Mitt Romney’s presidential candidacy has created a new wave of interest in the mechanics of private equity.

The debate has so far primarily been about whether what private equity does–take control of companies that are not making much money, reorganize them and sell them on–is socially useful.  The answer is generally “Yes.”

A secondary question is whether investors in private equity funds, primarily pension plans and university endowments, are getting a good deal. The answer here is generally “No.”  In a recently conducted study for the Financial Times, for example, professors at Yale (whose endowment has been a bastion of such “alternative” investments) and Maastricht University conclude that the vast majority of profits go to the organizers and promoters of private equity schemes, not to the investors who bear almost all the risks.

hedge funds

The same is true of hedge funds, which incidentally are putting the finishing touches on a decade of underperformance versus an S&P 500 index portfolio.  And that conclusion is based on the data the funds themselves voluntarily report.  There’s lots of evidence that some hedge funds routinely overstate their: investment performance, assets under management, and the size and qualifications of their professional staffs.

these are illiquid investments

…oh, and in addition to less-than-stellar profits, these vehicles can be highly illiquid.  In the Great Recession, investors in hedge funds learned to their dismay that the contracts they signed (which they apparently hadn’t read) allowed their managers to refuse requests for redemptions–even for years.  Recently, stories have also been circulating about failed private equity projects that refuse to liquidate, presumably because that would put an end to the management fees the organizers are collecting.

but they’re in high demand

That such a P.T. Barnum-esque situation should have developed with exotic investment vehicles isn’t that strange.  What is, however, is that despite a long period of lackluster performance, institutional investors want to put more of their money into hedge funds and private equity, not less.

Why is this?

correlation

The standard answer that institutions will give is that these “alternative” investments aren’t correlated with the movements of stocks and bonds.  Therefore, they’re a diversification.   That lowers the risk of the overall institutional portfolio.

This, of course, is not true.

Generally speaking, the fact that the returns on two assets aren’t correlated doesn’t mean that the risks of one partially offset those of the other.  It just means that you’re exposed to two different sets of risks.  The fact that in bad weather you speed in a racing car and pilot a small plane doesn’t mean you’re safer than if you just did one of the two.

Also, in the case of alternative investments, there’s no public market and holders have no independently verified information about their returns.  So they have no way of determining if risks are correlated or not.

political pressure

A second, less talked-about reason is that hedge and private equity funds hire powerful, politically connected, salesmen who wield influence over the pension plan managers.  There have been scandals about payments to such sales agents in California and New York.

damned if they don’t

To my mind, the main reason institutional investors are attracted to alternative investments is simple arithmetic.  Traditional pension plans don’t have all the money on hand today that will be needed to pay their future obligations to present and potential retirees.  They assume that they can invest the funds they do have to earn a specified return, usually around 7%, so that today’s assets can grow enough to meet future obligations.  If they can’t do this, the plan is underfunded and the employer has to eventually kick in enough to make up the difference.

Is 7% a reasonable annual rate of return in today’s world?  Not if you’re limited to publicly traded stocks and bonds.

Let’s say that you have a 50/50 mix of the two asset categories.

–Stocks can probably have a nominal return of 8% a year (inflation +6%).  History says that in the aggregate the managers you hire will deliver somewhat less than that.

–The 30-year Treasury is yielding about 3%; the 10-year yields about 2%; the return on cash is practically zero.  Interest rates are now at emergency-low levels.  This means chances of a capital gain from holding bonds are slim; chances of a capital loss on your bonds as the economy recovers and rates rise are high.  Let’s be super-optimistic and say you can collect a 3% coupon and make no losses.

With a 50/50 mix of stocks and bonds, then, a pension plan can achieve a return of about 5% annually.  That’s nowhere near enough to meet the 7% goal.  Even if the plan went to an allocation of 100% stocks,  it might not achieve a 7% return.  And doing so would give up all protection against the possibility that another year like 2008 rolls around–as one sooner or later will.

How does the executive in charge of the pension plan deal with this problem?

