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Bernard Thomas
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My real name is Thomas Byrne and I was a Fixed Income specialist at Citigroup. I was the auther of "Making Sense," the most widely-read commentary report at the firm.
My company:
Bond Squad
My blog:
Bond Squad
  • The Truth About Bonds - Sorting Through Hyped Structures And Trendy Strategies 0 comments
    Aug 25, 2012 8:20 PM | about stocks: LQD, HYG

    The following is an article from my weekend report: Bond Squad's In the Trenches report: We hope you find it as interesting and useful as did our subscribers:

    It all started when we reached out to about 50 former readers whom I asked to consider giving Bond Squad a try. These were not just names off a marketing list, but people who had sung our praises (in print) during our former professional lives. The reasons they gave us for not subscribing to Bond Squad startled us. We expected to see responses which questioned the cost of a subscription or that fixed income is no longer a focus in their practices. The most common responses were: "I don't have time to read" and "I just listen to the idea of the day. We admit that these responses left us somewhat dismayed. We spent more than a decade writing fixed income market commentary, which was accurate, honest, straightforward and went far beyond suggesting bonds because they were "cheap" or, in the case of preferreds, "affordable."

    That being said, this edition will be direct, frank and maybe a bit brash. However, it will provide information which is not generally available to retail financial advisors and their clients. "Clients" is the key word here. Although individual investors make up a portion of our readership, the vast majority of subscribers are financial advisors (along with about a dozen or so traders and strategists). We will be shifting our marketing efforts to focus on investors. We plan to expose suspect strategies, bonds and other securities for what they really are. We will also sing the praises of those which we find of value. Don't be surprised if a client, colleague or acquaintance questions a popular investment idea and informs you that they heard about it from Bond Squad. The investment world is a very small place and Bond Squad is everywhere.

    Now that we have this boring, but necessary, bit of housekeeping out of the way, let's get down to business.

    Did anyone notice that the yield of the 10-year Treasury dipped below 1.70% this week, ending the week at 1.687% from a recent high close of 1.8355% on August 16th? What happened to precipitate such a rally on the long end of the curve? Was it some technical pattern which simply had to play out? Has a war begun in some part of the world? Did some economist find a piece of economic data missed by his or her peers? No, none of those events occurred this past week. What did happen was that European officials and some market participants came home from the beach.

    We are not surprised that the sentiments of European officials and market participants have not changed for the better. After all, what has changed for the better in Europe or in the global economy? Let's discuss some hard facts:

    · Greece is a basket case. If it was a horse, it would have been shot already. Even the most ardent PETA member would be for putting Greece out of its misery. In the case of Greece, that means putting it out of the eurozone. In keeping with political traditions, European officials, both inside and outside of the European periphery have done their level best to kick the can down the road.

    The latest scheme being bandied about is a "temporary" Greek exit from the eurozone. The thinking here is that, Greece will leave long enough to devalue its currency, get its economy in order and re-enters the eurozone. Pay no attention to the fact that, if Greece does not completely restructure its economy its death spiral starts anew the moment that Greece re-enters the eurozone.

    Why go the temporary route? The idea here is that, if Greece's exit is only temporary, the contagion will not spread to Spain and Italy. Good luck with that plan. Neither Italians and Spaniards, nor market participants (vigilantes) are that stupid.

    · The global economy is slowing. Europe is heading into a recession, if it is not there already. China's landing, once thought to be soft, appears to be harder than originally anticipated. China's more dramatic slowdown does not surprise us. With its two largest export customers, Europe (probably in a recession) and the U.S. (experiencing sluggish growth), how in the world was China supposed to keep its economy chugging along? Oh that's right, internal consumer demand. That had about as much chance of happening as Argentina beating the U.S. in Olympic Men's basketball.

    The only economy which might be able to disconnect, at least temporarily, is the U.S. economy. The U.S. economy is the only large economy which can swim against the global tide and pull the rest of the world along with it. However, the U.S. is swimming with an anchor around its neck (household deleveraging) and an anvil on its chest (the upcoming "Fiscal Cliff").

