Charter Trust - Global Market Update

Credit risk counts.Corporate bonds are not Treasury bonds. That seemingly trivial observation explains not just credit losses, but a lot of price action. Corporate bonds carry interest rate risk and default risk. When an issuer’s chance of default is trivially low—like the recent Apple deal—almost all the price changes will come from movements in Treasury rates. But when an issuer is less creditworthy—like JC Penny, or Cooper Tire—then some of the price movement is attributable to credit changes. Ironically, this source of risk can reduce bond price volatility. That’s because if rates rise while corporate health improves, credit spreads will narrow. That means that Corporate bonds prices will fall less than Treasury bond prices. Conversely, if the economy weakens and rates fall, spreads on lower-rated Corporates will widen, and their prices won’t rise as much.So while Corporate bonds unquestionably bear credit risk, their spread activity—as a group—usually will reduce how much their prices vary. By some measures, practically, that means they’re less risky. Less risk with more return—this is a winning combination. Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpd

How do you control credit risk?Everything carries risk. People understand this intuitively, but they are notoriously bad at evaluating risk. For example, many folks are afraid of flying, but typically the most dangerous part of air-travel is the ride to the airport. In the same way, after Jaws came out people became much more aware of the risk of a shark-attack, but the most dangerous item in the book and the movie was the air-mattress one young boy was swimming on. Drowning kills lots more people than shark-bites.In investing, it’s important to quantify the risks and the returns that we expect from our investments. With the Fed engaging in “financial repression,” essentially artificially supporting the economy on the backs of savers, we can’t build a Treasury bond ladder and expect real returns. But by taking prudent credit-risk, investors can maintain their income.The key is to quantify the risk. I’d discussed in the past how credit hangs on five fundamentals: liquidity, solvency, efficiency, credibility, and growth. By watching these factors—and especially their trends—careful bond buyers can add to their returns.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpd

What is credit risk? The short answer is, credit risk is the risk that you won’t get your principal back. When you buy a corporate bond, you’re giving money to a company in exchange for a promise to give you money in the future. The time of repayment is usually fixed and contractual—the company can’t reduce or eliminate payments to its creditors without going through bankruptcy, which usually means stock-owners get wiped out and management loses their jobs.That’s why companies are usually pretty willing to meet their bond obligations. Not doing so can be a disaster. But whether companies are able to pay is another issue. The risk of non-repayment is embodied in the spread between Treasuries—the risk-free rate—and corporate bonds.The spread gets wider as credit risk goes up. Ba-rated bond, which are just below investment-grade, yield around 3.5% more than Treasuries. Caa-rated, a much lower grade, yield almost 9% more. This implies a 30% chance of loss for Ba-rated bonds, and a 50% chance for Caa-rated bonds.The risk of loss is built into these spreads. With investing, you never get something for nothing. But by doing your homework you can manage your risk and add to your return.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpd

How can income-oriented investors survive in today’s climate?With the Fed keeping rates near zero seemingly forever, it’s hard. Many investment portfolios grew during the ‘80s and ‘90s and stagnated during the ‘00s, but now investors need their portfolios to produce income.In the past we’ve encouraged an all-of-the-above approach that uses corporate bonds, dividend-paying stocks, long-dated municipal bonds, and even limited partnerships to replace the income that formerly came from a simple ladder of Treasury Notes. We live in interesting times; what worked before may not work anymore.Corporate bonds are particularly interesting. Unlike equities, they represent a contractual claim on cash, and so they are likely to be less volatile than stocks. But by taking some credit risk, investors can generate more income. That’s important, because “safe” Treasury Notes now yield less than inflation—so they are guaranteed to lose money in real terms.Every investment carries risk. If we understand the risks we’re taking, and choose wisely, our investments should be able to meet our needs.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpd

Will bonds ever return to “normal?” It’s a good question. For over four years the Fed has kept short rates near zero. With inflation running at 2% and the Fed’s target at zero, short rates have become a black hole, from which nothing seems to emerge. Long rates have drifted inexorably towards the event horizon surrounding the Fed’s short-rate singularity. But all things—even black holes—eventually come to an end. The Fed currently projects that the economy will gradually heal, and that unemployment will move below 7% by the end of 2014, and below 6% in 2017. Charles Evens, President of the Chicago Fed, has proposed that the Fed keep rates low and the QE flowing until unemployment gets below 6.5%. That would be sometime in late 2015—but of course, the further out the forecast, the greater the uncertainty. Still, it’s useful to know current expectations. So far, the Fed’s monetary spigot has kept the economy moving. It looks like it will be a while before they take that punchbowl away. Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all! Follow me on Twitter @GlobalMarketUpd

Every decade there’s a new star. And every decade, it starts with skepticism. In the ‘70s it was gold; the ‘80s had Japan; the ‘90s saw the Nasdaq; and the ‘00s had China. These markets rallied some 10-fold during their heyday. What’s next?One approach is to look for the asset that no one wants. In the early ‘80s Japan just made cheap electronics and small cars; in the early ‘90s no one wanted US stocks. Both Japan and the US started with financial crises. So which market gets no respect, today? My money is on Europe. The problems with the Euro are well-known: the industrialized north is growing at the expense of the service-oriented south, and financial and economic tensions are ripping the Euro apart. If the currency fails, all bets are off.But all this is priced into the markets. Sir John Templeton once said that bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria. The best time to buy is when pessimism is strongest.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpd

