Charter Trust - Global Market Update

Where you stand depends on where you sit.That’s what a lot of companies are finding. In order to increase collaboration and innovation, some firms are moving employees around every few months. The idea is that by seeing and hearing what different colleagues do, workers can get new insight into how to do their jobs differently.Companies have experimented with organizational charts seemingly forever. And research shows what common sense would dictate: changing reporting relationships rarely changes what work gets done. Sitcoms and comic strips satirize the clueless boss who thinks a new reporting structure can revolutionize the office.But casual conversations can. A New York ad agency tried intermingling its accountants and media buyers, hoping they would begin to each other’s skills. The idea worked so well that the media buyers started to do accountancy on their own, saving the company hundreds of thousands of dollars a year.But managers need to be careful. One 600-person firm which randomly changes its seating every three months found that no one can remember who sits where. Sometimes a little stability is useful.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpddirect: 603-252-6509 reception: 603-224-1350www.chartertrust.com • www.moneybasicsradio.com • www.globalmarketupdate.net

So how do we put it all together?Bond investors need to understand broad trends in the economy and the markets in order to invest profitably. It’s clear that the economy continues to expand, in spite of the drama we’re seeing in Washington. Interest rates are moving higher. Corporate balance sheets are healthy, and companies are expanding in emerging economies.So the right way to invest in bonds is to own bonds that either mature or reprice sooner than the benchmark; that have exposure to corporate expansion, and that have embedded options that will expire worthless. Taking modest credit risk in a portfolio is a sound strategy—but a limited one. The spreads of the most stable global corporations are quite narrow. For example, 5-year Coca Cola bonds only pay about 0.30% over Treasuries. Still, investing can be a game of inches.Floating-rate debt can keep a portfolio’s duration short. But be careful! Longer rates have gone up, but short-term rates may be anchored for a while. Mortgages have embedded options, because homeowners can refinance whenever they wish—but don’t when rates go up. Structured Mortgage-Backed Securities pay high current coupons, although we don’t know what Congress may do to reform Fannie and Freddie. The mortgage giants are the gifts that keep on taking—and taking, and taking.Finally, good old callable bonds—issued by Agencies and Corporations—are less likely to be called now than they have ever been. When rates rise, those calls become useless to the issuer.Keeping a portfolio short; taking prudent credit risk; writing value-free options—combining these strategies should give bond buyers the income they need to outpace gradually rising rates. The Fed has said that it wants higher inflation, and the Fed eventually gets what it wants. Long-term investors should be prepared.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpddirect: 603-252-6509 reception: 603-224-1350www.chartertrust.com • www.moneybasicsradio.com • www.globalmarketupdate.net

What is structural risk?With bonds, duration risk and credit risk are easy to understand. Duration risk comes from extending time to maturity, and the additional interest paid compensates investors for the possibility that inflation rises. Credit risk is the chance that the issuer defaults and the investor doesn’t get paid.But structural risk has to do with options. If the borrower has the right but not the obligation to do something, we say they have an option. The simplest option is a callable bond. When borrowers issue bonds, they have to pay interest on those bonds until they mature. When borrowers issue callable bonds, they have the right to pay those bonds off early at a certain “call” date. They do that if rates fall and they can save money.Investors get paid something for taking this prepayment risk—for “writing” this option. The key to profiting from writing options is understanding that they have a certain time when they can be exercised. Investors want to write options that expire worthless. That way they get paid for something that doesn’t happen.Lots of bonds have options: corporate bonds, agency bonds, mortgage bonds. If they understand how and when to write them, investors can appear to get “money for nothing”  (and write calls for free).Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpddirect: 603-252-6509 reception: 603-224-1350www.chartertrust.com • www.moneybasicsradio.com • www.globalmarketupdate.net

