Monthly Archives: October 2023

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.

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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/

Influential Reads – September 2023

Reading Time: 3 minutes

“One of the most important parts of developing an identity that can thrive, persist, and endure change is to diversify your sense of self. You can think of identity like a house. You want the house to have multiple rooms. Perhaps there is a “parent” room; an “athlete” room; an “employee,” “entrepreneur,” or “executive” room; a “community member” room, and so on. It’s okay to spend a lot of time in just one room, but you’ve got to ensure you keep the others in good enough shape. This way, when you experience a massive change or disorder event in one area of your life, in one room of your identity, you can step into other areas to gain your footing and stability. Like a diversified portfolio in investing, diversifying your sense of self makes you more rugged and flexible in the face of change.” — Brad Stulberg in Master of Change

Welcome to Q4! September was a month, for reasons that I won’t go into. I guess I should have just T-Billed and Chilled.

Actually, I’ve been doing that for quite some time. See this post. All the recent publicity around that makes me a touch nervous. I have gotten so used to being wrong, that apparently being within the consensus makes me uncomfortable.

There’s probably some sort of lesson in there somewhere. One day, I might figure it out.

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

Of boiling frogs and underperforming investments – “There are so many areas in life where we know we can reduce losses and avoid harm by taking preventive action, yet we wait and wait until it is too late.”
New 20+ year record high mortgage rates begin to impact home sales; bifurcation in new vs. existing home prices continues – “As per usual, interest rates lead sales…Further, sales lead prices.”
Should You T-Bill and Chill? – “You have a significant amount of reinvestment risk.”
Why TIPS Look Attractive – “Given recent events, as well as the ever-rising level of national debt, it seems prudent to treat future inflation prospects from a neutral perspective rather than being distinctly optimistic.”
Ray Dalio All Weather Portfolio Review, ETFs, & Leverage – “Utilities provided the lowest volatility, smallest drawdown, highest return, and highest risk-adjusted return:”
Fewer Losers, or More Winners? – “Neither maximizing winners nor minimizing losers is necessarily enough. It’s all in the balance. “
The Bond Bear Market & Asset Allocation – “The bond returns have been higher most of the time but it’s not a huge difference.”
Asset Class Correlations Convict Central Bank Activism – “While central bank largesse may undergird returns (at least most of the time), it does so while increasing portfolio risk by increasing asset class correlations. There is no free lunch, indeed, even when it looks like there is.”
Our future is Japan – ” In Japan, the central bank has been manipulating the bond market through its interest rate targeting policy for years. This has kept long-term bond yields close to zero and helped the government sustain debt levels well in excess of 200% of GDP.”
Have Bonds Finally Reached Escape Velocity? – “In short, bonds with a duration under 5 have likely already reached escape velocity. T-notes in the 5-10 year duration range are close to escape velocity, but not quite there yet. And long bonds are still far from escape velocity. “

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.

Updated stats:

	Read Articles	Books
January	80	0
February	62	2
March	67	2
April	140	4
May	37	3
June	65	5
July	85	4
August	66	5
September	80	1
October
November
December
Total	682	26

Reminder: I learned way back in 2000 not to give investment advice, especially to people I know well. So please do not take anything in any of these posts as financial or investment advice.