Risk Isn't Just About Volatility

Investors, not just mortgage lenders, whether owning bonds or stocks, need to pay more attention to creditworthiness now and in the future than they have in the past.

Investors have become used to thinking of risk as merely volatility (standard deviation of return), but there is also absolute risk — the risk of permanent loss of value.

Mortgage REITs and banks are examples from the past. Money market funds are “close call” examples of the present.  Tax exempt funds and exchange traded notes could be examples of the future.

Money Market Funds:

Bank of New York (BK) and Northern Trust (NTRS) have joined the list of sponsors contributing capital to bolster their money market funds to avoid “breaking a buck”.

Others including Wachovia (WB) and Legg Mason (LM) have done the same since the run on money funds began recently with the Primary Reserve Fund, the oldest money market fund and the first in 14 years to see its money market fund price drop below $1.00.

From Bloomberg :

Investors pulled a record $120.5 billion from the funds in the week ended Sept. 23, according to the Money Fund Report, a newsletter based in Westborough, Massachusetts. …

“Even with withdrawals there is more than $3 trillion in money market mutual funds that has to find a home,” Credit Suisse’s Jersey said.

The problem is that general money market funds invest in assets that include commercial paper and CDs that now have questionable creditworthiness, and therefore low Bids, and therefore market-to-market hits to money fund NAV.  Treasury Bills have Bids and don’t have mark-to-market problems.

Monday, the US Treasury opened a program to insure the value of all publicly offered money market funds for those funds that apply and pay a premium.  (see Treasury press release).

We have been advising clients during this difficult period (see prior articles) to use money market funds that invest only in US Treasury Bills.  We continue to make that recommendation, unless you are certain that your money fund is a participant in the US Treasury program that guarantees money fund value.

Tax Exempt Bond Funds:

We recommend investors with tax exempt muni funds be cautious about those funds relying on revenue bonds versus general obligation bonds.  The chance of default on revenue bonds is probably higher now.

Exchange Traded Notes (ETNs):

Similarly, we recommend limiting exposure to ETNs (single issuer bonds pegged in maturity value to some independent index), because ETNs are subject to the risk of the credit worthiness of the issuer.

We wouldn’t stop using ETNs in areas where they provide unique exposure if the credit quality of the issuer is high, but we would be aware of the nature of the counter-party risk and keep exposures in reasonable proportion to the overall portfolio. (see article on specific ETN issuers).  The most significant ETN issuers include Deutsche Bank (DB) and Barclays’ Bank (BCS).

Summary:

Investors have been too focused on yield and earnings growth at the expense of credit worthiness.  That has contributed to the market dilemma we face today.

Investors, as well as mortgage lenders, whether owning bonds or stocks, need to pay more attention to creditworthiness now and in the future than they have in the past.

Comments

[Ishortyou:]

Looks like Wachovia got rid off the prior toxic risky wasted bank subsidiaries and kept the good ones. Now it can start from scratch to build a new banking subsidiary with safe practice together with its remaining good outstanding subsidiaries. The current subsidiaries of Wachovia make it look like "Merrill Lynch without the toxic risky waste", good job from management it separated the good bank from the bad bank overnight, plus its CEO Bob Steel is one of the top rated mutual fund managers. Wachovia will keep the valuable human resources and the talent that have expirience in the banking business saving them for the new banking subsidiary. Buying the municipal bonds or the auction rate securities will give the inflow of cash as long as its hold even to maturity, so the prospects are good.

2008 Sep 30 01:09 PM

[Smarty_Pants:]

Mr. Shaw makes an excellent point and one that should be remembered, but which the big Wall Street banks seem to have overlooked of late.

Return OF capital before return ON capital.

2008 Sep 30 02:16 PM