Where do bond returns come from?With rates rising, it’s important to keep bond maturities short. That way their price declines won’t hurt the portfolio too much, and investors can reinvest the principle sooner when the bonds mature. But longer bonds pay more to compensate investors for interest rate risk. Short Treasury bonds pay less than inflation now, so those investments have negative real returns.Bonds carry three major risks: interest rate risk, credit risk, and structural risk. Credit risk is the risk of not being paid—that the issuer defaults. With Treasuries, the credit risk is virtually zero, so they pay almost no credit premium. Most other US Dollar bonds, however, can be quoted in relation to Treasuries. The difference between their yield and that of a comparable Treasury Note is called the “spread,” that can widen or narrow.Bonds with greater credit risk have a larger spread. As the spread narrows, the bonds go up in price. A key strategy, therefore, is to find bonds of improving credits—issuers whose spreads overstate the possibility of loss, and have potential to improve. Sometimes these will be pristine credits caught up in market turmoil; sometimes solid companies are in risky—but improving--industries; or a troubled issuer might be in a sound industry and change its managemement. In any case, it’s the direction of the credit risk—rather than its absolute level—that matters.This kind of approach is dynamic, but can provide some of the return bond investors need to outpace inflation. Finding returns from credit is hard—but the gain to a portfolio is worth the sweat that buyers need to put in.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpddirect: 603-252-6509 reception: 603-224-1350www.chartertrust.com • www.moneybasicsradio.com • www.globalmarketupdate.net

If rates are rising, how do bond investors make money?When rates go up bond market values go down. The return from bonds doesn’t come from the market, but from the coupon. That’s the interest rate promised when a loan is first made, and it compensates investors for the risk.So in order to invest profitably it’s important to understand the  risks involved. Bonds have three principal types of risk: interest rate risk, credit risk, and structural risk. Interest rate risk is clear: bond prices go down when interest rates rise. The longer the bond, the more the price declines for a given interest rate move. For example, a five-year treasury will fall 4.7% if rates rise 1%, while a 30-year bond will fall 15.7%.That’s why long bonds yield more than shorter bond normally—to compensate investors for the greater risk. But with rates rising, investors have to find other sources of return. So credit risk and structural risk are crucial: sources of risk can also be sources of return. As rates rise, structure and credit become the key to unlocking future bond market performance.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpddirect: 603-252-6509 reception: 603-224-1350www.chartertrust.com • www.moneybasicsradio.com • www.globalmarketupdate.net

How can bond buyers make money?Since 1981 bond investors have had the wind at their backs.  Not only could they collect their periodic coupon payments, but as rates fell the market value of their bonds would rise. If investors wanted to, they could sell 10-year bonds 5 years after buying  them and usually pocket a nice capital gain.In spite of periodic sell-offs, outperforming an index was fairly simple: go long. Lower discount rates would cover a multitude of errors. The rising tide of lower rates would deliver market value gains that would outweigh any errant security selection.But those days are over. Economic growth is rebounding around the world. Europe is emerging from recession; Japan is reflating; China is moving into the second year of its five-year-plan, and the US economy continues to grow in spite of Washington’s follies. Inflation expectations are muted for now, but with global central banks brimming with reserves, the risk is now be towards higher inflation. There is still much that we do not understand about the global economy.So be ready, investors. The arc of the bond universe is long, but it now bends towards higher rates.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpddirect: 603-252-6509 reception: 603-224-1350www.chartertrust.com • www.moneybasicsradio.com • www.globalmarketupdate.net

Does economic growth translate into market growth? On its face it should. A growing economy generates jobs, consumer demand, and opportunities for businesses. As businesses grow, they generate more profits. And stock market growth should ultimately track earnings growth, as stocks are a residual claim on earnings. But it doesn’t always work out that way.  The past four and a half years have seen fantastic stock market returns even as the economy has limped along. Part of that has been recovery from overly depressed levels in late 2008 and early 2009, when there was a real risk of an economic depression. But even allowing for the snap-back, the economy hasn’t lived up to the promise of the market. And it works the other way, too. The BRIC countries—Brazil, Russia, India, and China—have had tremendous economic growth, but their markets have been moribund over the past few years. Back when the US was economy was developing quickly—in the late 19th century—we had huge investments in canals and railroads. But 90% of these went bankrupt. A stock market investment is ultimately an investment in a management team. If the managers treat the market like a piggy-bank, watch out. Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all! Follow me on Twitter @GlobalMarketUpd direct: 603-252-6509 reception: 603-224-1350 www.chartertrust.com • www.moneybasicsradio.com • www.globalmarketupdate.net

They warned us.230 years ago the Federalist Papers admonished us about what would happen if we let partisanship run wild in our nation. The clearest warning comes in Federalist No. 10. Generally ascribed to Madison, it is a continuation of Hamilton’s essay entitled: “The Union as a Safeguard Against Domestic Faction.”Both worried that direct democracy would be a danger to individual rights, because a “common passion could be felt by the majority, and there is nothing to check the inducements to sacrifice the weaker party.” Their hope was that a larger republic could check these partisan passions.Both sides are to blame in the present shutdown debacle: Republicans for pushing their “defund Obamacare” agenda too far and Democrats for refusing to compromise. George Washington predicted what would happen if one party alternately dominated over the other: dissention, revenge, and paralysis, eventually broken by political tyranny. We aren’t up to the tyranny part yet, but so far we’re following the Founders’ script. Let’s hope our leaders can find a way back.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpddirect: 603-252-6509 reception: 603-224-1350www.chartertrust.com • www.moneybasicsradio.com • www.globalmarketupdate.net