Does he go to his boss and say he needs an extra $10 billion or so to fund the plan–taking the risk that the boss will shoot the messenger?   …or does he take the chance that, against the testimony of experience, alternative investments will deliver what they promise–big enough returns to get to the 7% goal?

The latter is certainly the path of least resistance.  And this fact also probably makes the political pressure from the hedge fund/private equity salesman that much harder to resist.

After the close of New York trading on Tuesday January 24th, AAPL announced results for 1Q12 (AAPL’s fiscal year ends in October).

The company reported its best single quarter ever, with diluted earnings per share of $13.87 on revenue of $46.3 billion.  Sales were up by 73% year on year for the three months; eps were up by 116%.  Wall Street analysts had been anticipating earnings of $10.16 per share.  AAPL not only handily beat that figure, but also blew through the high end of the estimate range at $11.26.

Management’s (notoriously lowball) guidance for 2Q12 is for revenue of $32.5 billion and per-share profits of $8.50.

AAPL shares rose by 6.3% in the Wednesday market.  On the surface at least, this strikes me as a tepid response to the numbers.  More on this topic below.

the details

quibbles first…

–AAPL is another one of those companies that uses the week rather than the month as their basic unit of time.  This creates a problem, because a year is equal to 52 weeks plus one day for regular years, plus two days for leap year.  So companies like AAPL have to throw in an occasional quarter that has an “extra” week in it to keep their reporting year and the calendar in sync.

1Q12 was one of those adjustment quarters.  Not only that, but the extra week was the high-volume sales period between Christmas and New Year’s Day.  So AAPL’s sales for the three months were likely 10% or so higher than they would ordinarily have been.

–the introduction of the iPhone4S shifted revenue out of 4Q11 and into 1Q12, because AAPL ran down inventories of its older phones and consumers deferred iPhone purchases until the new model became available.

–don’t make the same mistake I’ve heard from Bloomberg radio commentators of saying that this quarter’s earnings were more than AAPL made in a whole year not that long ago.  This sentiment is correct, but the comparison isn’t.  AAPL changed its accounting treatment for iPhone sales a couple of years ago to recognizing all the profits from a sale (markup on the device + a share of revenue collected by the telecom company over the life of a contract) up front, rather than recognize them gradually over the (usually two-year) contract term.

…followed by stunning numbers (ex the iPod)

iPhone

In 1Q12 AAPL sold 37 million iPhones, with iPhone4S leading the way.  That’s up 126% yoy, in a market that expanded by 40% over that time.  It’s also 17 million more than AAPL’s previous record for a quarter.   Sales would have been even higher except AAPL ran out of phones to sell in key areas.

iPhone 4S wasn’t available in China during 1Q12.  It went on sale there earlier in the month.  Demand has been “staggering.”

iPad

APPL sold 15.4 million iPads during the quarter, up 111% year on year.  According to CEO Tim Cook, the launch of AMZN’s new Kindle lines has had no effect, good or bad, on sales.

Macs

AAPL sold 1.48 million iMacs and 3.72 million laptops, both records, during the quarter.  Desktops were up 21% in units yoy; laptops were up 28%.  Industry growth was zero.

iPods

This declining category of devices was up 133% quarter on quarter for AAPL, but down 21% yoy.  iPod Touch remains the lion’s share of sales.  APPL retains a 70% share of the MP3 player market in the US and is the top-seller in most other markets (not that any investor is going to buy AAPL’s stock because of the iPod anymore).

other stuff

Sales at the Apple Stores, which make up almost a third of retail revenue for AAPL, were $6.1 billion during the quarter.  Average revenue per store was $1.7 million, up 43% yoy.

The iTunes store took in $1.7 billion.

Weak worldwide demand for tech components gave AAPL a lot of buying clout for NAND flash and DRAM during 1Q12.  As a result, the company’s gross margin was unusually high at 44.7%.  To give a basis for comparison, full-year 2011 gm came in at 40.5%.  This favorable development probably also boosted net income by 10%.

