Meeting Client Objectives

Last night I met with the investment committee of an endowment fund here in Boston. The fund has been a client of my bank's for several years.

I like meeting with this group.  Their focus is far removed from the financial world; instead, much of their daily lives are focused on helping others, especially those that are going through difficult times.

Their endowment fund provides a good portion of the resources necessary to do their important work in the community.

The focus of the endowment, therefore, should not be a benchmark like the S&P 500 or the Barclays Government/Credit bond index; instead, they simply need the endowment to provide the income and growth necessary to fund their outreach activities.

At the time I started working with them, they had allocated about 55% of their portfolio to stocks, with the remainder in fixed income. 

This is a fairly typical endowment approach, since historically an allocation of roughly 50/50 between stocks and bonds has proven to be a good balance of risk and return.

Problem is, with interest rates at multi-decade lows, allocating a large chunk of a portfolio to bonds may satisfy the desire for risk reduction, but offers little opportunity for growth.

Moreover, as older higher coupon bonds mature, reinvestment rates in investment grade bonds are unappealing.

For groups like the one I met with last night, lower income levels could mean that some of the work they are doing in the community might have to be curtailed, which is obviously undesirable at a time when so many are in need.

So last summer I recommended - and they approved - changing their allocation to stocks from 55% to 70%, with a particular focus on dividend-paying stocks.  This increase in stock allocations would doubtlessly mean more volatility, but would accomplish several important objectives.

First, buying high quality stocks that offer attractive dividends would gradually increase the income being generated by the portfolio.  In many cases today, stocks are paying higher dividend yields than bonds issued by the same corporations.

Second, investing in stocks of companies that were gradually increasing their dividends would mean more income in the years to come. 

Finally, increasing the opportunity for growth in the portfolio is an important consideration for the future.

Inflation may be muted but it is not dead.  If inflation runs at its current 2% rate for the next ten years, the fund will need to be worth roughly +22% more than today's value in order to maintain its real (i.e., inflation-adjusted) spending power.

The result?

Well, here's how I started the meeting:

I have some presentation material that will show how your portfolio has done versus the various benchmarks.  However, I can tell you that your investment strategy has been a success.

The income from your portfolio is up roughly +5% from what it was in 2011.  Since so many of the companies in your portfolio are increasing their dividends, I anticipate that income in 2013 will be even higher than in 2012.

The value of your portfolio has also increased, even after significant withdrawals to fund your activities in the community. 

In short, your decision to increase your allocation to dividend-paying stocks may have seemed slightly more risky at the time, but it accomplished the important objectives of more income and increased principal growth.

But after the material was distributed, I also observed:

You might notice that your stock portfolio has lagged the S&P 500 so far this year. While as your stock manager this obviously does not make me happy, I would also argue that it is somewhat irrelevant in light of the fact that your portfolios is meeting your objectives.

No one on the committee disagreed.

The Importance of the Boring World of Corporate Bonds

Years ago, when I was involved in managing corporate bond portfolios, I was interviewed about the bond market by the Wall Street Journal.

 

I had recently gotten married, so when I got home that night and told my wife that I had been interviewed she said that she would make a point of reading the article when it appeared.

But when I showed her my interview the next day, and she started reading, her attention quickly waned.

Finally she looked up from the paper and said with a sigh:

"God, this is boring."

 
Active management of bonds is a relatively recent phenomenon.

When I started in the investment business in 1982, bonds were mostly held to maturity, as they had been for decades.

Trading or selling bonds was a relatively clunky activity, mostly done over the phone with a handful of dealers.  Bid/ask spreads were wide, and the concessions to sell smaller bond positions could be significant.

This changed in the next couple of decades.  Billions of dollars of bonds are traded easily on a daily basis with a variety of different dealers.

As technology enabled bond settlements to be handled as simply as equity trades, institutional bond managers actively managed their clients' portfolios, and were judged against a wide variety of bond market benchmarks that had only recently been developed.

However, as my post yesterday indicated, secondary bond market liquidity is gradually disappearing, especially for issuers whose credits are either less stellar or businesses are less well known.

The Financial Times had a long piece about corporate bonds this morning.  Here's an excerpt:

The problem centres on large investment and asset management companies, known as the "buy side". These are flush with cash and have sought to expand their massive portfolios with corporate debt.  However, they are finding harder to purchase or sell bonds from "dealer" banks that act as the middleman, the so-called "buy side".


If investment funds have to spend more to trade, they could ultimately pass on their increased costs to companies whose debt they buy.


