Tag Archives: bonds

a second Greek bailout payment agreed: implications

February 21, 2012 By in Current Market Thoughts, Recent Market Action, Stock ideas, Strategy Tags: , , , , , , , , , , , Leave a comment

an agreement

Greece and the IMF/EU have finally agreed on conditions for the latest tranche of bailout money, €170 billion, to be paid to the troubled Mediterranean country.  Greece will now have the funds to redeem €130 billion of its bonds that mature in the next few weeks.

little stock market reaction

Stock market reaction in Europe has been muted–a 2% gain yesterday, a give-back of about half that amount today as I’m writing this.

what went on in the talks?

I find it hard to interpret with any confidence what has been going on in negotiations between Greece and the EU/IMF.  It’s possible that the brinksmanship displayed in the talks on the question of whether Greece would remain in the Eurozone was all a show, performed for home country voters by politicians eager to minimize the negative consequences of any accord for their future electability.  But that’s not what I think.  My take is that Greece–which hadn’t come close to fulfilling the conditions of its initial bailout payment–figured until recently that the EU was negotiating from a position of extreme weakness.  Until the EU made it clear it was willing to let Greece leave the Eurozone, Greece felt it could extract almost any concession, provided it didn’t do so all at once but rather moved the bar a little bit at a time.  Once the EU began to plan for a Greek exit, Athens was forced to become serious about striking a deal.

implications

It seems to me that at the very least both sides have bought themselves some time.  I’d expect that the core EZ countries will continue to strengthen the capital structure of their domestic banks.  It’s understandable that potential buyers of the public assets Greece supposedly has on sale would be reluctant to bid until they were sure that they weren’t purchasing just before a significant currency devaluation.  So we’ll now have a chance to see how serious Greece is about these divestitures–and how desirable they actually are.

We’ll also have a chance to see whether the EU will retain its hard line that starving yourself through austerity is the best prescription for a return to robust health, or whether the ECB monetary policy will be a bit looser than it has let on to date. My guess is that it will.

Implications for stock market investors?  I think they’re less about a change in strategy than about confidence that the strategy is correct.  I view the EU as a low-growth area for an extended period of time.  And, although fears of a “Lehman moment” are off the table (not that markets ever really factored this possibility into stock prices), Europe will be subject to periodic worries about weaker EZ countries like Greece.

So the appropriate stance remains, I think, to be underweight the area and to concentrate on companies which are listed in the EU but which have the bulk of their operations located in the Americas or in the Pacific.

what’s that about Japan?

Actually, a much newer and more interesting macroeconomic development has been going on half a world away.  It’s quantitative easing in Japan.  More on this tomorrow.

 

higher taxes on dividends? –implications for stock markets

February 17, 2012 By in cash flow/share vs. earnings/share, Constructing a Portfolio, currency effects, Current Market Thoughts, Dividends, Industry Analysis, Investment firms, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , , Leave a comment

the Obama proposal

President Obama has recently proposed that the current tax preference for corporate dividends paid to individuals be eliminated.  Instead of being taxed at most 15% of the amount received, dividends would be considered ordinary income and taxed by Washington at as high a rate as around 40%.

Personally, I’d prefer an overhaul–and simplification–of the current tax code instead of tweaks around the edges.  Rather than putting a foot into the  the quagmire of possible political motivations, however, let’s just take a look at what I think are likely results for US capital markets if it’s implemented.

what doesn’t change

1.  Tax-exempt and tax-deferred accounts would be unaffected.  For pension plans, 401ks and IRAs, and for non-profits, it will continue to make no difference whether they make money in the form of interest or dividend income, or of short-term or long-term capital gains.

2.  Aging Baby Boomers are developing an increasing preference for steady income over capital gains, which are sometimes there, sometimes not.  That won’t change either.

what does

3.  I think the biggest effect will be on company decisions to start making dividend payments or to increase a payout they already have.

It seems to me that most publicly traded corporations recognize the Baby Boom-induced change in investor preferences now happening in the US.  Understanding that a substantial, and rising, dividend is a positive for their stock, companies have been happy to return profits to shareholders this way.  They do this despite realizing that if you combine federal and state/local income levies, up to 25% of the payout will go to the taxman.

If dividends lose their tax preference, the percentage taken by the taxes will approach 50%.  That means a big drop in what the shareholder will retain, both numerically (a third) and psychologically.  For most companies, I suspect, it will tip the balance in favor of devoting free cash flow to share buybacks rather than dividend increases.

