REITs when interest rates are rising

Finally, to the question of REITs (Real Estate Investment Trusts).

A REIT is a specialized type of corporation that accepts restrictions on the kind of business it can do and limits to how concentrated its ownership structure can be.  It must also distribute virtually all its profits to shareholders.  In return it gets an exemption from corporate income tax.  It’s basically the same legal structure as mutual funds or ETFs.

Traditionally, REITs have concentrated on owning income-generating real estate.  But they are also allowed to to develop and manage new projects, provided they do so to hold as part of their portfolios instead of to resell.

Because they must distribute basically all of their profits, and to the degree that their property development efforts are small relative to their overall asset size, REITs look an awful lot like bonds.  That is to say, their main attraction is their relatively steady income.  Yes, they hold tangible assets of a type that should not be badly affected by inflation.  But current holders, I think, view them as bond substitutes.

As I suggested in Monday’s post, that’s bad in a time of rising interest rates.  Both newly-issued bonds–and eventually cash as well–become increasingly attractive as lower-risk substitutes.  This is the reason REITs have underperformed the S&P by about 5 percentage points so far this month, and by 9 points since the end of September.  I don’t think we’ve yet reached the back half of this game.

How can an investor fight the negative influence of interest rate rises in the REIT sector?   …by finding REITs that look as much as they can like stocks.  That is, by finding REITs that are able to achieve earnings–that therefore distributable income–growth.

This means finding REITs that can raise rents steadily or whose development of new properties is large relative to their current asset size.

 

stocks vs. bonds when interest rates are rising (ii)

yesterday’s post: bonds

To summarize yesterday’s post, when interest rates are rising, newly-issued bonds bear higher coupons than ones issued in the recent past. Older bonds look less attractive, because they provide less return.  So they have to go down in price until they’re trading at equivalent returns to new ones.

Other than inflation-indexed bonds, Treasuries have no defense against this.

What about stocks?

Here the issue is a bit more complicated.

Let’s make the useful, and more or less correct, assumption that stocks and bonds are in equilibrium before rates start to rise.  If so, if bonds get cheaper, stocks will also have to get cheaper in order to compete for investor money against now-higher-yielding bonds.

This means rising rates puts downward pressure on stocks, too.

But stocks do have a defense.  It has to do with why rates are rising.

In most cases, rates begin to rise when either bond investors or the Fed sense incipient inflation that threatens to erode the purchasing power of money.  This is what triggers the impulse to raise rates.  Since in advanced economies, inflation is always an issue of wage inflation, its early warning signs are that the economy is reaching full employment and/or wages are beginning to rise at an accelerating rate.  In the US, that’s where we are now.

But more workers employed and wages rising at a healthy clip imply that consumer spending is likely to rise at an accelerating rate.  This implies accelerating profit growth for, in sequence, retailers, their suppliers and the providers of capital goods to both retailers and suppliers.  To the extent that a given stock market represents the local economy (which about half of the S&P 500 does), profits of publicly traded companies will start to go up at an unexpectedly sharp rate.

Rising profits create upward pressure on stock prices that serves as at least a partial counter to the downward pressure created by rising rates.

currency

A second issue that will affect stocks directly is how the combination of inflation and higher rates affects the local currency.

If the currency falls, which is the most common case, export-oriented or import-competing companies will have the best results.  Purely domestic firms, and domestic firms that use foreign inputs, will fare relatively poorly.

If the currency rises, the opposite will most likely happen.

the S&P 500 in past times of rising rates

In the US in the past, the upward pressure from rising profits and the downward pressure from rising interest rates have most often neutralized each other.  There have certainly been diverse sector and industry performances, based on currency, technology, government fiscal policy and the overall state of the world economy.  So there have typically been substantial outperformance opportunities even in a sideways market.  But the overall market tendency in the early year or so of rising rates has typically been sideways, not down.

 

Tomorrow, REITs.

 

 

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?

 

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.

 

 

what’s going on at Pimco

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.

