Winds of High Yield Change

Since early May Treasury interest rates have shot up over 30% (still when put in perspective, not that all that much).  Bond prices and interest rates have an inverse relationship, so when interest rates rise bond prices fall. 

It’s easy to think about this relationship in a practical sense, if Bond A is yielding 5% at time 0 and a similar Bond B is yielding 6% at time 1 then why would anyone own Bond A at the same price they could buy the higher yielding Bond B?  Thus, the price of Bond A falls.

So given the above it logically follows that recent spike in interest rates would have led to a fall in bond prices.  That indeed happened: 

What’s interesting about the above is that high yield bonds and preferreds, HYG and PFF, also moved down in value.  This didn’t happen in late 2012 through March of this year when Treasury yields also had a 30% rise. 

This could be the start of another shift in the market.  In this instance, high yield bonds and the like may move more with the change in Treasury interest rates, where in the recent past they moved with equities:

There are a few takeaways here:   

• The spread (difference in yield from high yield bond over a Treasury) may be done contracting for the time being.
• Note:  Since I wrote this spreads have moved up, which makes high yield bonds more attractively valued
• If it consolidates into the current range, the spread return (e.g. yields on high yield bonds fall when Treasury yields stay constant or even rise) will no longer be existent.
• Thus, the return from high yield bonds will be a combination of the interest paid on the bonds and change in Treasury interest rates (ipso facto, Treasury yields rise, high yield bonds fall and vice versa).
• The caveat would be that if equity markets fall apart, high yield bonds will probably follow.
• Therefore, if high yield bonds are yielding 6.50% + another 2.50% if Treasuries revert back to 1.60% or so level (a rise from this level resulted in a 2.50% fall in Treasuries) and assuming the spread stays constant means the upside is roughly 9.00%.
• On the flip side, the risk is larger than 9.00% given the correlation to the equity markets, if they fall. 
• Further, if Treasury interest rates rise steadily this will also hamper returns, though I don’t think there is substantial downside to high yield bonds in this respect. 

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  Nothing in the above writing should be taken as an investment recommendation. 

Making Sense of Recent Market Moves

The last week or so has certainly caused some anxiety among equity and fixed income investors.  I decided Sunday and Monday to look more in depth and draw some conclusions.  

What follows is my analysis, which I sent out to our firm; however, does NOT include the corresponding research behind it or the awesome, pretty charts.  I should note that without the research in which to refer, the bullet points may be a bit hard to digest.  In those instances, if anyone wishes further details please email me (zabrams@capitaladvisorsltd.com).

As I write this, prices have seen some reversal, which in some ways encapsulates what I am trying to illustrate below.  The key, whether or not I am right or whether I am wrong, is to focus on the intermediate-term window, try and funnel out what is happening in these violent short-term moves, and don’t panic!!

• The markets of late have been interesting as stocks and bonds have both seen downward market volatility.  This makes asset allocation a nasty task
• Starting in 2009, rising yields have been bullish for stocks.  Falling yields have been bearish until they hit their floor.  However, the general low level of interest rates has been bullish for stocks (lower interest rates = lower discount rate = higher valuations AND lower interest rates = lower cost of borrowing = higher EPS).  Thus, it seems logical that the higher yields, higher stock prices makes sense for the time being as the move in interest rates has been large and could be construed as a secular change   
• When put in perspective neither stocks or equities looks as bad, but should continue to be watched.  Further, a 3% to 4% loss in bond portfolios is hardly reason for panic
• Bonds in particular appear due for at the very least a short-term bounce
• Stocks could have more to go, but should have a floor as:
• Lower prices increase likelihood of Fed loosing
• Economic data is too good for stocks to ignore
• It’s likely that either bond yields settle OR move down given at some point the rising yields will probably hurt the economy and loosen Fed policy
• Even If they don’t (e.g. the economy gains in strength) then properly allocated fixed income portfolios should be  hedged as:
• Stocks should perform well
• Active fixed income management should outperform passive
• Duration should be relatively low
• As it relates to portfolio management the above points to:
• Letting this FMOC re-calibration shakeout and remaining calm
• If there is a need to pull the trigger, a small move to cash is probably the best place to go instead of a secular change in the portfolio (e.g. selling a portion of intermediate-term bonds and moving to cash > selling all intermediate-term bonds and moving to short-term bonds)
• Even if this is the start of a secular move in interest rates, the odds are likely there will be a short-term reversal
• Use the market trends as a guide and not a road map to violent short-term moves
• At some point soon, diversification will work again in terms of moderating (though not completely containing) risk 
• I still think the highest probability path is this: rapid rise in interest rates hurts economy > equities struggle > yields lower in anticipation of Fed loosening (maybe not QE though) + safety > stocks fall until easing back on > yields range bound.
• Note: an alternative would be if interest rates continue to rise as growth improves, which again is bullish for equities.  Not so much for bonds

