Adding A Third Dimension to Bond Analysis

A paper I wrote "Adding a Third Dimension to Bond Analysis" was recently selected for publication in the Journal of Financial Planning. In the paper I describe how a bond varies in value over its lifetime and how to construct a bond price curve using a spreadsheet program. Although the paper is technical in nature and intended for a professional audience I though my readers might be interested in the concepts presented in the paper. I have included a link to the article here, and you can access the spreadsheet and download a copy to your computer here.

Understanding The Credit Crunch

Everyone has heard about the problems in the credit markets today. With all the press and airtime given to this topic I was surprised by a question from a client recently asking for an explanation. Sadly, while the problem has been discussed widely, the root of the problem has gone unexplained in the popular press.

To understand the credit problem you must first understand a little about how the bond market works. Nearly all bonds are sold out of a dealers inventory, like shirts sold at a department store. The bond dealer buys bonds, marks them up, and then resells them at a profit. Unlike stocks which trade actively everyday on the various exchanges, there are hundreds of thousands of different bond issues, and very few trade on a given day. So unlike stocks where everyone can see the value because the prices are published throughout the day, bonds are valued by using computer models. If you have bonds in your portfolio the value published each month on your statement reflects an estimate of the bonds value on that particular day. If you try to sell a bond, the price you receive could be higher or lower than the estimate your custodian provided on your statement. When dealing with bonds backed by mortgages, current and projected default rates are a factor in estimating the bonds value.

Mortgage backed bonds are created when banks and mortgage brokers pool large groups of mortgages and sell off smaller pieces to institutional and individual investors around the world. Very few mortgages are kept in house by banks, as this would tie up too much of their capital. Your mortgage has probably been sold off in this manner too. Banks and mortgage bankers make their profits from fees charged to originate the mortgage, and from fees received to service those loans. Your personal mortgage is probably part of a large group or tranche of mortgages owned by many different investors.

The current credit crunch probably began on June 20 when Merrill Lynch, a lender to a couple of Bear Stearns hedge funds investing in sub prime mortgages, asked for bids on some of the holdings held as collateral for loans made to the hedge funds. Suddenly, a large block of mortgage backed bonds had to be priced to market rather than priced to (computer) model. With a background of a weak housing market, and adjustable rate mortgages that were resetting at higher rates, the bids Merrill Lynch received from other bond dealers were significantly lower than the models had estimated. Merrill Lynch had issued a margin call, and sold the bonds off in a weak market.

This news caused others to question the value of mortgage backed bonds. Like dominoes, mortgaged backed bonds fell in value as more and more were offered for sale and bond dealers, hesitant to risk their own capital, we reluctant to buy them at any price. Suddenly awash in supply, the demand shrank to nearly nothing. It became like a run on a bank, a self fulfilling prophesy. The run was not contained to the sub prime segment of the market, it cascaded quickly to include any bond backed by any type of mortgage. Even Thornburg Mortgage, a company who specialized in jumbo mortgages, with very low default rates found it impossible to to find financing for its portfolio. The financing required to keep the mortgage market liquid suddenly ground to a halt. The only jumbo loans being issued were those that banks could afford to keep in their inventory, and they came with hefty interest rates.

What has happened to cause this credit crunch began with sub-prime mortgages, but the sub prime segment is not very important to where we are now. The challenge facing the credit markets now is how to restore faith and liquidity to this huge part of our economy. Without mortgage availability the housing market will plunge, taking along with it all the appliance sales, furnishing sales, legal services, etc that are part of this important sector of our economy. Without a housing industry our economy will surely slip into a recession or worse. The cries for an interest rate cut have been loud and often, yet when the federal reserve acted it was with a cut at the discount window not the fed funds rate.

The reason for this could be two fold. The Federal Reserve does not want to be seen as bailing out Wall Street. With the beginnings of this credit crunch so closely tied to predatory lending practices and hedge funds, the public perception is that the problem is contained there and it would be inappropriate for the government to in any way bail out bad business practices. Secondly, the federal reserve may believe that lowering interest rates will not solve the problem. Lower rates can make housing more affordable and even save some unfortunate individuals from foreclosure, but until the root problem of liquidity in mortgage backed securities is solved the specter of a housing collapse is more than just a nightmare scenario.

