actively managed bond funds in a rising interest rate environment

During my working career as an equity portfolio manager, I experienced the US bear markets of 1980-82, 1987, 1990-91 and 2000-2002. Because I spent the majority of my career as a global manager, I also lived through the collapse of the Japanese stock market (then by far the largest in the world) in 1989 and the currency-triggered bear market in many smaller Asian countries in the late 1990s. I started writing this blog as a way of helping myself think about the bear market of 2007-09 and what would follow.

In other words, for equity managers there have been lots of bad times to help us along with the painful process of being able to, as they say, make the critical distinction between brains and a bull market.

Also, the bad periods themselves have been long enough to force us to recognize that different investment styles (growth or value) work best in different economic circumstances.  We certainly won’t change our overall philosophies.  However, successful equity managers all realize that for them there are some times to be in fifth gear with the gas pedal to the floor and others to be in second gear and tapping on the brakes.

 

Looking at the bond world from the outside, it seems to me that little of this has been the case for bonds and bond managers since the early 1980s.  Yes, junk bonds or emerging markets debt may have gotten ugly now and again.  Nevertheless, the continual decline in interest rates from the early Volcker years to the present has made for a remarkably smooth, and consistently bullish, ride for bond investors and managers.

The amazing part is not a long bullish period–after all, equities in the US had that for most of the 1990s–but the fact that the benign environment lasted over thirty years.  To have experienced an ugly time for bonds comparable to what happens to stocks every business cycle, you would have to have been a bond manager in the 1970s!

This is my main concern for actively managed bond funds.

We’re (already) in a period in which interest rates are not going to decline.  They may fluctuate for a while, even a long while, but the new main trend is going to be for rates to rise.  And we haven’t had circumstances that have forced bond managers to cope with a situation like this for decades.

Instead, the recipe for success over the past thirty-five years has been to throw caution to the winds and bet as heavily as possible on continuously declining rates.  The most successful managers would have been the most aggressive, the ones willing to double down on any bet gone wrong and to stack their portfolios full of risk.  Brash, bold, stubborn, no sense of nuance, not the brightest crayon but tenacious.  Think Jon Corzine and what happened to him.

 

Will bond fund managers be able to adjust to the changing trend?  I don’t know.

Bill Gross is another interesting case in point.  He became the “bond king” by betting aggressively on lower interest rates.  My reading of his results for his last several years at Pimco is that he tried to keep his performance numbers up by layering on extra amounts of risk to the main bet that had stopped providing results.  That didn’t work so well, in my view.  Since leaving for Janus, where he could express his ideas in his portfolio without an outside sanity check (outside interference?), he’s done poorly.

This is not about old dogs and new tricks in the sense of age but only in having the temperament and mental flexibility to adjust to changing circumstances.

 

bond funds when interest rates are rising

This past weekend, the Wall Street Journal published an article in its Business and Finance section about what happens if interest rates rise and holders of bond mutual funds and ETFs start to sell in large amounts.  The article is based on a research report written by Barclays and co-authored by that firm’s co-head of fixed income research, Jeff Meli.  The article isn’t identified further.

Maybe that’s not so strange, since, as reported in the WSJ, I find the research itself to be weird.  Its conclusions seem to me to be either not that relevant or just plain wrong.  The article does, however, touch on a number of points that are important for bond fund holders to consider.

 

The report starts out by assuming what I guess the researchers think is a worst-case scenario:  the junk bond market drops 10% in a day, and a given mutual fund receives requests for redemptions equal to 20% of its assets.

It concludes that:

–the fund’s net asset value would fall by 12%

–the fund would sell its most liquid assets to meet redemptions

–the remaining assets would be mispriced at a value higher than the value they could be sold at

–therefore, the first investors to leave would receive more than fair value and would be the best off; later redeemers would get less than fair value for their shares

–ETFs don’t have these problems and should be preferred to mutual funds.

my thoughts

I think this is a very unlikely set of circumstances.  The most damning constraint would seem to be the “single day” provision, which is intended to give the junk bond manager in question the least possible time to raise funds to meet redemptions.  However, the other two conditions haven’t come anywhere close to being triggered on a single day, either in the downturn following the internet bubble or during the 2008-09 recession.  Some kind of gigantic external shock to the economy would seem to be necessary for either to happen– not something specific to a given type of asset.

In such a case, it’s not clear that any financial markets would be functioning normally.  It’s conceivable that trading in many/all financial instruments would be halted until calm was restored.  So the pricing of a given junk bond fund would be a moot point.