    These realities have many investors (and equity market participants) looking to the Fed to save the day. After all, Fed Chairman, Bernanke, says the Fed has tools remaining which could help the economy. Let's put this in perspective.

    Let's say that the Bond Squad team is in a small boat (the S.S. Bond Squad if you will). Unfortunately, our craft has sprung a leak. We are out at sea and cannot repair the leak, but we do have three tools; a one-gallon bucket, a 16 ounce cup and a teaspoon. As the water begins to pour in we begin bailing with our one-gallon bucket. This helps, but it cannot keep up with the volume of water coming in the boat. We have another team member join in with the 16 ounce cup. This helps, but not to the extent of the one-gallon bucket. However, the water is still coming in faster than we can bail. Now we are left with the teaspoon. Having no other tools, we press another team member into bailing with the teaspoon. The teaspoon removes water alright, but its benefits are negligible. What is really needed is a structural repair of our boat. This accurately describes the current condition of the U.S. economy.

    This is what media pundits, equity market participants and purveyors of "creative" fixed income instruments have yet to understand.

    We have grown weary of explaining the truth about various non-traditional fixed income investments. We used to enjoy blowing holes through faulty investment strategies and suspect trade ideas. However, many investors and advisors seem hell-bent on blowing themselves up. We have seen investors latch onto some real screwy ideas. Others were not so absurd, just misunderstood. What we have found over the years is that many investors and advisors want to believe the marketing story and ignore warnings to the contrary. Let's review some of the more "interesting ideas" we have seen during the past decade:

    Icelandic Bonds: About six or seven years ago; a newsletter made its way through the investor community hawking Icelandic sovereign debt. The newsletter suggested opening an account at a brokerage in Copenhagen, Denmark to buy sovereign bonds. After all, what could happen to bonds issued by a sovereign nation which can print its own currency? Investors found out that they can and do default (has anyone heard of Argentina?). Also, the bonds could not be delivered outside the Scandinavian countries, hence the required account in Denmark. We spent two years explaining the facts of life to financial advisors and their clients. Many did not believe us. All found out that we were correct.

    Corporate Inflation-Protected Bonds (IPIs): These beauties were marketed as having coupons which float at a specified number of basis points over CPI. Hold on there Sparky, that it is not how they work. In actuality, they float as a specified number of basis points over the year-over-year change in the CPI Urban Consumer Index; Non-Seasonally-Adjusted (got that?). This not-so-small nuance meant that if inflation ran at 3.00% one year and 3.00% the following year, and your coupon spread 200 basis points over the year-over-year change, your coupon was 2.00%. If it went from 3.00% to 2.50%, your coupon fell 50 basis points to 1.50%. What is the floor coupon you ask? The floor was 0.00%. If the year-over-year change in the rate of inflation matched or exceeded your coupon spread, your coupon was 0.00%. Many investors discovered this the hard way in 2009.

    How could there be so much misunderstanding of a product which we explained in a paragraph? We believe is that people wanted to believe what they wanted to believe. We experienced situations where we would correctly explain bond and the caller would call back and ask for another fixed income specialist in hope of getting the answer they wanted to hear. Sometimes they were successful, unfortunately.


    Preferreds: Where do we begin with this product? Somewhere along the line, both investors and advisors got it into their heads that preferreds were "five-year securities." To be fair, for about 15 years they had worked out that way. The problem was with the cause and effect perception (post hoc, ergo propter hoc). Many preferreds were called after five years (their first scheduled call date) because long-term rates were falling. They fell for approximately 25 years. However, many investors and advisors seemed to miss the cause and effect relationship between long-rates and preferred callability. Over the years we heard some wild theories.

    Theories we heard ranged from, "companies call preferreds because they like to come to the market to keep investors interested in their securities," to a crazy theory which compared the coupon of the preferred to Libor. What many investors and advisors seemingly failed to grasp was that preferred securities were long-term financing vehicles for which the company was advantaged by being able to refinance at a lower rates. Investors loved the fact that they were getting these great returns for five years, but when a call occurred, they would simply reinvest in the newly issued replacement. Investors were effectively buying step-down securities. Every five years, investors where having their income stream cut. Oh yeah, great investment idea.

