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Chart of the Day – Continued Strength in Economic Data

This morning, the Institute for Supply Management reported that The ISM Non-Manufacturing Index, which includes prices paid for all purchases including import purchases and purchases of food and energy excluding crude oil, showed the strongest print since August 2005.

ISM Highest Since 2005

Why Do investors care? Here’s the explanation courtesy of Econoday:

Why Investors Care
Investors need to keep their fingers on the pulse of the economy because it dictates how various types of investments will perform. By tracking economic data like the ISM non-manufacturing survey’s composite index, investors will know what the economic backdrop is for the various markets. The non-manufacturing composite index has four equally weighted components: business activity, new orders, employment, and supplier deliveries. The ISM did not begin publishing the composite index until the release for January 2008. Prior to 2008, markets focused on the business activity index. The stock market likes to see healthy economic growth because that translates to higher corporate profits. The bond market prefers less rapid growth and is extremely sensitive to whether the economy is growing too quickly-and causing potential inflationary pressures. While the ISM manufacturing index has a long history that dates to the 1940s, this relatively new report goes back to 1998.

Frequency
Monthly.

Source
Institute for Supply Management.

Availability
The third business day of the month.

Coverage
Data are for the previous month. Data for June are released in July.

Revisions
No.
Definition
The non-manufacturing ISM surveys nearly 400 firms from 60 sectors across the United States, including agriculture, mining, construction, transportation, communications, wholesale trade and retail trade.
Posted by John Adams on February 3, 2011 under Economics,Educational,Fed Watching
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Fear Higher Rates? Buy Individual Bonds Instead of Bond Funds

July 12, 2010

As we have discussed, bonds have outperformed stocks not only in 2010 but also on a longer term basis.  For 2010, Bonds as represented by the Merrill Lynch U.S. Corporate Index and the U.S. Treasury Index gained 6.1 percent and 5.9 percent, respectively.  Comparatively, equities, as measured by the S&P 500, have lost 7.6 percent for the year.

Over a longer period of time, the picture doesn’t really change much.  Trailing five-year performance for stocks stands at a total return loss of 13.5 percent while corporate and Treasuries gained 28.6 percent and 30.2 percent, respectively, over the same time frame.  To rub salt on the wound for stocks, even the high yield sector aka “junk bonds” outperformed its equity counterpart.  The Merrill Lynch High Yield Master Index gained 40 percent in the past five years.  Keep in mind that this impressive gain includes a period where spreads reached astronomical levels and well into the triple digits during the height of the financial crisis and recession.

Despite the fact that rates are low, bondsquawkers will be the first to tell you that we think the recent rally in the bond markets has some legs to it and rates could head even lower.  However and as is the case with a good money manager, it would be imprudent for us to not consider the alternative since it is our philosophy that discipline should always trump conviction, especially in this volatile market.  Without question, risk management should be the top doctrine for any investor.  With that in mind, Barron’s posted an article as its cover story, on preparing for a rise in yields, whether that’s now or years from now.

Although there’s scant evidence rates are about to jump sharply, bond-fund investors should realize that their risks rise as yields fall. They should make sure they know where the safest exits are. Among many alternatives to avoid rate shock: replace some bond-fund holdings with actual bonds to avoid getting trampled as fellow shareholders sell; diversify your fixed-income portfolio so you’re not too exposed to volatile, rate-sensitive areas; shorten the maturities of your holdings now (or possibly create a “bond ladder”) to make more money available to invest later as the economic outlook clears; buy variable-rate items and possibly snap up securities whose payouts are tied to other types of assets. You should also seriously consider moving some money into creditworthy big-cap stocks that pay healthy dividends.

NERVOUS INVESTORS SEEKING TO preserve their wealth and pick up yield have swarmed into fixed-income funds in the past two years. U.S. taxable bond funds saw estimated net inflows of $152 billion year-to-date through July 7, according to Lipper FMI. In 2009, the full-year total hit $384 billion (see chart, Taxable Bond Fund Flows). To put those figures into perspective, U.S. equity funds saw just $24 billion of inflows through July 7 and only $5 billion for all of last year.

Last week, we wrote that there is no bond bubble due to the fact that inflation is practically non-existent and that there is no evidence of an imbalance in demand as consensus forecasts are for higher rates.  Despite this, the Barron’s article reveals that Marilyn Cohen from Envision Capital Management argues that there is a bubble, which stems from her perspective of the tremendous inflows into bond funds.  The increase of fund flows, which is usually dictated by past performance and not future outlook ,may spell doom for many investors if rates rise.