The banks cannot satisfy the buy-side's needs because they are reducing their own holdings of corporate bonds, partly because of a raft of new regulations proposed in the wake of the financial crisis.

http://www.ft.com/home/us

Now, to be sure, the subject of bonds is probably no more interesting to most people than it was to my wife a couple of decades ago.

But it is important. 

Higher corporate borrowing rates can obviously have a negative impact on economic activity.

In addition, bonds of all types play an important role in millions of investment portfolios.  Most investors holding bonds or bond mutual funds today assume that their positions could easily be liquidated in the need arises.

But what if there is no bid?

Should I Worry About The Corporate Bond Market?

In 2008, well before the stock market collapsed in the aftermath of the Lehman Brothers bankruptcy, the corporate debt markets were signalling trouble ahead.

Corporate spreads (i.e., the yield premium of corporate bonds relative to U.S. Treasury obligations) started to widen in early 2008 as bond buyers nervously asked for more yield concessions in order to take on new positions, and continued to gap higher right into the Lehman failure.

Ultimately the credit markets froze in October 2008, and a full-fledged credit crisis ensued. It was not until March 2009, after aggressive intervention by the Federal Reserve and the U.S. Treasury, that some sort of relative calm returned to the capital markets.

So it was with some concern that I read an article in this morning's Financial Times titled "Investors demand big yield premiums on corporate bonds".  Here's an excerpt:

Investors are demanding significant yield premiums to buy new corporate debt being sold in the U.S. as compensation for the rise in market volatility stemming from the worsening of the debt crisis in Europe.

Bankers estimate that for investment-grade bonds, investors are asking for yields that are on average 20-25 basis points higher than where existing bonds by the same issuer are trading in secondary markets.

That is the highest so-called new issue concession since the start of the year.

http://www.ft.com/intl/cms/s/0/545b558c-b94f-11e1-b4d6-00144feabdc0.html#axzz1yFvs4Ikh

The piece goes on to note that new corporate bond issuance is running at just $28 billion this month, compared to a monthly average of $88 billion, according to Dealogic.

After reading this article, I walked down the hall to talk to my friend Barbara Cummings about what's going on in the bond market.

Barbara runs the bond area here at Boston Private Bank, and is particularly knowledgeable about corporate bonds.

Barbara told me that while things are not great in the credit markets - everyone is nervous about Europe - we are not yet in conditions similar to 2008.

Apparently there are a couple of factors influencing the debt markets today.

First, investors are reluctant to give up their existing bond holdings for new issues because of today's lower rates.  They would rather hold onto an older issue with, say, a 3% coupon, rather than swap into a new issue with a coupon of 2% or less, regardless of yield-to-maturity.

And, second, current bids for older corporate bonds in the secondary market also weak.  This is the result not only of investment concerns, but also because new stricter capital requirements make banks less eager to tie up capital in low margin fixed income business.  Thus bond swaps - selling older issues for new ones - are less easily accomplished.

So I asked Barbara:

"Should I worry?"

"Oh,"Barbara replied with a smile, "you can worry about lots of things - you always do - but I wouldn't read too much into the current corporate bond markets."

If You Haven't Already Read Enough About Greece...

Like many financial analysts, I've been scratching my head this morning trying to figure out the meaning of the Greek elections held last weekend.

It appears that the party that most of the financial community wanted to win - the New Democracy party - won a narrow victory over Syriza, whose platform was anathema to the euro zone.  Still, it appears that Syriza won enough seats in Greek's parliament to remain a very influential part of the political scene, which means we will be reading lots more about Greece in the weeks ahead.

Fortunately, one of my favorite columnists Ambrose Evans-Pritchard of the London Telegraph succinctly summed up what just happened in Greece:

Greece’s new leaders have a mandate from Hell. Almost 52pc of the popular vote went to parties that opposed the bail-out Memorandum in one way or another. There is no national acceptance of the Troika’s austerity policies whatsoever....
 
This is what Professor Vanis Varoufakis from Athens University has to say about the Troika policies (via Naked Capitalism):

"Consider what they are telling the Greek people: They are saying that Greece, to remain in the Eurozone, must,
(a) carry on borrowing from the EFSF at 4% (and thus adding to Greece’s public debt) in order to pay the ECB (which will be making a 20% profit from these payments, courtesy of the fact that it had previously bought Greece’s bonds at a 20% to 30% discount)
(b) reduce public spending by 12 billion euros in order to be ‘allowed’ to borrow for the benefit of bolstering the ECB’s profits from these transactions involving bankrupt Greece.