You know the story: The grand prize is hidden behind doors number one, two or three. Pick the right door, and you’re rich. Pick the wrong door, and you get a booby prize. The stage from “Let’s Make a Deal?”No, it’s the casket scene from Shakespeare’s Merchant of Venice. The heroin, Portia, must wed; her suitors are required to choose one of three chests. The chests are made of gold, silver, or lead, and each has a small riddle outside. If the suitor chooses correctly, he will Portia’s find portrait inside and may marry her—and enjoy her large inheritance. If he is mistaken, he must promise to forswear marriage.We know how this story ends: the hero, Bassanio, chooses the lead casket and wins both Portia and her money—after two fruitless attempts by suitors who fail due to their insecurity or arrogance. As he examines the boxes, he comments: “The world is still deceived by ornament,” citing examples from law, religion, war, and fashion. The correct casket appeals to him precisely because it is so plain.What investors can learn is more than “Don’t judge a book by its cover.” The unsuccessful suitors fall short because they see themselves in their choices. By contrast, Bassanio is able to get outside himself. Successful investors get past their own expectations and desires—even as they acknowlege them—and try to see the world as it is, without ornament or veil.Shakespeare shows us how to find reality: by not looking at the flash, but the flesh behind all the numbers.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpddirect: 603-252-6509 reception: 603-224-1350www.chartertrust.com • www.moneybasicsradio.com • www.globalmarketupdate.net

Why diversify? Mark Twain once famously said that the best way to invest is to put all your eggs in one basket -- and watch that basket! And there’s a lot of insight there. Concentrating your energy and your attention is a good way to grow a business or develop yourself professionally. It’s a reasonable approach to managing risks  you can control.But diversification is the way to manage risks that you can’t control. The economy, weather, government shutdowns—there’s not much you or I can do about these. So dividing assets among different ventures reduces your dependence on any single investment.Shakespeare understood this four centuries ago. Early in The Merchant of Venice one of his main characters says , “My ventures are not in one bottom trusted; / Nor to one place; nor is my whole estate / Upon the fortune of this present year.” Splitting up his interests makes him more secure.Diversification is the compliment that wisdom pays to prudence—because we don’t know the future. Specialization may build wealth, but diversification preserves it.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpddirect: 603-252-6509 reception: 603-224-1350www.chartertrust.com • www.moneybasicsradio.com • www.globalmarketupdate.net

What is a corporate bond? The short answer is that it’s a loan to a company. The yield is the price of the loan. The extra yield over Treasuries compensates investors for the risk of default. But there’s another way to look at a corporate bonds—as a contingent claim. In this view, the investor buys a risk-free bond but sells a put option on the company. If the business goes bankrupt, management puts the company to the debt-holders, wiping out their risk-free bond. The spread over Treasuries represents the premium they’re paid for selling the put option. The spread depends on the volatility implied by the option price. Usually, these two pricing models work well together. Low-risk companies, like pharmaceuticals, have little chance of defaulting. Similarly, their credit puts are inexpensive. Risky companies, like airlines or apparel makers are just the opposite. Because contingent claims are amenable to real-time market data, many quantitative managers use it to price their bond portfolios. What’s  interesting is when the two approaches diverge. Because computer models calculate dollars but not sense, when stocks get volatile financial risk is overstated and fundamentalists can pick up some bargains. Conversely, when stocks are booming implied volatility falls and risk becomes understated. A rising stock market may lift all equity boats, but when it tightens bond spreads too much it’s time to move up in quality. Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all! Follow me on Twitter @GlobalMarketUpd direct: 603-252-6509 reception: 603-224-1350 www.chartertrust.com • www.moneybasicsradio.com • www.globalmarketupdate.net

