gi­ble bonds are bonds issued by state owned enter­prises, which although have no CACs, are within Greece and are expected to participate.
• The only PSI sce­nario in which CACs are not acti­vated is if par­tic­i­pa­tion in the bonds under Greek law is almost full, bring­ing total PSI par­tic­i­pa­tion close to 87%, and par­tic­i­pa­tion in the bonds under British law is more than 50%, bring­ing total PSI par­tic­i­pa­tion to above 90%, on a vol­un­tary basis. In this case, acti­va­tion of CACs for bonds under Greek law would not bring any large sav­ings, while it may not be pos­si­ble to acti­vate CACs for most of the bonds under British law. Any hold­outs will be repaid in full, assum­ing there is not another debt restruc­tur­ing in the future. Such a “free-riding” may be polit­i­cally unpop­u­lar, but we believe that the Euro­zone author­i­ties may still pre­fer to avoid a credit event in a mem­ber coun­try if they have a choice.
• The worst case sce­nario is if con­sent to acti­vate the CACs on the bonds under Greek law is less than 66%. This is a low prob­a­bil­ity event, in our view, as con­sent to acti­vate CACs is likely to be well above the vol­un­tary PSI par­tic­i­pa­tion. To acti­vate CACs, Greece needs the con­sent of 66% of those who reply to the exchange offer, pro­vided those who reply are more than 50% of the total debt-holders. Those who ten­der their bonds – par­tic­i­pate in the PSI – give their con­sent auto­mat­i­cally. Those who don't ten­der their bonds will most likely also con­sent to acti­vate CACs, because they should still pre­fer the PSI hair­cut from what could be a larger hair­cut out­side the PSI. Those who don't reply to the offer don't count, but will be sub­ject to the same hair­cut if CACs are activated.

Mar­ket implications

In our view, an orderly default in Greece should be already priced in. An orderly default includes trig­ger­ing of CDS con­tracts and enforce­ment of the PSI scheme to all debt-holders for bonds under Greek law and some for bonds under British law, within an IMF pro­gram, funded by the new aid pack­age. In con­trast, a dis­or­derly default would take place if the March 20 debt matu­rity is missed, or the new pro­gram with the Troika is not approved. CDS spreads in Greece have increased sharply to record lev­els fol­low­ing the country’s recent down­grade to selec­tive default, sug­gest­ing a very high prob­a­bil­ity of a credit event (Chart 1). Although CDS spreads in the rest of the region are also increas­ing, they seem to move inde­pen­dently from Greek CDS spreads.

Acti­va­tion of CACs and trig­ger­ing of CDS in Greece could even have a pos­i­tive mar­ket impact, at least in the short term. Although we do not believe that PSI the scheme ensures debt sus­tain­abil­ity in Greece, it buys time and removes the risk of a dis­or­derly default, at least before the elec­tions in early May.

Some have argued that trig­ger­ing CDS in Greece could sup­port sov­er­eign mar­kets in the rest of the periph­ery, but we don’t con­sider this to be an impor­tant chan­nel. In the­ory, a cred­i­ble insur­ance mech­a­nism should help reduce sov­er­eign bor­row­ing costs. If Greece was to restruc­ture its debt with­out trig­ger­ing CDS, it is unlikely than any other advanced econ­omy would ever trig­ger CDS, with the excep­tion of a dis­or­derly default. This could cause a sell off of sov­er­eign bonds in the rest of the periph­ery. How­ever, net CDS pro­tec­tion is sur­pris­ing small for the coun­tries in the region (Chart 2), and it does not seem to be cor­re­lated with sov­er­eign risks.

A num­ber of devel­op­ments could still affect mar­kets neg­a­tively, at least in the short term, but we see them as hav­ing a low prob­a­bil­ity or a small impact:

• Gross CDS expo­sures in Greece are still siz­able (Chart 3). Con­cerns about coun­ter­party risk and blind spots could trig­ger some mar­ket tur­bu­lence fol­low­ing the trig­ger­ing of CDS.
• Some bond-holders may take legal action against Greece. Such cases could take years to resolve, par­tic­u­larly in Greek courts, but related head­lines could raise concerns.
• The deci­sion to acti­vate or not CACs could be delayed, caus­ing mar­ket uncer­tainty. The Greek author­i­ties now seem adamant to acti­vate CACs, but this is expected as they try to max­i­mize PSI par­tic­i­pa­tion. All related PSI legal doc­u­ments make the acti­va­tion of CACs sub­ject to a gov­ern­ment approval, fol­low­ing con­sul­ta­tions with the Troika. Such lan­guage could sug­gest that there is not an agree­ment yet on the PSI par­tic­i­pa­tion that is really needed to avoid acti­vat­ing CACs. We also note that the recent Eurogroup deci­sion makes the total size of offi­cial fund­ing con­di­tional on PSI par­tic­i­pa­tion (see Eurogroup early morn­ing hours). The Greek author­i­ties plan to final­ize every­thing by the end of the week­end, but this may not be possible.
• The par­tic­i­pa­tion dead­line could be extended. One week could prove to be a short period to allow some investors to get inter­nal approval for par­tic­i­pat­ing in the PSI, includ­ing from the boards, and to coör­di­nate with their risk man­age­ment units. “Arm twist­ing” of some debt hold­ers may also require more time, for exam­ple in the case of some Greek pen­sion funds that are not will­ing to par­tic­i­pate in the PSI. Indeed, in the first PSI that was planned for last sum­mer and was never imple­mented, bond­hold­ers were given almost a month to decide, while press reports sug­gested an increas­ing par­tic­i­pa­tion dur­ing this time.
• Con­sent for the CACs could be below the thresh­old. As we argued above, this is the worst case sce­nario, but has a low prob­a­bil­ity, in our view. In this case, the PSI scheme will have to be aban­doned for a forced debt restruc­tur­ing scheme. It could prove dif­fi­cult to design a cred­i­ble new plan given the lim­ited time and the num­ber or par­ties involved. More­over, legal chal­lenges to any such plan would be a sub­stan­tial risk. The fail­ure of the PSI after more than half a year prepa­ra­tions could fuel mar­ket con­cerns about the over­all abil­ity of the Euro­zone to deal effec­tively with the cri­sis, even beyond Greece.

