Friday, December 29, 2006

It was always just a matter of time...

I preface this post by reminding readers that I do not give investment advice on this blog. I may muse about investment decisions I'm making for clients, or for myself, but nothing I say is ever intended to be advice. Ever. Never. I'm serious.

In July, I wrote the following as part of a post about HCA's LBO:

The bottom line is this. If you own a diversified portfolio of stocks, odds are good one or more of them will become an LBO target, and you will enjoy wonderful profits. If you own a diversified portfolio of corporate bonds, one or more of them will become an LBO target, and you will suffer.

I wrote that knowing that at some point, it would hit the portfolios I manage. Today, rumors are swirling about Alltel, which is among my largest bond holdings.

This brings up two worthwhile questions. First, knowing that a portfolio of corporate bonds is likely to include some LBO targets at some point, why not eliminate your corporate bond holdings? Let's say you have a portfolio of investment-grade bonds which yields 100bps more than a similar portfolio of Treasuries. Now let's say that 10% of your positions wind up being LBO targets, and these bonds all lose 5 points. That's about 50bps in losses on a portfolio that started out yielding 100bps more. And I have to say, even if you were trying to buy bonds that were potential LBO targets, if you own 30-50 names, winding up with 10% actually getting bought out would be tough.

The second is, what to do now if you hold Alltel bonds? The 2012 issue, which is well-traded, has moved about 40bps wider over the last 2 months, all on speculation that Alltel could be a private equity target. So there is a fair-sized LBO possibility already priced in. Contrast that with how other telecom names are trading:

BellSouth (A2/A) +86
Duetsche Telecom (A3/A-) +121
AT&T (A2/A) +82
Vodaphone (A3/A-) +101
Verizon (A3/A) +87
Sprint (Baa3/BBB+) +161
Alltel (before today) (A2/A-) +189

So that implies that if the LBO thing doesn't happen, but another telecom thinks Alltel's wireless network is worth buying, there might be 100bps of tightening here. What's the downside? Since the Alltel thing is all rumor and no fact right now, we can't say what kind of balance sheet the privatized Alltel might have. That being said, B1/B rated Ford Motor Credit 7's of 13 are currently about +310 to the 10-year. That seems like a reasonable limit to your downside.

Another possibility is for private equity to buy Alltel only to dress it up for a sale back to another telecom. If that happens, there might be less leverage involved than in other transactions.

All in all, I'm holding my Alltel bonds. Its risky, but I think the risk/reward is worth it.

And now, your moment of bond market zen...

1) Admist various worries about interest-only mortgages, few have mentioned the largest interest-only borrower in the U.S... the U.S. Treasury. Treasury bonds pay periodic interest only, with principal paid only at the end of the term.

2) A poll of 68 economists conducted by Bloomberg at the end of 2005 showed a median prediction for the 10-year Treasury yield of 5.00% at the end of 2006. Currently the 10-year is 4.70%. Barring a large change in yield today, this will easily be the most accurate year-end survey Bloomberg since 2000. The survey vs. actual 10-year rate over previous five years?

2004 Survey: 5.04%, Actual (end of '05), 4.39%
2003 Survey: 5.25%, Actual, 4.22%
2002 Survey: 5.00%, Actual, 4.25%
2001 Survey: 5.50%, Actual, 3.82%
2000 Survey: 5.40%, Actual, 5.05%

Median of the same survey for year-end 2007? 4.80%.

3) If current levels hold, the 10-year Treasury will have finished each calendar year within 43bps of the previous year end in 5 of the last 6 years. In the previous 8 years, the 10-year changed in yield by at least 68bps every year and changed by more than 100bps 5 times.

4) Also if current yields hold, it will mark only the second time in 9 years that the 2-year changed in yield by less than 100bps.

Happy new year.

Wednesday, December 27, 2006

December economic review...

The market continues to be confused about the direction of the economy. After we rallied through 4.40% on tens early in December, we've now backed off over 25bps to 4.65% today. We've had two half point sell-offs in the last 5 days: on Friday the 22nd and today. Both were extremely light volume days.

I added some duration today. Not a lot, but I'm just not trusting this sell-off. My bet would be that we rally after January 1. I think the 25bps backup is borne out of technicals, not a real shift in market sentiment.

To this end, I took a look at all the U.S. economic releases of any significance so far in December. We can quibble over what constitutes a significant release, I used any release on which Bloomberg conducted a survey. I count 47 so far this month. 18 have come out stronger (or more inflationary) than in November, and 25 weaker. 4 were unchanged.

The picture isn't getting any clearer, so I'm betting that the recent trading range will hold. That means you're supposed to buy in at the high range and ride it down to the low range yield wise. We'll see if I'm right.

The week that isn't.