 

 

 

US bond market environment, October 2012

This is the quarterly letter sent by Strategy Asset Managers, LLC, a bond management firm, posted with permission from my friend and mentor, Denis Jamison.

Today’s post sketches out the current situation.  Tomorrow’s wil give Mr. Jamison’s investment conclusions.

a market of bonds

It’s an old saying on Wall Street–this isn’t a stock market but a market of stocks.  In other words, individual stocks can rise or fall regardless of the general direction of the market.  The same can now be said of the fixed income market.  formerly, the direction of interest rates dictated returns across most segments of the bond market.  If Treasuries called the tune and the rest of the fixed income market danced along–some a little slower or faster–but they were all moving to the same beat.

That’s now changed.

Policies implemented by the federal Reserve effectively have eliminated real yields for “riskless” securities like US Treasury bonds.  (By riskless, I mean credit risk–that is, the risk of not getting paid at maturity.  T-Bonds still have plenty of market risk.)  Without government bond yields calling the tune, all sorts of other factors are determining returns in various segments of the fixed income market.

The markets are now being driven by monetary policy designed to:

(1)  keep interest rates at zero for short-term, low-risk investment-like savings accounts and US Treasury bills and notes,

(2)  narrow the yield spread between “safe” investments like US Treasuries ans riskier investments like corporate bonds, and

(3) lower the return spread between fixed income assets and securities with no maturity–like common stocks.

In fact, the Federal Reserve would really like investors to go out and spend their money on real goods and services.  It has stated that zero interest rates are here to stay until the economy has fully recovered–that means much lower unemployment and much stronger economic growth.  Chairman Bernanke, unfortunately, doesn’t have a crystal ball and isn’t telling us when he thinks that will happen.  At the moment, however, he plans no change in interest rate policy through 2014.  Of course, he has pushed out the probable end date of his quantitative easing program before and is likely to do it again.  Market pundits have started referring to the Federal Reserve’s monetary policy as QE unlimited.

When the bank is playing…

…you just keep dancing.  We have just entered the third phase of the Federal Reserve quantitative easing.  in the wake of the 2008 financial collapse.  Essentially, “quantitative easing” means that the Federal Reserve will buy financial assets from banks and put cash in their–the bankers’–hands.  The hope is that, somehow, this money will filter through the system and the banks will loan that money to you and you will buy a house or a car or anything.

Why doesn’t the Federal Reserve just lower interest rates and make the loans cheaper?  Well, interest rates are already at zero so they need to do something else.  Since the banks are stuffed with money, will they loan the money to you?  No, because you don’t have a stellar credit history and your house is under water.  They refuse to take credit risk because they face political and regulatory retribution if they suffer any losses.

Has the quantitative easing program improved the economy?  Not yet, but it has certainly been a windfall for the financial markets.  The S&P market index is up 115% off the 2009 lows and every time it seems to be losing steam, we get another QE program.

Is all this going to end badly?  Probably, yes, but in the meantime don’t fight the Fed, don’t fight the tape and keep dancing.

The quantitative easing programs are having one clear impact–a massive increase in the Federal Reserve’s balance sheet.  The Federal Reserve was created in 1913 through a bill sponsored by two legislators, Carter Glass and Parker Willis.  Mr. Glass later went on to co-sponsor a bill that prohibited commercial banks from being securities firms.  (Interestingly, that 1933 piece of legislation was struck down during the Clinton administration.  Some say the repeal was a root cause of the 2008-2009 financial collapse.) The Federal reserve’s mandate was to provide liquidity to the banking system in times of crisis and to gradually expand the money supply to support non-inflationary economic growth.

Until 2008, the Federal Reserve provided that liquidity to the banking system by gradually expanding its assets through the purchase of government bonds from the banks.  That has changed.  Federal Reserve assets grew from $890 billion in June 2008 to $2.8 trillion most recently.  This is the result of asset purchases made by the Federal Reserve through its various QE programs.  Government bonds account for $1.6 trillion of those assets.  Another $800 billion are mortgage-backed securities and the Fed plans to add about $60 billion a month to that pile.  Unfortunately, the Federal Reserve’s capital base hasn’t kept up with the asset growth.  Now, $55 billion in capital supports those $2.8 trillion in assets–a leverage ratio of 50:1!

