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.


Greece in a nutshell

Greece joined the euro in 2001.  This gave it the right to print/mint euro currency, as well as to issue Greek sovereign debt in euros.  The second is important because issuing euro debt is like having access to a giant EU credit card–payment was at least implicitly guaranteed by every member of the EU, not just Greece.

Greece probably didn’t meet the criteria of economic health necessary to qualify to join the euro. Everyone in the EU seems to have known this at the time but thought that having the cradle of Western intellectual and political history in the euro was symbolically important.

In 2009, the ruling party lost an election.  The new administration discovered, and announced to the world, that Greece had been systematically falsifying its national accounts–official reports of the country’s fiscal health and growth–for years.  Greece’s apparent prosperity during the opening years of the 21st century turned out to be a combination of lies and living beyond its means, funded by large-scale euro bond issuance.  Most observers agree that Greece run up more debt that it can ever possibly repay.

Negotiations between Greece and its creditors are at an impasse.  Broadly speaking, the EU and IMF want to see structural economic reforms (which may prevent a repeat of the country’s woes) in Greece before any debt forgiveness.  Greece, whose current government has already reversed some of the few reforms implemented over the past six years, wants debt forgiveness first, talks about structural reform later.

The EU put a take-it-or-leave-it offer on the table about a week ago.  The Greek government has decided to call for a national referendum vote on the issue, scheduled for Sunday.  In the meantime, it has shut down its banks, so no one can take their money out of the country.

There are some odd technical issues with the referendum.  For example, one political party is suing to stop the vote, saying it’s unconstitutional.  It’s also coming at the start of vacation season, so it’s not clear whether people can get home to vote, especially with atm withdrawals limited to €60 a day.

Domestic Greek polls indicate that likely voters favor accepting an EU bailout plan by 52/48–even though the administration is campaigning against it.  A “No” vote probably means Greece leaves the euro, and maybe the EU as well.

I have mixed feelings about the negotiations themselves.  On one hand, I’ve got to admire the ingenuity and determination of the Greek side in trying to get the best possible deal.  On the other, everything I’ve I’ve read and heard to make me think Greece regards negotiation as a blood sport.  The point is not to get a fair deal, but to suck the other side dry and toss the husk to the side of the road.  –even a little bit–about the needs of the other side.  It’s turned the negotiations into a fool me once, fool me twice situation, in my view.

I think the current Greek administration may have done a huge amount of damage to the country’s long-term economic prospects by trying so wriggle out from responsibility for the current crisis.

Ironically, the better outcome for the EU might be for Greece to vote to leave the euro.  The resulting damage to the Greek economy will be enormous, I think.  Seeing what happens will likely silence separatist movements elsewhere in the EU.

surviving the next twelve months (iv)

what makes me optimistic

I’m a growth stock investor.  So I’m optimistic by nature.

More to the point, the two worries about thinking stocks will go sideways to up as the Fed normalizes interest rates are that:

–recovery in the US may continue to be sub-par..  

If so, the normalization process is going to take a looong time, since the Fed’s goal is to raise interest rates at a slow enough pace that the economy in unaffected.  Yes, the Fed may make a mistake, but the error it typically makes is to wait too long to raise rates, not to raise them too fast.

In addition, there’s serious discussion in economic circles that maybe the way we have measured economic progress in the US in the post-WWII era has passed its “use by” date and isn’t capturing what’s going on in an Internet-centric world.  After all, it took many years for government data to acknowledge that personal computers enhanced productivity and increased consumers’ well-being.  We’re now in the midst of a much greater period of change–the baton-passing from Baby Boomers to Millennials and the demise of the post-WWII corporation designed on the model of the 1940s Army.

Maybe the economy is a lot hardier than we now think.  If so, the strength of earnings growth may not be the issue the market perceives it to be.

–the rest of the world is a mess…

therefore the 50% of S&P 500 earnings that comes from abroad will  be a source of disappointment.

As far as commodity-based emerging economies are concerned, “mess” is probably an apt characterization.  But they’re (thankfully) only a tiny portion of the foreign 50% of S&P earnings.  The key areas for the index are Europe and Asia, especially China.

As far as Europe goes, there’s evidence that the worse of the recession is behind it.  The euro may have bottomed against the dollar, as well.  The EU is still struggling with the problem of Greece.  But that’s not because Greece is a key economic driver for the EU (quite the opposite), but because Brussels fears that allowing/forcing one member to leave the union will set a precedent, and encourage separatist political parties elsewhere.

I have no idea whether Greece goes or stays.  But I think that the negative economic consequences for Greece–Cuba is the only analogue I can come up with, and it’s not a very good one (Argentina?)–of leaving the EU will be so devastating for the country that Grexit itself will silence separatists.

There are also the first signs of economic stabilization in China.

So maybe the half of S&P earnings that come from abroad also won’t be as bad as the market now thinks.

an active strategy

areas to avoid–stocks whose main attraction is their dividend

areas to emphasize–Internet economy, firms catering to Millennials



surviving the next twelve months (iii)

In the past in the US when the Fed has raised interest rates from recession-emergency lows, bonds have gone down and stocks have gone sideways to up.