If the Devil wanted to guarantee that Greece is pushed out of the Eurozone, he and his evil handmaidens could not make up the above, satanic, scenario...

http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100017978/greek-agony-drags-on-as-asphyxiation-bloc-wins/

So what should the investor do?

Here's one interesting, very contrarian thought:  Buy Greek Stocks.

I'm not sure I have enough courage to dive into the Greek stock market, but Jacob Walinsky writing in the blog ValueWalk makes some interesting observations.


..It is possible that the {Greek} stock market is trading at 3x, 2x or even 1x 2014 earnings.

On every metric, this is cheaper than the US stock market has ever been going back to 1870... 

The country still remains a popular tourist site, being the 16th most visited in the world. If Greece adapts the Drachma and the currency is cheap, expect a lot of tourism. Greece has a large shipping industry. The country is strategically located in the Mediteran. Despite the country being in a recession for several years, GDP per capita is number 32 in the world, just two places behind South Korea.

Greece was not always known as a ’lazy country (which itself is not accurate). The economy had rapid growth until the past few years. Between 1960 and 1973, the Greek economy grew by an average of 7.7%. Even under the Euro, The Greek economy was growing rapidly. Annual growth from 2001-2007 was over 4%.

The economy clearly can boom again, and this would be a big catalyst for Greek stocks. Greek stocks could repeat performance of post-war German equities.

http://www.valuewalk.com/2012/06/ignore-greek-elections-stocks-might-be-the-best-buy-in-over-60-years/

I'm not sure I totally agree with Mr. Walinsky, but I like the idea of looking for opportunity where others fear to tread.

Retirement Blues

From 1979

One of the ways to tell if we are approaching the end of the secular bear market for stocks is to gauge investor sentiment.

Market bottoms are never made when sunny optimism abounds.  It is only when investor sentiment is approaching utter despair, and when all hope seems lost, that opportunity for serious gains arise.

I don't know whether we're at that point yet, but anecdotal evidence suggests that we are approaching bearish sentiment levels that often mark an important inflection point.

First, money continues to flee domestic equity mutual funds, as it has been doing for the past 5 years. Here's what  Bloomberg noted yesterday:

Investors withdrew $7.2 billion from American equity mutual funds during the five days ended May 23 after $178 billion of outflows in the previous 12 months, data from the Investment Company Institute in Washington show. 

 http://www.bloomberg.com/news/2012-06-10/wien-unbowed-by-u-s-equities-slump-joins-birinyi-seeing-rally.html

Bond yields are at historic lows, and the possibility of capital loss on longer maturity bonds is very real.

For example, a buyer of a 10 year Treasury note at 1.6% yield will have a negative total return for the year if rates "soar" to 2%.

Yet the stock market continues to scare investors, despite rising earnings expectations, reasonable valuations, and dividend yields that in many cases are far higher than bonds issued by the same corporations.

I think this article written in Toronto's The Globe and Mail newspaper sounded just depressing enough to merit attention from a contrarian standpoint.

Titled "The Sad End of Saving and Investing", the article reflects the utter despair being felt by investors around the world. Quoting a 55 year old investor named Murray Eastwood, the article notes the following:

Mr. Eastwood has a background in risk management and underwriting, which means he’s well equipped to understand why the global economy is in such bad shape today. His main points are as follows:

• Bonds and guaranteed investment certificates offer returns below the inflation rate, and the differential has grown in recent days.
• People who try for higher yields with longer-term bonds could get hurt if interest rates rebound.
• The stock market is being pounded by the European banking crisis and a poor global economic outlook that has reduced demand for the resources so important to Canada.
• Our energy industry is under pressure as a result of rising production of oil and gas in the United States.
• Tax relief, at least in Ontario where he lives, is unlikely.

“It is very hard to remain positive about the magic of finance with this experience and the current outlook,” Mr. Eastwood wrote in his e-mail.

(The author noted that he contacted Mr. Eastwood to tell him that his thoughts were among the most depressing that he has read recently).

My contention is that eventually investors who are parking their retirement assets in bonds will realize that they are being played for a sap by governments around the world.  Low interest rates have allowed deficits to balloon with only a modest budget impact.

