Category Archives: bond market

regulating money market funds

July 22, 2014 By in Banks, bond market, Industry Analysis, Investment firms, money market funds, securities markets Tags: , , Leave a comment

In the aftermath of the financial crisis, the government has been considering the risks to financial stability posed, not only be banks but also by asset management firms.  As part of this effort, the SEC is about to set new regulations for money market funds this week.

what money market funds are

One of the most important economic (and stock market) trends of the past half-century has been the emergence of focused single-purpose entities to compete with large conglomerates.  In retail, specialty firms selling jewelry, toys, household goods or electronics have offered an alternative to department stores.

In finance, money market and junk bond mutual funds, have offered alternatives–to borrowers and savers alike–to commercial banks.

Money market funds have several important characteristics:

–they provide short-term, working capital-type loans to borrowers

–as mutual funds, they promise to accept daily subscriptions from savers and allow daily withdrawals in unlimited amounts

–they have typically offered higher yields than bank savings accounts–sometimes far higher yields

–they can offer the ability to write checks against deposits

–they promise, at least implicitly, to maintain net asset value at a stable $1 per share.  In other words, they promise that, like a bank deposit, you won’t lose any of the principal or interest you have in the fund

–because a money market fund is not a bank, its deposits are not government insured.  The “no loss” promise relies solely on the good will and financial strength of the investment company offering the product.

the risks

According to the Investment Company Institute, US money market funds currently hold $2.57 trillion in assets.  That’s a lot of money.

In times of stress, the warts in money market funds begin to show.

They come in two related varieties:

–as a practical matter, many funds are so large that they might not be able to meet redemptions if large numbers of shareholders lost faith in either the industry or a particular fund and headed for the exits,

–because money market funds compete with each other primarily on yield, inevitably someone (or more than one) will hold his nose and make a sketchy loan simply because the interest payments are high.  In a crisis, such loans may not be worth what a fund paid for them; in the worst case, the borrower will default.    In past crises, including 2008-09, there have been times when dud loans are big enough to make it questionable whether the real NAV of a given fund should still be $1.00 and not $.99.  These situations have typically been resolved by the management company that offers the fund buying the securities in question from its money market fund at face value.  But there’s no guarantee this will happen in the future.  And a single fund that “breaks the buck” by writing down assets in a crisis could easily spark an industry-wide panic.

new rules

This week the SEC is expected to issue new money market rules to meet these concerns.  They’ll include:

–many money market funds that don[‘t exclusively own Treasury securities will be required to have a floating NAV, and

–funds will have the ability to suspend redemptions in times of financial stress and/or impose withdrawal fees on those wishing to get their money back.

my take

I think new rules will have their greatest impact on the investment practices of money market funds.  They’re now generally regarded as a utility-like service that requires little investment skill or management oversight to run.  That will change.  No firm will want to be the first to impose withdrawal fees or suspend redemptions.  Certainly, no one will want to destroy their reputation for financial integrity by recording an NAV different from $1.00.  As a result, management oversight will increase and investing practices will become more conservative.

For all practical purposes, NAVs will remain stable at $1.00.

For savers, the FDIC insurance offered by bank deposits will become a bit more attractive.  Since, however, 2/3 of money market shares are held by institutions, I don’t think there will be a massive shift away from money market funds when the new rules take effect.

exit fees for junk bond funds?

June 17, 2014 By in bond market, ETFs Vs. Mutual Funds, Industry Analysis, Investment firms, junk bonds, pik bonds, securities markets Tags: , , , , Leave a comment

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.

 

 

what’s going on at Pimco

March 11, 2014 By in bond market, Current Market Thoughts, Getting financial advice, Portfolio management Tags: , , , , , , Leave a comment

1.  It’s important to understand that although investment management companies can have immense revenues and profits, and may employ hundreds or thousands of people, many have management structures more like an old-fashioned corner candy store than an industrial conglomerate.

There’s a Chief Investment Officer who has a history of superior investment performance, and who is sort of like the star player on a basketball team.  He/she manages the portfolios and may (or may not) supervise other, lesser, investment professionals.  And there’s a CEO/Chief Marketing Officer, who handles the acquisition/retention of clients, administration–and everything else.

In the PIMCO case, the CIO is the bond market’s equivalent of Michael Jordan, Bill Gross.  Bonds are its main product.

2.  Mr. Gross is fast approaching 70.  Although he may still be sharp as a tack and healthy as a horse, this is ten years past the age when clients–who, after all, may be staking their own careers on Mr. Gross’s prowess–begin to worry about the management company’s succession plan.  Deutsche Bank, PIMCO’s parent, may have a concern or two as well.

3.  Until recently, interest rates in the US had been on a steady downward course for thirty years, meaning (in hindsight) a bond manager would have been most successful by setting up an aggressive portfolio and holding to it through thick and thin.  That is much harder to do in practice than the last sentence might suggest (think:  the collapse of Long Term Capital Management).  Bill Gross has done the best job over this period.

Still, it seems to me (even though I’m an equity manager) that the bond market has changed.  Mr. Gross himself has on several occasions declared the long bond bull run to be over.  Yet, as far as I can see, he has still committed himself to put up the big numbers he achieved when the rules of the game were more supportive.  The result has been big bets, greater volatility and so-so returns.

