Posts Tagged ‘inflation’

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What is happening to my municipal bond investments?

Wednesday, January 26th, 2011

The municipal bond market has been in a state of turmoil since the fall fo 2008.   It started with the short-term auction rate preferred muni’s, then companies insuring municipal bonds went into bankruptcy (late 2008 and early 2009) and finally the credit quality of municipalities themselves came into question (late 2009).   Starting in late 2010, individual investors (the main buyers of municipal bonds) awoke to the realization that there is real credit risk to municipal bonds.   Credit risk is rating the ability of the municipality to pay the interest and principal as promised.

Apart from Build American Bonds, a program offered thru the US Treasury Department which no longer exists, municipal bonds provide tax exempt income.   There are exceptions relating to AMT bonds, private activity bonds and a few other types.   Individuals buy muni bonds in 3 ways: 1) ETFs, 2) mutual funds (open and closed) and 3) individual bond purchases (mostly done thru professional money managers for the benefit of individuals).   There has been a ton of research, publicly available starting in late 2010, about the credit risk in muni bonds.  Subsequently, there has been billions of dollars withdrawn from muni bonds especially in the long and intermediate maturities space.   Interestingly, ETFs and especially mutual funds, have been providing long lists of muni bonds they want to sell to meet the sell requests of individual investors.  Around 30% of the muni bonds on those lists get sold (industry source).  These lists generally show muni bonds that have the highest quality and liquidity.   This means two things: 1) muni investors in high quality bonds have seen the larger declines compared to lower quality bonds; and 2) municipal bond mutual funds are now sitting with shorter maturity and lower quality bonds.

Bottom line:  Investors are lumping good and bad municipal bonds together.   They are demanding liquidity (via their sell orders) and the liquidity providers (those buying the muni bonds) are extracting a higher and higher price for that liquidity (via a lower price of the bond itself).   History provides great examples of what happens when liquidity providers have the upper hand over liquidity demanders (think supply and demand).

Always Asking, Never Assuming™

Christopher Holtby

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Diversification Cuts Through the Market Noise

Friday, November 26th, 2010

The markets are giving investors a lot of mixed signals right now that can be confusing or even frustrating on a day-to-day basis.  Example: Gold recently climbed to a new record. Normally, strong gold prices indicate that investors are worried about currency devaluation and inflation, which is bearish for bonds.  But bonds were actually stronger, which normally means that investors are worried about deflation and reducing their overall risk.  But stocks were stronger as well, which normally indicates that investors are eager to take on more risk in search of correspondingly greater returns.  Commodities prices — a key component of inflation — were soaring. But the dollar, which normally trades weaker in an inflationary scenario, was firm.

 

How can all these conflicting signals coexist in the same market system?  Believe it or not, it happens all the time.  Historic economic transitions like the Argentine debt default or the Canadian bank crisis teach us that when investors are adjusting their portfolios to reflect shifting probabilities, this kind of confusion is normal until the market corrects past excesses.  Until that happens, we will probably see investments seesaw in ways that seem odd or even illogical. We may even see exotic scenarios like inflation-protected Treasury bonds paying negative yields — in effect, charging investors for the right to lend the U.S. government money.  But markets do not always predict the future correctly or even unanimously.  Investors who learn the benefits of diversification know that even if some investments go down, others will go up and their long-term rewards will remain intact.

 

Bottom line: No matter how much short-term noise the market generates, staying tuned to that clear signal is crucial.

 

Always Asking, Never Assuming™

Christopher Holtby

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Devaluation of one’s currency and gold

Tuesday, September 28th, 2010

Not since the 1930′s has the world seen developed and developing countries either blatantly devaluing their currencies (Switzerland 2009, Japan 2010) or attempting to debase their currencies (US and UK 2010).  There is more to this story than most people expect, which I will explore in latter postings.

In the 1930′s, the major countries of the world, based the value of it’s currency against a fixed exchange price to gold.  The effect of this policy, in a period of decreasing private demand (another term for a recession or depression), magnified the effects of deflation as the government could not ”print money” due to the gold/currency fixed rate (the central bank could not print money that is linked to a  corresponding value of gold).  Beginning with Spain (1927) and ending with France (1937), countries de-linked their currencies to gold, allowing the central bank to devalue their currency (i.e. print money).  In the US, this allowed the Roosevelt administration to “pump” money into the system as the household and corporate sector demand evaporated.  The 1930′s showed that when all countries de-value at once, little was gained in relative international trade competitiveness.  The only real result was political tension and foreign-exchange rate uncertainty.

Fast forward 70 years.  Today, the daily foreign exchange market of roughly $4 trillion makes moving foreign exchange markets more difficult.  Printing money to devalue one’s currency needs to be done in massive amounts.  Switzerland gave up the attempt to de-value it’s currency last year after the intervention involved 40% of it’s GDP.   There is a struggle between the surplus countries keeping their currencies artificially low and deficit countries choosing to rectify their deficit positions.