Who’s right? Stock prices have been rising, which usually predicts a rising economy. At the same time, bond yields have been falling, which usually goes means trouble ahead. Which is it? Maybe it’s neither. Prior to the European Central Bank announcing last spring that they would do “whatever it takes” to defend the Euro, the global economy was characterized by slow growth and high instability. Investors were preoccupied with a potential repeat of 2008, of the “Lehman moment” that almost precipitated Depression 2.0. Fears of a “double dip” were rampant. But the ECB’s policies have reduced the risk of catastrophic failure from the European banking system for now, with its attendant threat of financial contagion. The equity risk premium has fallen globally, so equities have risen. But the underlying growth in the world’s economy remains low and slow. Stock prices have gone up on a lack of fear; bond yields have fallen with the global savings glut. There is no inconsistency. Markets alternate between fear and greed. We’ve been leaving the fear behind. Are we greedy yet? Time will tell. Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all! Follow me on Twitter @GlobalMarketUpd

Why is the Chinese economy slowing?China’s GDP growth has slowed from 9% per year to 7.5%. Their torrid growth has produced tycoons in real estate, manufacturing, and financial services. Indeed, many have suggested that there are bubbles in these economic sectors, and that China’s slowing growth may pop the bubble.China’s average savings rate is around 50% of the economy—compared with around 5% in the US. This allows Chinese businesses to capitalize on profitable opportunities at the drop of a hat. But this can create over-capacity. Their steel industry is an example: China can now produce up to 900 million tons a year, while the most it needs right now is 625 million tons.A high savings rate goes along with a high investment rate—and some of those investments are bound to be duds. Unless the central government loosens the reins and lets businesses make their own decisions, those mistakes will just get bigger and bigger. Only the free flow of capital and ideas can allow them to adapt and avoid colossal waste. Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpd

Are we saving too much?That’s what it seems like, at least in the larger economy. Corporations had a near-death experience during the Financial Crisis, when the money market dried up. Since then cash balances have soared while capital expenditures have shrunk. Ditto for consumers. Excluding student loans, consumers have consistently deleveraged every year since the crisis.As a consequence, there is a savings glut. This is one reason why interest rates remain low, in spite of the Federal Government’s record borrowings. And if everyone else is saving, government dissaving is the only way to keep the economy growing. Otherwise, either the economy shrinks or prices fall. That’s one reason why fiscal austerity in Europe is deepening the recession over there.The problem with government spending isn’t the spending so much as the government. Give someone a blank check and a broad mandate and fraud and abuse will arrive like ants at a picnic. The question is what to spend on: there are economically beneficial projects, but there’s always a gravitational pull towards wasteful cronyism.That’s why private investment is more efficient than public spending. Only it’s not here yet. When your only tool is a hammer, it’s better to use it than let it sit in the toolbox.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpd

Why should the markets celebrate Easter?On Friday our stock market was closed for Good Friday. Today most of Europe is closed for Easter Monday as well. Long weekends are a nice break from the daily grind, and allow people to spend time relaxing and reflecting. But why do we do this?Easter is of course a Christian holiday, celebrating the story of Christ’s resurrection. The European and American markets, with their western roots, respect this tradition. The word “Easter” is Germanic, and appears to stem from Eostre, an Anglo-Saxon dawn goddess—who was also associated with spring and rebirth. (Most scholars do not think it derives from Istar, the Babylonian goddess of love, war, and sex.) In its early years Christianity adapted to local customs and cultures.Without getting into the religious issues, renewal and rebirth are good things. We’ve seen companies reinvent themselves in order to adapt to new circumstances. IBM has gone through at least three different incarnations during my years in the market, and the entire market has changed many times: in the late ‘70s stocks were dominated by the oil-patch, in the ‘80s we were all turning Japanese, the ‘90s were the go-go internet era, and the ‘00s were dominated by the Financial Crisis and Great Recession.Success breeds failure and failure breeds success as capital seeks returns. As long as the earth keeps spinning and cash keeps flowing, we’ll continue to see new life. Long live the bunny! Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpd

Does Europe have its own Tim Geithner? In January I asked rhetorically whether Jeroen Dijsselbloem was up to the task of leading the Euro Stability Group during these tumultuous times. It turns out we may have an answer, and it isn’t good. To deal with its banking crisis, the President of Cyprus proposed taxing all deposits—even small deposits. Over Dijsselbloem’s objections, this plan was aired last week. After being voted down, it was back to the drawing table—this time directly with Europe’s “troika,” cutting Dijsselbloem out of the process. Then, when the group came up with an approach that kept small deposits whole but could wipe out some large depositors, he called it a “template” for the future. Not good. If you want to maintain faith in the rest of Europe’s banks, telling large depositors that they might get nicked isn’t wise. He was immediately slapped down by other leaders, who said flatly that his comments were wrong. For years Tim Geithner was the whipping boy for the Obama Administration, taking flack when its policies failed to revive the US economy. With his clumsy comments and awkward negotiation style, Dijsselbloem may play the same role over there. Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all! Follow me on Twitter @GlobalMarketUpd

