It’s August in Memphis, Tennessee and the heat and humidity hang in the air as heavily as the phrase “double-dip” at an FOMC meeting. It’s so hot and wet outside that even the mosquitoes are on strike. As I walk through the neighborhood there are no people on the porches to say hello to…everyone has retreated inside air-conditioned fortresses and they are praying for November and the change in the weather that comes with it. It’s 9:00 PM and I’m sweating bullets as I walk lazily down the street with the dog and my thoughts. With weather like this it’s no wonder that music we know as “the blues” was born here.
In a way this weather is analogous to the market. The government intervention hangs so thick in the air that it affects everything…and everyone is sweating. No product is immune from the heavy hand of the Fed and the Government and investors are singing the blues. Many investors are no longer on their front porch and wanting to talk…they’ve retreated inside the air conditioned confines of the bank and find the discomfort of selling Fed Funds at 25 bps preferable to being on the front porch talking about bonds. In a way it’s hard to blame them. Nominal yield levels are so low that even I find myself periodically asking “Really? The yield is THAT low?”
From a purely investment portfolio standpoint (that is ignoring asset/liability and liquidity concerns for a moment) we are presented with an ugly set of options. The combined actions of the Fed and the Government have created an environment of low yields and high uncertainty. The Fed’s asset purchase program has crushed spreads on investments, and their monetary policy is keeping the short interest rates exceptionally low “for an extended period”.
What is an investor to do? The short answer is that it’s not much different than before…you’re just doing it at lower rates. Asset/Liability concerns are still addressed first, then liquidity, then investment structure, yield, and price volatility. We’ll talk about these a bit further down the page. Before that lets briefly look at the two issues that currently dominate the discussion.
Inflation or deflation?
Up until very recently the Fed has maintained that they are concerned about inflation. That is understandable as the Feds dual mandate says they must maintain maximum employment and price stability (i.e. they must keep inflation in check). From the outset of this business cycle the Fed has focused exclusively on inflation and virtually ignored the “D” word…Deflation.
In fact we’ve asked some very pointed questions of the Fed Presidents that we’ve been able to corner. It’s always a bit funny to me that Fed Presidents show up at meetings such as the Economic Club of Memphis and they get the usual cabal of business owners who have general concerns about the economy but really don’t have enough knowledge to launch a serious question. Then we come in. Sometimes I’m there by myself…other times there will be a whole table of us…Fixed Income Salesmen.
Oh, they must loathe us. We have the knowledge to ask some tough questions and we have absolutely nothing to lose by asking them. So…if we rewind the tape a few years we find ourselves at a meeting where Fed President Sue Bies is the speaker. I worked for Sue a number of years ago and it was good to see here come back to Memphis. With the formalities and dinner out of the way we got on with the speech and the Q&A.
After a bunch of softball questions from the crowd Sue recognized our table to provide the next question. Will Taylor, Director of our office launched one at her. He asked her what the Feds plan was for deflation. The room was silent and our Fed official verbally parried and spun past the question and returned an answer about inflation, then she tried to move on to the next question. Before she could do that Will pounced on her with a clarification that he had asked specifically about deflation not inflation and he wanted to know what the Feds plans were to combat this threat if it were to materialize. The short answer was that the Fed had no plan to combat deflation…then the answer returned again to inflation. She moved on to the next question and we stared at our mass produced desserts and banquet hall coffee and cogitated on our newly found knowledge that the Fed had no plan they could implement to combat deflation. It was a sobering moment.
Over the next several years the Fed would continue to ignore deflation as a threat and focus instead on inflation. By most measures we don’t have an inflation problem on our hands. The one exception I can proffer immediately would be that of hot wings. I was driving home the other night and I passed a guy on the sidewalk waving a sign that said “50 cent Wings.” I said out loud “wow…I remember nickel wing night.” I couldn’t bear to ponder what a bucket of beer would cost at that joint.
So to say there is no inflation anywhere would be incorrect. However…on average we’ve had disinflation for a period of time followed by very subdued inflation currently. The Fed would love nothing more than for some inflation to pop up. It’s the easiest thing in the world to fight…you just raise rates...and since they are starting at zero percent the Fed really has a lot of ammo with which to fight the war on inflation.
Deflation however is another story. How do you combat falling price levels? This is a very dangerous thing as it relates to entities that are highly leveraged. In this situation the value of the asset falls but the value of the debt you hold remains the same. You become more underwater as deflation sets in. As prices fall you become less and less able to liquidate the asset to discharge the debt. Margin calls come next as your LTV numbers get out of whack, then comes the forced selling which causes prices to decrease at an even faster rate, which in turn worsens your debt ratios which triggers even more margin calls. This is what Irving Fisher called the Debt-Deflation spiral and his works conclude that this ends only after an almost universal bankruptcy.