AAPL has $97.6 billion in cash on the balance sheet.  Of that, $64 billion is being held offshore.

the stock

Trying to “normalize” 1Q12 eps by correcting for the extra week and the elevated gross margins, I come up with a figure of $11.50 or so for the quarter.  If I had to guess, I’d peg full-year eps at least $40, even after a downward adjustment of 1Q12 results–meaning reported figures could be closer to $45 a share.

If I’m correct, AAPL shares are currently trading at, at most, 11x this year’s earnings, with 40%+ earnings growth in prospect.  That strikes me as really cheap.  Subtract AAPL’s cash from the equation and the forward multiple is 8.5x.

In contrast, WMT, which has nothing like the recent growth record or current prospects of AAPL, is trading at about 12x.

COH, a global semi-luxury company, whose stock has paralleled AAPL over the past year, and which has far better growth characteristics than WMT, trades at almost double the PE of AAPL.  But even COH probably won’t grow as fast as AAPL this year.

Why the low valuation for AAPL?

I think Wall Street views AAPL as a firm built at present on a single product, smartphones.  It perceives the global transition from feature phones to smartphones, which is at least part of what’s driving the company’s extraordinary growth, to be mostly played out.  Therefore, investors theorize, AAPL will sooner or later–and probably sooner–be reduced to depending on replacement demand.  When that happens, its earnings growth will shift into a much lower gear.

There’s some truth to this idea.  Look at the breakout of AAPL’s revenues during the current quarter:

iPhone     53% of sales

iPad     20%

Macs     14%

iPods     6%

Music services     4%

Other stuff     3%

Total = $46.3 billion.

After iPhone and iPad, nothing else moves the needle that much.  A half-decade ago, the iPod doubled the size of AAPL; the iPhone then doubled (a much larger) AAPL again.  Can iPad perform the same trick for AAPL a third time?  Eventually, maybe, as part of a transformation of the personal computer market over the next decade.  But I’m not sure many people would like to bet on that.

And, of course, NOK and RIMM are reminders of how fast the tech world can change.

Potential pitfalls may be Wall Street’s current focus, but it’s by no means the whole AAPL story.

As I’ve been writing for some time, AAPL shares have suffered immense PE contraction over the last four or five years, both in absolute terms and relative to the market.  According to Value Line, AAPL traded at a 40% premium to the market multiple in 2007 and a 60% premium in 2008.  By my reckoning, AAPL is now selling at a 25% discount to the market–a much lower level than firms (like WMT) with weaker business models and balance sheets.

That’s actually the good news.  The fact that a huge amount of potential future bad news seems to me to be already baked into the stock price is a powerful argument for owning the stock.  In fact, I think the market is discounting a far worse future for AAPL than is likely to develop.

Can AAPL do anything to help its own cause?  The company could begin to pay a dividend or split the stock.  Either would give the shares a short-term boost.  In the final analysis, however, all AAPL can really do is continue to post strong earnings to show that Wall Street fears are overblown.

Investor sentiment is a funny indicator.  Outside the US, investors try to figure out what way the tide of sentiment is flowing so they can set their portfolios to benefit from the prevailing direction.  Inside the US, on the other hand, professional investors try to determine the direction of sentiment so they can bet against it.

Surveys, of course, have the limitation that they tell you what the respondents have to say.  Normally secretive professionals may simply not respond, so you may end up surveying interns rather than senior managers; or they may not give their true opinions, for fear their views will be incorporated into the consensus before they are able to exploit them to the fullest.

Once you’ve set your portfolio, whether you then seek publicity for your largest holdings is a matter of personal preference or taste.  I would prefer not to do so, although I don’t regard the practice as border-line unethical, as some do.

two surveys

Anyway, I’ve come across two peculiar investor sentiment surveys recently.

–The first comes from the Chartered Financial Analyst Institute.  The Institute conducts a series of exams on academic portfolio theory, passing all of which results in the test-taker qualifying for a CFA charter (suitable for framing) that attests to the holder’s knowledge of the concepts. Once the province solely of professional portfolio managers and securities analysts, the current 90,000+ holders of the CFA designation are much more widely distributed through the various functions of investment-related organizations and the academic world.

