Tag Archives: Markets

Hold To Maturity – A Fuzzy Framework for Fixed Income Investing

Reading Time: 3 minutes

I have been seeing quite a few articles about the decline in bond prices and the bond bear market.

These are excellent headlines, but appear to be fighting the last battle.

Many investors appear to be evaluating fixed income investments without considering hold to maturity. Isn’t hold to maturity the primary way you should be evaluating fixed income?

You lend money to the borrower for a fixed amount of time, the borrower is contractually obligated to pay you a coupon, and at maturity give you your principal back. That is why they call it fixed income. The returns are not ambiguous. As a fixed income investor you care about yield, duration, and credit quality (i.e., getting your principal back).

Decades of declining interest rates appear to have made that framework fuzzy. With fixed income, declining yields lead to price increases. A long period of declining rates appear to have lulled fixed income investors to sleep a bit. Or distracted fixed income investors from the fundamentals.

However, if investors are focusing on the short-term price movements of fixed income investments, then they are trading, not investing. Price increases have historically not been what fixed income investors should be counting on. Again, fixed income investors should be focusing on yield, duration, and getting their principal back at the end of all that.

Expecting price increases in fixed income implies expecting lower rates in the future. Another dimension that investors need to realize is that the Fed does not control longer rates. The Fed sets short term rates. Longer rates are determined by many things including supply and demand and the inflation outlook. So the Fed could lower short rates, but that’s no guarantee that long rates follow suit. The yield curve is still inverted mind you.

This topic also ties into Howard Marks’ latest article where a main point was – if an investor could achieve their target returns with fixed income, why would they consider investing in equities. Marks is using the traditional framework for fixed income – hold to maturity. Short term price movements are not something to focus on.

ETFs could also be causing some issues here. ETFs tend to hold many issues, even if they are the same type, and therefore do not have a clear maturity date. For example, the iShares 7 – 10 Year Treasury Bond ETF (symbol: IEF) holds 13 issues with a 2.93% current yield, 4.69% 30 day SEC Yield, and weighted average duration of 8.37 years. So ETFs hold multiple issues, which are changing as the fund sells issues and purchases new ones. And, the yield is not fixed as is the case with a single issue. So, bond ETFs are sort of a composite issue, but not really, which also makes hold to maturity a bit fuzzy.

What is also interesting here is the difference between the current yield (last dividend annualized) and the 30 Day SEC yield, 2.93% and 4.69% in the case of IEF, respectively. The current yield is nowhere close to the yield on new 10 year treasuries, but this would be expected since older issues are yielding much lower rates. The fund cannot payout income it is not receiving.

The older issues would also have a current market price well below par. Those issues should theoretically increase in price as they get closer to maturity. Recall, bond investors will get their principal back at maturity unless the borrower defaults.

It is not entirely clear to me why the current yield and 30 day SEC yield differ so much, but presumably reflects the fact that some of the issues the fund holds are below par and would be expected to increase in price as they get closer to maturity. I am also unclear how price increases would eventually make their way into investors’ hands, since iit does not appear to be happening through the current dividend. It seems possible the funds are reflecting that “accrued interest” in the 30 day SEC yield.

All of that makes ETF bond funds a bit confusing and not exactly like an individual bond.

This commentary on this website reflects personal opinions, viewpoints, and analyses and is not financial or investment advice.

The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data, or any recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

Surging Bond Yields with Downtown Josh Brown

Reading Time: 2 minutes

This was so good on so many levels.

Catch me on Scott Galloway’s show

Long End of the Curve + Velocity:

28:11

An absolutely great dissertation on the yield curve, impact of rates, and flow through into the economy so far. So many good points here, you just need to listen to the whole conversation.

Keep in mind, velocity matters a lot. Long rates matter way more than short rates. There may be lags and some structural weirdness, but I am in this camp.

Catalyst:

44:07

“You need the shock. What is the exogenous shock that is going to happen that is all of a sudden make the recession real.?”

