Risk and Return (Part 2)

What is credit risk?

The short answer is, credit risk is the risk that you won’t get your principal back. When you buy a corporate bond, you’re giving money to a company in exchange for a promise to give you money in the future. The time of repayment is usually fixed and contractual—the company can’t reduce or eliminate payments to its creditors without going through bankruptcy, which usually means stock-owners get wiped out and management loses their jobs.

That’s why companies are usually pretty willing to meet their bond obligations. Not doing so can be a disaster. But whether companies are able to pay is another issue. The risk of non-repayment is embodied in the spread between Treasuries—the risk-free rate—and corporate bonds.

The spread gets wider as credit risk goes up. Ba-rated bond, which are just below investment-grade, yield around 3.5% more than Treasuries. Caa-rated, a much lower grade, yield almost 9% more. This implies a 30% chance of loss for Ba-rated bonds, and a 50% chance for Caa-rated bonds.

The risk of loss is built into these spreads. With investing, you never get something for nothing. But by doing your homework you can manage your risk and add to your return.

Douglas R. Tengdin, CFA

Chief Investment Officer

Risk and Return (Part 1)

How can income-oriented investors survive in today’s climate?

With the Fed keeping rates near zero seemingly forever, it’s hard. Many investment portfolios grew during the ‘80s and ‘90s and stagnated during the ‘00s, but now investors need their portfolios to produce income.

In the past we’ve encouraged an all-of-the-above approach that uses corporate bonds, dividend-paying stocks, long-dated municipal bonds, and even limited partnerships to replace the income that formerly came from a simple ladder of Treasury Notes. We live in interesting times; what worked before may not work anymore.

Corporate bonds are particularly interesting. Unlike equities, they represent a contractual claim on cash, and so they are likely to be less volatile than stocks. But by taking some credit risk, investors can generate more income. That’s important, because “safe” Treasury Notes now yield less than inflation—so they are guaranteed to lose money in real terms.

Every investment carries risk. If we understand the risks we’re taking, and choose wisely, our investments should be able to meet our needs.

Douglas R. Tengdin, CFA

Chief Investment Officer

[tag risk/return, bonds, credit]

Yield Booking

Will bonds ever return to “normal?”

It’s a good question. For over four years the Fed has kept short rates near zero. With inflation running at 2% and the Fed’s target at zero, short rates have become a black hole, from which nothing seems to emerge. Long rates have drifted inexorably towards the event horizon surrounding the Fed’s short-rate singularity.

But all things—even black holes—eventually come to an end. The Fed currently projects that the economy will gradually heal, and that unemployment will move below 7% by the end of 2014, and below 6% in 2017. Charles Evens, President of the Chicago Fed, has proposed that the Fed keep rates low and the QE flowing until unemployment gets below 6.5%. That would be sometime in late 2015—but of course, the further out the forecast, the greater the uncertainty.

Still, it’s useful to know current expectations. So far, the Fed’s monetary spigot has kept the economy moving. It looks like it will be a while before they take that punchbowl away.

Douglas R. Tengdin, CFA

Chief Investment Officer

If you have questions or comments, please write to us at questions.

A Star Is Born?

Every decade there’s a new star. And every decade, it starts with skepticism.

In the ‘70s it was gold; the ‘80s had Japan; the ‘90s saw the Nasdaq; and the ‘00s had China. These markets rallied some 10-fold during their heyday. What’s next?

One approach is to look for the asset that no one wants. In the early ‘80s Japan just made cheap electronics and small cars; in the early ‘90s no one wanted US stocks. Both Japan and the US started with financial crises.

So which market gets no respect, today? My money is on Europe. The problems with the Euro are well-known: the industrialized north is growing at the expense of the service-oriented south, and financial and economic tensions are ripping the Euro apart. If the currency fails, all bets are off.

But all this is priced into the markets. Sir John Templeton once said that bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria. The best time to buy is when pessimism is strongest.

Douglas R. Tengdin, CFA

Chief Investment Officer

If you have questions or comments, please write us at questions.

A Schizophrenic Market?

Who’s right?

Stock prices have been rising, which usually predicts a rising economy. At the same time, bond yields have been falling, which usually goes means trouble ahead. Which is it?

Maybe it’s neither. Prior to the European Central Bank announcing last spring that they would do “whatever it takes” to defend the Euro, the global economy was characterized by slow growth and high instability. Investors were preoccupied with a potential repeat of 2008, of the “Lehman moment” that almost precipitated Depression 2.0. Fears of a “double dip” were rampant.

But the ECB’s policies have reduced the risk of catastrophic failure from the European banking system for now, with its attendant threat of financial contagion. The equity risk premium has fallen globally, so equities have risen.

But the underlying growth in the world’s economy remains low and slow. Stock prices have gone up on a lack of fear; bond yields have fallen with the global savings glut. There is no inconsistency. Markets alternate between fear and greed. We’ve been leaving the fear behind. Are we greedy yet? Time will tell.

Douglas R. Tengdin, CFA

Chief Investment Officer

If you have questions or comments, please send an email to questions.

A Chinese Fortune?

Why is the Chinese economy slowing?

China’s GDP growth has slowed from 9% per year to 7.5%. Their torrid growth has produced tycoons in real estate, manufacturing, and financial services. Indeed, many have suggested that there are bubbles in these economic sectors, and that China’s slowing growth may pop the bubble.