His solution is to “re-flate” asset prices back to the levels at which the debt was contracted on them. The implication there is for the government to spend their way out of deflation…or monkey with the system to get prices back to where they were before deflation set in. There are no pretty solutions for deflation. So far we’ve seen the government do a little of both (think huge stimulus bill and mortgage modification programs).
What do you do?
If your outlook is for inflation then you buy short maturities or floating rate bonds. As bad as bond yields are they are almost universally better than the rate offered on Fed Funds. Make sure you have you’re A/L and liquidity bases covered and then make sure the bonds you are buying match your outlook on rates. If you are having trouble coming to a decision on an interest rate forecast you might start with the monthly survey data that I put out and make changes from there.
If your outlook is for deflation then you buy the longest bonds you can find. Most banks can’t execute a “best case” plan for deflation because the ultimate bonds for that scenario would be the longest final maturity, lowest coupon bonds you can find. We’re talking something like a 30 year zero-coupon bond. First of all you’d have to have the ability to buy such a product…and not many banks do. Secondly you’d have to have the guts to buy such an instrument…it could easily turn into accidental suicide.
If you are wrong on the “deflation/longest maturity you can buy scenario” then you are very…very…wrong. You are the type of wrong that gets your name on a billboard in town with bad words printed underneath. You are the type of wrong where everyone who works at the bank ever again will be told the story of how wrong you were. It’s the kind of wrong that has you saying things like “it seemed like a good idea at the time” as you cry in your beer and tell the bartender how you were so right until the impossible happened. Lucky for us we all have policy constraints that would keep us from embarking on such an ambitious plan even if it were to come to us.
The real point here is that if your forecast is for deflation then you need to be extending duration. Buy longer product that has call protection. This will provide higher yields (yes…current yields will seem high if deflation visits us), large gains, and will insulate you from having to make reinvestment decisions on those dollars in a deflationary environment.
What is the definition of risk?
A long time ago I read that a good definition of risk is that more things can happen than will happen. The point of a risk manager is to navigate through this uncertainty. Generally this involves not making any big bets one way or the other. If the ship is properly loaded you can take some waves and not capsize. If on the other hand you have loaded the boat all to one side you stand a good chance of losing the ship when you encounter the wrong wave, wind, or current.
So we start Asset/Liability management. Once we have our earnings insulated from adverse interest rate moves we can move on to liquidity. After we establish that we’ve got the necessary liquidity to fund our upcoming obligations we can move on to the final step. Given our prior constraints, how do we deploy our investment dollars to maximize our earnings?
Rates up or down? You call it.
Rates up
Our interest rate forecast will guide this process (remember…if you don’t have one we can provide some guidance). If we expect rates to begin moving higher in the next year or two then you either buy short final maturities or you buy floating rate product. Short final maturities obviously have a significant drawback right now…they offer very little in the way of yield. But such is the price for staying short. No risk, no reward. A 2.5 year non-call 1 year callable will bring roughly 1.00% currently. While that is an awfully skinny yield it beats Fed Funds by 75 basis points and it insures that you’ll have all of your dollars back to reinvest inside of two and a half years.
Floating rate product offers more options for the short buyer. The two most popular vehicles in this arena have been Hybrid ARM MBS and corporate floaters. There are pros and cons to each, but they represent higher yielding options for those that want to stay short. In this arena we’re not talking about short FINAL maturities…we are talking about the time until the instrument re-prices. A hybrid ARM has a 30 year final…but it re-prices on a much shorter basis which keeps your coupon near the current market and reduces price volatility. The point here is that you have options that allow you to minimize your price volatility yet pick up more yield than you could on a short final maturity product.
Rates down
If on the other hand you expect rates to fall then you need to extend your duration and get call protection. Think bullets. Possibly the best bond for this scenario would be a zero-coupon bullet municipal bond in the 10 to 20 year maturity range. This offers call protection and a great deal of yield. Currently you can get yields well north of 6% on AAA rated Texas PSF insured municipal paper.
Another popular option among buyers with this outlook has been 7 to 10 year Agency bullets.
I’ve got no idea
If you’re unsure which way this thing will go then maybe you consider a barbell strategy. Most investment portfolios are very short right now. As bonds have been called many investors have replaced them with very short instruments. This leaves room for some longer final maturities that will allow you to pick up yield without saddling the entire portfolio with undue risk. So the barbell keeps a great deal of money in the short buckets to fund your liquidity needs, and still allows you to generate some earnings on the longer maturities. How long you go is up to you.
If you have any questions on this material or if there is anything I can be doing just let me know.
Steve Scaramastro, SVP
800-311-0707
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