a French sovereign debt default?!?

First there was the surprise Brexit vote in the UK, after which sterling plunged.

Then there was the improbable victory of Donald Trump in the US presidential election, which sent the dollar soaring.

Now there’s France, where the odds of a far-right presidential victory by the Front National have improved.  A competing right-of-center candidate, former frontrunner François Fillion, has been hurt by allegations that his wife and children did little/no work in government jobs he arranged for them (with aggregate pay totaling about €1 million).

If Marine Le Pen, the FN leader and standard bearer, were to win election in May (oddsmakers now give this about a 1 in 12 chance), her victory might conceivably snowball into a similar sea change in the National Assmebly election in June.  Were the FN to win control of the legislature too, the party says it will leave the euro and re-institute the franc as the national currency.  In addition, it intends to, in effect, default on €1.7 trillion in French government bonds by repaying the debt in new francs, at an exchange rate of 1 Ffr = 1 €.

Improved prospects for Ms. Le Pen–plus, I think, President Trump demonstrating he means to do his best to keep all his campaign promises–have induced a mini-panic in the market for French-issued eurobonds.  Trading at a 40 basis point premium to similar bonds issued by Germany as 2017 opened and +50 bp in late January, they spiked to close to an 80 bp premium last week.

my take

At this point, the conditions that would trigger a French exit from the euro and its refusal to honor its euro debt instruments seem high unlikely.  Still, the possibility is worth thinking through, since the financial markets consequences of Frexit would likely be much more severe than those of Brexit.

More tomorrow.








stocks in a 4% T-bond world

There are two questions here:

–what happens to stocks as interest rates rise? and

–what should the PE on the S&P 500 be if the main investment alternative for US investors, Treasury bonds, yield something around 4%?

On the first, over my 38+ year investment career stocks have gone mostly sideways when the Fed is raising short-term interest rates.  The standard explanation for this, which I think is correct, is that while stocks can show rising earnings to counter the effect of better yields on newly-issued bonds, existing bonds have no defense.

Put a different way, the market’s PE multiple should contract as rates rise, but rising earnings counter at least part of that effect.

The second question, which is not about how we get there but what it looks like when we arrive, is the subject of this post.

in a 4% world

The arithmetic solution to the question is straightforward.  Imagining that stocks are quasi-bonds, in the way traditional finance academics do, the equivalent of a bond coupon payment is the earnings yield. It’s the portion of a company’s profits that each share has a claim on ÷ the share price.  For example, if a stock is trading at $50 a share and eps are $2, the earnings yield is $2/$50 = 4%.  This is also 1/PE.

A complication:  Ex dividends, corporate profits don’t get deposited into our bank accounts; they remain with management.  So they’re somewhat different from an interest payment.  If management is a skillful user of capital, that’s good.  Otherwise…

If we take this proposed equivalence at face value, a 4% earnings yield and 4% T-bond annual interest payment should be more or less the same thing.  In the ivory tower universe, stocks should trade at 25x earnings if T-bonds are yielding 4%.  That’s almost exactly where the S&P 500 is trading now, based on trailing 12-months “as reported” earnings (meaning not factoring out one-time gains/losses).  Why this measure?   It’s the easiest to obtain.

More tomorrow.


interest rates: how high?

the speed of interest rate rises

The best indicator of how fast the Fed will raise the Fed Funds rate will likely be the pace of wage gains and new job creation, as shown in the monthly Employment Situation report issued by the Bureau of Labor Statistics.  Infrastructure investment legislation that may be passed by the new Congress next year may also factor into the Fed’s thinking.  On the other hand, the continuing example of Japan, whose quarter-century of no economic growth is due in part to premature tightening of economic policy is also likely to play a part in decision making.

Much of that will be hard to be certain about in advance.  Current Wall Street thinking, for what it’s worth, is that the pace will be north of glacial but not fast at all–maybe a move of +0.50% next year, after a boost of +0.25% later this month.

The endpoint of policy, however, may be somewhat easier to forecast.

the final policy goal


Fed policy is aimed at holding inflation at +2.0% per year.  Its main problem recently is that it can’t get inflation that high, in spite of having flooded the economy with money for the past eight years.  So let’s say we’ll have inflation at 2%, but not higher, some time in the future.


If so, and if the return on cash-like investments during normal times continues to provide protection against inflation and little else, then the final target for the Fed Funds rate is 2%.


If we consider the 30-year bond and say that the normal annual return should be inflation protection + 2% per year, then the target yield for it would be 4%–vs slightly over 3% today.