So when are acquisitions justified? We’ve all seen the compulsive, serial acquirer. Sometimes they’re justified—like when they’re in a disaggregated, fragmented industry with small, inefficient players. By rolling these up, the acquirer can offer better prices to customers, a simpler outlet for suppliers, and a growing revenue stream, earnings yield, and stock price. Such Borg-like M&A machines plow through an industry saying, “You will all be assimilated.”But more often than not serial acquirers are serial value-destroyers, who need to be stopped before they kill again. In these cases the CEO gets rich, the acquired company cashes out, and stockholders get—nothing, or worseBut there are acquisitions that make sense. They’re the small bolt-on or tuck-in variety that adds new technology, or a new product, or a new service to the mother-ship. In these cases defections and culture aren’t an issue, since the parent is purchasing the boutique specifically for its people and products. In these cases, value is created as a strong offering gets distributed more widely.But such an approach is a lot of work, and can’t be analyzed on the golf course between rounds. Maybe that’s why it’s so rare.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpd

Why do companies acquire other companies?Imagine this: you’re CEO of a fairly successful company. Your cash-flow margin is solid, and your sales are growing. You’re hiring new people, integrating them into your culture, increasing your dividend, and gradually expanding. Life is good. You only have one problem: your cash-hoard keeps growing.Normally, that’s not a problem, or at least, it’s better than the alternative. But eventually that cash calls to you, telling you that it wants a new home. What do you do?If you’re like many CEO’s, a major acquisition might be in store. Buying someone else out can instantly expand your top line, promise you operating synergies, and—since you’re now CEO of a bigger company—expand your personal compensation as well. What’s not to like?Consider: bought out firms usually lose their top engineers and sales people, because the new parent almost always favors its own people. Cultures are hard to merge; people do things for a reason, and they resist change. Big deals attract big competition, and often big scrutiny from government and industry watchdogs.These are all reasons why the synergies from large acquisitions never seem to live up to the hype. But small acquisitions—they’re another story.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpd

Is gold money?That’s the question Ron Paul asked Ben Bernanke a couple years ago when he testified before the House Banking Committee. Rather than lecturing the congressman on the proper role of a central bank in a modern welfare economy, Dr. Bernanke punted, feigning surprise at the question, graciously letting Dr. Paul pontificate on the manifold virtues of the yellow metal.In any economy, money serves three functions: a store of value, a medium of exchange, and a unit of account. In the US the only tool that satisfies all three is our fiat currency, the dollar. But 90 years ago, that wasn’t the case. People regarded gold as money. If folks had a $20 bill, they’d probably take it to the bank to see if they could exchange it for “real” money—gold. Kind of like the way we look at a personal check. Now, we take a check to the bank and see if we can exchange it for “real” money—cash. Money is the ultimate social network. It ties people together who might not have anything in common except a desire to effect a transaction. And our social fabric has changed. After a century of depression, recession, inflation, and regulations and executive orders, cash is king. There’s nothing more liquid.Gold used to be money, but it isn’t any more. What it really is today is a symbol—of stability, value, and perhaps a bygone era.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!Follow me on Twitter @GlobalMarketUpd

Could Cyprus happen over here? Many folks look at their problems and say, “Nah.” We don’t have an outsized banking system mostly funded by foreigners, and we’re working with our worst problems. Meredith Whitney was wrong; the muni market didn’t see dozens of major bankruptcies with hundreds of billions of losses, right?Well, maybe.One glaring issue in an otherwise sound municipal credit universe is Puerto Rico. The Commonwealth has a population of 3.7 million, of which only about a million have jobs, and over 40% of which lives below the poverty line. Its public debt is enormous: almost $68 billion, or more than $18 thousand for every man, woman, and child. By contrast, the most indebted US state, Connecticut, has $5400 per person in debt.But the main problem in Puerto Rico is the pension system. Many states have underfunded their pensions—New York by 10%; Massachusetts by 27%; New Hampshire by 42%, which is pretty bad. But Puerto Rico’s pensions system is 93% underfunded, and probably will run out of cash sometime in 2014. When that happens, look out!Because Puerto Rico bonds are tax-exempt in all 50 states, they are widely held in many state-specific and national tax-free mutual funds. But the Commonwealth’s fiscal difficulties have them dancing with a downgrade. Both Moody’s and S&P have PR on the edge of a junk bond rating; if they do become non-investment grade, there will be a lot of soul-searching and forced selling by muni investors. Is Puerto Rico too big to fail?Any default is unlikely—the Commonwealth is constitutionally required to satisfy their debt obligations before paying anyone else. The problem is that over 40% of the labor force works for the government. Are they going to stand in line behind Nuveen and Fidelity? And if the island does default, it will shock the financial world.Think Cyprus can’t happen over here? Think again.Douglas R. Tengdin, CFA Chief Investment Officer Hit reply if you have any questions—I read them all!