Conclusions from the Global Market Sentiment Survey:

–Almost two-thirds of the 58,000 respondents to the survey expect the world economy will show no growth in 2012.  34% expect economic contraction; 29% think the world will tread water this year.

–About 60% expect that equities won’t be the highest return investment asset this year.  Among the competing alternatives, precious metals gets the most votes for top-performing asset, followed by commodities, bonds and cash.  Sentiment on this topic is split geographically, as well.  Of investors in the Americas, 45% think equities will have the best returns in 2012;  elsewhere, the proportion is only about a third.

The second survey is one conducted by a popular small-cap service I recently subscribed to.   Asked what they thought the probable returns for the S&P 500 this year might be, the most frequently given answer was a loss of 20%.

the respondents

As to the second survey, I was very surprised at how negative subscriber sentiment appeared to be.  I also looked at a couple of other surveys, one of which had some respondents saying small caps were too risky to invest in–yet, as subscribers, they were paying for information about small-cap stocks.  I don’t know what to make of that.

The CFA survey had one remarkable characteristic.  Half of the respondents had either not yet passed all the exams or had held their charter for two years or less.  Another 19% had been CFAs for five years or less.  These are not portfolio managers or senior analysts actually making investment decisions.   They’re much closer to being the man in the street.

my thoughts

I think the relative inexperience of the CFA survey respondents means that they’re much more indicative of what the man in the street thinks than of what the “smart money” is doing. In a section about employment opportunities, over half the respondents from Europe said that the job situation has deteriorated.  39% of those in Asia Pacific said the same.  So it’s also possible that the respondents have been unable to distinguish between their own career outlook and prospects for world equities.  My guess is that their macroeconomic and asset market answers are contrary indicators.

The (potentially oddball) respondents to the small-cap survey?  Clearly a contrary indicator, in my opinion.

All in all,  two small reasons to want to be bullish.

4Q11

After the close of trading in New York on Thursday January 19th, INTC reported 4Q11 results.  Revenues came in at $13.9 billion.  Profits were $3.4 billion, eps $.64.  Both figures were down slightly quarter on quarter during what’s normally the company’s seasonally strongest period.  Eps surpassed the Wall Street consensus of $.61, though.  Wall Street’s habitually somewhat downbeat stance toward INTC was certainly influenced by the firm’s early December warning that near-term orders for its PC chips were being cancelled by device manufacturers who are unable to get enough hard disk drives to make new PCs.

On a non-GAAP basis (adjusting for acquisition-related goodwill),  eps came in at $.68.

Investors were pleased with the results.  INTC shares rose by about 3% in a flat market on Friday.

full year 2011

During 2011, INTC achieved lots of all-time financial highs, including:  revenues at $54 billion; net income at $12.9 billion; eps at $2.39 (non-GAAP, $2.53).

one-time factors

There are two:

–Historically, INTC has used the week as the basic time period for its accounts rather than the month.  Because  52 weeks x 7 days/week = 364 days, or not quite a year, this approach requires the company to have occasional 53-week years to keep their accounting in sync with the calendar.  2011 was one of those “extra-week” years.  That probably added $.05 to 2011 eps.

(By the way, INTC has just shifted to the month as its basic time measure, so the “extra week” adjustment will no longer be necessary.)

–Thailand produces about 40% of the world’s hard disk drives. Massive flooding there during 4Q11 took many HDD factories out of commission.  In early December, unable to build PCs without storage, device makers began to cancel orders for the INTC chips slated to go into those machines.   INTC thinks we’re now passing the worst of the HDD shortage and that Thailand will be back at full HDD production late in 2Q12.  INTC is adamant that component supply, not a falloff in demand, is the problem.  Assuming the company is correct–and I see no reason to doubt it–the result of the cancellations has probably been to shift $.10 – $.15 a share in earnings for INTC from 2011 into 2012, as well as to make the firm’s 2o12 eps more second-half loaded than normal.