So, the Federal Reserve has done an excellent job of reducing leverage in the banking system through the purchase of all those assets and, as an additional benefit, helped keep government borrowing costs low.  But it has transferred a large portion of private sector bank leverage to its own balance sheet.  Any percentage change in the price of the assets on its balance sheet will be reflected fifty-fold as percentage change in the Fed’s capital.

In the movie”It’s a Wonderful Life,” the banker,George Bailey, was lucky enough to have an angel when his depositors make a run on the bank.  I hope Mr. Bernanke has an angel on his side if interest rates ever rise.

 

More tomorrow.

fixed income prospects for 2012

My first boss on Wall Street, who taught me securities analysis in the late 1970s, switched to the fixed income arena in the early 1980s.  He runs Jamison and McCarthy Investment Advisors LLC, which manages money for institutions and high net worth individuals.  His 4Q11 letter to clients gives a polished industry veteran’s view of the current global economic situation and its implications for bonds.  He’s relatively bearish.

The analysis is very worthwhile reading.  It’s long enough, however, that I’m going to publish it in three posts, all sans charts.  Here’s the first, an outline of the current bond situation:

Is it time to get off the bus?

2011 was a remarkable year.  The bond market encored its 2008 performance as investors flocked to the safety and liquidity of US Treasury securities.  We brought back the same actors–inept central bankers, anxious politicians, sketchy borrowers and frightened investors.  The accents were a little different–more European–but the plot was the same–a financial system supposedly on the verge of collapse.  And the ending for investors was also the same–the frugal, risk averse bond buyer won the prize in the final scene.  The prize in this case was a whopping 30% return from investing in long term US Treasury bonds.  And this came on top of a good showing in 2010–a 9.4% return for US Treasury bonds.  But as all moviegoers know–the third installment in a series is usually a dud.

We don’t think the numbers add up for another bond market rally in 2012.  Last year’s increase in bond prices lowered yields sharply.  For example, the Barclay’s Long-Term US Treasury Index closed the year with an effective yield to maturity of just 2.7%.  This compares with 4.1% a year ago.  The smaller yield means a smaller cushion against any price decline.  Meanwhile, the mathematics of bonds is such that lower yields equal greater price risk for any given change in interest rates.  The measure of risk is called duration and the duration of the Barclay’s Long-Term US Treasury Bond Index on December 31st was 16.2 compared with 13.9 for a similar basket of bonds a year earlier.  Now, investors should expect that a one percentage point change in interest rates would cause a 16.2% change in the price of the bonds, a very nice gain if interest rates for twenty year government bonds fall to 1.7%.  If, however, the yield of such securities rises to just 3.7%–a level 50 basis points below the average of the last five years–get ready to book a 13.5% negative total return (yield plus price change).  Of course, the returns from bonds with shorter maturities would be less damaged.  Nonetheless, there would be plenty of red ink for all.

If you think current bond market returns aren’t very generous, you’re right.  The sub-2% ten year government bond yields produced during the final quarter of 2011 were the lowest on record.  In fact, they were lower than the rate of inflation.  This has rarely occurred.   This occurred during the inflation tsunami of the Seventies, and again, briefly, in 2005 and early 2008 when oil prices spiked.

The bond market has reached these low levels because of:

(1)  fears of a European banking crisis,

(2) the free money policies of the Federal Reserve, and

(3) modest non-government domestic credit demands.

The impact of these factors is being amplified by hedge fund “risk-on, risk-off” trading that pushes short term money between various capital markets.  If any of the three legs supporting the bond market cracks in the months ahead, a substantial interest rate increase is in the cards.

That’s it for today.  More analysis tomorrow and Wednesday.