July 2007: What are the Bond Markets Signaling?
Although financial headlines usually focus on the equity markets, during the three months just ended important investment developments have been taking place in the global fixed income markets. Until as recently as late last year, the world’s central bankers (e.g., in the U.S. our Federal Reserve Board, or FED) had been manipulating the level of interest rates, influencing the structure of borrowing costs, and generally controlling the pace of economic growth. In addition to providing a deluge of liquidity, this accommodative monetary policy allowed individual, corporate and government cash reserves to accumulate to unprecedented levels. Seeking relatively riskless returns during the past few years a good portion of these cash reserves found its way into the fixed income markets, bidding up bond prices and unnaturally suppressing interest rates in both the short and long maturity sectors. Thus the emergence of what most investors now recognize as the flat yield curve (see page 5) reflecting the indifference on the part of fixed income investors to distinguish between short and long-term interest rate risk.
As improved GDP growth rates throughout the world have become more firmly entrenched, central bankers have begun to reabsorb their policy-generated excessive liquidity, allow currency markets to more freely adjust, while at the same time moderate their reflationary monetary policy stance. One could argue that the more timely availability of freely exchanged country-by-country economic data enables these better coordinated global central bank policies. So far, the effect has been salutary.
During the three months ended June 30th, as our FED indicated the chances of lowering interest rates in the near future were next to nil, bond markets responded by moving rates on longer maturity U.S. Treasuries up above 5%, an initial shift toward a more normalized borrowing cost structure. This prompted a bond market sell-off (when interest rates rise, bond prices decline). Such interest rate behavior is often also consistent and coincides with actual and anticipated better sustained economic growth, improved profits and stronger stock markets around the world. Importantly, this mild credit tightening has occurred in a non-inflationary environment where the competitive forces of globalization and the application of technology tools to control corporate costs, both against a relatively free market trade backdrop, have conspired to create a best-of-all-possible global investment market scenario. In the current U.S. inflationary environment of 2.0% per annum, long Treasury bond yields of 5% to 5.5% would appear realistic.
However small an adjustment from the lower interest rate range of the past 4-5 years this recent upward drift may appear, the result, as savers and investors around the world continue to reprice risk, is to set in motion a number of recalculations for many in the alternative investment business. As rates escalate, the rising cost of leverage (think hedge funds and other “structured” financial instruments) diminishes the returns achievable in many of today’s alternative investment vehicles. This applies to commercial and residential real estate in particular, as well as to the world of private equity, merger and acquisition financing arrangements, and certainly, hedge fund investment programs.
As the structure of interest rates shifts upward, many central banks have chosen not to intervene and allow free market forces to sort all this out. It’s an enlightened approach, but if the fall-out (e.g., most recently, the Bear Stearns hedge fund collapse) gets to be too painful, never underestimate the instincts of regulators to intervene to appear to be doing something to bail out aggrieved investors. The first ranks to feel the heat will most likely be the deal-makers in the private equity world, as well as some of the more highly leveraged hedge funds. Left alone, the markets will reward those who have carefully assessed and anticipated the relative risks.
These letters don’t usually spend much time discussing mundane bond market gyrations, but today with our financial markets so highly leveraged, the cost of borrowing takes on added significance. The subprime lending problems facing many commercial banks today and the likes of Bear Stearns’ hedge fund are but an early warning of how the unwinding of these highly leveraged speculative financial techniques could unfold.
Do Hedge Funds Really Know How to Hedge?
Presumably the answer to this question is yes, but in the current more normal interest rate and credit market environment we will have to reserve judgment. Since hedge funds (now numbering 9,000 funds with approximately $1.9 trillion in assets under management) account for more than 45% of combined U.S. daily equity market volume, those of us who are long-term stock and bond investors have a more than passing interest in how the ‘hedges’ weather what’s ahead.
In past letters we have aired our concerns about the impact of hedge fund activity on the equity and bond markets, and our confidence was not necessarily buoyed when it was revealed that a Bear Stearns hedge fund invested in subprime mortgage-backed securities ran into “unforeseen difficulties” forcing liquidation. For Bear Stearns, one of Wall Street’s supposedly bond-savvy investment bankers, this is a costly, humiliating development, indicating their hedging programs lacked risk control algorithms to offset weakness in the subprime mortgage markets.