Will this time be an exception?   …another way of saying, Will stocks go down this time around?

The generally accepted explanation of the divergence between stocks and bonds while the Fed is normalizing interest rates after a downturn is that the negative effect of higher rates is offset, in the case of stocks, by the positive effect of strong earnings growth.  Bonds–other than junk bonds, or municipal bonds–don’t have this offsetting factor.  So for Treasuries the news is all bad.

(There are at least two reasons why interest rates matter for stocks:

–broadly speaking, people (me being a possible exception) don’t actually want to own stocks.  What they want is to own liquid long-term investments so they can fund their retirements and send their kids to college.  Those can be either stocks or bonds.  A decline in the price of bonds makes them more attractive, taking some of the shine off stocks.

–in broad conceptual terms, the worth of a company should be related to the value in today’s dollars of its future earnings.  To the extent that investors use today’s interest rates to discount future earnings back to the present, rising rates will result in lower present values.)


I remain squarely in the “sideways to up” camp, but I can see, and am monitoring, two possible worries that may weaken the case for s-t-u:

–in what has been to date a sub-par rebound from recession, earnings growth may not be as strong as in prior recoveries, and

–the S&P 500 is a global index, about half of whose earnings come from abroad.  Even if US-sourced earnings are great, the same may not be true for foreign-sourced.  In particular, an increase in the value of the dollar vs. the euro caused by increasing interest rate differentials (the worry of the IMF and World Bank) could mean a lower dollar value for EU-sourced earnings (which make up about a quarter of the S&P 500 total).

More tomorrow.


surviving the next twelve months (ii)

two types of tightening

The Fed raises rates in two different situations:

1  to slow down an overheating economy.  This is not where we are now.  In the overheating situation, the economy is expanding at an above-trend rate.  Inflation is accelerating.  Wages are rising rapidly.  The stock market is frothy.  The long bond is trading at inflation +2% – +3% (meaning a nominal yield of 4% – 5%, in a 2% inflation scenario).

As the Fed ups short-term rates, what  follows is a garden-variety recession/bear market.  Bonds go down.  Stocks go down.  The damage to stocks is worse than the damage to bonds–often by a lot.

Again, this is not the situation we’re in now.

2)  to restore money policy to normal after a period of extreme easing aimed at ending a recession or combating a severe economic shock.  That’s where we are now.


In situations like this, bonds go down but stocks go sideways to up.  There’s no theoretical reason I can see for the latter behavior.  It happens, I think, because, unlike the overheating situation,  the Fed doesn’t intend to bring growth down dramatically.  It just wants to wean the economy off a sugar high of very easy credit.

Two things make todaydifferent from past rate normalization periods, however:  the amount of easing has been very large and of unusually long duration; and dysfunction in the legislative and executive branches in Washington has meant fiscal policy has failed to do its part come to the country’s support, other than in the earliest days of the financial crisis.

Some argue that beause of this, today’s situation may be different enough that the past won’t be a sure guide.  I’m going with history.  But I take th point that we can’t just be on cruise control.

two different portfolio responses

The two types of tightening call for different stock portfolio construction, in my view.

In today’s world:

–bond-like stocks will probably not do well.  Years of ultra-low interest rates have forced Baby  Boomers to search for income in the stock market.  As rates rise, and bonds become increasingly attractive, some Baby Boom money will return to bonds.  At first, the reverse flow may only be new money.  At some point, however, Boomers may begin to liquidate their income stocks.

–rising rates may make the dollar spike.  In fact, the IMF recently expressed this fear in an emphatic plea to the Fed to postpone the start of the rate normalization process into 2016.  It’s not clear to me that the dollar will appreciate much further, however.  But if it does, stocks with foreign exposure will become less attractive, since the dollar value of their foreign earning power declines.  On the other hand, foreign companies with large US exposure become more attractive, both to local investors and to you and me.

–companies with their own special growth story become more attractive than those that are mostly dependent on the general business cycle for their oomph.  Cloud computing and Millennial favorites should be relatively fertile fields.  Arguably, the market’s preference for growth stocks over value has been in place for some time.  But the preference for the former should intensify.


More tomorrow.

why bonds go down when interest rates go up

This is  pretty straightforward story.  The example that follows is much too simple, but it makes the point.


Suppose I bought a 10-year Treasury bond with a coupon yield of 2.38%–the going rate–for $1000 yesterday afternoon. For my $1000 I get interest of $23.80 each year for ten years plus my $1000 back at the end of the term.

Let’s say that the Fed raises short-term interest rates sharply this morning, in a way that makes the yield on the 10-year rise to 3.00%–completely unrealistic, but this is just an illustration.

After this happens, for $1000 I can now get a 10-year Treasury that makes ten payments of $30.00 per year–a total over the next decade of $62 more than on the 2.38% bond–in addition to return of my $1000 at the end.

How much is my original 2.38% -coupon bond now worth? Put another way, how much would someone else now pay me for it?   I don’t know exactly   …but it’s certainly less than $1000.