Spenders gonna spend. This has been my thesis for a while. The American consumer is not going to stop spending until they are literally stopped from spending. American consumers will spend until they run out of money or, more likely, cannot get credit any longer.

Rates are impacting this already.

Hold To Maturity:

50:52

I disagree with this somewhat. Not his attractiveness of the starting yield discussion; I agree with that point.

However, if I buy a 30 Year Treasury Bond with a 5% yield, and hold it for 30 years, then my (nominal) return is literally going to be 5% every year. How would it not be, assuming the U.S. government doesn’t default (I felt I had to add this caveat, unfortunately)? Only if I look at price on a short term basis and mark-to-market or sell the bond prior to its maturity will my return vary. This is like the whole point of a bond. It is why they call it fixed income.

In my opinion, too many fixed income investors are focusing on price movements (i.e., trading) and not focusing on yield and duration. The fact that yields have come down for 20 years, has probably caused too many fixed income investors to focus on price movements. ETFs also distort this a bit for a couple of reasons. More on this later.

Credit Spreads:

53:37

“Spreads have not blown out…and until they do stop saying recession.”

Yes, totally, spot on. Watch credit…especially consumer credit. See above.

The World of Low Rate Mortgages

Reading Time: 3 minutes

File this under things I don’t understand.

During the Covid-19 pandemic, the Federal Reserve lowered short term interest rates and rates across longer maturities followed suit. The rates on mortgages, such as the 30 year mortgage which is common in the U.S., hit all time lows of 2.65% in January 2021.¹

Home buyers and existing home owners financed new purchases or refinanced existing mortgages at these historically low rates. This appears to be a very rational financial decision.

Banks and financial institutions; however, lent substantial sums of money at these historically low rates. In hindsight, this appears to be a less good decision. Using TLT as a proxy for the value of longer dated bonds, the value has fallen close to 50% in three years.

Now, rates have increased sharply to unexpectedly high levels. Mind you, these are not historically high rates. The highest rate on a 30 year mortgage in the U.S. is 18.63% set in October 1981.¹ But the rates are certainly local maximums in terms of the memories of most people. You would have to go back to 2000 to find rates this high.²

So now what?

Existing homeowners are understandably reluctant to give up these rates – in other words – sell any property financed with low rate mortgages or paydown low rate mortgages quickly.

Banks, financial institutions, and investors who hold these low rate mortgages appear to have locked themselves into an under-performing asset for a long time. The thesis appears to be that these entities are going to hold these assets to maturity, which means they will eventually get the principal back, so the unrealized loss sitting on their books is not a concern. In this case, they will be earning roughly half as much interest as a similar mortgage made today. In a poorer scenario, these institutions sell these assets – for whatever reason – and take a substantial realized loss.

It seems to me that I am missing something somewhere, and do not see how this plays out (efficiently).

Mortgage owners that locked in low rates appear to have received a huge financially engineered (one-time?) benefit. But now have little incentive to sell their properties or pay down their debts. So the gains are literally trapped in their house.

Lending institutions lent money at historically low rates and picked up transaction fees along the way. But are now holding under-performing assets for a couple of decades.

Is that it? Are we stuck in the world where:

Most existing homeowners are unlikely to sell for discretionary reasons.
Refinancings appear to be highly unattractive.
Repaying mortgage debt would also be less attractive since Tbills are earning well above the low rate mortgages.
Banks and financial institutions are holding relatively unattractive mortgage assets regardless of how accounting rules make these appear.
Real estate transaction volumes are going to be substantially lower for the foreseeable future.

It is almost like the average U.S. mortgage holder outfoxed the supposedly sophisticated financial institutions. But somehow the financial institutions appear to be unimpaired in any way. And participants are going to wait in their respective corners until…until…until what?

Bears Watching: 30 Year Mortgage Rates

Reading Time: < 1 minute

The trend is your friend….