For at least the past quarter-century, junk bond funds have generally been priced by third parties at “fair value.”  I’ve seen them work for illiquid stocks or for NY pricing of stocks trading abroad.  My judgment is that they work incredible well.  So I don’t think fast redeemers get the best pricing.  The opposite may well be the case.

Fund families have lines of credit that they can use to meet unanticipated redemptions.

No portfolio manager worth his salt is going to sell only the most liquid assets first.  On the contrary, it’s better to sell illiquid ones while there are still buyers.

In the past, big investment companies have ended up buying the most illiquid assets from junk bond funds they manage at a price determined by a neutral third party, in order to make redemptions easier and shore up confidence in the fund.

In general, fund management companies have no incentive to price a fund too high.  If anything, they should want to price it too low.  That way, they can send the extra to redeemers once they find their error.  No one is going to send anything extra back.

I don’t get the ETF stuff at all.

More tomorrow.

 

surviving the next twelve months (iii)

In the past in the US when the Fed has raised interest rates from recession-emergency lows, bonds have gone down and stocks have gone sideways to up.

Will this time be an exception?   …another way of saying, Will stocks go down this time around?

The generally accepted explanation of the divergence between stocks and bonds while the Fed is normalizing interest rates after a downturn is that the negative effect of higher rates is offset, in the case of stocks, by the positive effect of strong earnings growth.  Bonds–other than junk bonds, or municipal bonds–don’t have this offsetting factor.  So for Treasuries the news is all bad.

(There are at least two reasons why interest rates matter for stocks:

–broadly speaking, people (me being a possible exception) don’t actually want to own stocks.  What they want is to own liquid long-term investments so they can fund their retirements and send their kids to college.  Those can be either stocks or bonds.  A decline in the price of bonds makes them more attractive, taking some of the shine off stocks.

–in broad conceptual terms, the worth of a company should be related to the value in today’s dollars of its future earnings.  To the extent that investors use today’s interest rates to discount future earnings back to the present, rising rates will result in lower present values.)

 

I remain squarely in the “sideways to up” camp, but I can see, and am monitoring, two possible worries that may weaken the case for s-t-u:

–in what has been to date a sub-par rebound from recession, earnings growth may not be as strong as in prior recoveries, and

–the S&P 500 is a global index, about half of whose earnings come from abroad.  Even if US-sourced earnings are great, the same may not be true for foreign-sourced.  In particular, an increase in the value of the dollar vs. the euro caused by increasing interest rate differentials (the worry of the IMF and World Bank) could mean a lower dollar value for EU-sourced earnings (which make up about a quarter of the S&P 500 total).

More tomorrow.

 

want index underperformance …try an actively managed bond fund

Indexology

‘For a while I’ve been following the Indexology blog written by S&P.

As the name and source suggest, the blog extolls the virtues of indexing–after all, S&P makes them and sells information about them.  I find the posts to be generally interesting.  My only quibble is that the Indexology people seem to be true believers in a strong version of the efficient markets hypothesis.  They’ve all drunk the Kool-aid and don’t stop to question how it can be that basically every professional active manager underperforms   …nor do they try to imagine what circumstances could create even a temporary burst of outperformance.

I’m well aware of all the figures about equity manager underperformance.  However, I’d never thought much about bond funds, the subject of the Indexology post of March 12th.

The numbers are stunning.

bond fund (under)performance vs. benchmarks

Here they are:

–in 2014, 97% of the government bond funds underperformed, as did 98% of the investment-grade corporate bond funds

–in both categories, over 95% underperformed over the past five- and ten-year periods

73% of the junk bond fund managers underperformed in 2014; over the past five years, 88% underperformed; over the past ten, the number is 92%.

Bright spots?:

–among actively managed senior loan funds (which don’t contain bonds;  they hold pieces of syndicated bank loans to non-investment grade corporate borrowers), 70% outperformed last year.  Over the past decade, though, underperformers and outperformers are just about equal in number.

–61% of municipal bond managers outperformed in 2014.  55% did so over the past fie years.  However, over the past ten, 70% underperformed.

reasons for this woeful showing?

Indexology offers none.  Personally, I have no firm ideas.

Looking only casually at the results of Bill Gross over his years at Pimco left me with two impressions of the former Bond King:

— he continually bet very aggressively (and correctly) that interest rates would fall–sort of like an intelligent version of Jon Corzine, and

–a large chunk of his outperformance disappeared through the high fees Pimco charged for his services.

Indexology doesn’t talk about fees, which can’t have improved the situation for bond managers generally–and I presume the Indexoogy numbers are after them.

The better areas for relative performance are smaller and contain less liquid securities.  I wonder what role pricing–which I presume is not based on daily trading but on the theoretical models of third-party experts–plays?

