Sunday, October 18, 2009

Bond Mutual Fund Fees

A recent Wall Street Journal article by Jason Zweig discussed the annual costs of owning a taxable bond fund. He referenced Morningstar research which showed that the average taxable bond fund charged over 1% in annual fees with some bond funds charging as high as 2.98%. His recommendation? Look to a bond index fund rather than an actively managed bond mutual fund. The example Zweig gave was the Vanguard Total Bond Market Index Fund which charges only 22 basis points, or 0.22 of 1%....about 1/5 what the other funds charge on average. Another example of an inexpensive fund group would be Dimensional, which charges approximately half of what Vanguard charges. (Blue Haven Capital uses both Vanguard and Dimensional products for its client portfolios).

A third choice is for the investor to use a money manager to build his or her own bond portfolio using individual bonds. The trick here is to make sure that the money manager really knows bonds. Most retail stock brokers are not familiar with bonds and will often purchase bonds at very uncompetitive prices. By finding a money manager that really knows bonds, the investor can capture the low cost structure that Dimensional and Vanguard offer, but also end up owning a highly customized bond portfolio which provides exactly the income stream the investor needs. (Blue Haven Capital also builds portfolios using individual bonds).

It pays to shop around when looking for fixed income products. ETFs, funds, and individual bond portfolios all make sense, but not at the prices that Morningstar found.

Thursday, October 8, 2009

The High Cost of Waiting for Interest Rates to Rise

We were recently asked by a foundation to quantify the cost of sitting in cash (money market) with a $1mm portion of their fixed income portfolio. The foundation assumed that rates would be going up starting in 2010, and that one alternative would be to buy a 3 year agency bond with a one time call which would occur 12 months from now...often described as a 3yr/1yr 1x call. Is it better to sit in cash and wait for rates to rise, or is it better to get invested now in what could be a rising interest rate environment?

We assumed that money market rates were 1/4% and that starting in 2010, money market rates would increase by 25basis points (1/4 of 1%) every quarter for the next three years. We also assumed that the market could give us a 3yr/1yr 1xcall Agency bond at 2.00%.

At the end of 12 months, sitting in cash (even with rates rising) has cost the foundation $15,625. At this point, if the bond gets called, the foundation will need to reinvest in another bond. If the bond does not get called, the foundation will hold the bond for another 24 months. At the end of that next 24 months, even with rising rates, sitting in cash has cost the foundation a total of
$18, 125.

Unless one thinks that rates are going to increase dramatically in a very short period of time, the cost of sitting in cash is too high. If the interest rate curve were flatter, it might make sense. But, with low money market rates combined with very attractive 3 and 5 year bond rates, it pays to grab some of those yields right now.

Friday, September 18, 2009

FDIC, Banks in Receivership, Your Certificates of Deposit (CDs)

Bank failures are on the rise and accelerating according to statistics released by the FDIC on its Failed Bank List which the FDIC has maintained since the year 2000.
Here are some quick statistics on annual failure rates:

2000: 2
2001: 4
2002: 11
2003: 3
2004: 4
2005: 0
2006: 0
2007: 3

From January 1 through June 30, 2008, there were 4 bank failures
From July 1 through December 31, 2008, there were 22 bank failures

From January 1 through June 30, 2009, there were 45 bank failures
From July 1 through September 11, 2009, there were 47 bank failures

The number of failed banks is increasing with an increasing frequency...more than doubling each semi annual period for the last 3 years.

Beware of the brokered CDs that are offered. Even if your CD is insured, if it is issued by a bank that fails, the FDIC will NOT refund the premium you paid for that CD and you could easily end up losing money. If your broker tells you the CD you are buying at a premium is non callable-beware. The FDIC can refund any CD at any time once a bank goes into receivership.

Curious about other anomalies in the fixed income markets? Talk to Blue Haven Capital.

Monday, August 31, 2009

Fiduciary Duty- Now Coming to a Town Near You

The Obama administration has proposed holding the broker/dealer community to a stricter standard than ever before and the brokerage community is furious about it. What is the brokerage community so upset about? What is it that has brokerage firms spending millions of dollars in a battle against the proposal? What sort of egregious proposal did the Obama administration propose that has brokers so enraged?

The Obama administration is proposing that brokers act "in their clients' best interest."

Oh horrors of horrors.

A recent Wall Street Journal article details the inevitable move by brokers towards accepting fiduciary duty when making recommendations to clients. For 70 years, money managers have accepted fiduciary duty regarding their clients. Brokers simply sold securities that clients and money managers wanted. Nowadays, brokers offer themselves out as "financial managers," "investment counselors," and "financial advisors." In their scramble to become more than securities transactors, brokers have crossed the line into money management...and with that ability will come extra responsibility.

As investment advisors, we welcome the additional requirement. A person or firm which provides investment advice should provide that advice in light of a client's best interests, period. Doctors do it, attorneys do it, money managers do it, and brokers will soon do it too if the Obama administration has its way.

Tuesday, August 25, 2009

Cramer is Harmless

Professors Paul Bolster and Emery Trahan of Northeastern University in Boston recently concluded and published a 33 page report examining the popular CNBC Television program Mad Money with Jim Cramer. The program is the most watched program on CNBC and has an estimated 380,000 viewers tuning in per night.

The research looked at the effect that Cramer had on the stocks he mentioned on his show, and the research also examined the success rate that Cramer had in choosing stocks.

