Category Archives: bond market

fixed income speculation and tapering

February 13, 2014 By in bond market, contingent convertibles, Current Market Thoughts, junk bonds, pik bonds Tags: , , , , , , , , , 1 Comment

One of the earliest attempts by technical analysts in the US to link their work to economic variables was in charting the relationship between growth in the domestic money supply and stock market advance.

This wasn’t Milton Friedman.

This was–and is–a common sense attempt to create a barometer to measure the degree of speculation inherent in the stock market.  The idea is that the economy needs a certain amount of money to grease the wheels of commerce–to keep factories humming, meet payrolls, build inventories.  Anything in excess of that amount will inevitably find its way into financial speculation in equities, real estate and commodities.  Speculation, in turn, will lead to intervention by the Fed , “to take away the punch bowl,” as William M. Martin, a former Fed Chairman put it.  (Or, in the most recent case, where the punch bowl was heavily spiked and stayed out forever, a near-meltdown of the world financial system.)  So it’s an early warning indicator of a market decline.

Although still used by at least one famous hedge fund, this simple rule has lost much of its usefulness in a globalized world with supply chain management systems, ubiquitous, but only semi-visible derivative contracts and the increased prominence of businesses based on intellectual property.

I think, however, that the Fed is using this rule, but has reversed the inference, as part of its rationale for tapering.  I think the Fed sees increasing speculative activity in fixed income markets as evidence that there’s too much money sloshing around in the world.  (I know I am.)

Three areas worry me:

—pik bonds.    Pik stands for payment-in-kind.  It’s a type of junk bond where the issuer has shaky cash flows and may not be able to afford to make interest payments on its debt.  So lenders allow the firm to pay interest “in kind,” meaning issuing more junk bonds to cover the interest expense.  As is always the case in investment banking, there are variations on the theme:  the bond may be pik from inception; the issuer may have the right to convert the bonds from cash to pik, if he needs to; or the issuer may be able to “toggle” back and forth between cash and pik as he desires.

In my limited junk bond experience, pik bonds only rear their heads at bond market peaks.  And they’re here again.

—contingent convertibles, or “cocos.’   The original cocos, spawned by the financial crisis, are bonds issued by financial companies that can be forcibly converted into equity–thus shoring up regulatory capital–if the issuer gets into financial trouble.  In my view, the buyer is exposed to all the downside of owning an equity with few of the rewards.

According to the Financial Times, a new variation on the coco theme has recently appeared.  The new securities are called “sudden death” or “wipeout” bonds.   Their attraction is that they pay coupons of around 8%.  The catch is that if the issuer’s regulatory capital falls below a ratio specified in the bond indenture–so far its been if a bank’s Tier One equity ratio falls below 7%–then coco holders lose all their money.  

To me, this looks like an equity put dressing it up in bond clothing so fixed income managers can buy it.

—the Fragile Five.  2014 opened to a bout of bondholder angst about their positions in the debt of places like Argentina.  Argentina?   Really?  Isn’t this the same place that nationalized Repsol in 2012?   …the same place that defaulted on its sovereign debt in 2001?   …where capital flight has accelerated to the point that the government has shut down online shopping to prevent money from leaving the country?  Talk about risky.

I think these areas worry the Fed, too.  They’re why I think we’d have to see considerable economic weakness in the US before tapering comes to a halt.

the shakeup at Pimco

January 28, 2014 By in bond market, securities markets Tags: , , , , Leave a comment

Pimco shakeup

Last week bond management giant Pimco announced a number of high-level promotions.  But the biggest headline was the resignation of its well-known market commentator Mohamed El-Erian.  Mr. El-Erian, who will remain a consultant to Pimco’s parent, the German insurance company Allianz, had been touted as the heir to Bill Gross (who is Pimco’s version of Warren Buffett) when he was hired back from Harvard in 2007.

Why?

foundering equity business

A small part of this is an effort to revitalize the equity business Pimco launched several years.  It hasn’t had notable success so far.  Maybe this area didn’t have the strongest leadership.  But Pimco’s main overall marketing message continues to be that bonds are a better choice than stocks.  Hard to sell a product when your own company is telling potential customers to stay away.

who succeeds Bill Gross?

The main issue, however, is Mr. Gross himself, who will be 70 years old on his next birthday.

When a star manager reaches, say 60, the first question any potential pension client (prompted by the pension consulting firm he hires) asks in a due diligence interview will invariably be “Who is your successor?”  The client, who is spending hundreds of thousands of dollars on the search for a new manager, has two worries:  what happens if the star retires?, and what happens if the star stays on but (think: any aging sports figure) begins operating at only a fraction of his former speed?

While the manager’s performance remains stellar, this may not be a serious obstacle.  But if it begins to become merely ordinary, as seems to be the case today with Pimco, the age/successor becomes key.

That’s how I read last week’s news.  The promotion to deputy CIO of two bond managers with long practical investment experience and visible track records attributable to them says to me that clients weren’t happy with the idea of Mr. El-Erian as Mr. Gross’s successor.