The worry is that a pre-emptive monetary tightening by the Federal Reserve, as in 1994, or possibly a big sovereign or corporate default could send much of the bond throng to the other side of the boat. Bond prices would swoon, as they did 16 years ago. Any whiff of inflation—stemming from the Federal Reserve’s massive easing, the Obama administration’s ambitious stimulus and social spending programs, as well as the huge Treasury Department borrowing needs—would spook the whole market. Other countries around the globe, like the U.K., have even more pressing needs for funding.

An interest-rate rise of 1½ percentage points, particularly at these low levels, can be devastating. Take pharmacy retailer CVS Caremark (ticker: CVS). Its 4¾% bonds due May 18, 2020, were recently quoted at a price of 103 to yield 4.372% to maturity. It’s a $450 million investment-grade issue with a solid triple-B-plus rating. But Cohen says it could fall to 92 cents on the dollar and yield 5.871% under the higher rate scenario. That would be an 11% price loss.

To avoid having to sell into such a decline is one reason it’s prudent—if you have the money—to hold at least a portion of your portfolio directly in bonds, rather than shares in a fund. An individual bondholder isn’t forced to dump securities in a falling market, as a fund portfolio manager must when redemptions mount and he needs cash on hand to meet them. The individual bondholder can ride it out, collect his interest and wait until the bond is called by the issuer or matures, to get back all of his principal. Because he owns shares in a fund rather than bonds, a bond-fund investor is stuck: Either he has to bail out or take his lumps as the decline in the value of the fund’s holdings cascades. There is no repayment of principal in a bond fund.

A bond fund can also seem expensive at these rate levels. A typical fund might have an expense ratio of about 1% while providing a return of 3% or 4%. The means your paltry gain is being sliced still thinner.

The article also adds that owning your own bonds is accessible for many investors.

WE’RE NOT SUGGESTING YOU plunge into emerging-markets debt on your own or start swapping high-yield bonds from your desktop computer. Envision’s Cohen, who works with 45 brokers, advises do-it-your-selfers to consult more than one broker to get the best information and prices on bonds. The most popular bonds for retail buyers are typically tax-exempt municipals, Treasuries, Federal agencies and some utility issues. Experts say an individual with an investable portfolio of $500,000-$1 million has the financial wherewithal to own bonds directly.

Another strategy in minimizing the damage done in a rising yield environment is being mindful of your interest rate risk aka duration.  In addition, an investor can create a bond ladder strategy for their portfolio.

A popular strategy of investors who own bonds is building a bond ladder—staggering maturity dates so as not to get locked into a particular bond for a long period and face the full blast of increasing rates. In the meantime, you’re getting steady cash flows. As, say, an existing 10-year bond approaches maturity, a new 10-year bond could be placed at the top of the ladder.

For more information on both duration, as a tool for investors, and bond ladder portfolio strategies, visit Bondsquawk’s Bond School.

After all that is said and done, the Barron’s author suggests that fears of a violent move toward higher rates fueled by rampant inflation may be unfounded.  Furthermore, in the event that inflation rears its ugly head, the risks for such an environment may be manageable for investors.

OF COURSE, THE WORRIES ABOUT the effects of massive government spending and borrowing—serious as they are—are just that at the moment. Recent government data strongly suggest that a surge in rates isn’t right around the corner. The unemployment rate remains stubbornly high at 9.5%, housing prices fell 3.2% in the first quarter, and inflation is running at about a 2% rate. Economic conditions are “likely to warrant exceptionally low levels of the federal-funds rate for an extended period,” as the Federal Reserve’s monetary policy-makers, the Federal Open Market Committee, put it after their recent meeting.

And even if rates do go higher, they don’t necessarily have to go through the roof. James Kochan, fixed-income strategist at Wells Fargo Funds Management Group, says a measured move is more likely. “With the 10-year [Treasury] in the 3% area, and the yield curve so steep, I don’t think it will go much above 4%,” he says. “There’s a cushion for long maturities.” Just because the Fed notches rates up doesn’t mean that all maturities of debt have to move in step. From 2004 to 2006, when fed-funds went from 1% to 5¼%, longer Treasuries hardly moved, Kochan notes.