Bottom line: Every country cannot have a surplus account because for every net exporting country there has to be an offsetting net importing country.  A currency cold war, of sorts, has begun between the surplus and deficit countries.

Always Asking, Never Assuming™

Christopher Holtby

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Is there currently a US bond market bubble?

Friday, August 27th, 2010

An economic bubble that can occur for any investment is an example of the greater fool theory.  It assumes that the price of an investment (no matter how ridiculous) can be justified, eg. A buyer believes that there is another future buyer who will pay an even higher price for the same investment.   Recent examples are the tech boom in 2000 and the residential property boom in 2008.  These asset purchases were all about return on investment and speculation.  Bonds, on the other hand, are typically purchased (excluding junk bonds in normal environments) for return of investment.  In addition, bonds are not normally purchased using leverage.

Is there currently a rush into bond investments?  It depends.  US households hold 6% in bonds versus 27% in stocks and 27% in real estate.  Are these households re-balancing their asset allocation to “capture more income, limit their risks and preserve their capital?”  Will those goals change materially over the next 10 years?  The average baby boomer is in his/her mid-fifties and requires a different investment asset allocation than when they were in their 40s.  Are investors allocating money to bonds because of the uncertain economic environment?  Yes.  Are investors allocating too much too soon into bonds, based on their future needs?  Nobody knows. Are some investors chasing after higher yielding bonds without a complete understanding of the credit quality and interest rate risks over various economic cycles? Yes.

A bond is a contractual agreement between a lender and borrower.  The borrower/issuing entity must pay interest and repay, at maturity, the par value of the bond.  A stock represents  ownership in a public company.  The investor or owner of this stock “hopes” or “expects” that the investment over the long-term will be worth more in the future.   In a bankruptcy, stock owners get wiped out, loose everything, while bond holders get at least something.  Bond and stock investments have different mandates and purposes.

Whether an investor purchases a bond with a yield of 10% and rates go to 20%, or an investor buys a bond with a yield of 2.5% and rates go to 5%,  the losses are the same.  In 1999, the US had a fiscal surplus, and US Treasury bonds had one of their worst years.  In 2010, the US has a ridiculous sized fiscal deficit, and US Treasury bonds have had a great year, so far.  The US economy is dealing with deflation challenges without the Fed talking about increasing rates.  Even inflation, on a year-over-year basis (setting aside the difficulty of calculating it), shows no sign of an uptick. Eventually these facts will change.  That is why investment portfolios should not be directionally structured one way or the other.

Bottom line:  Investors purchasing bonds today “expecting” or “hoping” prices will increase (and yields decrease) are bubble investors.  Investors purchasing bonds today as part of a diversified asset allocation strategy to reach their short and long term goals are not bubble investors.  The latter will make proactive changes to their portfolio as the economic and financial facts change to ensure that their short and long term goals are reached.  But the former will react, because they had unrealistic expectations when they originally purchased their bonds.

Always Asking, Never Assuming™

Christopher Holtby

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What type of U.S. Treasury bonds should I own?

Wednesday, May 26th, 2010

There are three different types of U.S. Treasury bonds: interest bearing (e.g. coupons), interest paid at maturity (e.g. zeros), and inflation adjusted (e.g. TIPs). 

As of 5/24/10, the US Generic Government 10 year TIP had a yield of 1.2748, the US Generic Government 10-year bond had a yield of 3.2287, and the US Generic Government 10-year Zero had a yield of 3.53 (source: Bloomberg).  Zeros have a higher yield in order to compensate for the risk involved with being the most sensitive to interest rate changes.  A zero does not receive annual interest payments, but is purchased at a discount to par.  Today the bond market has priced in a 1.95% inflation rate over the next 10 years.  Do you agree with that assumption?  As of 3/10, the spread was 2.26%.  As of 11/09, the spread was 2.12%.  From late 2008 to early 2009, the spread was zero to slightly negative, implying no inflation.   Throughout 2009 the spread has widened but has remained within a band of approximate 0.40%. 

Over the last 3-6 weeks, the bond market decided that zeros were a better investment.  Actually, bond traders decided that zeros, based on duration, convexity, correlation and spread differentials were a better trade than coupon or TIP bonds.  Recently, the media has reported that zeros are outperforming other Treasury bonds, and the sheep of the sea are now rushing to buy zeros.   Traders will ride the wave until the next arbitrage opportunity comes along.

Which type of U.S. Treasury bonds to own depends completely on the investor’s need.  If you need to fund a liability 10 years from now that requires only 3.53% a year to fund, then buying a US Treasury zero could be the right answer.  If the investor needs more interest or needs income etc., than a US Treasury zero does not fulfill the need.  Whenever an investor buys an individual bond, a bond ETF, or a bond mutual fund, it is important to know how the historical spreads compare to other bonds. 