Max: 18.63% on October 9, 1981

Min: 2.65% on January 7, 2021

Source: https://fred.stlouisfed.org/series/MORTGAGE30US/

That’s A Bunch of: Debt Ceiling Debate

Reading Time: < 1 minute

Harlan Crow told Justice Thomas that he doesn’t want to be poor; expect Supreme Court to rule debt ceiling is unconstitutional.

We will be fine…

Three Take-Aways: The Go-Go Years: The Drama and Crashing Finale of Wall Street’s Bullish 60s

Reading Time: 4 minutes

“The structure is not genius; even for the exclusive hedge funds, genius turned out to have been a rising market.” – The Go-Go Years (pp. 348)

One of my goals with some additional time is to embark on “learning projects” across a few domains. Capital market history is one of those domains. That is where this book fits in. Expect more notes along similar lines.

Overall, I personally found the writing style of the author to be difficult to follow, in spite of my interest in the content. The story covers the period including the evolution of mutual funds and the stock exchanges, the rise in prominence of conglomerates, and the “Nifty Fifty” growth stocks.

It is possible that I am over-fitting, but history does seem to rhyme.

Three take-aways from the book:

The Cause of Investor Amnesia

“Indeed, by 1969 half of Wall Street’s salesmen and analysts would be persons who had come into the business since 1962, and consequently had never seen a bad market break.” (pp. 113)

This sounds familiar to a theme I hear today. Or maybe a theme I believe in today. Many investors today, if they came of age post-Great Financial Crisis (2007 – 2008) have known mostly good times with few meaningful setbacks. That has been a long period of time; close to 15 years, where any setbacks have quickly been reversed.

Wall Street Crisis

“At the start of December, Wall Street hung by its fingertips. Roughly one hundred Stock Exchange firms had vanished over the past two years through merger or liquidation. Forty thousand customer accounts were involved in the thirteen cases of liquidation, and most of them were still tied up, the customers unable to get their cash or securities.” (pp. 341)

“Legislation to create a federal Securities Investor Protection Corporation, on the model of the Federal Deposit Insurance Corporation to protect bank depositors, was before Congress; it had no chance of passage until the present mess in Wall Street was cleared up, and thus, while it might help in future crises, it was powerless against this one.” (pp. 341)

The details on the crisis within Wall Street itself was all new to me. See take-away #1. And, so were the origins of SIPC.

There were brokerage failures during the GFC. The causes of those were mostly characterized based on bad decisions and investments. Whereas, the brokerage failures during the period covered in the book appear to be based more on a bad business model that was not keeping up with the times.

Regardless, the thought of investors losing their securities or not having access to them for an extended period was a “new” risk to consider (https://www.investors.com/etfs-and-funds/sectors/stock-market-schwab-implodes-money-safe/).

Fun With Accounting

“Where a series of corporate mergers is concerned, the current earnings per share of the surviving company lose much of the yardstick quality that the novice investor so trustingly assumes. The simple mathematical fact is that any time a company with a high earnings multiple buys one with a lower multiple, a kind of magic comes into play. Earnings per share of the new, merged company in the first year of its life come out higher than those of the acquiring company in the previous year, even those neither company does any more business than before. There is an apparent growth in earnings that is entirely an optical illusion.” (pp. 157)

“Moreover, under accounting procedures of the late nineteen sixties, a merger could generally be recorded in either of two ways – as a purchase of one company by another, or as a simple pooling of the combined resources. In many cases, the current earnings of the combined company came out quite differently under the two methods, and it was understandable that the company’s accountants were inclined to choose arbitrarily the method that gave the more cheerful result.” (pp. 157)

“The conglomerate game tended to become a form of pyramiding, comparable to the public-utility holding company game that flourished in 1928, crashed in 1929, and was belatedly outlawed in the dark hangover days of 1935. The accountant evaluating the results of a conglomerate merger would apply his creative resources by writing an earnings figure that looked good to investors, they, reacting to the artistry, would buy the company’s stock, thereby forcing its market price up to a high multiple again; the company would then make a new merger, write new higher earnings, and so on. The conglomerate need neither toil nor spin – only keep buying companies and writing up earnings. It was magic, until the pyramid became top-heavy and fell.” (pp. 158)

This is why my favorite financial statement is the Cash Flow Statement; a topic for another post. At least investors during the period were focused on earnings. That seems to be a novel idea for current investors.