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  Nothing in the above writing should be taken as an investment recommendation. 

The Equity Paradox

The equity markets have scorned investors like young love gone badly.

As a result investors are scared to get back in the game.  And herein lies what I like to call the paradox of equities – in order to get the larger returns needed to make it comfortably to and through retirement, an investor needs to take on more risk, which thus increases the chances of catastrophic portfolio loss, which in turn severely inhibits gaining those larger returns.

A recent NYT article a friend sent me outlines this in more detail.  The gist of it is that the bulk of Americans are under saved, regardless of income level and net worth and thus need higher returns to meet their goals.  For example, if you have a $4m in savings, but are accustomed to spending $300K a year it may not last through retirement.  If we assume a 5% return, that money runs out in about 22 years.

There are a few things that complicate the above calculation and could cut that 22 years down even more – low bond returns, unfavorable longer-term equity valuation levels, timing of initial investment, and large drawdowns earlier in retirement, among other things. 

This is where a good advisor can help seek balance in this paradox by assisting a client in taking on the risk needed to get the returns and meet their retirement goal. This can be accomplished as follows:

• Cash flow modeling to see if/when client runs out of $ and adjust accordingly
• Moderate AND contain portfolio risk
• Make sure the client is understands and is comfortable with the risk/return profile of his/her portfolio
• Prevent the client from making the psychological mistakes (e.g. go all in at the top and sell out at the bottom)
• Increase the after-tax rate of return. As is said, it’s not what you make, it’s what you keep.
• Most Underrated:  an advisor can provide counsel to clients, who have questions about their portfolio, how it’s constructed, the market environment, etc.  Getting piece of mind and being able to sleep at night is imperative to prevent some of the biggest mistakes investors make. 

That list is by no means all encompassing; however, I do think it provides and adequate short summary of things advisors MUST do to get their client to and through retirement.  In most cases that involves taking on some sort of equity exposure, even if equities are no longer as popular as they once were. 

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  

From the High

The S&P hit its high for the year May 21^st and then pulled back -3.61% through June 5^th.  Such a small pullback in such a small time frame is no reason to sound the alarm unless it shows signs of morphing into a more pronounced move.  Currently, none of my quantitative screens exhibit more vulnerability to a sustained downside move. 

Still I wanted to look at this move and see what provided a good hedge against this decline.  The short answer – nothing except Gold.

May 21st to June 5th
S&P 500	-3.61%
Bond Index	-1.50%
Developed Intnl Stocks	-7.00%
Emerging Market Stocks	-6.80%
Gold	2.00%
USD Index	-1.60%

What’s interesting here is that stocks and bonds moved down together.  The last time the S&P had a pronounced move down in the summer/fall of 2011, bonds provided a decent hedge and were up close to 5%.  Also of note was that the dollar was positive, all of which indicate deflationary concerns taking precedence.  Gold was also positive, which can fit into the deflationary narrative depending on one’s perspective about how that shiny metal operates.

When gauging the current numbers, I initially thought inflation concerns helped drive these moves; in theory such concerns should cause bonds and the dollar to fall and gold to rise.  Equities are a mixed bag, depending on the type of inflation.  For example, strong recovery causing inflation = good, while too much money without offsetting production = bad.  This would lead to the conclusion that too much money is forcing the dollar, bonds, and stocks down at the same time.  Except…

Inflation isn’t a concern at all, in fact inflation expectations actually fell during the period.  So what happened?  My wild guess is a combination QE tapering and Japanese market volatility, which was not unexpected.  