Accrued Interest is back after a great Christmas. Hope every one had a great holiday as well.

The week between Christmas and New Years is always a weird week. Many proprietary buyers (banks, insurance companies, etc.) are focused on getting their books in order for year-end, and are often not doing anything in the market this week. Meanwhile, mutual funds are trying to do a little window dressing before they have to disclose their portfolio holdings. They are also dealing with year-end related withdrawals, be that for IRA distributions, gifting, or taxes. Dealer desks are generally trying to pare inventory as it makes their ROA look better when quarterly and annual reports come out.

What's that mean to investors? If you aren't subject to these artificial constraints, and you are in the market to buy bonds, you might be able to get some deals. Particularly if you can be flexible. Over the last two weeks I've received several calls from traders saying "Tell me where you care on this bond." That translates as "I really really really REALLY REALLY REALLY REALLY want to sell this, you name your price."

On the flip side, if you want to sell something, liquidity blows this week. The same trader who just called you trying to give away his positions isn't too keen on bidding on anything. If you are managing your own portfolio of bonds, here's a tip: figure out what cash you will need at year-end before Thanksgiving. Sell bonds before 12/1. Or else get a margin loan and sell bonds in January. In the municipal market, January 1 is the biggest coupon paying date of the year (along with 7/1), so lots of cash flows into the market that people are looking to reinvest. Combine that with low dealer inventories, and you have a situation where municipals are often very well bid in January.

Thursday, December 21, 2006

How to calculate accrued interest

Looking at the logs from this website, I see that every day at least a couple people land here looking for how to calculate accrued interest on some interest bearing instrument. Since it’s a slow holiday week, I thought why not actually post the calculation? So the following is a little bond 101.

What is accrued interest?
Bonds generally pay interest every six-months. The interest payment is called a coupon. Whoever is on record as holding the bond on the coupon paying date receives the entire coupon payment regardless of whether they've held the bond for 1 day or for the whole six months.

If that were the end of the story, bonds would gyrate in price based on how close to a coupon date you are, creating all kinds of distortions in the market. To prevent this, bonds trade with accrued interest. Any time a bond trades, the buyer pays the seller a fraction of the upcoming coupon payment, with the fraction being equal to the fraction of the coupon period which has already passed.

How to calculate accrued interest
In order to calculate accrued interest, you must first know what day count fraction (DCF) is to be used. The most common is 30/360, which means that each month is assumed to be 30 days long, and the year is assumed to be 360 days. So if 15 days have passed since the most recent coupon paying day, the accrued interest on a 5% coupon, semi-annual paying bond would be…

15/360 * 5%

That’s 15 days out of a 360 day year, so the fraction of coupon earned is about 4.17% of 5%.

Note that because we've assumed a 30 day month, any time there is a 31st, no interest accrues. Also at the end of February, its possible to have more than 1 day accrued between the 28th or 29th and March 1.

Treasury bonds are done on an actual/actual (sometimes noted as ACT/ACT) basis, which simply means you take the actual number of days that have past and the actual number of days in the year when calculating the fraction.

There are also some conventions where the divisor is 365, which works just like the ACT calculation except leap years are ignored.

Why does the 30/360 convention exist? I've heard different stories, but one reason is that it makes various couponing periods easy to calculate. You can do monthly, quarterly, or semi-annual couponing easily, because 360 divides evenly into 12, 4, or 2. You’d never run into a problem where one period is actually longer than another, resulting in more accrued interest being paid than the coupon! The actual/actual DCF doesn't have that advantage. The 30/360 convention is also easy to calculate by hand, which before the days of Bloomberg was probably helpful.

I’m thinking of running these Bond 101 posts from time to time, so if anyone reading this is interested in the definition of something bond related, please post a comment.

Wednesday, December 20, 2006

Beta and Bonds

Yesterday's post was all about Alpha. A commenter asked me about leverage in bond portfolios, which got me thinking about the other half of the CAPM equation: Beta.

For those who didn't major in finance, the CAPM theory proffers that the return on an asset or portfolio is based on three components: the risk-free return, the general market return (beta), and a residual (alpha). Its fairly easy to understand if you think of a stock portfolio. Let's say you have created a portfolio of 50 stocks all of which are in the S&P 500. Any day in which the S&P 500 is up, you're portfolio is most likely up as well, and vice versa. This sort of general market effect is the beta.

Now let's say that your portfolio seems to be consistently more volatile than the market. I.e., if the market is up 1%, you are usually up 1.2%. We'd say you have a beta of 1.2. If at the end of the year, the S&P is up 20% and you have a beta of 1.2, we'd expect you to be up 24%. Same if the market is down, we'd expect you to be down more. Notice that if the beta concept really holds, then someone with a higher beta only outperforms or underperforms because they've taken more risk. Not because of any skill on the manager's part.