    During the 1990s and early 2000s, many individuals refinanced their mortgages, taking advantage of falling interest rates. Why would it be different for corporations? It wasn't. In the primarily retail-driven preferred market, it was fairly easy for corporations to issue long-term securities with relatively-low coupons (when subordination was considered) with an option to call them in if interest rate and credit spreads conditions favored the issuer. That's right folks, call features always favors issuers. Just like the ability to refinance a mortgage without penalty favors borrowers.

    What investors should have been doing is building ladders with bullets (non-callable bonds) with a bias in to the seven-year to ten-year area of the curve. They would have kept higher income streams longer. Also, preferreds are very subordinate securities, in most instances; investors were not being sufficiently rewarded, in terms of yield, for accepting such subordination.

    Because preferreds had been so popular among retail investors, some investment banks created synthetic preferreds (with names such as Corts, CBCTS, Saturns, Preferred Plus, etc.) which were not issued by the reference companies, but were trusts containing securities issued by the reference company. At first, senior notes were placed in trusts and shares of the trusts were sold to investors. Later on, $1,000-par trust preferreds (called junior-subordinated debt to make them seem more bond like than they were) were placed in trusts. Since investors liked the call feature, a five year first call date was included, but that call option was often sold to speculators. Very few investors realized what they were buying. Surprisingly-few financial advisors knew what they were recommending. Even more surprising was that many fixed income marketing specialists were not quite sure what "corporate trust securities" actually were. All they knew was that they had a new preferred to sell. This was a source of frustration for us. We actually had a colleague tell us once: "Our job is not to understand bonds, it is to sell bonds." Never in our long career have we ever taken that approach to our jobs.

    Preferreds continued to be a source of misunderstanding as the Collins Amendment to the Dodd-Frank financial regulation legislation took effect. Immediately upon the announcement that trust prefererreds (Trups) and enhanced trust preferreds (E-Trups) would lose their Tier-1 eligibility (they only had partial Tier-1 eligibility to begin with), fixed income markets, mutual funds and their wholesalers went out with their "strategies" on how to play the situation. Many (seemingly the most popular) hypotheses were flawed. Some were just plain incorrect.

    One popular theory that, because the Collins amendment triggers capital event clauses embedded in most debt/equity hybrids (the most accurate description of Trups, E-Trups and junior subs), banks affected by the new financial regulations would call in most or all of their trust securities. The counter strategy was that banks would not wish to anger investors and would not call their trust preferreds prior to their first call dates, or at least until the Collins Tier-1 haircuts (one-third each year beginning 2013) took effect.

    Our take on the situation was that banks would do what was economically advantageous for them. If banks would call in any preferreds early, they would likely begin with their highest coupons first. This is exactly what has happened during the past two years. That some of the lower-coupon Trups and E-Trups are now getting called in is more a function of Fed policy keeping rates extremely low across the yield curve than any Collins-related phenomenon. In fact, most of the preferreds being called in now have reached their firsts stated call date. Those investors who purchased deeply-discounted low-coupon preferreds in 2010 and early 2011 in hopes of a short-term windfall had better kiss the ground and thank the almighty for creating Ben Bernanke (or those who caused the housing bubble and financial crisis). If not for the extraordinary policy accommodation set forth by the Fed and the crises which were the impetus for extraordinarily accommodative monetary policy, these low coupon preferreds (with coupons below 7.00%) would probably be trading in the low $20 area (or lower). Sometimes it is better to be lucky than good.

    Investors who were not so lucky were those who purchased trust preferreds with high coupons with the belief that they were unlikely to be called prior to 2013 or were unaware that the new Collins regulations enabled banks to call in many of their trust preferreds early. Some investors purchased preferreds at significant premiums only to have them called in at par, days or weeks later. The situation was not helped by wholesalers and fixed income product marketers proactively soliciting trades based on flawed strategies.