For my money, that takes a lot of the shine away from what I consider to be the most attractive part of the dividend-stock universe–companies with above-average dividends today and for which you can reasonably project a quickly rising free cash flow over the next few years.

4.  If the government continues to  keep interest rates at emergency lows and, by accident or design, it also removes much of the incentive for individuals to buy dividend-paying stocks, how do investors adjust?  Maybe there’s a boost in demand for junk bonds, although income-oriented investors have been buying riskier forms of fixed income for a long time.

I think biggest effect would be for investors to broaden their horizons further.  The 7%-8% yields on EU telecom stocks will suddenly look more attractive, despite currency risks.  So, too, emerging market securities, both bonds and dividend-paying stocks.

5.  Looking at #3 another way,  provided they’re large enough to lower the share count, stock buybacks raise earnings per share.  All other things being equal, that should mean a higher per share stock price.  If so, the higher share price would likely offset some or all of the negative effect of dividends increasing at a slower rate.  In other words, the mix of returns (price appreciation + dividend income) changes, and in a way that increases risk.  But the crucial investment question is whether the total return from both sources will be higher or lower than before.

No one knows the answer.  But if the total return is lower–that is, if the effect of higher taxes on dividends is to decrease the long-term value of US equities–then one would expect US investors of all stripes to look increasingly to stock markets outside the US.  In addition, on the margin, US companies might also begin to look to foreign venues to raise new capital, if they could achieve higher prices for their stock by doing so.

My bottom line:  this proposal is one to watch closely.  Like a snowball that starts rolling down a hill, its consequences could be far greater than just to raise taxes on older, upper middle class city dwellers.

there may be a real life for contingent convertibles, after all

February 14, 2012 By in Banks, hybrid bonds/contingent convertibles, Industry Analysis Tags: , , , , , , , Leave a comment

why I don’t like co-cos…or, (more) evidence investment bankers are on the dark side

Investing is conceptually very simple but emotionally very difficult.

Under most conditions, professionals can resist the Dr. Frankenstein-like impulses of investment banks to create bizarre security hybrids.  Not at the top of the market, though.  There’s something in the air that makes portfolio managers throw away their pocket protectors and revel in the purchase of the trashiest securities.

PMs will rue these buys for the rest of their careers–which may, incidentally, be quite short periods of time if they don’t recover their senses and sell the stuff on while a market for them still exists.

One of my favorites in this genre was a convertible bond issued in 1993 by Hong Kong-based New World Development, an indifferently managed family-owned property conglomerate.  It carried no coupon and was convertible on undisclosed terms into shares of a mainland Chinese company that did not yet exist.

And you ask me why I’m not a fan of investment bankers.

As it turned out, the issue met with high demand despite its dubious character–a sure sign that the markets were in the grip of speculative fever.  Right afterward, I was chatting about it with a highly skilled colleague, who confessed she had actually taken part in the deal.  Her reasoning?  In her peer universe there might be a half-dozen offerings during the year that would make or break performance versus competitors.  She felt she couldn’t take the chance that the deal would not only be successful but would trade up strongly in the aftermarket.  She didn’t want to be left in the unusual (for her) position of eating competitors’ dust.

co-cos, the brokers’ latest creation

Contingent convertibles are more recent spawn of the investment banking tendency to birth nightmarish creatures.

The idea is that the vehicles, known as “co-cos,” would be issued by financial companies, especially banks, that are required to maintain minimum levels of equity capital.  They start out as bonds.  But if the issuer’s financial condition deteriorates beyond a certain level, they automatically convert into equity.  Therefore, investment banking proponents argued, they should be considered as equity by the regulators even before conversion.  (True to form, when the original idea was floated, the intention was to not specify in the offering documents what circumstances would trigger conversion.)

not a winner…

Co-cos have never taken off.

The obvious flaw, other than that no one would know what would prompt conversion, is that the buyers would be bond portfolios.  They’d be reeled in with the promise of higher-than-average coupons.

If the issuer’s capital ratios deteriorated, its stock would sag significantly.  If conversion of the co-cos followed, that would leave large amounts of stock in the hands of PMs whose client agreements don’t allow them to hold equities.  So they’d have to dump the securities right away into a depressed market, sending the issuer’s stock lower and making its problems worse.  In fact, anticipation of conversion might launch the stock of the issuer into a severe downward spiral.