Three possible reasons:

1.  Mr. El-Erian is in his mid-50s.  If Mr. Gross were to work for another five years (he’s tweeted he’s up for another 40!), then the age question recurs, only with Mr. El-Erian as the subject.  So to have a credible succession story Pimco needs forty-somethings.

2.  Mr. El-Erian’s credentials are unusual.  He’s an expert on emerging markets debt, which makes up only a tiny fraction of the total bond universe.  He worked for two years as the CIO of Harvard’s endowment, where it isn’t clear whether he had a positive or negative effect on returns.  The scanty press reports I’ve read suggest the latter.  Since his return to Pimco, Mr. El-Erian’s main role seems to have been as the public marketing face of the firm, where his professorial demeanor and/or his Pimco connection make him vary popular with financial talk show hosts.

It could be that Mr. El-Erian doesn’t have a long enough, or strong enough, identifiable track record as a portfolio manager for clients to take a chance on him.

3.  It might also be that one or more of the the forty-somethings–who have strong track records identified with them–were about to leave, either to start their own firms or to join a rival.   Their motivation to depart would be that the door to advancement was closed at Pimco by Mr. El-Erian’s presence.   If so, Pimco would have been compelled to choose between them and Mr. El-Erian.

Of course, it’s possible that…

4.  … Mr. El-Erian is leaving Pimco voluntarily.  But the lack of detail he’s providing about his future plans suggests otherwise.

high yield (junk) bonds (ii)

December 2, 2013 By in bond market, Getting financial advice, Industry Analysis, Investment firms, junk bonds, junk bonds, Portfolio management, securities markets Tags: , , , , , , , , Leave a comment

what went wrong

1.  Junk bonds began to be used as a substitute for bank financing–but to a large degree by takeover specialists targeting either mediocre industrial companies or consumer staples firms of any stripe.  In both cases, more efficient management would boost cash flow enough to service the massive debt incurred in the acquisition.  Fear of the required debt service would act as a powerful motivator toward greater profitability.

Arguably, the substantial change of control among underperforming companies during the 1980s that junk bonds made possible laid the groundwork for the industrial renaissance the US experienced in the early 1990s.

Nothing wrong with that.

But in some cases, rapacious acquirers went further.  They targeted well-funded employee pension plans, replacing a conservative investment menu with a diet of exclusively junk bonds.  Others, particularly in the natural resources area, forced the acquired firms to operate for maximum near-term cash generation.  Timber companies, for example, harvested 3x-4x the usual number of trees every twelve months–leaving no time for replacement trees to grow.  As a result, companies went out of business; employees found their pension plans, after the junk bond collapse, unable to meet obligations.  The acquirers just walked away with the cash they’d drained from the firms.

Drexel also pleaded no contest to SEC charges that it illegally supported acquirers through stock manipulation and by helping them avoid 13-D reporting requirements.

2.  By the end of 1986–maybe a little later–Drexel and Milken had done all the junk bond/leveraged buyout deals in the US that made any economic sense.  What to do then  …close up shop or continue to do junk bond deals, even though they made no sense and might ultimately fail.  Drexel/Milken chose curtain #2.

By early 1989, the consequences were becoming evident.  Junk bond default rates were rising sharply, depressing junk bond prices.  To my mind, October 13th of that year marked a tipping point.  That’s when the media reported the failure of a proposed $6.75 billion leveraged buyout of United Airlines.  This was the first big junk bond deal not to get done.  Psychology changed decisively for the worse.

That’s when retail investors, who had been sold junk bonds on the idea that they had all the return potential of stocks plus all the safety of bonds, found out their dark side   ..if nothing else, how illiquid they are.  Junk bonds fell, on average, by about 30% in the following months.  Some investors also found out, to their sorrow, that up until that time their mutual funds had been pricing their holdings at what proved to be unrealistically high levels.

3.  We can all understand, though not condone, why Drexel/Milken would want to continue to sell dud junk bonds.  It’s what they did.  But why would any professional buy them (I know I characterized bond fund managers as not being among the best and brightest in my Friday post, but you;;d think they’d catch on eventually)?

The Federal government had an answer.  It was that Milken and Drexel bribed prominent junk bond fund managers to look the other way and take part in bad deals for their clients.  The Wall Street Journal had an in-depth investigative series on this issue in 1990.  I’ve been unable to find in the the WSJ online archives, however.

The government was unable to prove its case.  A New York Times article and one from the LA Times that describe the charges are the best documentation I can find.

Personally, it feels to me that the government was right, but that it had no way of getting any of the small number of people who would have been involved in a scheme like this to testify against themselves.

still, a revolutionary idea

By the early 1990s, the junk bond market had revived, though on a firmer footing as a result of the government action.

high yield (i.e., junk) bonds

November 29, 2013 By in bond market, junk bonds, junk bonds, securities markets Tags: , , , , , , Leave a comment

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.

Who would ever buy a bond?

November 25, 2013 By in bond market, Current Market Thoughts, securities markets Tags: , , , , , 2 Comments

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.