 

the Mainstay Marketfield fund (ii)

I’ve been thinking about the Mainstay Marketfield fund. The I shares (the ones with the longest track record) = MFLDX.

Is this a risky fund?

A lot depends on what you mean by “risky.”  And a lot depends on the time frame you use.

The standard academic way of assessing risk is to equate it with the short-term volatility of returns.  The idea has some initial plausibility.  All other things being equal, and for everyone besides roller coaster junkies, a smooth ride is better than a bumpy one.  Greater assurance that the price tomorrow isn’t going to deviate much from the price today sounds good, as well.

The main virtue of risk-as-volatility, though, is that it’s easily quantifiable and the data for measuring it are readily available.  There’s no need to delve into the actual investments and make potentially messy judgments about what a security/portfolio is and how it works, either.

On this way of looking at things, MFLDX isn’t risky at all.

During late 2008 – early 2009 the fund declined less than the S&P 500.  From the beginning of the bull market in March 2009 until mid-2013 it tracked the S&P relatively closely.  Less volatile in down markets, average volatility in up markets.  Not a bad combination–if this is all risk is.

Regular readers will know that I’m not a fan of this academic orthodoxy–which is, by the way, also universally accepted by the consultants who advise institutional pension plans.  It isn’t only that you don’t need any practical knowledge of the products you’re assessing–just a computer and a data feed.  Nor is it that my portfolios routinely had part of their excess returns explained away by their greater-then-average volatility.  No, it’s that, in my view, for an investor with a three-, five- or ten-year investment horizon whether a security goes up/down a little more or a little less than the market today and tomorrow has very little relevance.

Risk-as-volatility has done serious damage in financial markets in the past.  For years, academics and consultants regarded junk bonds as relatively safe because their volatility was close to zero.  They didn’t realize that the prices never moved  because the securities were highly illiquid and seldom traded.  In fact, during the 1990s, i.e., even after the junk bond collapse of the late 1980s, Morningstar continue to have junk bond funds in the same category as money market funds.  Since NAVs never moved, the former got all the highest ratings.

Back to MFLDX.

Suppose we look at the fund in a commonsense way.

Marketfield’s website portrays ithe firm as consisting of three principals who concentrate on macroeconomics.  The career descriptions indicate that only the director of research, who arrived in 2011, had any prior portfolio management experience.

The group runs a highly sectorally concentrated portfolio.  MFLDX can be both long and short.  It has a global reach.  It can own/sell short stocks, bonds, currencies, sectors, indices.

Despite having all these potentially return-enhancing weapons at its disposal, the fund was unable to outpace an S&P 500 index fund during the first four years of the bull market.

Yes, short-term price fluctuations were not extreme.  And I’m not saying that one could have predicted that MFLDX would be down 12% in 2014, in a market that is up 13%–sparking massive redemptions.  But it seems to me that risk-as-volatility didn’t come anywhere near to capturing the risk elements present in this fund.

 

 

 

peer-to-peer lending, the next big banking innovation

the demise of the department store

The story of the big commercial banks over the last forty years is sort of like that of the department stores, only in slow motion.  In the case of the latter, entrepreneurs targeted the most profitable “departments” of the cumbersome retailing giants and competed against them with freestanding specialty store chains offering a wider selection, trendier products and lower prices.  Toys, consumer electronics, jewelry, household goods, cosmetics, and, of course, various types of apparel were all targeted.

The financial world, for some bizarre reason known only to itself, calls this process “disintermediation.”  It has been underway for almost a half-century.

Consider what a bank does for a living:

in the simplest terms, it borrows money from some people, paying, say, 2% interest, and lends it to others at, say, 8%.  It uses the difference (the spread) to cover costs and make a profit.

money market funds

The first big disintermediation came in the 1970s, with money market funds.  These substitutes for bank checking or savings accounts take deposits from customer and make short-term (meaning a few months) loans to governments and corporations.  The entire spread, less expenses, goes to the money market shareholder.  So in normal times, money market funds pay considerably higher interest than banks.  The banks’ only advantage has been government deposit insurance.

The emergence of the money market fund produced a massive shift of customer deposits away from banks.

junk bonds

The second was  junk bond funds.  The first junk bonds were “fallen angels.”  That is, they were issued with low coupons by companies whose businesses subsequently deteriorated.  As a result, their bond prices had dropped sharply (and therefore the bonds’ yields had risen to high levels).  Careful credit analysis would turn up either companies that were on the cusp of a favorable turn in their fortunes or others where the market had considerably overestimated the chances of default.