Still, the longer-term effects of such a huge increase in government spending and debt, not just in the U.S. but worldwide, are pretty well documented. Eventually inflation—and interest rates—go up, too. Better to hedge your bets now than to get run over by the bond-fund crowd later.

Posted by Rom on July 12, 2010 under Bond Chatter,Bond Trading,Educational
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Fixed Income Portfolio Management 101: An Introduction

Constructing an effective investment portfolio requires much more than just assembling a selection of investments- it requires careful planning, research, and discipline.

Preliminary Steps

Before any investment decisions are made, it is important to give careful consideration to the following items:

Investment Objectives

As in most endeavors, setting goals is an important part of the process of creating an investment portfolio.  After all, it’s very difficult to get somewhere if you have no idea where you are going.  Investment objectives are the goals that every investor should consider when creating a portfolio.  Investment objectives should not only be identified, but prioritized as some goals may conflict with others.

Read more.

Posted by Ray on April 29, 2010 under Educational
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Municipal Bonds 101

Introduction

Municipal bonds (referred to as “munis”) play a very important role in the national economy by providing financing for public projects and allowing municipalities to create and maintain important infrastructure projects.

The tax advantages of municipal bonds make them very popular with investors, but the large number of bond issuers and types can be confusing to the uninitiated.  This lesson is designed to clear some of that confusion and provide a basic understanding of the characteristics, advantages, and risks of municipal bonds.

Characteristics of Municipal Bonds

Like all bonds, municipal bonds is a loan made by the bondholder to the issuer that will be paid back at a specified time (the maturity date) and pays a specified rate of interest (the coupon rate).  Most municipal bonds mature from 1 to 30 years but some bonds have been issued for longer periods up to 100 years.  Municipalities also issue short term instruments (less than thirteen months to maturity) that include notes and commercial paper.  Municipalities also issue floating-rate and zero coupon securities.  Municipal bonds are typically issued in denominations and multiples of $5,000.

Read more here.

Posted by Ray on April 27, 2010 under Educational
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Fixed Income Portfolio Management 101

Bond Ladders

One very popular and effective way to create a bond portfolio is to create a bond ladder.  A bond ladder consists of several different bonds with differing maturity dates. For example, if one had $200,000 to invest, they could buy $40,000 in bonds that mature in 2 years, 4 years, 6 years, 8 years, and 10 years.  This would result in a portfolio that has an average maturity of 6 years.  Another possibility is to purchase $20,000 in bonds that mature each year for the next ten years, which would create a portfolio with an average maturity of 5.5 years.

More here.

Posted by Ray on April 22, 2010 under Educational
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Debt Instruments 201

In this lesson, we will delve further into the characteristics and properties of bonds and become familiar with bond related terminology.  Bonds are often referred to as debt instruments, debt obligations, or fixed income securities (despite the fact that some bonds pay variable rates of interest, or none at all).

Click Here for the full article

Posted by Ray on April 15, 2010 under Educational
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The Bond Market

According to the Securities Industry and Financial Markets Association (SIFMA), the outstanding value for U.S. debt securities grew almost threefold from $12 trillion in 1996 to more than $34.2 trillion in the first quarter of 2009.  Additionally, average daily trading volume in 2008 was $1,036.0 billion for U.S. bonds, compared to $169.1 billion for U.S. equities.  The number of bonds outstanding is:

  • Treasury: $6.63 trillion
  • Federal Agencies: $3.14 trillion
  • Corporate: $6.72 trillion
  • Mortgage-Related: $8.86 trillion
  • Asset-Backed: $2.60 trillion
  • Municipal: $2.67 trillion

Investors can buy bonds as new issues on the primary market from underwriters, or trade them with other investors through a brokerage firm on the secondary market.  Unlike stocks, the vast majority of bonds trade in the over-the-counter market (OTC), which is made up of a network of brokers and dealers.  While no large organized exchange exists for to facilitate the trading of bonds, small amounts of bonds do trade on the New York Stock Exchange, the American Stock Exchange, and the NASDAQ.

By far, the biggest investors in bonds are institutions that include banks, insurance companies, pension funds, corporations and central banks.  Individual investors account for a relatively small portion of the bond market.

The U.S. Treasury Market

The U.S. Treasury issues debt obligations that are backed by the full faith and credit of the U.S. government, making it the safest investment there is.  According to SIFMA, trading volume of treasury securities averaged over $425.1 billion a day in the fourth quarter of 2008.  The U.S. treasury market is the most efficient and liquid securities market in the world.