    We actually listened in to a call conducted by a competitor of our former firm advocate buying trust preferreds at discounts because nearly all would be called in shortly. Only a few months later, this same firm marketed the idea that few, if any, would be called in prior to Collins. We do not believe that there was any intent to harm investors. They simply misunderstood the tenets of the Collins amendment and how the fixed income markets operate.

    Not to be self-congratulation, but the desk on which the Bond Squad team worked did not go out with such flawed strategies. To a person, our desk knew the story correctly and conveyed accurate information. Unfortunately, the truth is often not "sexy" and investors and advisors chose the get-rich-quick approach.

    Fixed income marketers spewed forth flawed strategies regarding Libor floaters and fixed to floaters. Many of the floaters strategies were based on two incorrect beliefs

    1) As "rates" rise, floaters outperform, protecting investors from a rising rate environment.

    2) Floaters always trade at or near par.

    If one would sit and ponder this for a few minutes, the flaws in these lines of thinking become painfully apparent.

    Why would a corporation issue a bond which removed interest rate risk from investors and heap it on themselves? The answer is they wouldn't. Oh sure, they can hedge with options, swaps, etc., but hedges are risks unto themselves. It is better for a corporation to issue floaters which are a little more "creative." Enter long-dated and perpetual Libor floaters.

    With rates very low, corporate issuers came to two realizations:

    1) With rates low, they would like to issue long-term debt with fairly low coupons, but investors might be resistant to extending far out on the curve while earning lackluster yields.

    2) Investors desire income streams which would increase with "rising rates."

    How can corporations obtain long-term financing at fairly low interest rates while attracting investors seeking the potential for rising income streams? The answer was the Libor floater.

    It is not by accident or whim that corporations issue long-term or perpetual securities which float off of Libor, nor is it because Libor is the standard benchmark. The Fed maintains Constant Maturity Treasury rates for the various points on the curve (which are updated every day). Bonds can be created (and have been created) using CMT rates which closely match the maturity, but where would be the advantage for the issuer in doing that. This is why most CMT floaters offer no coupon spread over CMT. This permits corporations to finance at the same rate as the U.S. Treasury. Any time a corporation embeds optionality into a bond, it is always done in a manner which favors the issuer in most circumstances.

    U.S. Constant Maturity Rates as of 8/24/12:

    Description Cur. Rates Curr Dt

    Treas Const Mat 1 Month .10 08/24

    Treas Const Mat 3 Month .10 08/24

    Treas Const Mat 6 Month .13 08/24

    Treas Const Mat 1 Year .19 08/24

    Treas Const Mat 2 Year .28 08/24

    Treas Const Mat 3 Year .37 08/24

    Treas Const Mat 5 Year .72 08/24

    Treas Const Mat 7 Year 1.14 08/24

    Treas Const Mat 10 Year 1.68 08/24

    Treas Const Mat 20 Year 2.41 08/24

    Treas Const Mat 30 Year 2.79 08/24

    Note: CMT rates are set daily by the Federal Reserve Bank to reflect a specified amount of time from a given date by interpolating the yield curve.

    How does issuing a long-dated security linked to Libor benefit an issuer? As long as the yield curve is positively-sloped (which it is about nine out of every ten years), the issuer is financing for the long-term at interest rates which are below prevailing rates for long-term securities. This is why we saw a spate of new issuance of Libor floaters in 2003, 2004 and 2005, as well as in the period from 2010 to 2012. Corporations tend to issue such floaters when the yield curve is steep, particularly when policy rates are historically low. As long as the curve is positively sloped, it is "advantage issuer. "

    Do you disagree with this assessment of Libor floaters? Ask yourself this question: Where would a Libor floater which spreads its coupon 300 basis points over Libor trade when Libor is at 3.00%, the ten-year note is at 6.00% and the 30-year is at 7.00%. It is not inconceivable for non-cumulative preferreds or so-called "junior subs (the most common structures for Libor floaters) to trade at 250 basis points above the 30-year U.S. Government bond yield. This would result in a trading yield of 9.50%. However, your coupon would only be 6.00%. Yes, your coupon has held up from what was available when the security was issued (many Libor Floaters offer a fixed coupon for the first five years), but your trading yield is 350 basis points higher than your coupon. The result would be a trading price around $70.00. This has happened in the past. If your floater of choice is perpetual, it does not even roll in on the curve.