Tags: Athens, Bofa, Bond Basis, Bonds, Cac, Cacs, Collective Action Clauses, Complacency, Consensus, ECB, Greek Law, High Impact, Impact Events, Initial Deadline, Market Implications, Negative Connotations, Participation, Psi, Threshold, Troika
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Jeff Gundlach: Complete "Fall Of The [BLANK] Empire" Slideshow

Wednesday, February 15th, 2012

The defin­ing sound­bite from Jeff Gundlach's call Q&A: Regard­ing Bank of Amer­ica — "It is wise to avoid banks. Not sur­prised BAC has gone up — just like NFLX — just like Ital­ian bonds. Reduce risk right now, includ­ing, Bank of America."

While the star of multi-billionaire Bill Gross may or may not be fad­ing (the jury is still out on what the final out­come will be for the man who so far alone among his peers has dared to point out the lunacy in the Fed's actions), that of his far smaller and nim­bler peer Jeff Gund­lach of Dou­ble­Line Cap­i­tal has been ris­ing rapidly, and at last check has his fund's AUMs at over $25 bil­lion, a dou­bling in a few short months. Gund­lach is con­duct­ing his peri­odic web­cast live at 4:15pm East­ern (i.e., yesterday).

And by the title of the pre­sen­ta­tion, it promises to be quite interesting.

Now enjoy the Gund­lach slides in the leisure of your own unre­hy­poth­e­cated con­crete bunker, 50 feet below sea level.

"The decline and fall of the Roman Empire"

2–14-12 JEG Web­cast Roman Empire — FINAL

Tags: Bac, Bank Of America, Banks, Bill Gross, Billionaire, Bonds, Concrete Bunker, Decline And Fall, Decline And Fall Of The Roman Empire, Empire 2, Fall Of The Roman Empire, Feet Below Sea Level, Gundlach, Lunacy, Nflx, Peers, risk, Slides, Soundbite, Webcast
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The Great Market Disconnect Seen All Around The Globe (Business Insider)

Thursday, February 9th, 2012

via Busi­ness Insider

We've spent a lot of time this year dis­cussing this chart.

Bloomberg

The green line is the S&P 500. The orange line is the yield on a 10-year US Treasury.

It's weird because you'd think that as stocks rose — indi­cat­ing increased risk appetite and expec­ta­tions of growth — that yields would rise too, since demand for risk-free instru­ments would want. But that hasn't hap­pened. Stocks have had a really nice run, but yields have gone nowhere.

In a note out this morn­ing, Credit Suisse's Andrew Garth­waite listed this as his top anom­aly in the mar­ket right now.

There are var­i­ous the­o­ries as to why this dis­con­nect is in place: Some blame the Fed and "finan­cial repres­sion", arti­fi­cially depress­ing rates.

But one thing you'll notice is that to a vary­ing degree, this is a global phenomenon.

So for exam­ple, check out Australia.

The green line is the Aus­tralian All Ordi­nar­ies Mar­ket and the orange line is the yield on the Aussie 10-year.

Once again, the great dis­con­nect emerges, and it's espe­cially appar­ent since mid-December.

Bloomberg

And here's Sweden.

Bloomberg

And here's Ger­many. Once again, you see a mas­sive dis­con­nect begin­ning in December.

Bloomberg

And finally Japan. Again, the equity-bond dis­con­nect begins in December.

Bloomberg

So this is a global phe­nom­e­non, which strongly sug­gests that this isn't just about the Fed buy­ing Trea­suries in the US, though nat­u­rally all mar­kets are connected.

One thing that all these coun­tries have in com­mon is their bor­row­ing is done in their home cur­ren­cies, mean­ing they're essen­tially risk-free except from a cur­rency perspective.

A decent the­ory is that despite the big pickup in opti­mism, there's still a short­age of vehi­cles avail­able to investors look­ing for "risk-free" assets. So the coun­tries that can offer these bonds are still see­ing unusu­ally high demand. That's just a the­ory. Bot­tom line though: This isn't just an S&P/Treasury phe­nom­e­non. It' global.

Tags: Amp, Anomaly, Assets, Bloomberg, Bonds, Bottom Line, Business Insider, Credit Suisse, Currencies, Decent Theory, Financial Repression, Free Instruments, Global Phenomenon, Globe, Optimism, Orange Line, Risk Appetite, Stocks, Treasuries, Treasury
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