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.



Janet Yellen and popping speculative bubbles

During her Senate confirmation hearing, Janet Yellen, the soon-to-be Fed chief, was asked what action she would take if she saw a speculative bubble forming in financial markets.  Would she, like her predecessor Alan Greenspan, simply watch it grow, while presumably making ready to pick up the pieces after it popped?  …or would she act–presumably by raising interest rates–to nip it in the bud?

She said she would do the latter.  She added that at present she sees no bubbles on the financial horizon.

I’m not sure what this means.

It could just be that she’s saying she doesn’t believe in the theory of “rational expectations.” a simplifying assumption of academic economists that people are cold, calculating, wealth-maximizing automatons all of the time.  This is also a premise of most academic research in finance, despite centuries’ worth of overwhelming evidence that real people seldom act that way.

Or it could be that she’s making a stronger statement  …that if she’d been in charge, she would have raised interest rates to pop the Internet bubble of 1998-99  …and that she’d have done the same to pop the housing bubble of 2006-07, as well.

At the moment, I think her’s is a statement without much content.  Millions of Americans laid off in the Great Recession are still out of work.  The economy is scarcely overheating (although I think what we’re seeing now is as good as it will get).  And government policy in Washington is retarding economic expansion, not helping it along.  So it’s hard to see where the impetus for higher interest rates would come from–which is what the Fed is communicating by saying it will leave short-term interest rates at the current zero for at least the next two years.  Also, the Fed can’t get more accommodative than it is now.

Still, I think the Yellen statement is one to keep filed away for future reference.  It implies that when we eventually get out of the mess we’re in–and assuming Ms. Yellen is still around–that the financial markets will be on a shorter leash than during the professional lives of just about everybody working on Wall Street.  Chances are what she does will take Wall Street completely by surprise.


why commodities companies overinvest, turning boom to bust

This is a continuation of my post from yesterday.

It may be that, as Chris Hackett suggests in a comment to yesterday’s post, that everyone has his head in the sand, not only commodities company CEOs and boards.  Maybe it’s some deep-seated psychological need to have the good times continue, or maybe a denial of the finitude of man, or…  Yes, commodities companies aren’t the only ones who extrapolate chiefly from the recent past in forecasting the future.  Nevertheless, I can think of three reasons why commodities companies feel most comfortable reinvesting cyclical cash windfalls back into new capacity in their primary business–even though that action itself inevitably triggers a cyclical downturn.

1.. It may be the best they can do.

Looking back at yesterday’s post, I think I was a little unfair in saying that there firms never think of diversifying.  During the first oil crisis in the early 1970s, all the big oils did diversify.  Gulf Oil bought the Barnum and Bailey circus (great job, Gulf; no wonder you got taken over); Mobil bought Montgomery Ward and Container Corp of America (both disasters); Exxon started a venture capital arm, which produced nothing of note.

Peter Lynch, of Fidelity fame, called this kind of move “diworsification.”  Ugly word, but an accurate observation.  Look at HPQ or Microsoft as other serial diworsifiers.

Of course, this is not really the best a company can do, either.  The firm could pay a special dividend to shareholders, but this sensible action rarely occurs to CEOs.  Reinvesting in a business they has some expertise in always seems to be the safest bet.

2.  Holding on to cash may be personally risky to a CEO, for two reasons:

–a cash hoard may make the company a takeover target.  Great for shareholders, not so much for the ego of a person who’s a demi-god to employees, but just a broken down old guy (albeit a rich one) if he loses his position.

–a sensible strategy would be to amass cash with the intention of buying assets on the cheap from semi-bankrupt competitors a couple of years after the cycle turns.  Suppose the cycle lasts longer than the CEO expects, however.  His profits are less than competitors; his company’s stock underperforms.  Maybe he’s ousted before he can act and his successor reaps the glory of making canny acquisitions.

Arguably you have more job security by staying with the herd.

3.  I can believe that adding capacity at or near the top of the cycle can make a perverse kind of sense under three (or maybe four) conditions.  They are the assumptions that:

–all attempts to diversify into other businesses will end in disaster,

–the company’s industry is in secular expansion, so that new capacity will be very valuable in the next upcycle,

–the company will be the first to add significant capacity, and will therefore have a year or two of supernormal profits from the new plant.   That will ease the pain of the downturn and put the firm in a stronger market position in the next upturn.

–(the, maybe, fourth)  even if a firm can’t be alone as the first to add new capacity, it should expand anyway.  This extra industry capacity will at least foil rivals’ plans to cash in big with their expansions.  Yes, the downturn will come earlier than otherwise, but the present market structure will be preserved.  A bit Machiavellian, and maybe giving undue credit to guys who think buying the circus is a great idea.  But it’s possible.

My bottom line:  long-cycle commodities, epitomized by base metals mining, are a true boom and bust industry.  As such, they’re a value investor’s dream come true.  For the rest of us, if we want to play we have to be in the uncomfortable position of buying when the stocks are very beaten down and it seems all hope is lost.  If you’re not accustomed to thinking this way, picking the right point to buy will be very difficult.  In any event, that point is not today.