And a bonus take-away:

“For example, those familiar old forces so long so helpful to business management in getting the most possible work out of low-level employees – company loyalty and personal competitiveness – scarcely seemed to operate on the new breed of back-office employees at all.” (pp. 196)

Apparently they had millennials back in the 1960s too.

A few other recent book notes:

Bears Watching: Cash & Real Estate

Reading Time: < 1 minute

I love this chart produced by Capital Spectator on a monthly basis:

Two things I find interesting:

Cash is still the best performing asset through the one year mark. Actually, cash is the only positive performing asset (in nominal terms).
And the poor performance of Foreign Real Estate over five years. Foreign real estate is the worst performing asset, at least in U.S. dollar terms.

Influential Reads – March 2023

Reading Time: 3 minutes

Influential Reads – March 2023

“If you’re going to panic, panic first.” – Old adage

Well, March was exciting. Inflation and bank failures…a recipe for…the stock market to crush it?

In my first full month of semi (?) retirement, we had a bunch of house guests and made a short trek up to Ketchum, Idaho for some skiing at Sun Valley and skating at Galena Lodge .

Here are my most influential reads for the month – in no particular order:

Satyajit Das: SVB Collapse and Bank Turmoil – Latest Chapter in the Unwinding – “The assumption that raising rates and withdrawing monetary stimulus would result in a painless adjustment back to a new normal was naïve in the extreme.” SMS here: It’s not just the change in magnitude, it’s the velocity.
Dissecting Goldman’s gory $2.25bn SVB equity issue – “Second, the stock offering has to be underwritten. Hard-underwritten. Or already subscribed-for. Investors must assess the equity offering on the basis of a repaired balance sheet. They must know you don’t actually need them.”
The Powell of Positive Thinking – “He clearly signaled (again) that once Fed overnight policy rates reach a peak, they would not be declining for a while. “
Risk Capital and Markets: A Temporary Retreat or Long Term Pull Back? – “It behooves both investors and traders to therefore track movements in risk capital, since it is will determine when long term bets on value will pay off for the former, and the timing of entry into and exit from markets for the latter.”
Highlights from Charlie Munger’s Conversation with Todd Combs (2022 Singleton Prize for CEO Excellence) – “It’s the nature of things that a bunch of democratically-elected politicians will eventually print too much money.”
Free Money Turned Brains to Mush, Now Some Banks Fail – “And when I say “free money” with regards to banks, I mean it literally. Since 2008, banks have been borrowing from depositors at 0% interest or near 0% interest. Even today, even as some banks are trying to attract more deposits by offering higher interest rates, even today when the Fed’s short-term rates are near 5%, the average interest rate on savings accounts is still only 0.4%. Even today, 0.4%.” SMS: This is nuts.
Venture Catastrophists – “There are no libertarians in foxholes.”
Is Inflation Mean-Reverting? – “What that means – and it is super important – is that inflation has momentum. Keep in mind that during most of the period shown here, the Federal Reserve was actively trying to make inflation mean-revert. And they didn’t succeed, at least on a one-year basis.”
Banking Woes Hark Back to the S&L Crisis of the 1980s – “Former Fed Reserve Chairman Paul Volcker used high rates to squeeze inflation out of the economy four decades ago, and the savings & loan industry was among the unintended victims. “
The easiest way to spot a market bubble – “New Metrics get invented while timeless investing principles become a thing of the past.” See Cash EBITDA. SMS: During the sale of my business last year, the investment bankers wanted me to use “Cash EBITDA”, but they could not even provide a definition.

Note: This is based on when I read the article, not necessarily when it was first published. Unfortunately, my backlog of things I would like to read always seems to dwarf the amount of time I can devote to reading.

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