The point of the post is not to breakdown market moves and assuage cause and effect.  The point is that every market environment is different.  While the current time frame is short and for now insignificant, it does help illustrate that markets change and the past correlations and subsequent hedging strategies may not work in the future.  So the takeaway is:

• Portfolio construction must evolve to meet current conditions
• Investors must look to intermediate market moves to remove the noise
• Investors make sure their portfolio doesn’t stray from their comfort zone
• As always, moderate and contain portfolio risk

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  

Macro Musings via El-Erian

Josh Brown recently wrote a blog post highlighting what Mohamed El-Erian said at the PIMCO Investment Conference.   Since my invitation got lost in the mail, I had to settle for reading his summary, which was quite good. 

Like Mr. Brown, I think that Mohamed El-Erian is not only a great macro thinker, but communicates his/PIMCO’s views as clear as anyone.  Further, their track record has been extremely solid since before the financial crisis despite the occasional misstep.   I doubt you could find much better.

Three things really struck me.  For ease, the big bullets are Josh’s notes along with El-Erian’s quotes.  The highlights are mine to add emphasis.  My comments are in italics under their respective bullets.

1. Risk management: People used to think that diversification was good enough, but no more. "Diversification is necessary for any investor but it is not sufficient when central banks have distorted prices."  He says the way to think about insuring tail risk is the same as you would car insurance. You maintain it at all times, not try to guess when you'll need it. He is talking about far-out-of-the-money options that hedge against unforeseeable outlier events, which is what his fund does.
• I totally agree that diversification is no longer adequate to control risk, given how correlations move to 1 and -1 in times of stress.  Tail risk insurance, using momentum to move risk on/off, and/or stop-losses at waterlines are good ways to contain risk.  Diversification only manages to moderate risk.  That is an important distinction.
2. Beta heavy lifting:  He thinks the beta heavy lifting is probably over in asset markets. In bonds, he says the capital appreciation returns from treasuries, corporates and high yield bonds are done too.  Lastly, someone asked him a Vanguard-related passive indexing question. Mohammed tells a killer anecdote from early in his career about how EM bond indexes were once made up of 22% Argentinian bonds pre-default, and that the other managers who were hugging that index got hammered. He says that passive makes sense only if you'll be driving in reverse up a road that is completely straight. Because you're essentially looking at snapshot of the way things were.
• Passive is less preferable to active in this environment.  Again, I think he is spot on here, though PIMCO would have this view given they are an active shop.  This is especially true on the Fixed Income side.  I will say the caveat is finding the right active managers, which is more of a qualitative function and can prove to be difficult.
3. Central Bank Brand Management:  He says basically a brand is like a wedge you can shove in between fundamentals of your company or product and raise prices. But that brand wedge is finite and cannot keep things apart or elevated indefinitely, there is a limit to what a brand can do… Central banks are also a brand. The brand is "we can deliver outcomes today to improve the future."  Right now people believe in the central bank brand, watch out for when that belief in the brand turns. Right now the psychology about the Fed's brand is positive, "but psychology goes both ways."
• What if Central Bank psychology in regard to the market reverses?  Admittedly this is something I need to look into more.  He elaborated more on that thought recently.  His basic point is that even powerful brands can only continue for so long until fundamentals justify (or on the negative side, no longer justify) the price (e.g. he mentions APPL).  In this specific instance, it’s that central bankers are hoping that in increase in financial market prices will filter down to the real economy.  El-Erian is skeptical this will work, and notes risks about the unintended consequences. He wonders what happens if investors no longer believe the fundamentals justify the financial market prices, even if central bankers continue their current policies.  All of these are legit concerns; however, in my opinion they are all fixable.

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  

QE Taper or Not… and What Happens if it Does Occur?

When will the Fed taper its purchases of Treasuries and mortgage backed securities as part of its Quantitative Easing?  That seems to be the biggest discussion going on at all the hottest clubs.  The chief economist from my favorite econ research team (Goldman) said “A September tapering is certainly possible”.

