Thursday, March 11, 2010

Yield not to temptation

Guambat never even took an introductory class in physics, so as best as he can understand it, according to the theory of relativity, so long as we're all going hell to beat leather, it looks to each of us as if we are all standing still.

And to investment managers, that's a nightmare. No matter how fast they can make their money grow, it ain't good enough unless it beats the other guy.

Their focus is relative growth, to prove that the nominal growth they get from doing what all the others are doing is worthless, even if those others are behaving prudently or wisely.

Absolute growth or return is unworthy so long as better relative growth or return is achievable. It sort of throws out any notion of all the other theories of portfolio management in favour of blinded one-upmanship.

And the way they measure their relative performance is usually by means of standard deviations. And, as Nassim Taleb reminded us over and over and over again, standard deviations do not account very well for the non-standard black swan, which is itself a fairly standard event.

This, of course, is old hat. It was all the talk around the tables a couple of years ago when the stock and credit markets fell into a deep hole, marked if not caused by the subprime bust and extended credit implosion. But that's all forgotten now that everyone has been bailed out by the governments around the world, right?

The overwhelming common denominator in that credit collapse was the extent to which market participants pushed aside notions of absolute returns, ignoring what is reasonable, in a mad reach for relatively higher yields, ignoring what is foolhardy.

And as Bloomberg, Barry Ritholtz and FT Alphaville have brought to our attention, the credit markets have not learned anything much from that experience.

Investors in search of better returns poured $7.8 billion into high-yield municipal bond funds last year, pushing assets to a two-year high.

Below-investment grade munis are typically issued by companies raising debt through a municipality for a project with a public interest such as hospitals, nursing homes, housing developments and sports stadiums, said Eric Jacobson, director of fixed-income research for Morningstar Inc. [In other words, these projects don't have a lot of money backing them or expected to flow from them.]

High-yield municipal bonds rated BB+ or lower by Standard & Poor’s or Ba1 by Moody’s Investors Service, one level below investment-grade debt, have returned about 31 percent in the last 12 months compared with 11 percent for investment-grade municipal securities, according to the indexes from S&P/Investortools.

High-yield municipal bonds due in 8 years to 12 years were yielding an average 6.63 percent last month, almost double the 3.42 percent on similar maturity bonds in the broader tax-exempt market, according to Barclays Capital indexes. The average dividend yield on a stock in the Standard & Poor’s 500 Index was 1.98 percent on March 9 and the average interest on a taxable money market fund was 0.02 percent as of March 2.

U.S. state and local government tax revenue fell 6.7 percent as of September from a year earlier, marking the fourth consecutive quarter of decline, according to a December Census Bureau report. That may drive defaults higher this year and next, according to Moody’s, which didn’t provide a number.

The risk of municipal-bond defaults in the future is “higher than it’s been in quite some time,” said Deutsche Bank’s Pollack, because of the unprecedented stress on state and local budgets. From 1970 to 2009, the average five-year default rate was 3.43 percent for speculative-grade debt, Moody’s said. Harrisburg, the capital of Pennsylvania, has considered filing for reorganization under Chapter 9 of the U.S. bankruptcy code as it faces $68 million in debt.

About $2.4 billion of Florida’s so-called dirt bonds, or debt to finance real-estate developments, used reserves or failed to make interest payments in November, up from $1.7 billion in May, according to Interactive Data Corp. That’s the largest amount on record and “reflects an increasing trend,” said Edward Krauss, an analyst for the Bedford, Massachusetts- based research firm, in an e-mail.

Taxing Authority

State and local governments can raise taxes and cut services to continue to pay the interest and principal on their debts, said Scott Cottier, who oversees the $6.4 billion Oppenheimer Rochester National Municipals fund of New York-based OppenheimerFunds Inc. It had a 44 percent total return in the past 12 months, the most among high-yield municipal funds, according to Morningstar.

“The fear of defaults is over-baked in the muni market,” Cottier said.

Here, Guambat would like you to refresh your coffee or drink, lie back and think of California, and reflect on a couple of posts from the last few months:
Deleveraging by default and
Oregon tosses out the first snow ball??

Barry Ritholtz
One of the factors that caused the great credit crisis to spread far and wide was the “reach for yield.” This is one of the most expensive ways a fixed income investor can obtain a higher potential return on their bond investments.

Note that I used the term “higher,” not “better,” and the word “potential,” not “actual.”As we have seen, high yielding junk paper often goes bust, making the yield grab an exercise in foolish futility.

Rather than accept ultra low yields as a consequence of Federal Reserve action in 2001, bond buyers poured into various mortgage backed securities. Even though they were paying 250 to 350 basis points more than Treasuries, they were rated the same: AAA.

This time, they are eschewing the fraudulent AAA ratings from Moody’s and S&P, and instead are buying naked junk. The bet is that the cities will be bailed out, and their grab for higher yield will be safely rewarded.

FT Alphaville:
while [the Bloomberg piece] does quote bullish opinion on state and local governments’ ability to keep paying interest and principal on their debts… we note that much of that opinion comes from high-yield fund managers.

Oh dear.

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