high yield (i.e., junk) bonds

Addled perhaps by too much turkey and a football triple header, I’ve decided to write a (very) brief outline of the development of junk bonds .  Today’s post is the first of two installments:

The first junk bonds were “fallen angels,” that is, corporate bonds that were investment grade when they were issued but whose credit ratings fell as the issuing company encountered difficulties and its finances deteriorated.

In an investment banking class in business school in the late 1970s, I heard a speaker from Drexel Burnham Lambert, the junk bond kings, deride the corporate bond establishment as a bunch of clubby coupon-clipping Ivy Leaguers without a brain among them, who simply sold such poor-performing bonds without analyzing the underlying fundamentals.  Drexel, he said, thanked God for creating these slackers, whose pockets they picked daily.

He then gave an example of a small oil exploration company that was in the midst of a sharp positive surge in profitability but whose bonds were still priced as if Chapter 11 loomed the next day.  As it tuned out, working as an equity analyst, I covered the company he mentioned.  Everything he said was accurate–and apparently unknown to the general run of bond managers.

The problem with the Drexel business at that time was that you used up the available pool of fallen angels pretty quickly.  How did you make money then?

The innovation of evil (and I do mean evil, despite the SEO puffery you see if you Google his name) genius and convicted felon Michael Milken was to realize Drexel could offer junk bonds as original issues.

Companies with less than pristine credit were already getting financing from banks, which were making a fortune on the business.  They were taking in retail deposits that they paid, say, 3% interest to customers on–and lending the funds to sub-prime corporates at, say, 12%.  To state the obvious, that’s a gigantic spread.

Suppose, Milken, thought, Drexel were to float bonds for these companies at 9% instead and market them to junk bond mutual funds + pension investors.  Retail investors would get around an 8% yield after fund expenses, the companies would get a cheaper interest rate, Drexel would collect enormous investment banking fees.  Everyone, ex the banks, would be happy.

The banks would be “disintermediated” (cut out of the action), as the term goes, in the same way as money market funds were cutting them out of the market for time deposits.

As it turns out, there was another gigantic plus for the issuing companies.  The junk bond fund managers appear to have had either terminal brain freeze, clubby Ivy League bond backgrounds, or absolutely no prior experience in corporate lending.  Cluelessly, they failed to require that the junk bond issues they bought have any of the protective covenants that Banking 101 would have taught you to demand.  No wonder sub-prime issuers were chomping at the bit to obtain Drexel’s underwriting services.

More on Monday.

Microsoft (MSFT)–a stock for 2014?

Just a thought, not a recommendation.


In some ways, I find it hard to believe that I’m writing this.  I’ve been mentally making fun of the value investors who have witlessly piling into MSFT over the past several years.

What’s wrong with them, I thought.  The stock is trading at 4x book value, a statistic they used to beat growth investors over the head with as an obvious indication of preposterous overvaluation.  More important, don’t they realize how weak the current management is?  …and how deeply entrenched the top is through personal friendship with founder Bill Gates?  If a decade+ of squandering corporate resources isn’t enough to force change, what would be?

Perversely, the golden goose of the Office suite has still been laying enough eggs not to impinge on the personal lifestyle of Mr. Gates, so there has been no practical reason for him to question the way his company is being run.  And Gates’ public statements show him to be very deeply committed to providing jobs for his friends.

What has changed, you ask?

Two things:

–Steve Ballmer, Bill’s now-billionaire college friend, is out.   …and the search for a successor looks to be going far beyond the ususal (for MSFT) well-dressed, glib self-marketers to  include people with actual management credentials.  So maybe change is possible, after all.

–2014 may well be an average year in terms of gains, meaning that a stock that goes up by 10% (remember, MSFT has an above average dividend, too) will probably be an outperformer.  So the bar is set pretty low.  Earnings don’t necessarily need to show any acceleration, either.  MSFT has been trading at about 2/3 of the market PE multiple for the past several years.  Just the idea that the status quo is no longer acceptable to the MSFT board may be enough to give the stock the boost it needs.



coasting toward the finish line

My sense is that Wall Street is, at least temporarily, beginning to run out of steam.

This is partly the way the calendar plays out.  Thanksgiving is this week.  But it falls on the latest possible day, the 28th.  When turkey-stuffed traders return to work next month, it will already be December–meaning only two weeks to go before Wall Street closes down for yearend.

At the same time, 2013 has been a spectacular year in absolute terms for equity investors.  The S&P is up by almost 30%, year to date, including dividends.  Why do anything in the final lap to muck up what has been an unexpectedly good outcome?

This is the mindset I see driving–or really not driving market momentum right now.

Two conclusions:

–this gives us much more time to think over how to play 2014, which at first blush seems likely to be a flattish year, and

–the coming trading sessions may well be dominated by yearend house cleaners, without much effort by anyone to bargain hunt.  This implies possible mild downward pressure on the S&P.  This also suggests that serious portfolio reshaping, if any, will probably be put off until January.  I doubt we’ll have much more clarity a month from today about 2014 than we do now.  But there’s a chance we will.  And until then most portfolio managers–outperformers and underperformers alike–will probably be content to bask in the glory of the absolute gains in assets under management (and, therefore, management fees) they’ve achieved this year.

Who would ever buy a bond?

That was my daughter’s question when my wife and I had lunch with her the other day (she paid!).

She certainly wouldn’t.  Even after this year’s rise in yields, a 10-year Treasury still only provides income of 2.7%, or not much more than the dividend on the S&P.  And, although, unlike most bonds, Treasuries are liquid, there’s a good chance that if you buy a 10-year today you’ll lose money if you have to cash in early.  Not an attractive proposition for a twenty-something.

Her question, though, brought home to me how long it has been since we’ve had a normal bond market in the US.  You have to go back to the second half of the 1990s to see a 10-year bond yielding 6% (a real yield of 3%).

It shows what a peculiar world we live in today–and how thoroughly unappealing bonds are at present.

Why doesn’t everyone see this?  We all tend to extrapolate from past experience, and for almost three decades bonds have been a one-way street going up.  In addition, bond management firms are spending tons of money–much of it customers’ money–on advertising and public relations saying their superior investing skills will let them weather the coming rise in interest rates without a hitch.  To my mind, the best you can say is that this is a classic case of confusing brains and a bull market.

bond buyers

To answer my daughter’s question, there are normal buyers of bonds, though.  They include:

1.  senior citizens and the wealthy.

As people get older or become rich, they also become more risk averse.  They shift from wanting to make a fortune to preserving what they have and providing steady income for their retirement.  During economic emergencies–the current one having lasted five years(!) and slated to last another two–the government disadvantages these two groups for the good of everyone else by lowering interest rates sharply.

2.  financial institutions, especially life insurance companies and pension funds.

The former are legally required to invest conservatively so they’ll always have enough to pay off claims.  The latter deal with the same kind of issue, but aren’t as heavily regulated.

3.  governments of countries where there’s more foreign demand for local goods and services than there is local demand for foreign equivalents (think:  China).

The result of this imbalance is that in the foreign exchange market every day there’s more demand for local currency than there is for foreign.  To keep the local currency from rising sharply, the local government prints more currency and exchanges it.  In doing so, the local government accumulates piles of foreign currency (Beijing, for example, has $3 trillion, more or less, in US$).  Rather than let the funds lie idle, the treasury buys foreign government bonds.