The stock market seems to be pricing in a rate cut from the Fed. So we are set up for a major disappointment should the fed forgo a cut at its September meeting. Again, this may be what chairman Bernanke wants. He does not want to bail out Wall Street, but if a stock market decline is unavoidable, he certainly wants that decline to be orderly in nature and not a fear driven plunge like we witnessed in the weeks preceding the latest Fed action. The Fed has been injecting liquidity into the banking system on an almost daily basis. More probably should be done. Allowing Fannie Mae and Freddie Mac to purchase mortgage securities over the current $417,000 limit should be a first step. This would allow banks to begin selling jumbo loans from their in- house portfolio and provide further liquidity. Yet, so far the politicians who could make this happen have failed to grasp the true nature of the problem, instead referring to such a move as a bail out.

Update

Rebalancing Act

My previous entry on reversion to the mean may have seemed a little academic, but it has a very practical application in managing your portfolio. Over time investments, like closets, tend to become disorganized. You may have spent considerable time and effort in setting up an asset allocation for your 401k, but if you stop there you will eventually have a portfolio that no longer meets your needs, and could potentially expose you to much more risk than you originally intended.

Rebalancing your portfolio can insure that your risk remains tolerable, and can actually improve your investment returns over time. There is always disagreement over when you should rebalance, some prefer quarterly, some monthly, some have complicated formula's that trigger rebalancing. You can put me in the annual camp. When I have looked at hypothetical portfolios and compared annual to quarterly rebalancing I usually find that annual rebalancing provides more return, while quarterly rebalancing does a better job of reducing risk. No matter what choice you make, the process of rebalancing can benefit you.

The reason rebalancing works is that "reversion to the mean" shows that different asset classes and subsets within those classes go through periods of under performance and out performance. By rebalancing your portfolio you force yourself to take some profits in areas that are outperforming, and purchase securities that have become relatively cheaper. This goes against human nature because we all tend to want all our money in whatever is providing the best return right now. Just remember that all things in life have cycles. You may not be able to predict when a cycle will begin or end, but you do know that it will. Rebalancing provides discipline to your investment process and can keep you from making the big mistake of being late to the party and late to leave, like the dot com investors of the last bull market.

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technorati tags:re-balance, Finance, financial planning,

Reversion to the Mean

One of the most important concepts in investing is reversion to the mean. This is a fancy way of saying things tend to return to normal.

You have probably noticed that like a pendulum the stock market is subject to wide swings up and down, and like a pendulum spends little time in the middle. This is true of the market as a whole and in the groups and individual securities that make up the market. Everything seems to go too high or too low.

Look at the chart above of the S&P 500 rolling monthly returns from 1975 to 2006. The mean (average) return for this period was about 13% but the rolling annual returns varied from up almost 50% to down nearly 30%. While there is no rhyme or reason to the swings of this pendulum you should be able to see that when things look the best you should be taking some profit, and when things look the worst you should be buying bargains. Trouble is this goes against what comes naturally.

This process of reversion to the mean takes place in all subsets of the market too. Remember tech stocks in late 99 and early 00? Or telecom? Or oil? For the last few years small caps have been outperforming and many on Wall Street have predicted a resurgence in large company growth that has yet to materialize, but has shown recent strength relative to small and mid size companies. Maybe it is finally time for their reversion to the mean.

The first step to profiting from this phenomenon is to recognize its existence. The next step is to have the discipline and courage to act. Remember, things are never as good or as bad as they seem.

technorati tags:Finance, investing, Stocks

The Security Of Your Securities

On more than one occasion a client has come to me with securities they have found or received from an inheritance that they cannot find a value for. Sometimes it is a company that is now defunct, or it could be that there was a buyout or merger in the past where the original company is no longer in existence. But they have a certificate and no idea of the value.

Sometimes when a client has a relative die they know the deceased had shares of a company but they can't locate the certificate, or they receive a dividend check from a company they knew nothing about.