prospects for 2012

INTC expects another up year in 2012, with revenues advancing by “high single digits” and gross margins expanding by 1.5 percentage points to around 64%.  Despite a massive increase in R&D spending to $10.1 billion this year (up by 21% from the 2011 level) this company guidance probably implies eps on a GAAP basis of $2.60 ($2.75, non-GAAP).  If we correct for the one-time factors I’ve cited above, I read the guidance as being for flattish eps on, say, 5% revenue growth.

my thoughts

down Memory Lane

At the peak of the internet bubble in 2002, INTC was a $75 stock.  It traded at 36x eps (a relative multiple of 2.4x the market) and yielded .1%.  After a decade of wretched relative performance, the stock is now trading at less than 10x 2012 earnings, yielding 3.4% and at a price earnings multiple discount to the market of about 25%.

If you think that’s bad, in early October 2011 INTC was trading at 7.3x 2012 eps and yielding 4%+, more than the 30-year Treasury!  Interestingly, despite Wall Street skepticism, INTC shares are enjoying their longest period (and one of only a few) of relative strength in the last decade.

where to from here?  (I wrote this on Sunday January 21st)

I think there are four potential positive points to the INTC story:

1. valuation.   …low PE, high dividend yield, massively cash generative operations

2.   demand for PCs.   …that emerging markets have reached wealth levels where average citizens are able to afford PCs.  According to INTC, two-thirds of PCs worldwide are currently being sold to customers in emerging economies.  None of these markets are as yet well-penetrated.   So this business, INTC’s biggest by unit volume, appears to me to have much better growth prospects than is commonly thought.  Ultrabooks, using reference designs supplied by INTC, may well be an added plus.

3.  servers/the cloud.   …the continuing evolution of the internet is creating strong demand both for the INTC chips that drive sophisticated servers for the cloud and for those used for general corporate purposes.  These tend to be advanced (read: expensive and high-margin) chips.

4.  INTC’s immense technology investments.     …in 2012, INTC plans capital expenditures of $12.5 billion, in addition to R&D outlays of $10.1 billion.  In 2011, those figures were $10.8 billion for capex and $8.3 billion on R&D.  The two-year total comes to $41.7 billion!

Three possible consequences:

–increasing INTC’s already large technological lead over other manufacturers

–creating chips that will be accepted by makers of cellphones and tablets.  For instance, Lenovo has announced its first INTC-powered smartphone for the mainland Chinese market.

–creating an environment for collaboration on design of increasingly complex multi-function chips, either with independent design firms or with device manufacturers.  In other words, INTC would use its advanced chip fabs to attract and lock in customers.     …like AAPL?

It seems to me that at $20 a share, Wall Street was factoring into the INTC stock price a belief that:

–none of its turnaround efforts would be successful,

–that the parlous state of the PC market in the US and Europe is indicative of the global market for these devices,

–that INTC parts will be displaced by ARMH components, and therefore

–that INTC will gradually go out of business.

the stock

To buy the stock at $20 a share, you’d only have to believe that stories of INTC’s demise have been greatly exaggerated.

At the current $26 or so, in contrast, it seems to me the price already factors in a grudging acceptance that the PC business may not be on its deathbed.  I don’t think, however, that the value of the server business is fully reflected.  Nor is there anything, in my view, for the possibility that ultrabooks may expand the PC category or that INTC will have any success cracking the smartphone or tablet market.  Wall Street analysts are merrily downgrading the stock, meaning they don’t want to be seen as endorsing any of these possibilities.

$30 a share seems to me to be the next price objective.  At that level, I think the idea that the current business, PCs and servers, is viable would be in the quote.  But I don’t think there would be very much for new products.  In addition, I don’t think that very many have considered the thought that, after more than a decade of foundry success, the economic winds may be shifting in favor of integrated design/manufacturing firms like INTC or Samsung.