Europe Squabbles

Your Move, Greece

I liked this quote that appeared in Gideon Rachman's column in yesterday's Financial Times.  I think it nicely summarizes some of the reasons behind the current angst in Europe right now (my emphasis):

Consider just one of the proposals on the {euro bailout} shopping list:  a Europe-wide bank deposit insurance scheme.  As a senior Dutch politician  who shares the German view, puts it: "We cannot push through a banking union when the French have just cut their retirement age to 60 and we have raised ours to 67." From the Dutch and German point of view, it is unfair for their citizens to underwrite the banks of countries using their own money to pay social benefits that are more generous than those on offer in Germany or the Netherlands.

http://www.ft.com/intl/cms/s/0/bfc6959c-b158-11e1-bb9b-00144feabdc0.html#axzz1xgWyFvut

The New York Times this morning carried an editorial that also highlighted the German frustration at being asked to make the euro work.

Authored by Hans-Werner Sinn from the University of Munich,  the article notes that the German efforts at stabilizing the euro have already been substantial, particularly when it comes to Greece:

Some critics have argued that Germany, having benefited from the Marshall Plan, now owes it to Europe to undertake a similar rescue. Those critics should look at the numbers. 

Greece has received or been promised $575 billion through assistance efforts, including Target credit, E.C.B. bond purchases and a haircut after a debt moratorium. Compare this with the Marshall Plan, for which Germany is very grateful. It received 0.5 percent of its G.D.P. for four years, or 2 percent in total. Applied to the Greek G.D.P., this would be about $5 billion today. 

In other words, Greece has received a staggering 115 Marshall plans, 29 from Germany alone, and yet the situation has not improved. Why, Mr. Obama, is that not enough? 

http://www.nytimes.com/2012/06/13/opinion/germany-cant-fix-the-euro-crisis.html?_r=1&hpw 

Still, I continue to believe that the most likely outcome for Europe will be to "muddle through".  Reports from European companies (especially in Germany and France) continue to indicate that business trends remain positive, despite the high levels of unemployment throughout much of the euro block.

Possible Investment Strategies for the Coming Fiscal Cliff

One of my very smart clients called me last  Friday.

He wanted to make sure that I had seen an editorial in that morning's Wall Street Journal that highlighted some of the potential changes in tax rates that could occur in 2013 if Congress does not act.

The piece - titled "Bernanke's Cliffhanger" - was accompanied by a table that summarized some of the different scenarios:




These changes, of course, are the result of the expiration of the Bush tax cuts, originally implemented in 2001.  Most observers are calling the event a "a fiscal cliff", although opinions vary widely as to the actual economic impact that will be felt.

The Journal, naturally, sees higher taxes as a road to economic ruin:

Meanwhile, the cliff that could break the economy's neck is the scheduled tax hikes. These include a tripling of the tax on dividends, a near 60% increase in the capital gains rate, a 20% increase in personal income-tax rates that will hit small businesses, and the repeal of tax breaks allowing businesses to write-off capital purchases. (See the nearby table for the comparisons.) 

Even if the lower rates for those earning less than $200,000 are extended, the rise in rates for high-earners will hurt the incentive to invest or take risks—and may already be doing so. As Mr. Bernanke put it, "Uncertainty about the resolution of these fiscal issues could itself undermine business and household confidence." 

http://online.wsj.com/article/SB10001424052702303753904577452674278573122.html?KEYWORDS=Bernanke%27s+Cliffhanger

I am in the process of trying to gather more information and thoughts from various sources as to what changes, if any, should be made in my current investment thinking.

However, here are a few initial thoughts:

1. Dividend-paying stocks could be hit fairly significantly. Tripling the tax rate on qualified dividends obviously reduces the after-tax yield;
2. On the other hand, my client pointed out dividends from non-qualified sources (e.g., REITs, or MLPs) could be helped, since they tend to offer higher yields;
3. My client also questioned whether it might make sense to realize any long-term capital gains in 2012.  The idea here is that it is unlikely that capital gains rates will ever be as low as they are currently, and next year's increase only represents the start of future rate increases;
4. On the other hand, loss-harvesting strategies probably should be delayed until next year.  At higher tax rates, realized losses have more economic value;
5. Estate planning, however, will be essentially impossible until after the election, given the wide differences in estate taxes from Obama and Romney.

It doesn't seem likely that we will get any clarity on next year's tax policy until the last few weeks of this year.

One final cynical observation: 

The fact that dividend rates will be much higher than capital gains tax rates is a wise move; after all, most would agree that we should encourage long-term investing strategies.

On the other hand, most hedge fund managers are paid via a so-called "carried interest" method, which is taxed at capital gains rates. 

No matter what happens, then, the managers of hedge funds and private equity companies (such as Romney's old firm Bain Capital) will continue to enjoy historically low tax rates on their income.