Also, the Bank of International Settlements said the idea wouldn’t fly.  Finally, the co-co idea also came too close to the disastrous demise of their close cousins, hybrid bonds.

…until now

It now looks like co-cos may actually have a use, according to the Wall Street Journal.  The buyers won’t be private investors, however.  They’ll be the governments of Spain and Portugal, which will use the vehicles to inject money into ailing banks.

Why use co-cos? Three reasons:

–the injections of money will look like investments, not the bailouts they really are,

–Spain and Portugal will get securities in return for the money they pour in, so their government deficits won’t increase, at least on paper, and

–Madrid and Lisboa won’t appear to be partially nationalizing the weak banks, which is what buying equity directly would mean.

I’ve never seen this before–an instance where a crackpot, top-of-the-market, caveat emptor ploy by investment bankers to boost their bonus pool is actually useful.  It’s nothing like what the i-bankers envisioned, of course, but still…

searching for yield in a zero Fed funds rate world

February 13, 2012 By in Constructing a Portfolio, Current Market Thoughts, Dividends, Strategy, Utilities, Wireless Tags: , , , , , , , , Leave a comment

conventional wisdom

Two traditional general rules about the appropriate allocation between equity and fixed income are:

1.  Take your age in years.  That percentage of your assets should be in fixed income; the rest can be in equities.  A thirty-year old, for example, should keep 30% of his assets in bonds and 70% in stocks.  A seventy-year old should have the reverse proportions.

2.  For a retiree, figure what your yearly expenses are.  Keep enough fixed income so that the interest earned will cover these expenses; the rest can go into riskier assets like stocks.

Neither rule applies in today’s world, however, at least in my view.

Only a lottery winner has the luxury of using #2.  Fifteen years ago, when the 10-year Treasury was yielding 8%, $1.25 million worth of them would generate $100,000 in interest income.  Nowadays, you’d need a $5 million investment to earn the same.

Both rules subject the follower to considerable risk as/when interest rates begin to rise.  My friend Denis Jamison deals with this subject in detail in his recent posts on PSI.    …his conclusions.

my quandary

One of my former employers notified me recently that I’m being removed from participation in its fixed income pension plan.  I can either take lump sum distribution or buy an annuity.  I’ve chosen the former, which I’m rolling over into an IRA.

I want to keep the IRA money in income-generating assets, to counterbalance to some degree my growth investor desire to own stocks.

Believe it or not, it takes a month for my old company to process my request.  Also, quaintly enough, it will issue a physical check and send it in the mail to my IRA account.  Looking on the bright side, this gives me some time to figure out what to do.

So I’m looking for dividend-paying stocks.  I’m not the only one, of course.  And with this account I’m starting at a time when the search for such equities by individual investors is close to entering its third year.  Has everything been picked over already?

first thoughts

My preliminary look around for information has turned up two interesting articles:

-the first comes from BCA Research, an independent organization headquartered in Canada (BCA stands for Bank Credit Analyst, its best-known publication).  BCA continues to be very fundamentally sound.  At one time it served primarily individuals and was somewhat technically-oriented and decidedly bearish in tone.  Not so much any more.  Today’s clients are mostly institutions.

In a February 2nd article titled US Equities:  The Total Return Trap,  BCA opines that traditional high income stock groups–utilities, telecom and REITS–are currently overvalued.  It recommends looking for yield among pharmaceuticals, integrated oils and hypermarkets.

–A February 5th piece in the Financial Times points out that significant dividend yields are available among stocks in the EU and in the Pacific.  The article lists the following current yields on various FT regional indices:

Europe (ex the UK)     3.80%

UK          3.40%

Asia Pacific (ex Japan)          3.16%

Global          2.70%

Japan          2.51%

US          1.96%.

my first stops

My order of preference is:  US, UK, Asia ex Japan, Europe.

I’m not so keen on Japan.  I think companies there prefer to pile up cash rather than pay dividends.  The high yield is more a function of wretched stock market performance than rising payouts.

I don’t have strong thoughts on the relative strength of the € vs. the $.  My hunch is that the € is going to be relatively weak, though, undermining the attractiveness of any dividend payment to a dollar-oriented recipient.  If we’re going to enter an extended period of economic stagnation in Euroland, much like the “lost decade(s)” in Japan, however–and I think that’s the most likely scenario–one can reasonably make the argument that, like the ¥, the € could show surprising strength.   I just don’t know.  Until I have more conviction, why take the chance?