China’s average savings rate is around 50% of the economy—compared with around 5% in the US. This allows Chinese businesses to capitalize on profitable opportunities at the drop of a hat. But this can create over-capacity. Their steel industry is an example: China can now produce up to 900 million tons a year, while the most it needs right now is 625 million tons.

A high savings rate goes along with a high investment rate—and some of those investments are bound to be duds. Unless the central government loosens the reins and lets businesses make their own decisions, those mistakes will just get bigger and bigger. Only the free flow of capital and ideas can allow them to adapt and avoid colossal waste.

Douglas R. Tengdin, CFA

Chief Investment Officer

Saving Ourselves?

Are we saving too much?

That’s what it seems like, at least in the larger economy. Corporations had a near-death experience during the Financial Crisis, when the money market dried up. Since then cash balances have soared while capital expenditures have shrunk. Ditto for consumers. Excluding student loans, consumers have consistently deleveraged every year since the crisis.

As a consequence, there is a savings glut. This is one reason why interest rates remain low, in spite of the Federal Government’s record borrowings. And if everyone else is saving, government dissaving is the only way to keep the economy growing. Otherwise, either the economy shrinks or prices fall. That’s one reason why fiscal austerity in Europe is deepening the recession over there.

The problem with government spending isn’t the spending so much as the government. Give someone a blank check and a broad mandate and fraud and abuse will arrive like ants at a picnic. The question is what to spend on: there are economically beneficial projects, but there’s always a gravitational pull towards wasteful cronyism.

That’s why private investment is more efficient than public spending. Only it’s not here yet. When your only tool is a hammer, it’s better to use it than let it sit in the toolbox.

Douglas R. Tengdin, CFA

Chief Investment Officer

If you have questions or comments, write to us at questions

Getting Schooled

Are massive student loans restraining economic growth?

That’s what a new study by the New York Fed seems to show. College loans have grown dramatically in the past few years. Some 43% of adults under 25 now have student debt, up from 25% a decade ago. And the average debt–$20 thousand—is double what it was.

That seems to be getting in the way of other kinds of borrowing, now. It used to be that folks with college loans were more likely to have mortgages than those without; ditto for car loans. But that state has reversed. Either borrowers are running into their own limitations, or the banks are just saying no. That’s quite possible. The same study shows that the average credit score for student-loan borrowers has diverged dramatically from non-borrowers. Those without student debt have much better scores.

Everyone knows that college costs are getting crazy. Now that craziness may come back to bite all of us. For years young, highly-skilled workers have been a vital source of new, affluent consumers. With the explosion of students going into debt to pay for college, those days may be over.

Douglas R. Tengdin, CFA

Chief Investment Officer

If you have questions or comments, please write to us at questions

Don’t Be Stupid

What is bitcoin?

Bitcoin is an alternative currency that is purely electronic. It’s distributed platform and open-source algorithms have made it popular among some who think it could be a viable way to store your savings–away from the prying eyes of the government. More trenchantly, it received a big boost when the government of Cyprus proposed to tax (i.e. confiscate) part of the wealth its citizens—down to a single euro.

Is bitcoin a threat to the government? It could be. If many vendors accept bitcoins for merchandise, there’d be no way that we now know to track those transactions. Right now there’s not that much bitcoin currency out there—around $1 billion worth. But that could rise, if the currency becomes popular.

Bitcoin’s problem is the problem every alternative currency faces: liquidity. Eventually you have to convert those bits into bucks, and the buck stops there. Dollars exist in banks and exchanges, and their computer servers can be seized and examined by the authorities.

Back in the ‘30s, pulp fiction was filled with stories of bearer bonds being used by refugees, criminals, and anyone else who wanted to keep the government’s eyes off their finances. But a funny thing happened: the government changed the redemption rules. Now a trustee won’t pay out on a matured bond unless you give them your Social Security number. So much for anonymity.

So don’t plan on bitcoin being the next substitute for money. Chances are, they’ll go the way of greenstamps.

Douglas R. Tengdin, CFA

Chief Investment Officer

If you have questions or comments, please send an email to questions


What’s the reason for yesterday’s tragedy?

That’s all anyone wants to know. Amidst the speculation about pipe-bombs and foreign nationals, people want to put a label on the tragedy so they can begin to understand it. On one level, it’s because the act seems so senseless. After all, if someone would bomb a joyful event like the finish line to the oldest competitive marathon in the world, what would they not bomb? And there’s a natural curiosity that people have: how did this happen, why did this happen, and who did this?

I must confess myself impatient with the last question. While of course I want yesterday’s murderer (or murderers) brought to justice, I don’t really want to know about them. We know too much about Adam Lanza and not enough about Dawn Hochsprung, the principal at Sandy Hook. We know too much about Bernie Madoff and not enough about Thierry de la Villehuchet, the French money manager who killed himself after seeing billions in client money disappear. I really don’t want to know everything about the perpetrators of such crimes.

Life will go on, as it always does. 11 ½ years after 9/11, going to Ground Zero in New York City is still a moving experience, but the traffic noises and commercial clamor of the city seem largely unchanged. It will be the same with Boston. Our ability to adapt and move on is a source of strength.

But such tragedies still leave me with a great sense of loss.

Douglas R. Tengdin, CFA

Chief Investment Officer

Hit reply if you have any questions—I read them all.