The 10-year?  subtract 50 basis points from the 30-year annual yield.  That would mean 3.5% as the target yield.

If this is correct, the important thing about the domestic bond market since the US election is the substantial steepening of the yield curve.  While cash has another 150 bp to rise to get to 2%, the long bond is within 100bp of where I think it will eventually settle in.

In other words, a substantial amount of readjustment has already occurred.







closed-end funds

Investment companies in the US are a specialized form of corporation that is exempt from corporate income tax, a privilege they get in return for agreeing to restrict activities to investing in securities and to distribute to shareholders virtually all their realized profits (which become taxable income to recipients).

The predominant form of investment company is the mutual fund/exchange-traded fund, also called an open-ended fund.  What makes the fund “open-ended” is that the investment company itself regularly issues new shares to buyers and redeems them from holders who wish to sell.  Put another way, the number of shares of the company–and therefore the amount of money under management–is variable.  It typically ebbs and flows with market sentiment or with the track record of the professionals the company hires to manage the money.


A less common form of investment company is the closed-end fund.  In this format, the investment company raises initial capital in an IPO and trades its shares on an exchange.  It does not allow shareholders to purchase and redeem directly from the company (the reality is slightly more complicated, but nothing to worry about).  Instead, buyers and sellers find a counterparty on the exchange, just as if they were selling a regular stock or bond.

What makes closed-end funds interesting to you and me is that they almost always trade at discounts to net asset value.  There are some exceptions, like if they specialize in some exotic foreign market that’s hard to invest in directly and which happens to be flavor of the month, or if the managers have been shoot-out-the-lights successful in their investing (I can’t think of one in this second category).

This is particularly true in times of stress.

If the discount to NAV becomes too great, or persists for too long a time, predators may try to take control of the fund and liquidate it–which, of course, makes the discount disappear as well as the fund.


Why am I writing this today?   …because I’ve been reading that closed-end bond funds are trading at unusually high discounts to NAV at present.  I presume that this is in anticipation of higher interest rates.

I’m by no means an expert on these funds.  And I can’t imagine rushing out to buy bonds today.  But these may be a class of securities to begin to learn about and keep an eye on.


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 (ii)

Yesterday I referenced an article in the Wall Street Journal that talked about possible liquidity problems with junk bond funds as rates begin to rise. Based on information provided by Barclays, a huge provider of ETFs, the reporter, Jason Zweig, concluded that junk bond ETFs are a safer alternative to traditional mutual funds.

My comment from yesterday, boiled down perhaps to the length it should have been, was that since the first junk bond crisis in the late 1980s, junk bond funds have adopted very rigorous pricing mechanisms, so the chances a junk bond fund is badly mispriced are very small.  On top of that, mutual fund companies have lots of tools available to deal with high levels of redemptions.


As to ETFs, while as a practical matter it may be that these vehicles themselves may not be subject to the same selling pressures as traditional mutual funds, the way that ETFs insulate themselves can be an issue for you and me.

In the case of traditional mutual funds, we buy and sell directly with the fund, once daily, after the close, at NAV.

ETFs are considerably more complicated.   We deal with broker intermediaries who make a continuous market throughout normal trading hours, though with no guarantee about how closely the bid-asked spread they set will match up to net asset value.  (Authorized participants, who typically deal in minimum blocks of 50,000 shares are the only ones who transact directly with ETFs.)

The tendency of ETF market makers in times of market stress is to widen the bid-asked spread.  This does two good things for the broker.  He gets a higher return for transacting at a risky time.  And the wider spread discourages people from trading.  Translation:  liquidity for you and me dries up.

How bad can it get?  I don’t know.  Several years ago I tried to collect data on the performance of stock ETFs at the market bottom in early 2009.  The only information available then was a comparison of the last trade on  given day with the NAV calculated after the NY close.  In one case, for a foreign stock ETF, the last trade was at a 12% discount to NAV.  The discount may have been considerably wider during the day.  At that time, ETF companies told me they just didn’t know.

I haven’t checked since. I haven’t done this for bond funds.  And one might argue that the 12% discount is an outlier. But the horrible problems ETFs had during the last week of August suggest to me that the situation hasn’t changed for the better.

My experience is that trying to trade during highly emotionally charged times is usually not a good idea.  But it also seems to me that the potential risks inherent in trading in mutual funds at times like this to you and me, not to the fund company, pale in comparison to those involved with ETFs.


This has gotten much longer than I intended.  More tomorrow.




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.