Do markets make us immoral? That’s what a couple of German researchers concluded. They took surplus laboratory mice scheduled to be killed and asked some university students if they were willing to pay ten Euros to give the lab mouse a nice, quiet retirement. About half were willing to do so.When the researchers put participants into a social context, only a third wanted to pay to save the mouse’s life—the experiment actually had them “exchange” a credit that would save the mouse. Then they put the students into a social “market,” with 9 mouse sellers and 7 buyers, and even fewer were willing to spend their money.The researchers concluded that the market for mouse life eroded the value of that life. Maybe. But I don’t like mice and I don’t think paying for their comfy retirement is moral—to me they’re pests that I pay to get rid of. I’m not interested in their retirement. But I live in rural New Hampshire.It seems to me that this research shows that when people talk about a decision, they become more rational. And  having more sellers than buyers lowers a price. That’s not morality, that’s just common sense.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpddirect: 603-252-6509 reception: 603-224-1350www.chartertrust.com • www.moneybasicsradio.com • www.globalmarketupdate.net

Maybe they’ll care now?On Sunday Germany’s electorate gave Angela Merkel a stunning victory, increasing her party’s share of the vote from 33.8% to 41.5%. It’s the best result for the Christian Democrats since 1990, when Helmut Kohl won a third term. In fact, she almost won an outright majority in the Bundesrat, Germany’s lower house. Now she has to form a coalition.The CDU’s current partner, however, is not available. The Free Democrats’ share fell from 14.6% four years ago to 4.7% now—not enough to send delegates to Parliament. It’s a painful comedown for a party that has frequently played the role of kingmaker in German politics. Because their libertarian philosophy is adaptable, they have been a junior partner in several government coalitions.Merkel’s most obvious associate is now the Social Democratic Party, which also picked up seats. This election saw the center-left and center-right parties gain seats, while the more extreme parties lost them. So a national unity government seems possible.Such a combination would provide strong support for the Euro. While there is still considerable skepticism regarding bailouts—the anti-Euro party gained share, but no seats—a CDU-SPD government would have enough votes to amend Germany’s constitution, if necessary, to sustain the common currency.The Euro has always been a political project. Germany’s voters just gave Merkel—one of the currency’s most powerful sponsors—the political strength she needs to keep the project alive.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpddirect: 603-252-6509 reception: 603-224-1350www.chartertrust.com • www.moneybasicsradio.com • www.globalmarketupdate.net

Why don’t wages fall during a recession? That’s the question a lot of economists ask when there’s a downturn. After all, the theory goes, if employers cut wages, their profits would go up they wouldn’t have to fire people. And if workers didn’t like the wage cuts, the recession would make it difficult for them to find a job elsewhere.A researcher from Yale went out and interviewed over 300 employers, labor leaders, unemployment counselors, and business consultants and asked just this question. The answer: businesses are obsessed with morale. If they cut compensation, workers get discouraged and resentful. And bad morale leads to poor worker productivity. Unhappy workers are not productive workers.All kinds of schemes have been tried, like cutting wages for new hires, or replacing the entire workforce with a new one at a lower wage scale, but inevitably these schemes fail. Productivity depends on trust, and an employer that takes advantage of its workers when the economy goes south won’t get any extra effort from its workforce.Culture matters and a healthy culture depends whether people think they’ve been treated fairly. When a company starts cutting nominal wages, watch out.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpddirect: 603-252-6509 reception: 603-224-1350www.chartertrust.com • www.moneybasicsradio.com • www.globalmarketupdate.net

Is the Fed having difficulty making up its mind?When the Fed announced that they would put off changing their asset purchase plans, I wondered if Ben Bernanke was playing Hamlet: “To taper or not to taper, that is the question.” All along, he and the other governors have been uncertain as to what they might or might not do, because the economy is uncertain.It reminds me of Shakespeare’s great play, where the hero learns that his uncle had murdered his father in Act I, and is ready to kill his uncle in Act III, but at the last moment puts up his sword because the time isn’t right. Indecisiveness proves to be Hamlet’s undoing.Is indecisiveness plaguing the Fed? We’re certainly seeing it in other branches of government: Larry Summers will be the next Chairman, then Janet Yellen will; we’re about to bomb Syria, then we aren’t; the House will vote to de-fund Obamacare, or won’t. Everyone’s getting into the act.But indecision breeds uncertainty, which isn’t good for the economy or for markets. There may have been a relief rally in stocks and bonds on Wednesday, but it’s unclear how long it will last. It is hard for managers to move forward when they don’t know what will come next out of Washington.And where will this lead? Hamlet postpones action in Act III, and Act V doesn’t end well. Let’s hope the Fed’s irresolution doesn’t fall on all our heads.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpddirect: 603-252-6509 reception: 603-224-1350www.chartertrust.com • www.moneybasicsradio.com • www.globalmarketupdate.net