4.  All these issue have come to a head with the recent resignation of Mohamed El-Erian, the presumed successor to Mr. Gross.  Mr. El-Erian, the marketing face of PIMCO, was always a curious choice to take the reins from Mr. Gross, in my view.  The fact that he spent so much time marketing implied to me that he was not well-integrated into the portfolio management process.  And the only independent portfolio management experience Mr. El-Erian has had, that I’m aware of, was a short stint at Harvard that ended badly.  I would have pegged him as CEO/Chief Marketing Officer, not CIO.  Yet clients didn’t seem to mind.

Where to from here?

Let’s ignore the gossipy press commentary about conflict between Mr. Gross and Mr. El-Erian, or the former’s reported references to the latter’s lack of investment experience (makes you wonder how he was chosen to succeed Mr. Gross).

–PIMCO appears to have addressed the succession issue with the promotion of a number of successful in-house forty-something portfolio managers.

–That leaves the performance issue.  The prudent course of action would be to try to stabilize performance by reducing risk (read:  get close to the index) and aiming to be slightly north of middle of the pack.  Not very ego-satisfying for Mr. Gross, but the right thing to do.   But that might be like telling MJ not to shoot the basketball.   Let’s see if that can happen.

 

 

 

the February 2014 Employment Situation

March 7, 2014 By in bond market, Current Market Thoughts, employment, Employment Situation report, stock market, Strategy Tags: , , , , , Leave a comment

The Bureau of Labor Statistics of the Labor Department released its monthly Employment Situation this morning at 8:30 est.  The report was awaited with some trepidation by economy watchers, who were uncertain how badly the workforce would be hurt by continuing severe weather in many of the most highly populated regions of the country.

The report tuned out to be a very good one, in three respects:

—the headline figure was a gain of +175,000 jobs, consisting of an increase of +162,000 positions in the private sector and +13,000 in government (a large gain in state and municipal workers offset by a small reduction in the Federal payroll).  The dividing line between good and bad in ES reports is typically seen to be +150,000 new positions.  That’s the average needed to absorb people finishing school and entering the workforce for the first time.  The  December and January ES had both come in well below that line, leading to worries that the economy was beginning to lose steam.

The February figure looks especially strong, given that winter storms likely subtracted from the jobs total.

—revisions to prior months’ figures were positive.  The December ES job gains were revised up by +9,000 positions to +84,000.  The January numbers went up by +16,000 to +139,000.

—wage gains were surprisingly strong.  Over the past year, wages have been rising at a +2.2% annual rate, more or less in line with inflation.  The monthly rate of wage gains in February, however, were at a +5.2% annual rate.

This is a good news/bad news figure.  Rising wages means the corporate profits are strong enough for firms to pay more to workers. In other words, the economy is showing a sign of better health.   On the other hand, Sharply rising wages can indicate that all the slack in the workforce has been used up–that the only way a company can add to employees is to headhunt them away from other firms at sharply higher pay.  Great for the workers concerned   …but since inflation in developed economies is all about rising wages it’s also a warning sign that the economy may be overheating.  That would imply higher interest rates are coming from the Fed much sooner than anyone has thought.

Let’s not go overboard, though.  This is only one strong data point that comes after a whole slew pointing in the opposite direction.  It could just be a quirk in the seasonal adjustment the BLS does to the raw data.  And it’s not a good idea to project the future from a single month’s data.  The stock market is taking the correct approach, I think, by taking this number with a grain of salt.

Still, a second strong wage gain figure would start to turn heads.  It would also be in line with my long-held view that much of current US unemployment is structural, not cyclical.  So next month’s ES is going to be important.

 

 

Tesla (TSLA) is proposing a $1.6 billion convertible bond offering

February 27, 2014 By in bond market, Convertibles, Portfolio management, Recent Market Action, securities markets Tags: , , , , , , Leave a comment

TSLA, the electric car company whose stock has risen over 12x since its IPO in late 2012, has just announced a $1.6 billion convertible bond offering.   Proceeds will be use to build the company’s “gigafactory” plant.   The deal could be being priced as I’m writing this.

The offering will be divided into two tranches, half of the bonds repayable in 2019, the other half in 2021.  Proposed interest rates will be negligible–around those of comparable Treasury securities.  The conversion premium for each will likely be about 40%, meaning the owners will only make money by converting into TSLA common if the stock price rises above $350 a share.

Two points:

–the deal could be transformative for TSLA, giving the company a large cash infusion at an earlier than expected date

–who would buy a bond like this rather than the stock?  After all, a convertible is just that–a deferred issue of stock.  It’s like buying TSLA at $350 today in return for the promise of a 1% dividend for each of the next few years.  For an equity investor, this sounds crazy.  But there are two groups of potential eager buyers.

—-bond fund managers, who are desperate for anything that can provide a little zip to their returns.  Even a deal like this one is better than buying a straight bond.  Putting the stock issue in a bond wrapper allows bond managers to buy it without violating their mandate to invest only in fixed income.

—-convertible funds.  They, too, have a mandate.  They can only invest in convertibles.  If they don’t participate and the Tesla bonds rise sharply, they may fall behind in the performance race to their rivals who do.  And there aren’t that many new issues in any given year.  So there’s considerable pressure on these managers to take part in every convertible offering,

In any event, this is good news for current TSLA holders.   (Note:  I bought the stock at $120 and sold it at $175.  If I still held it, I’d be selling now.)