My bottom line:  INTC is no longer the one-way street it was in October, but I think it still has very attractive prospects.  I have no desire to sell any of the stock I own.  On the other hand, given the strong run it has made over the past four months, the size of my holding, and the possibility that good news probably won’t arrive before 2H12 begins, I don’t feel a powerful urge to buy today.  I do think the stock will outperform the S&P over the coming year, though.

Mitt Romney’s partial disclosure of his tax situation has reopened debate on the issue of how private equity managers and some hedge funds use carried interest as a device to shelter their earnings from tax.

Since Mr. Romney left the private equity business a decade ago, it seems to me that he isn’t currently using carried interest as a tax shelter.  In all likelihood, it’s some combination of itemized deductions, like charitable contributions or state and local taxes paid, and the favorable treatment of long-term gains on investments that’s producing his low tax rate.  But he was a prominent figure in the private equity community, so the press–and his political opponents–have made the connection anyway.

Powerful lobbying efforts by the private equity industry have defeated repeated attempts to close the tax loophole it uses to lower its executives’ tax burden.

I wrote about this topic in mid-2010.  But I haven’t read anything, wither in the current discussion or in the past, that explains exactly what a carried interest is.  Hence this post.

carried interest

A carried interest is a participation in an investment venture where the holder gets a share of the cash generated by the project (profits or cash flow) without having to contribute anything to the venture’s costs.  The holder of such an interest is “carried” in the sense that the other venture participants pick up the burden of his share of project expenses.

Carried interests aren’t just a private equity phenomenon.  They’re very common in the mining industry, which is where I first encountered them thirty years ago.  But they also occur in lots of other industries, particularly those where highly specialized experience or skills, or possession of crucial physical resources are key to a project’s success.  In the extractive industries, holders of mineral rights may be carried.  The fund raisers or organizers of any sort of projects may be carried, as well.  So, too, famous actors or holders of key intellectual property.

variations on the theme

As with everything in practical economic life, there are myriad variations on this basic idea.  For example,

–a party may not be carried for the entire life of the project, but only up to a certain point–say, when cash flow turns positive.

–the other parties may be entitled to recover the “extra” costs they’ve paid to subsidize the carried interest before the carried interest receives a dime (there are also lots of variations on the cost recovery theme), or

–the carried interest may only be paid if the project exceeds specified return criteria.

In plain-vanilla projects, the carried interest receives a portion of the recurring revenue that the venture generates.  This is ordinary income and taxed as such.  The private equity case is different.

private equity and carried interest

Private equity raises equity money from institutions or wealthy individuals, arranges financing of, say, 3x -5x that amount, and uses the assembled war chest to make acquisitions.  It targets mostly badly run companies.  It spruces them up and resells them a few years later.  There’s no conclusive evidence that this process adds any economic value, although it certainly sets the process of “creative destruction” in motion in the affected company–but that’s another issue.

Private equity companies appear to me to act as a blend of business consultants and managers of a highly concentrated (and extremely highly leveraged) equity portfolio.  What’s really unique about them is their pay structure.

Private equity charges its clients a recurring management fee of, say, 2% of the assets under management plus a large performance bonus if the turnaround projects they select are successful.  This bonus is structured as a carried interest (an equity holding) in each individual project.  Because the projects last several years and result in an equity sale, the bonus payments are capital gains, not ordinary income.  This means the private equity executives’ tax bill is much less than half what it would be if the payments were income.

my thoughts

You’ve got to admit that turning investment management income into capital gains is a clever trick.  Should the loophole be closed?  When I first wrote about this I thought so.  I still do.  But I’d prefer to see more comprehensive tax reform that achieves this result rather than specific legislation that targets the private equity industry.  I also find it somewhat disturbing that private equity political contributions and lobbying allow them to “own” this issue in Congress, despite the fact that private equity’s taxation is clearly different from other investment managers’, from management consultants’ and from corporate executives’ for basically the same activities.

Risk and Return

Bond investors will face some difficult choices in the months ahead.  Our base case for 2012 includes a modest acceleration of GDP growth accompanied by an improvement in employment and personal income.  US housing prices will finally stabilize and inflation, as measured by the Consumer Price Index less food and energy costs, will continue to rise.  (This inflation measure bottomed at 0.6% year over year in October and now stands at 2.2%.)  The Federal Reserve, however, is likely to keep short term interest rates at virtually zero.  All this points to a significant rise in government bond yields.