In an economic sense, QE is more debated than JB at the Heat Game 7.  Regardless of whether QE works, is destructive long-term, neither, or both, I want to focus on its impact on equity markets where I see 3 common reasons why it’s bullish:

1. Higher earnings of companies through refinancing as interest rates are pushed down.
2. Low bond yields force investors into higher yielding assets (e.g. stocks), which in turn forces up stock prices and valuations.
3. QE creates liquidity (e.g. I hold a bond, the Fed buys it, I now have cash), which has to be put somewhere.  One of those places is the equity market.

Ipso facto, QE tapering would be bearish for equities.  I do believe that is a risk, but at least for now under the current facts and circumstances – facts and circumstances which can and do change – I am less concerned, and here is why:

1. Econ Data Still Not There:  from the same article “I think that is going to depend on the data… Chairman Ben S. Bernanke expresses caution over trimming the program too soon… The likelihood that the economy will continue to grow about 2 percent over the next couple of quarters with inflation ‘well below’ target will probably stay the Fed’s hand until December”.
2. Closer to End of Recovery Cycle: Cullen Roche at Pragmatic Capitalist elaborates on the last bullet: we’re in the backstretch of the recovery, unemployment is still way too high, corporate revenues are starting to falter.
3. Tapering Not Huge Anyway: if they do taper, consensus isn’t exactly a large change to the Fed’s balance sheet.
4. Good Economic News Drives This Decision: as insinuated earlier, if the Fed is tapering then economic data is good.  If economic data is good, then stocks should do well.   

That last bullet is the key.  If economic data falters as the Fed tapers their purchases then equity markets will be in trouble.  A good article at Learning Bonds points out that fact QE and equity prices is even a conversation points to artificially inflated equity values.  Thus, if data comes in weak stocks would be more likely to revert to their fundamental value. 

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  

Max Pain – Investing, not the Awful Movie

When I get bored I crunch numbers and build spreadsheets just like everyone else.  This time I wanted to see the maximum amount of money an investor would have lost over the last 40 or so years.

It’s an important number to me for 2 reasons:

1. How far is the deviation from what one would expect given the historical average and standard deviation (i.e. variance around the average)?
2. Investors tend to panic when the losses get really bad.  The results in a sell at the bottom mentality, locking in the already large loss.

Here is what we got:

Let’s breakdown US Stocks (i.e. S&P 500 month-end values, dividends reinvested) because that is what most people care about: 

• From 1970 through April of this year stocks had an annualized return of 10% with a standard deviation of 16%. 
• To elaborate, that means 95% of the time we can expect stocks to fall between -22% and 42% return in a 12-month period. 
• While the max drawdown was 51%, over a full 12 month period that number drops to 41% (not shown).
• During that time frame, the lowest return over a 10 year period for stocks was -29% (also not shown).  This sticks out as there have been 10 year holding periods where investors could lose money by holding equities.  There were 24 times this happened; however, they were all consecutive and took place between 2008 and 2010 corresponding with high equity values (e.g. the start date) prior to the tech bubble.

Risky assets (stocks, REITs, commodities) all have large drawdowns and are relatively correlated (again, not shown) with the exception of maybe commodities.  Thus, diversifying from just US Stocks to other risky assets will most likely not be an adequate hedge in the event of a large drawdown in US Stocks.  The addition of bonds helps; however, from my data is no panacea. 

 Note: Portfolios are rebalanced annually.  For a breakdown of the allocations and the indices used please email me for details.

The above numbers indicate that portfolio diversification can lessen risk (i.e. standard deviation) without sacrificing much, if any, return.  However, the max drawdowns are still large and well outside 2 standard deviations.  So while a diversified portfolio can mitigate maximum drawdown risk, it doesn’t necessarily restrict it.   This leaves the investor with 2 choices:

1. Mentally prepare himself or herself for a large drawdown so that if it does happen he or she doesn’t liquidate at the bottom and lock in a devastating loss.
2. Put risk control measures in place so the max drawdown is limited.  

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.