The results? Yes, Cramer beats the S&P500...but he does it through beta, not alpha. What does that mean? Well, it means he takes more risk...and therefore gets more reward...than the S&P500. The next question should be "Does Cramer beat an index with similar risk characteristics?" IE, by accepting the same risk tolerance, is a person better off following Cramer or buying an index? The answer is that the person is better off just buying an index...something like the Russell 1000 Growth, the Russell 1000 Value, and a bit of the Russell 2000 Growth. In other words, save the transaction costs, the frenzied buying and selling, the inanity of the television program, and just buy the index.

Cramer did not outperform a similarly styled index, nor did he underperform it by much. He evidently has no stock picking ability, nor is he especially dangerous. As Professor Bolster stated in his conclusion: "He's harmless."

Wednesday, August 12, 2009

Bond Math: High Coupons versus Low Coupons

Recently we have had a few people ask us why we are buying larger coupon rather than smaller coupon bonds and it became evident that many don't understand the effect rising interest rates can have on a bond portfolio. Here is a good example of the price change rising interest rates can have on a bond portfolio:

Let's imagine there are two bonds in the market, both by the same issuer. One bond is a 7% coupon due in 2029 and the other is a 5% coupon due in 2029. Let's also imagine that both are trading at 6% yield to maturity. Now let's move out one year from today...and let's imagine that interest rates have moved up. Let's imagine that both these bonds have now moved to a 7% yield to maturity...so their prices have fallen.

The price of the 5% coupon bond has fallen approximately 10.75%...but the price of the 7% coupon bond has fallen only 10%. In other words, with the same rate of change in interest rates, the lower coupon bond has changed more in price relative to its original price than the higher coupon bond has changed relative to its original price.

What does this mean for the investor's portfolio? Well, for a $1mm portfolio, it means that our decision to buy a larger coupon bond rather than a smaller coupon bond just saved the investor $7500 in portfolio losses.

Wednesday, August 5, 2009

5 Months of Strong Returns

The Standard & Poor's 500 Index returned over 44% in less than 5 months between March 9, 2009 and July 31, 2009. Interest rates, although higher than 6 months ago, remain at historically low levels. Unprecedented amounts of cash are being pumped into the economy by the US Government. Corporate bond spreads have tightened, and municipal bond yields in relation to Treasuries are returning to more normal times. What's ahead? Possibly inflation. How does one mitigate the effects of inflation on one's portfolio? Maintain some exposure to commodities through broad based inexpensive commodity index etfs, and make sure your bonds have enough coupon that they can weather the storm.

There are still enough inefficiencies in the bond market that one can occasionally shorten maturity and pick up yield and still hold the same credit. Maturities can be shortened, coupons can be increased, and some preparation can be made for the upcoming inflationary times.

Thursday, July 23, 2009

Rhode Island Pension Fund

It came to light today that the Rhode Island Pension Fund lost 19 percent of its value over the last 12 months...outperforming the major indices and most major pension funds. Rhode Island's General Treasurer Frank Caprio has gone to great lengths to lessen the investment management costs of state's pension funds including using index funds for the fund's equity exposure. In fact, in a recent article he claimed that the move to indexing saved the fund upwards of $9 million in fees.

A recent study by Eugene Fama and Kenneth French once again points to the fact that fewer than 1% (0.6%) of fund managers actually add value above their most appropriate benchmark. Even more depressing is the fact that as years go by, fewer and fewer equity managers actually bring any alpha to the table at all.

The key of course is "appropriate benchmark." We see many active managers benchmarking themselves to the S&P500 and then showing alpha of 1% plus. A little digging shows that the stocks they are buying are considerably smaller in capitalization than the S&P500, and that when capitalization and risk are taken into account...the manager is actually underperforming a similar index.

The key? Unless you can find the 0.6% (and falling) of active managers who truly bring alpha, just buy the index.

Tuesday, May 26, 2009

Bond Returns vs Stock Returns Over Long Periods

According to Research Affiliates LLC's Robert Arnott in an article found here in the May/June issue of Journal of Indexes, for the previous 10 years, 20 years, and 40 years long-term Treasury bonds have outperformed the broad stock market. In fact, over the long term, the out performance of stocks versus bonds from 1802 through February 2009 averages only 2.5% per year- a much lower figure than most investors would ever imagine.

The article goes on to say that "For the long-term investor, stock markets are supposed to give us steady gains, interrupted by periodic bear markets and occasional jolts like 1987 or 2008. The opposite-long periods of disappointment, interrupted by some wonderful gains-appears to be more accurate."

The answer? Don't shy away from having bonds in your portfolio. The long term yields are not that different than stock yields and bonds will certainly add a bit of income and stability to your overall portfolio.

Wednesday, January 7, 2009

Merrill Lynch, Standard and Poor's, Bank of America

Yesterday afternoon Standard & Poor's upgraded Merrill Lynch's long term credit rating to A+ from A. At the same time, the short term credit rating of A-1 was affirmed. This equalizes the Merrill Lynch ratings with the Bank of America credit ratings and is due to the fact that the Bank of America purchase of Merrill Lynch is now complete.

It has been a while (seems like forever) since we have seen an upgrade announcement out of Standard & Poor's. Don't put on the party hats yet though, the S&P credit outlook on both is negative.