Having physical possession of stock and bond certificates can make things hard for your heirs and yourself. If a certificate is lost or stolen the owner must complete an affidavit with the facts surrounding the loss or theft, obtain a indemnity bond to protect the corporation and the transfer agent against the possibility that the certificate may be presented later by an innocent purchaser, and the request must be made before must be received before the company receives notice that the missing certificate has been acquired by another bona fide purchaser. Indemnity bonds generally cost about 2% of the value of the lost certificates.

In the event of a corporate merger or acquisition you may overlook the instructions for having certificates of the new company issued and your heirs may not know what happened to the company you originally invested in. If the certificates become part of your estate an affidavit of domicile and copy of your death certificated must be sent to each company to have the shares reissued to your heirs.

Finally, if you wish to sell your shares they must be presented and deposited with a broker dealer before they can be sold. This could cause an inopportune delay in executing your sale.

Having your certificates held in an investment account can make things much easier. You will be informed of any corporate actions requiring your attention, any changes in corporate name, merger, or acquisition will be handled by your custodian, your shares will be in a safe place, will be available for sale on any day the market is open, and if you die your heirs only have one entity (your brokerage firm) to provide with affidavit of domicile and death certificate.

technorati tags:Finance, stock certificates, financial planning

SEC Podcasts

The Securities and Exchange Commission has begun a series of short (five minute) podcasts. The series titled "Your Money" is designed for beginning investors but has information that is appropriate for all investors. My favorites are "Choosing a Financial Professional" and "No-Load Funds". You can access the series here.

Technorati Tag SEC Podcast financial planning

Playing With A Stacked Deck - Equity Index Annuities

Bob Clark, a columnist for Investment Advisor magazine, recently said, "...the role of advisors is to protect their clients from the financial services industry". Many times the products pushed by the large financial service firms do more harm to investors than good. The "hot" product de jour is currently the Equity Index Annuity.

While the equity index Annuity itself is not an evil thing, the way they are presented to investors is many times misleading, and they are often pushed to be a much larger part of a portfolio than prudence would justify. Regulators have become so concerned that the SEC has issued an explanation of equity index annuities, and the National Association of Securities Dealers has issued an "investor alert".

In brief, an equity index annuity, provides returns that a related to some stock market index. As such they can be viewed as an equity derivative (remember those?). Investors typically receive a return that is some portion of the return of an index like the S&P 500 (for example 90% of the point to point return of the price increase of the index, not including dividends), the average monthly return of the index over a predetermined period (again not including dividends), or the monthly gain of the index with a predetermined cap (often 2-3% per month cap). The big draw is that you receive a guarantee that your account will not have a negative return over some period of time. Often touted as "heads you win, tails you don't loose". On the face that sounds enticing. It is only if you kick the tires that problems become apparent.

First, like most annuities there is a long period of time where you a charged a surrender charge if you want or need to withdraw more funds than allowed in the contract (I have even seen instances where the surrender charge is applied to any withdrawal except in the case of annuitization).

Second, any gain from annuities is considered to be distributed first, and taxed as ordinary income (you do not get favorable dividend of capital gain rate when you file your taxes), and any distribution before age 59 1/2 could be subject to a 10% premature distribution tax penalty.

Worst of all the returns investors receive will likely not measure up to expectations. A good place to find information on how different equity index annuities would have performed is available at Personalyze.org. The pitfalls of monthly caps and averaging returns is also available here. This site is great for comparing equity index annuities to each other but for the investor to make a true comparison the returns need to be compared to the benchmark. To give you a means to compare check the growth of a $100,000 investment in a equity index annuity given by Personalyze.org to the following values derived from the sites own data for an investment in the index (of course this does not include dividends). For the period 1970 through 1979 (considered a bear market era by personalyze) $100,000 invested in the index grew to $117,250. For the period 1990 through 1999 (considered a bull market era by personalyze) $100,000 grew to $415,762, and for the past 10 years an investment in the index grew to $202,657.

Technorati Tag Equity Index Annuity

Investor Behavior - Common Mistakes

Harvard's Daniel Gilbert explains the psychology of errors in estimating. If you listen with an ear toward the investment applications it helps explain many of the common errors investors make over and over again. It is a long piece ( about an hour) you can listen here or download mp3 to listen when you have the time or take with you on the road. If you choose to down load look for the file SXSW06.INT.20060311.DanielGilbert.mp3

Technorati Tag behavioral investing