    What happens if the curve flattens? That is when Libor floater performs best. However, the par-call feature embedded on these securities limit price appreciation, especially as the call date approaches. The best scenario for Libor floaters is the one in which we are in. The curve has flattened, with long-term rates coming down. That, combined with robust investor demand, has pushed prices of some, but not all (see GSprA, GSprC and GSprD) Libor floaters higher. Our advice is to take any profits now and get out.

    What about CMT linked floaters? Such floaters do better when the curve is steep (the opposite of a Libor floater). However, because that it's the most typical shape of the yield curve, issuers need to protect themselves. They do so by offering zero spread over CMT. Usually, as with Libor floaters, CMT floaters have a call feature which allows issuers to call them in, should conditions become adverse for themselves.

    The bottom line is that there are no magic bullets in fixed income. There is no one single product which is advantageous for investors in nearly any market or economic environment. Every kind of adjustable and variable instrument performs well under specific conditions and poorly under others. Issuers structure securities manners which favor them under the most likely scenarios. Wouldn't you if you could?

    Another misconception among investors and some advisors is that bond funds and ETFs are just as good as a portfolio of bonds. Although both bonds and bond funds can be useful for many investors, they are not the same.

    Bonds should be viewed as income-generating vehicles. At some point (if the issuer doesn't default and the creek don't rise), bonds will mature and investors will not only enjoy a return on investment, but return of investment as well.

    Bond funds offer no such guarantee of return of investment. Bond funds, both mutual funds and ETFs, turn bonds into an equity-like investment. By that we mean; investors are rewarded for total return and, possibly, the performance of the fund manager. Investors looking for income and a greater degree of certainty should probably build a bond ladder.

    Where bond funds offer advantages is in the high yield bond arena. Most investors who consider high yield bonds do so for potential total return opportunities (or they should be). This is especially true of the very low end of the junk bond ratings scale where relatively few bonds mature at par. Recovery value is what is most important. Most individual investors do not have the financial resources to build a sufficiently diverse junk bond portfolio which can protect against negative outcomes among issuers. Mutual funds and ETFs can be useful vehicles for equity-like speculations in the bond market (Bond Squad has invested in funds such as, HYG (high yield bonds) and LQD (high grade bonds) for total return speculations on the bond market (always invest in something you understand).

    Another, perhaps the best, use for funds is equity investing. Equity funds offer the kind of diversification beyond what most individual investors are able to obtain by purchasing individual stocks. It also takes stock picking out of the hands of amateurs. During the past two years, we have seen a trend in which some traditional fixed income investors have ventured into high-dividend -paying stocks in search of income. Although we also see the merits of high-dividend stocks (we have owned HDV in the past), they cannot be considered direct surrogate for bonds. Why? They have no maturity! Because equities do not have the same degree of principal return certainty offered by bonds, investors seeking dividend income may wish to consider a dividend income fund. At the very least, investors should attempt to build a portfolio of high-quality, non-cyclical dividend-paying stocks. Investors must be able to accept the reality that they might not be able to get 100 percent of their invested principal on a given date, if ever.

    This concludes the "gloves-off" portion of "In the Trenches." We will begin offering an investor-centric subscription package. Although we are still working out the details, the package will be priced in the $100 to $150 range and provide weekly commentary and support to fixed income-oriented investors. If their advisors do not have time to read the truth about fixed income, we will make it possible for investors to know the real story behind the products and strategies being marketed to them. We will spread the truth, one investor at a time, if necessary.

    Tom Byrne


    Twitter: @Bond_Squad

    Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

    Stocks: LQD, HYG
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