The Treasury issues bills that mature in one year or less, notes that mature between two and ten years, and bonds that mature between twenty and 30 years.  The treasury also issues Treasury Inflation-Protected Securities (TIPS)

New issue treasuries are sold direct to the public in regularly scheduled auctions.  Secondary market treasuries are traded through brokerage firms or dealers.

The Federal Agency Market

Government-sponsored enterprises (GSEs) issue bonds at favorable rates in order to support home ownership, farming, small businesses and public works.  Although most agencies are not guaranteed by the U.S. government, investors feel there is an implied government backing that allows them to borrow at favorable rates. Some agencies, however, do have the full-faith-and-credit guarantee of the U.S. government (Ginnie Mae, for example).

Federal Agency issuers include the Freddie Mac, Fannie Mae, Federal Home Loan Bank, the Tennessee Valley Authority, the Federal Farm Credit Bank, and the aforementioned Ginnie Mae.  Because of they have a higher yield than treasuries, but still have a high credit rating, agency securities are very popular with institutional investors like pension funds, insurance companies, banks, state and local governments, mutual funds, and investment trusts.

The Corporate Market

Because of its size, the corporate bond market is very liquid, although the amount of liquidity can vary greatly for different issuers and even between different bonds of the same issuer.  According to SIFMA, trading volume in corporate debt is estimated to be $15.1 billion per day.  Outstanding debt totaled $6.7 trillion in the first quarter of 2009 and accounted for 20% of U.S. fixed income debt.

Corporate bond financing is an important source of capital for corporations, and it has become even more important since the financial crisis has limited banks’ ability to lend.

Corporate bonds’ credit quality run the gamut from AAA rated to high yielding junk bonds, and their risk profile is much more complicated than government and agency bonds.  Corporate bond prices are determined by much more than just the general level of interest rates- the macroeconomic outlook as well as the profitability outlook for an issuer’s industry, and the issuer’s competitive position within that industry play important roles in determining a bond’s market price.  Credit rating, and expected changes to an issuer’s credit rating are also critical determinants of a bond’s market value.

Most corporate bonds trade on a dealer basis with markups (when the investor is buying a bond) and markdowns (when the investor is selling a bond).  A markup or markdown is the spread between the bid and ask price, or price that the bond is bought and sold at.  For example, a dealer may sell a bond to an investor at 102½ that they simultaneously buy from another dealer at 101½.  In that particular transaction, the dealer earned a one point mark-up.  This simultaneous purchase and sale is known as a riskless principal transaction.  Dealers also purchase bonds to hold in inventory with the hope of selling it in the future at a profit.  This type of principal transaction puts the dealer at risk, since there is a chance that the price of the bond will fall.  Corporate bonds also trade on an agency basis where the broker is acting as an intermediary between a buyer and seller without taking ownership of the bond.  In agency transactions, the broker collects a commission or fee for facilitating the transaction, instead of a mark-up or mark-down.

Although regulators introduced the Trade Reporting and Compliance Engine (TRACE) in 2002 to increase price transparency in the corporate debt market by reporting the price that bonds trade at, investors still have no idea of the dealer’s markup or markdown when they buy or sell a bond on a principal basis.  All types of bonds trade on a principal basis with a markup, but spreads are usually smaller for treasury and agency bonds.

The Mortgage Securities Market

The first mortgage security was issued in 1970 when the Government National Mortgage Association (GNMA or Ginnie Mae) packaged together mortgages to sell to investors.  A mortgage security represents ownership interest in a bundle of mortgages (usually referred to as pools).  Investors that hold mortgage securities receive a pro-rata share of the mortgage payments made on the mortgages that comprise the security.  These payments consist of both principal and interest so, unlike most bonds that pay principal in a lump sum at maturity, mortgage securities pay principal back on a monthly basis.  To the extent that some mortgages may get paid back before they are due (usually because the owner is moving or buying a different house) the cash flow and maturity of the security is uncertain.

Other government agencies that issue mortgage securities are the Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHMLC or Freddie Mac).  Ginnie Mae securities are guaranteed by the federal government, but Fannie Mae and Freddie Mac securities are not.

Not all mortgage securities are issued by agencies- private financial institutions also securitize pools of mortgages to sell to investors.  At $8.86 trillion, the mortgage security market is the largest segment of the bond market.