Bottom line: Wall Street bond traders make a lot more money than stock traders.   Try to trim down their bonuses. 

Always Asking, Never Assuming™

Christopher Holtby

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What does Discount Rate hike mean to you?

Saturday, February 20th, 2010

Definitions:  Discount rate is the “penalty rate” for banks needing emergency funds from the Federal Reserve (normally around 1% higher than the Fed Funds Rate).  Fed Funds Rate is the interest rate at which banks lend their balances (known as federal funds) held at the Federal Reserve to other banks, usually overnight.  The Discount Rate is set by the Fed Board of Governors, and the Fed Funds Rate is set by the Federal Open Market Committee (FOMC).

Last week the Fed’s Board of Governors raised the Discount Rate from 0.5% to 0.75% inter-meeting.  The surprise was not the amount, but the timing.  Two weeks ago, Bernanke’s prepared text to Congress stated the intent to raise the Discount Rate soon (defined normally as “in the future”, and market didn’t really appreciate that would be in 7 days).  The Fed also reduced the length on discount window borrows to the normal overnight term (since the Fall of 2008 the term had been extended to 28 days).  Currently, only $14.9 billion of window borrowing is outstanding, compared with over $1 trillion of cash held in Federal Reserve funds.  The Dow Jones rallied 233 points with the first discount rate decrease (Aug 2007), and markets declined with the discount rate increase.  The effect on the economy, bank lending and non-bank company profitability has nothing to do with the discount rate over the long-term.  It took increasing the Fed’s balance sheet to almost $2 trillion to arrest the downward spiral in the economy and markets (current financial crisis was a credit crisis, not a liquidity crisis, so reducing Fed Funds Rate and Discount Rate had a negligible effect on arresting the downward spiral).

For months, the Fed has written and talked extensively about exiting from the various strategies used to stabilize the financial markets.   The raising of the discount rate means the exiting has started, even if done gradually.  Markets of any kind really dislike uncertainty.  The inter-meeting change created uncertainty about the market pricing of all financial assets.  Interest rates, foreign exchange rates, and implied volatility of all assets have now been priced into the market.  This is reflected in an uncertainty premium.  The dollar has strengthened and solidified it’s strong trend relative to the Euro, Pound and commodity exporting countries.

Bottom Line:  1) Uncertainty is now firmly entrenched into the markets, 2) Investors need to be very clear on the timeline of their investments – short-term, intermediate and long-term – and the acceptable level of uncertainty on those investments, and 3) Looking at over 200 years of financial and economic history, this is a normal process.

Always Asking, Never Assuming™

Christopher Holtby

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Inflation debate information

Friday, January 15th, 2010

As you probably aware, by March 31, 2010, the US Federal Reserve will have completed the purchase of $1.25 trillion of federal agency mortgage paper from Fannie, Freddie and broker-dealers.  The mechanics of this process starts with the Fed printing money and paying this newly minted money to the sellers of the mortgage paper.  When the sellers are private companies, such as banks, this can cause the money supply and monetary base in the US to rise significantly.  The banks can choose to invest, lend or deposit the funds at the Federal Reserve in an interest bearing account.  Because the velocity of money has not increased (as of 1/15/10), this means that, so far, the banks, constrained by current or future loan problems, have deposited the sales proceeds at the Federal Reserve.  Currently, analysts do not know exactly how much of the mortgage paper was sold by banks versus Fannie and Freddie, which makes the analysis more difficult.  These details will not be available for another few months.

As long as these deposited reserves remain at the Fed, the monetary base has increased, but the money multiplier has not started ($1 of reserves can be leveraged around 10x).  The worry for all investors is: when and why will the banks move money from their Fed interest bearing accounts and lend and/or invest the money for a higher rate of return?  This would increase the money multiplier and eventually cause inflation. Right now, the largest part of the Fed’s balance sheet is comprised of GSE-based residential mortgages.  The great debate centers around the how to “unwind” or “exit” the program of holding GSE-based residential mortgages.  If the Fed signals they will begin to sell, these securities will drop in value very quickly in anticipation of the largest owner of these securities coming to market.  That is not a good option.  The Fed could just hold the mortgages until maturity, but that would cause another set of problems.  The Fed could completely stop purchasing mortgage bonds from Fannie and Freddie.  In essence, the Fed is trapped, as all options have less than perfect outcomes.

The Fed can increase the reserve deposit rates offered to banks holding deposits there at any time.  The Fed could raise those reserve deposit rates if they feel banks are beginning to loan or invest those original mortgage paper proceeds.  They can also engage in term deposit auctions of bank’s deposits at the Fed, thus “locking in” money and avoiding this money leaking into the economy.  These actions do not withdraw liquidity from the banking system as asset sales would; they only temporarily limit the effects of the money multiplier.  It appears likely the Fed can manipulate and extend this system for quite some time.