The current yield curve for government bonds looks strikingly similar to that which prevailed at the close of 2008.  Based on the improving domestic economy and our assumption that the European debt problems will be contained (admittedly, not a universally held point of view), we think the changes in bond market yields will be very similar to those which occurred in 2009.  If so, it implies interest rate increases in excess of 150 basis points for US Treasury securities with maturities of five years or more.  That translates into a near 12% price decline for ten year government securities.  To avoid these possible losses, investors would need to shrink the average maturity of their portfolios to two years or less and accept current returns of 0.25% versus the 2%-plus yields now available on longer dated investments.

Mortgages, normally a refuge for investors in a rising rate environment, pprobably won’t be a good port of call in 2012.  The market prices of high coupon mortgage securities are astronomical–GNMA pass-thru mortgages with coupons between 5% and 7% are being valued at 110% to 115% of par value.  These premiums are much higher than during previous low yield episodes; for example, GNMA 7% coupons never traded above 106 until mid 2010.  The current mortgage market bubble has occurred because mortgage refinance activity in these premium coupon mortgages has been exceptionally low, limiting prepayment losses for investors.  Borrowers have been unable to refinance because they are underwater on their existing mortgages and lack the equity to meet requirements on new mortgages.  That could all change with the stroke of a pen.

It is rumored that President Obama wants to replace the acting Federal Housing Finance Agency head with a more activist chairman and push for a multi-trillion dollar refinancing plan.  It would permit current borrowers in the government agency guaranteed programs to refinance into lower coupon mortgages with no requirements other than being current on the existing mortgage.  No appraisals, no income verification, no upfront payments.  This is actually a great idea.  It would save consumers tens of billions of dollars a year, increase housing demand and lift home prices, and boost economic growth–in an election year no less.  The losers under the plan would be holders of high coupon mortgage securities who would probably see the market value of their investments drop at least 5%.

While a change in the rules could hurt high coupon mortgages, their lower coupon cousins–the mortgage pass through securities with 3.5% to 4.5% coupons–would be crushed if interest rates rise.  Given the already inflated prices of even these securities, their upside appreciation potential, even in a declining interest rate environment is very limited.  (And we could see that further reduced if government actions unleash a flood of new low coupon securities.)  Meanwhile, they would suffer sizeable price declines and negative total returns if interest rates rise.

Making choices

As we begin 2012, most of our accounts are 20% to 30% below their benchmark maturity targets.  This is at the outer end of our usual duration bands and represents a significant call on the direction of interest rates.  During the fourth quarter of 2011, we added to our holdings of short term US Treasury notes.  We are generally overweight US Treasury securities compared with mortgages.  Nonetheless, a large rise in market yields would result in losses for most of our portfolios.  Accordingly, it is possible in the months ahead we may adopt an even more defensive maturity stance if the economic and political scenario we envision begins to materialize.

In closing, we thank you, our clients, for your support during 2011 and we will continue to work to merit your loyalty in the year ahead.  We wish you a healthy and prosperous New Year.

Note:  The Market Environment reflects the vies of the Investment Advisor only through the date of this report.  The Investment Advisor’s views are subject to change at any time based on market and other conditions.  December 31, 2011.

Thanks again to Strategy Asset Managers for allowing PSI to publish “Bond Market Environment, Fourth Quarter 2011.”

Follow the money

The Federal Reserve recently released its quarterly flow of funds study for the period ending September 30th.  Despite a brisk pace of federal government borrowing, aggregate credit demands remained weak.  Total non-financial debt grew at about a 4% pace as households shrank their borrowings.  This provided plenty of space for federal government debt to expand.  Meanwhile, the Federal Reserve was dumping huge amounts of money into the economy.  A broad measure of money supply–so-called M2–increased 9.8% over the last year.  Lots of money and little credit demand resulted in very low interest rates.  This could change quickly, however.