The Asset-Backed Market

After the success of mortgage-backed securities, financial institutions began to securitize other types of loans, including credit card debt, student loans, auto loans, and various forms of business loans.  Financial lending institutions are limited in the amount of loans they can underwrite by the amount of capital they possess.  By securitizing and selling loans and mortgages, financial institutions can raise more capital and make more loans.

The asset-backed market is one of the fastest growing sectors of the bond market.  According to SIFMA, asset-backed debt totaled $404 billion in 1996.  That number reached $2.67 trillion by the end of 2008.

The Municipal Securities Market

State and local governments issue bonds to finance the building and maintenance of schools, airports, hospitals, housing projects, utilities, transportation infrastructure and other projects.  According to SIFMA, Municipal bonds, or “munis”, trading volume averaged $21.8 billion and 43,383 trades a day in 2008.

Investors are attracted to municipal bonds because their income is free from federal income tax, and bonds issued in an investor’s state of residence are also state income tax free.  Some munis are also exempt from local city income taxes, as well.  Since municipal bonds yield less than taxable bonds of equivalent credit quality, they only appeal to investors in higher tax brackets.

Municipal bonds issue two types of bonds: General Obligation (GO) and Revenue Bonds.  General obligation bonds are backed by the full taxing power of the issuing municipality.  Revenue bonds are backed from the revenue of the project that they were issued to finance, such as an airport, toll road, or power plant.

Munis are often graded by credit rating agencies such as Moody’s, Standard and Poor’s, and Fitch and carry various degrees of risk.  Some issues carry credit insurance that guarantees both interest and principal payment in order to increase their credit ratings.

Posted by Ray on April 14, 2010 under Educational
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Up Close Look at Debt Versus Equity

As debt instruments, bonds represent an obligation of the issuer to pay the bondholder a rate of interest over the life of the investment and to repay the principal at maturity.

Equities (stocks) represent an ownership interest in the issuer, and do not represent a contractual obligation. Equity investors hope that their ownership interest will increase in value as the issuing company grows revenues and profits.

While stock issuers may pay a dividend, they do so at the discretion of the issuer’s management and board of directors. As a legal obligation, the failure of a debt issuer to pay a debt obligation would put them in default, which could force the company into bankruptcy, although this rarely happens.

Bondholders are secured creditors and are the first to be paid in the event of bankruptcy liquidation.

The hierarchy of payment in the event of liquidation is:

  • Secured Creditors (including bondholders)
  • Unsecured Creditors (typically bank loans)
  • Preferred shareholders
  • Common shareholders

Typically, there is nothing left for the common shareholders.

Posted by John Adams on April 13, 2010 under Educational
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The Carry Trade

The principal behind the carry trade is to borrow short to purchase a longer-term bond that will pay a higher rate than the rate of the short-term loan.

Dealers finance their treasury purchases by borrowing against their treasury holdings by doing repo transactions, which are essentially loans collateralized by treasuries.

The risk/reward is determined by the spread between the treasury yield and the repo rate the dealer pays.

Longer maturity bonds will trade at a greater spread because:

  • They are more price-sensitive to changes in interest rates
  • They have a longer time horizon that presents more uncertainty as to the level of interest rates.

If the Fed raises rates – a dealer could end up with a negative spread.

The two-year note is a particularly popular security for the carry trade because its yield is closely tied to the fed funds rate and it is extremely liquid.

Posted by John Adams on April 10, 2010 under BondSquawk,Educational
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Repurchase Agreements (Repos) and Reverses

Repo, short for repurchase agreement (also known as RP), is a form of short-term borrowing for government securities dealers.

In a repo transaction, the dealer sells a treasury security to investors with an agreement to repurchase the security at a later date, usually the next day, and at a fixed rate of return to the investor (the repo rate).

Repos can also be done for a longer term, such as a week or a month (this is known as term repo) or a Repo can be done on open without a fixed repurchase rate.

The rate for an open repo is most often renegotiated on a daily basis.  It is effectively a short-term loan that is collateralized by a treasury security.  The investor (lender) in the transaction is entering into a reverse repurchase agreement or reverse.

Typically, the term repo is used for both repos and reverses since the terms only refer to which side of the transaction one is on.

Dealers use repos to finance their activities because treasury securities are subject to market risk (because the price fluctuates). Due to the changing price, the investor will not lend the full value of the security.  The difference between the value of the security and the amount that is borrowed is called a haircut.

Posted by John Adams on under BondSquawk,Educational
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