As they become popular, junk bond funds soon faced a shortage of suitable bonds to buy. This led to the creation of an original-issue junk bond market–or junk bonds as we know them today.  These bonds were direct competitors to the corporate lending operations of banks.  However, junk bond issuers offered lower interest rates plus fewer restrictive covenants to borrowers and they delivered the entire spread, less expenses, to the fund shareholders.

Again, there was a massive shift of profitable business away from banks.

peer-to-peer lending

We’re in the early days of a third big disintermediation.  Peer-to-peer lending is, I think, will end up replacing banks as makers of small personal and commercial loans.

As things stand now, P2P lenders are simply internet-based intermediaries.  They do credit analysis to determine an interest rate for a given loan, put potential lenders and borrowers together and take a fee.  As I see them, they’re very much like the creators of money market funds or junk bond funds, only targeting a different “department” of the banks.  In the junk bond case, though, the “department” quickly morphed into something else.  That could easily happen with P2P, as well.

What’s most interesting about peer-to-peer to me is that the leading firms are preparing to go public by issuing common stock.

More when IPO dates are closer.

 

exit fees for junk bond funds?

contingency planning

The SEC is doing contingency planning for the time when the Fed will declare the current five-year+ economic emergency over and begin to raise interest rates back to normal.  What “normal” is in today’s world is itself a subject of debate .  The official Fed view is that overnight money should carry an annual interest charge of 4% vs. the current zero.  Even if the right number is actually 3%, that’s still a huge jump (more on this topic in a couple of days).

According to the Financial Times, the SEC is worried about what will happen to junk bond funds/ETFs when rates begin to rise.

the problem

The issue is this:

–investors wary of the stock market but searching for yield have put $1 trillion into corporate bond funds since the financial crisis.  Such funds now have about $10 trillion in assets under management.

–the charm of mutual funds is that the holder is entitled to cash in any/all of his shares at any time before the market close on a given day, and cash out at that day’s net asset value.

–junk bonds are relatively sensitive to changes in interest rates and go down when rates go up, and

–many junk bonds trade “by appointment only,” meaning they’re very illiquid and basically don’t trade.

So, the question arises, what happens if/when holders see their net asset value eroding and decide to all withdraw at once?  Arguably buyers will disappear when they see an avalanche of selling coming toward them.  The initial selling itself will tend to put downward pressure on bond prices.  A falling NAV can conceivably generate even more, panicky, selling.

If a big no-load junk bond fund is hit with redemptions equal to, say, 25% of its assets over a period of several months, will it be able to sell enough of its portfolio to meet shareholders demands for their cash back?  Maybe   …maybe not.

operates like a bank…

Put a different way, a junk bond fund is a lot like a bank.  It takes in money from depositors and lends to corporations.  In the pre=-junk bond days, a bank would lend at, say, 10%, pay depositors 2% and keep the rest for itself.  That opened the door to junk bond funds, which reverse the revenue split, keeping a little for themselves and paying the lion’s share of the interest income to shareholders.

…but no FDIC or Fed

If there’s a run on a bank, the government steps in and stands behind deposits.  If there’s a run on a mutual fund, there’s only the fund management company.

a real problem?

How likely is any of this to happen?  I have no idea.  Neither does the SEC   …but it’s apparently thinking it doesn’t want to find out.

Allowing/requiring junk bonds to charge exit fees would do two things:  it would decrease the flow of new money into the funds from the instant the fees were announced–and maybe trigger redemptions in advance of the imposition date; and it would make holders think twice before taking their money out.

footnote-ish stuff

Historically, there’s a sharp difference between the behavior of holder of load and no-load funds.  In experience, load funds that I’ve run have experienced redemptions of maybe 5% of assets in bad times.  Similar no-load funds might lose a third of their assets.

Mutual funds typically have tools they can use to deal with high redemptions.  They can usually buy derivatives that will hedge their portfolio exposure; they have credit lines they can use to get cash for redemptions immediately; in dire circumstances, they can suspend redemptions or meet redemptions in kind (meaning you get a junk bond instead of your money ( ugh!)).

Junk bond ETFs are a tiny portion of the whole.  They’re a special type of mutual fund.   Holders of ETF shares don’t deal directly with the management company.  They buy and sell through designated market makers, who have no obligation to transact at or near NAV.  Therefore, they can staunch selling simply by swinging the market down far enough.  At the bottom of the stock market in March 2009, for example, I can recall specialized stock ETFs trading at over 10% below NAV!

This issue is part of a larger government debate about whether large investment management companies are systematically important to the financial system and, as such, should be more highly regulated.