Bear Stearns will have to cough up $3.2 billion to cover investor losses, but the liquidation process has highlighted another problem with these alternative investment vehicles. Never mind that these funds are leveraged sometimes as much as 5-7 times underlying holdings, the Bear Stearns liquidation reveals that a large portion of the assets in these funds lack liquidity, particularly in distressed, forced sale conditions. Truth be known, the daily values for the underlying assets in most hedge funds are priced by computer formula and do not represent what a willing bidder would be ready to pay to acquire the holding in a buyer’s market. In the Bear Stearns fund firesale presently underway, some of the fund’s underlying assets attracted no bids! It will take a few more weeks before fund investors learn the scope of the financial aftermath of this fund’s demise.
So there are times when one should monitor bond market developments, since the level and trend of bond yields are often very sensitive to shifts in central bank policy, as well as the inflation and economic growth outlook. All of this ultimately sets the tone for stock markets around the world. If this bond hedge fund unraveling were taking place in 1999 in the midst of the then internet stock market bubble, we might well have opted to lower the risk profile in client portfolios. But in today’s equity market, with relatively reasonable valuations throughout the world, it doesn’t seem necessary, yet.
The ETF Craze: a Sales Success, a Buyer's Dilemna
Exchange Traded Funds (ETFs) are today’s “must have” market-proxy portfolio product. They are a sponsoring money manager’s dream come true, a broker’s annuity, but they continue to strike us as a low cost vehicle designed to achieve disappointing long-term investor results. Most ETFs are developed around computerized back-tested models based on past circumstances which may never repeat. There are roughly 500 ETFs available at the moment with a combined market value of $480 billion (vs. 15,000 plus mutual funds with a total market value of $12 trillion). New ETFs are being launched regularly these days at the rate of nearly 20 per month.
As mentioned in past letters, ETFs are useful as temporary parking-place investments in various stock and bond market sectors. Some do-it-yourself investors may wish to employ ETFs in their portfolios, as many used sector mutual funds 12-15 years ago. But the proliferation of ETF offerings today may tempt the unwary to treat these vehicles as stocks, narrowly attempting to maximize return by investing in sharply defined sectors better covered with actively managed or passively diversified mutual funds. ETFs investing solely in narrow indexes or exotic areas like Malaysia, Vietnam, Latin America, or other emerging markets, are beginning to look like actively managed funds. Before investing, the stock selection skills on the part of the purveyor need to be understood, the internal rebalancing approach considered, and the fee structure carefully assessed. For traders and brokers, the fact that ETFs are priced in real time and can be sold short is important. For longer term fundamental investors, these features are of no value. Whether considering Barclay’s iShares, State Street Global’s SPDRs or Vanguard’s newly introduced low-cost offerings, understanding how the “sausage” is made has become essential. The continued proliferation of these currently trendy vehicles gives Wall Street’s sales force something new to merchandise, but buyers should beware until the inevitable shake out takes place.
Recent Portfolio Changes
Generally, the equity funds in client accounts performed relatively well against their benchmarks (see “Mutual Fund Performance Sorted by Asset Class” table which follows). As has been the case during the past few years, both the International and Natural Resource segments are responsible for any better-than-US-market overall portfolio results during the second quarter. Our shift to large company overweight in the summer of 2005 is now beginning to yield better relative results in the Domestic Equity category. The recent increase to Japanese market-neutral weighting in the International segment has yet to impact performance. However, measured against longer term relative valuations (see accompanying graph), we think given time this shift will produce positive incremental results.
Source: BCA Research
At the moment, except for a few “fine tuning” rebalancing programs, we are content to await developments before implementing further alterations in portfolio fund composition.
In the Fixed Income portion, we are not yet ready to move out on the yield curve attempting to capture higher rates of interest income, preferring instead to protect capital by staying short in the highest quality credits. It appears that although rates are beginning to plot a steeper pattern (i.e., longer maturities offering higher yields) a more “normal” slope has yet to fully develop. By remaining short and avoiding credit risk, we may forgo a small amount of increased income from portfolio fixed income positions. If and when a steeper yield curve slope materializes, we will be prepared to extend maturities reaching out for more current income and it will have been possible to do so without having had to sacrifice capital while waiting.
Source: Thomson Baseline
In today’s benign inflationary environment, with short-term riskless investments yielding close to 5%, a slightly inclined yield curve means that cash as an asset class takes on added attraction. Historically, six month maturity U.S. Treasury Bills have returned 3.7% against an average inflation background of 3% (i.e., 0.7% real return). Currently offering a 3% real rate of return (i.e., 5% nominal against a CPI of 2%), cash, or short-term riskless securities, is an attractive parking place for at least a portion of the fixed income segment of most investment portfolios. Some of our U.S. equity funds have even allowed cash reserves to build up marginally, a tactic with which we currently cannot find fault.
As always, we welcome your questions, comments, and suggestions.
Sincerely,
James L. Joslin
Chairman, CEO