Wednesday, November 30, 2011

November Ends with a Bang

Isn't it amazing what a little perceived bank liquidity will do to the stock markets? Central banks all over the world agreed to lower the cost of funds by 50 basis points and that concerted effort was recognized as a strong positive. The Dow closed on November 30 at slightly over 12,000 for a 4.23% return on the day, with some of the biggest gains being made in the financial sector.

This week, Standard & Poor's announced downgrades on 37 global banks, including Bank of America, Citigroup, Credit Suisse, JP Morgan Chase, RBS, and UBS. In true market fashion, the combination of Central Bank action and the fact that most banks were downgraded only half a notch (from "A" to "A-" for example) led to a strong rally.

Less bad news (the downgrades COULD have been worse) is interpreted these days as extremely GOOD news...and the markets reacted accordingly.

On the bond side, the US Treasury 30 year bond was all over the place today, ending the day down around 2 points for a yield of 3.06. The 10 year was down 3/4 of a point and ended at 2.08%, a 10 basis point change in yield.

Other numbers out this week look good, but we are a long way from being out of the woods. In the bond markets, credit risk rather than interest rate risk is still the thing to watch out for. The street is pumping out floating rate to fixed rate paper along with a fair amount of absurdly low coupon step-coupon bonds. We continue to monitor credit situations, buy premium coupon callable paper, and try not to get overly enthusiastic on the big up-days in stocks.

Wednesday, November 2, 2011

Big Rally in Stock Market

What a month it was for stocks! The last 4 weeks has seen an almost 12% rise in the Dow Jones Industrial Average, yet the year-to-date performance is only slightly ahead of the various bond indices. We continue to believe that stock performance over the next 5 years will be only marginally higher than bond performance, yet the stock market volatility will be dramatically higher. For those who have had a reluctance to take on stock market volatility, fear not. If stocks and bonds perform as expected, your bond results should not be too different than the stock market's results.

As interest rates eventually begin to rise, Blue Haven Capital is poised to take advantage of the opportunity for our client accounts. We continue to recommend a balance between short and longer term bonds and an emphasis on higher coupons. Why higher coupon bonds? See this post from 2009 for a quick explanation.

Credit Spreads and Perceived Risk

The US fixed income markets trade in relation to the US Treasury market. If McDonald's has a 10 year bond, and McDonald's is perceived as riskier than the US Treasury 10 Year Note, then McDonald's will trade at the 10 year Treasury yield PLUS some extra yield spread. In trade lingo, one might hear someone say they have "McDonald's of 2021 at +100 to Tens" meaning they are offering McDonald's 10 year bonds at 100 basis points (1%) higher yield than the US Treasury 1o Year Note.

As the bond buying public perceives more risk in the US economy, spreads widen. In other words, that same McDonald's bond might trade at "+150 to Tens" when corporate profits and the US economy is suspect. Likewise, in a stronger economy with higher confidence, that bond may trade at +60 to Tens.

Over the last 12 months, corporate spreads on Industrial bonds in general have tightened. For example, on average a non-bank 10-year bond was trading at +103 a year ago and is now trading at +86. Consumer confidence is higher and the public's perception of risk is a bit lower. The one area that has widened over the last 12 months has been bank and finance paper. Some weeks ago when the future of Greece and perhaps all of Western Europe was in question, bank and finance paper widened out to +200 in the 10-year part of the curve. Over the last week, as the EU came to some agreement about how to help Greece, those spreads have tightened to +190, but bank and finance paper still has the highest yields available in the market.

As industries fall in and out of favor, and as corporations go through various events (HP deciding to stay in the computer business or Apple's death of Steve Jobs) Blue Haven Capital looks for opportunities to capture the incremental yield increases that such events generate.

Update: Latest Bank Failures Versus Previous Years

The latest numbers from the FDIC's Failed Bank List show that bank failures are decreasing.  The last time Blue Haven Capital discussed banks going into receivership was September 2009 at which time the number of banks failing had been doubling every six months for the previous 4 years. The first half of 2010 saw the first decrease in the number of failed banks since 2005, and we have seen a steady decline for each of the last three semi-annual periods. One might logically argue that there are fewer banks around to fail, but tightened lending standards and increased FDIC oversight also have much to do with the better numbers.

Here is an updated list of annual bank failures:
2000: 2
2001: 4
2002: 11
2003: 3
2004: 4
2005: 0
2006: 0
2007: 3
2008: 26
2009: 140
2010: 157

From January 2011 through June 30, 2011 there were 48 bank failures. 
Between July 1 and October 30, 2011 there have been 37 bank failures. 
We should see fewer than 100 bank failures for 2011, which would be a decrease of more than 33% versus 2010.

Again, we encourage those who are buying CDs from a brokerage firm to be suspect of premium CDs. If a bank fails, the FDIC will NOT refund the premium you paid for that CD and you could easily end up losing money. We would welcome your questions regarding this little known fact of the brokered CD market. 