The UK is a very income-oriented market and doesn’t carry the same degree of currency uncertainty as the Eurozone, in my opinion.

I’ve got a couple of weeks to do some research.  I’ll write more as I make progress.

two more years of emergency-low interest rates!

January 31, 2012 By in Current Market Thoughts, from growth to value: the life cycle, growth vs value, Recent Market Action, Shaping a portfolio for 2012, Strategy Tags: , , , , , , , , , , Leave a comment

the January 25th Fed meeting

Last week’s meeting of the Federal Reserve’s Open Market Committee had two important results:

1.  Chairman Ben Bernanke said the Fed funds rate, which has been at effectively 0% for just over three years (since December 16, 2008–how time flies) will likely remain at or near the current low rate into 2014.

2.  The Fed gave more detail than ever before on its thinking about prospects for the US economy and the appropriate level for the Fed funds rate.

The Fed thinks:

–the long-term growth rate of the US economy is  +2.4%-2.5%  a year (vs. 3%+ a decade ago).  The agency is content, however, to allow growth at somewhat above that rate from now into 2014.

–the appropriate long-term level for the Fed funds rate is about 4.5%, which amounts to a 2.5% real rate of interest (“real” means after subtracting inflation from the nominal rate).  This contrasts with the current rate, which is a negative real rate of about 2.5%.

–although the process of normalizing interest rates will probably begin before the end of 2014, the Fed is unlikely to raise the funds rate above 1% until at least 2015.

–despite the immense monetary stimulation going on now, inflation will not be an issue.  It will remain at 2% or below.

–the “natural” rate of unemployment, that is, full employment, is 5.5% of the workforce (in theory, the 5.5% is friction in the system–like people in transit from one employment location to another, or who decide to take a short break between jobs…).

According to the Fed’s projections, the unemployment rate will remain above 8% until some time in 2013.  It probably won’t crack below 7% for at least the next three years.

implications

The forecast itself isn’t a shocker.  The Fed has been talking about slow but steady progress for the economy, with no inflation threat, for some time.  The real news is that the Fed expects the current situation to persist into 2105, a year longer than it had previously indicated.

1.  To my mind, the biggest implication of the Fed announcements is that it makes less sense than ever to be holding a lot of cash.  How much “a lot” is depends on your economic circumstances and risk preferences.  But the Fed is saying that a money market fund or bank deposit is going to yield nothing for the next two years and well under 1% for the year after that.  Yes, you have secure storage in a bank and substantial assurance you won’t make a loss, but that’s about it.

To find income in liquid assets–as opposed to illiquid ones like, say, rental real estate–you have to look to riskier investments, dividend-paying stocks or long-dated bonds.  That in itself is nothing new.  Savers have been reallocating in this direction for the past couple of years.  Last week’s Fed’s message, though, is that it’s much too early to reverse these positions.  If anything–and, again, depending on personal circumstances and preferences–investors should think about allocating more away from cash.

2.  When the process of normalizing interest rates is eventually underway, the yields on long-dated bonds and dividend paying stocks will be benchmarked–and judged–against cash yields of 4%+.  For stocks, a static dividend yield of 3% won’t look that attractive.  At some point, low payout ratios (meaning the percentage of earnings paid out in dividends) and the ability to increase cash generation will become key attributes.  Both are indicators of a company’s ability to raise dividends.

3.  It’s my experience that when the Fed begins to tighten, Wall Street always underestimates how much rates will rise.  Last week, the Fed told us that when the Fed funds rate goes up this time, its ultimate destination is 4.5%.

4.  Investors taking a top-down view, that is, looking for the strongest economies, will have to seek exposure outside the US–which will only look good vs. the EU and Japan.  The main issue is demographics–an aging population.  It’s probably worthwhile to try to figure out what characteristics of the latter two economies, both of which have older populations than the US, are due to social/cultural peculiarities and which are due to aging.  The second set of traits may well turn up in the US market as well.

5.  The mechanics of how growth stocks and value stocks work may change in a slower-growing economy.  It’s hard to know today how that will play out.  True growth stocks may be harder to come by.  Value investors who say they buy asset value of $1.00 at $.30 and sell it at $.70 may have to buy at $.20 and sell at $.60 if there’s less room for second- and third-tier companies to succeed.

I think it’s way too soon to be worrying about anything other than #1.  The rest are thoughts to be filed away for next year, maybe.