The US consumer has been tightening his/her belt since 2007.  The bursting of the housing bubble resulted in lower home prices, lower turnover and a decline in mortgage debt outstanding–from $14.8 trillion in June 2008 to $13.6 trillion in September 2011.  Faced with a troubling job market, consumers reduced non-mortgage debt as well.  This peaked at $2.6 trillion in 2008 and now stands at $2.47 trillion.  This borrowing metric seems to have stabilized recently as consumer confidence in future economic prospects has improved.

While the household sector of the economy has been paring back debt, the financial sector–commercial banks and savings & loans–has been reducing debt and balance sheet leverage.  This explains why few are worried about the leakage of European banking problems into our financial system.  So, once folks are ready to buy a new car or upgrade to a bigger house, banks will be able to provide them credit.  Despite the massive (+300%)  growth in federal government borrowings over the last decade, households remain the largest sector of the credit market with $13.2 trillion of debt outstanding versus $10.1 trillion of federal government debt.  If household borrowings increase by just 5%–less than half the rate experienced in the first half of the last decade–aggregate credit demand could rise by 7%.  This rate of expansion is not compatible with the current low level of interest rates.

That’s it for today.  SAM, LLC’s conclusions tomorrow.

Here’s yesterday’s initial post in this series.

The analysis is very worthwhile reading.  It’s long enough, however, that I’m going to publish it in three posts, all sans charts.  Here’s the first, an outline of the current bond situation:

Is it time to get off the bus?

2011 was a remarkable year.  The bond market encored its 2008 performance as investors flocked to the safety and liquidity of US Treasury securities.  We brought back the same actors–inept central bankers, anxious politicians, sketchy borrowers and frightened investors.  The accents were a little different–more European–but the plot was the same–a financial system supposedly on the verge of collapse.  And the ending for investors was also the same–the frugal, risk averse bond buyer won the prize in the final scene.  The prize in this case was a whopping 30% return from investing in long term US Treasury bonds.  And this came on top of a good showing in 2010–a 9.4% return for US Treasury bonds.  But as all moviegoers know–the third installment in a series is usually a dud.

We don’t think the numbers add up for another bond market rally in 2012.  Last year’s increase in bond prices lowered yields sharply.  For example, the Barclay’s Long-Term US Treasury Index closed the year with an effective yield to maturity of just 2.7%.  This compares with 4.1% a year ago.  The smaller yield means a smaller cushion against any price decline.  Meanwhile, the mathematics of bonds is such that lower yields equal greater price risk for any given change in interest rates.  The measure of risk is called duration and the duration of the Barclay’s Long-Term US Treasury Bond Index on December 31st was 16.2 compared with 13.9 for a similar basket of bonds a year earlier.  Now, investors should expect that a one percentage point change in interest rates would cause a 16.2% change in the price of the bonds, a very nice gain if interest rates for twenty year government bonds fall to 1.7%.  If, however, the yield of such securities rises to just 3.7%–a level 50 basis points below the average of the last five years–get ready to book a 13.5% negative total return (yield plus price change).  Of course, the returns from bonds with shorter maturities would be less damaged.  Nonetheless, there would be plenty of red ink for all.

If you think current bond market returns aren’t very generous, you’re right.  The sub-2% ten year government bond yields produced during the final quarter of 2011 were the lowest on record.  In fact, they were lower than the rate of inflation.  This has rarely occurred.   This occurred during the inflation tsunami of the Seventies, and again, briefly, in 2005 and early 2008 when oil prices spiked.

The bond market has reached these low levels because of:

(1)  fears of a European banking crisis,

(2) the free money policies of the Federal Reserve, and

(3) modest non-government domestic credit demands.

The impact of these factors is being amplified by hedge fund “risk-on, risk-off” trading that pushes short term money between various capital markets.  If any of the three legs supporting the bond market cracks in the months ahead, a substantial interest rate increase is in the cards.

That’s it for today.  More analysis tomorrow and Wednesday.