Bottom line:  This is a complicated topic.  Investors should pay attention to the reserve deposit rate, as well as other policy interest rates.  The inflation debate centers on more than just the increase of the Fed’s balance sheet.

Always Asking, Never Assuming™

Christopher Holtby

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Paths for the US ecomony

Tuesday, December 29th, 2009

Much like any long, alcohol-infused party, there is always the painful morning-after hangover.  Over the last 25 years, America had a great credit-infused party (sadly, there was an uneven participation in wealth creation), and now we must deal with and work through our credit hangover.

It is easy to look at old data to make interpretations about what the future could resemble.  The basic tenets of the old data was: low saving rates, high consumer consumption, and low unemployment.  Investors who do not believe that the new economic and financial paradigms will involve these same tenets need to make adjustments.  Economics and history has taught participants that government spending, over the long-term, has a zero multiplier effect on economic growth, whereas tax cuts, over the long-term, have a 3x multiplier effect on economic growth.  Looking at Washington, what are the paths for the US economy? (source: Mauldin)

Argentina – Hyperinflation.  Unlikely.

Austrian school of economics - VERY dramatic spending cuts.  Long and large depression.  Unlikely.

Eastern Europe – structural change (per Niall Ferguson) and restructuring everything.  The current Congress can’t even agree on health reform which they all agree needs to be reformed.  Somewhat likely.

Japanese disease – large deficits, low growth, no net new jobs, no productivity growth, and this can continue for a long-time.  Bond market eventually stops negative feedback loop with higher interest rates.  Somewhat likely.

US glide path option – high unemployment, tax increases, slow growth, eventually leading to spending cuts and current account deficit to GDP at 2-3%.   Somewhat likely.

This means nobody knows for sure the path of the US economy.  We do know that the bond markets will tell Congress (as they are telling the governments of Greece, Spain, Lativa, etc.) when enough debt is too much, requiring an increase in the cost to continue purchasing that debt.  This leads to higher interest costs for a country, which eventually leads to a change.

Bottom line:  Creating and monitoring an investment portfolio that finds the middle route through this credit hangover phase is key.  Investing is part art and part science.  

 

  

 

Always Asking, Never Assuming™

Christopher Holtby

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Why is it so hard to manage money in these times?

Wednesday, December 2nd, 2009

Anybody who is either younger than 65 or not a student of economic/financial history would find it difficult to remember a time period with these three characteristics: increasing interest rates, decreasing complex financial innovation and tight regulation.  Since 1982, these three characteristics existed in the reverse, leading to consistent US GDP growth somewhere between 5-7% (source: PIMCO).  This consistent growth caused financial assets to appreciate and financial/operational leverage to increase as companies felt comfortable about the consistency US GDP growth.  This situation no longer exists.

Today, the US economy and financial markets are entering a transition period which will eventually lead to decreasing complex financial innovation, increasing regulation and, at some point, increasing interest rates.  The housing market, savings/consumption patterns, and the financial sector are reversing their past trends of the last 25 years or so.  The effect of these new characteristics will be: lower US GDP growth and lower returns on assets.  

Currently, the US financial and economic system is in a transition period.  We are moving from the old paradigm to a new paradigm.  As people from the Midwest and Northeast know, any transition between the main seasons (summer or winter) are a pain in the neck.  The effects of the new paradigm will be dragged out over time, due to our politicians not allowing for true price discovery of all assets (I am agnostic as to who is in power, because I can’t really control that outcome, and like a hand in poker, I am where I am).  Investors must focus on keeping their assets working during this transition period (5 years, 10 years, who knows?), while not forcing their strategies to “fit” into the old paradigm.  That is just plain hard to do.  It takes a lot of patience, reading, learning and thinking.

Bottom line:  Four suggestions: 1) spend less, 2) save more, 3) lower your return expectations on financial assets, 4) focus on matching the maturities of your liabilities to the maturities of your assets, based on suggestions 1-3, and 5) be patient.  Economics and finance, much like nature, will take their course.  Wearing a bathing suit on a NY City beach in January, in the hope of warmer weather, is not a good plan.

  

Always Asking, Never Assuming™

Christopher Holtby

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An investment riddle for investors over the next decade

Wednesday, June 10th, 2009

How do you manage your investment portfolio over the next decade when the following factors exist?:

1) More government regulation

2) Increasing government deficits in developed countries

3) Inflation and deflation

4) De-leveraging and re-structuring of debt

5) Increased need for capital

6) Higher taxes

7) Status quo investment assumptions of last 25 years are no longer valid

Bottom line: Investing is an art, not a science, and the person who is managing your money must know how to ask these questions in the context of creating and monitoring an investment portfolio.

Always Asking, Never Assuming™

Christopher Holtby

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