Wednesday, February 16, 2011

Dimensional Funds Ranked Number One by Barron's

The February 15 Edition of Barron's Magazine, noted that Dimensional Fund Advisors (DFA) was ranked #1 in  US Equities in the Barron's/Lipper ratings. DFA attributed the continued success of its funds to low trading, wide diversification, and a continued focus on value investing.

Interestingly enough, Dimensional Funds are not offered through the mainstream retail stock brokerage outlets. In its attempt to shave costs and increase returns to customers, Dimensional has decided that most, if not all, of its funds will carry no 12b-1 fee and will not pay a commission to selling brokers. And, despite the fact that Dimensional Funds are some of the best performing and lowest cost funds in the country...stock brokers will not and cannot offer them. In fact, only 15% or so of investment management companies in the United States are approved by Dimensional to offer their funds. (Full disclosure- Blue Haven Capital is an approved Dimensional Fund Advisor Firm).

Dimensional Funds are similar, but not identical, to index funds. The fund's expenses are often lower than even some of the best known low cost funds in the industry...and that attention to expenses pays off. Hats off to a firm that operates much quieter (and much cheaper) than its competition.

Tuesday, February 8, 2011

Rising Rates and Falling Bonds

As higher interest rates have begun to appear, professional hand wringers, nervous Nellies, wet blankets, and killjoys have all come charging into the streets, arms waving and warning bells ringing. Higher interest rates means lower bond prices and the rush to exit the bond mutual fund arena has lately become a stampede.

Has anyone slowed down on their way to the exit doors and considered what the bonds of various maturities will do in a rising interest rate environment? Has there been any consideration given to the opportunity cost of selling a bond yielding 4% and moving into a money market fund paying 1/4%?

Let's take a look at two bonds: One is due in 2021, and one is due in 2041. Both bonds have 5% coupons. The ten year bond is yielding 3.38%, the 30 year bond is yielding 4.92%. Let's bump up interest rates on each bond 3% over the next 4 years. Voila! Come 2015, the 2021 bond is now down 14.2% in amortized value versus its purchase, and the 2041 bond is now down 32.8% in amortized value versus its purchase. If interest rates rise another 2% over the following three years, then in 2018 our 2021 bond would be down 12.7% in amortized value versus its purchase price and the 2041 bond would be down 44.8% in amortized value versus its purchase price.

Focusing on the 2021 bond: If one moves from 3.38% to money funds, the opportunity cost is approximately 3.25% each and every year. By the seventh year, that equates to a lost opportunity of almost 23%. Compare that to the 12.7% loss in principal value coupled with the 23.66% total coupon income received over those years for the bond holder. The bond holder's portfolio is ahead by almost 11% versus the nervous Nellie who went to money funds. 11% better on a portfolio is significant.

Pick your spots on the curve wisely. Yes, there is higher yield available in longer maturities, but there is significantly higher risk also. Before dismissing bonds altogether, quantify the risk of an interest rate change of 5% over the next 5 years or so. You may be pleasantly surprised.

Saturday, January 22, 2011

Getting Around Municipal Bond Default Risks

By now, many in the US have either seen or heard the latest municipal default risk opinion by Meredith Whitney which was broadly distributed by that venerated news program "60 Minutes" in December, 2010. At the conclusion of the program, many bond investors picked up both their babies and their bath water and dutifully hauled both out to the curb without even a second thought.

Along with weak credits such as Harrisburg PA, stronger credits have suffered. In fact, the very strongest type of municipal bond credit in the country ended up on the curb, right next to its lesser counterparts. Escrowed to maturity municipal bonds and pre-refunded municipal bonds have suffered the same fate as Harrisburg PA bonds.

When an individual borrows high and sees rates drop, such as with a mortgage, the individual can go and borrow at a new lower rate and pay off the higher rate mortgage with the newly borrowed money. Municipalities do much the same. High interest rate debt from years ago can be refinanced with money borrowed at lower rates. The older municipal bonds that get paid off are escrowed to maturity or pre refunded...often by US Treasuries...which are held in an escrow account and are used to pay the principal and interest of the old bonds. In effect, the holder of an escrowed or pre refunded bond has a tax exempt municipal bond backed by US Treasuries paying tax exempt interest.

Along with names such as Harrisburg PA, various escrowed and pre refunded bonds have similarly gotten cast aside by investors rushing for the exit doors in order to avoid municipal defaults. Currently, many escrowed and pre refunded munis are trading cheaper than Treasuries. That's right- cheaper - than Treasuries, which has happened only a handful of times since the mid 1980s.

Municipal bond investors have been leaving municipal bond funds for over 2 months. We have had 9 or 10 weeks of steady outflows from municipal bond funds to the tune of some $25 billion. The muni bond fund managers of the largest fund companies in the world wake up, come to work, and begin putting bonds out for the bid to satisfy investor withdrawals.

There are always opportunities in the midst of panic, and right now, one of the highest quality municipal bonds in the country is being treated like a lowly incinerator bond. Want safe, tax exempt income? It's right out there on the curb....