This is why a lot of people in the business focus on alpha, which is the residual return after accounting for market movement and portfolio volatility. Again, if the beta concept holds, then someone with a positive alpha is producing returns over and above the risk taken. That's obviously what everyone wants.

The beta concept is fairly easy for stocks, but more complicated for bonds. We know that over the long-term, stocks tend to rise in price, which compensates investors for their risk. So generally investors want a positive beta to the stock market, to capture this long-run price appreciation tendency.

Ignoring income, bonds do not have a long-term appreciation tendency. For a general bond portfolio to experience price appreciation, interest rates must fall. While we can agree that over the next 50-years, stock prices are highly likely to rise, we can't say that interest rates are highly likely to fall persistently. So it follows that investors would generally want a positive beta to stocks, but would be ambivalent about the beta to rates. If we assume that there is no long-run tendency for rates to rise or fall, then the desired beta is unknown.

In fact, if we assume that you could enjoy the income regardless, you'd probably want a beta of zero. Why be exposed to movements in rates at all?

Getting back to the real world, you can't get the income without taking interest rate risk. Today's yield curve is unusual; in most environments you would be giving up a large chunk of income by eliminating duration risk, whether through hedging or buying short-term bonds. Most of the time, there is a large increase in yield as you move from 0 to 5 years in maturity. Then there is a smaller yield advantage to increasing duration from 5 to 10 years. From 10 to 30 years, the yield pickup is usually relatively small. So you can get most of the income by sticking to 5-10 year maturities, and avoid the volatility of holding longer bonds.

Monday, December 18, 2006

Value investing?

A commenter recently asked me what the best way to add alpha for a bond manager was. Its a very interesting question, and one worth exploring.

There are five basic strategies I see most bond managers employing to try to add alpha. Now, I'm speaking of bond managers who have a mostly taxable investment-grade mandate, and the flexibility to move in and out of various sectors and maturity ranges. They are:

1) Interest rate anticipation. This involves moving duration around to try to time interest rates. I know of very very VERY few managers who make a living doing this successfully. Most guys I know make small interest rate bets hoping to add a little value if they are right but not killing themselves if they are wrong. That's basically what I do as well.

2) Sector rotation. This is where one overweights one sector vs. another. In practice, this is a lot like interest rate anticipation, because certain sectors tend to perform better in different rate environments. Some managers use sector selection as a less risky way to make a bet on rates. For example, if you are bearish on rates, MBS are probably a good sector, while Treasuries are probably the worst sector. You can keep your duration neutral but overweight MBS and outperform if rates rise, but limit your under performance if rates fall.

I do some of this, but its hard to overweight Treasuries for very long, because the negative carry eats you alive. So if I'm bearish on corporates, I'm more likly to just own higher quality names. If I'm bearish on MBS, I'll own more 15-year paper or ARMs vs. 30-year paper.

3) Credit analysis. This is where most bond managers live and die. They overweight credit, try to pick the right names, and win the day on extra carry and spread tightening. People can be more or less aggressive with this, some putting big chunks in high-yield trying to buy into recovery situations. Others just try to find yieldy bonds and any tightening is gravy. Because the overweight corps strategy is so pervasive, any time corporate spreads generally widen out, most fund managers under perform.

I do less with corps than a lot of other managers. I like to pick steady names which have certain long-term, fundamental things going for them. I particularly like names where the company has a motivation to maintain their credit rating. Here is an old post about my credit philosophy.

4) MBS analysis. Something a lot of non-bond people may not realize is that mortgage bonds are the largest sector of the investment grade world. They make up about 35% of the Lehman Aggregate vs. only about 20% for corporates. Interestingly, a large number of investment managers try to index their MBS positions or else just buy in the TBA market. Why I hate TBA is another post for another time. Suffice to say that buying only TBA, in my opinion, is like admitting you can't analyze MBS and are trying to minimize the alpha you subtract in this sector. No one can look me in the eye and tell me that buying TBA is a way to add alpha. No way.

Anyway, I think MBS is the best sector for adding alpha, which I posted about here.

5) Quasi-arbitrage. This strategy has become the favorite of many gigantic mutual funds, in part by necessity. This is where a manager builds a portfolio which has the general credit and interest rate risk of a traditional bond portfolio, but its constructed with a series of derivatives and hedges in addition to traditional bonds. So when PIMCO wants to increase its duration, they may well enter into a futures contract or swaps contract as opposed to actually buying any bonds. And that makes sense, because PIMCO is too damn big to actually go around buying bonds. They are forced to act in the derivatives markets, at least in part, because their monsterous size is such a liability. Take a look at the sector weightings in their flagship Total Return Fund (scroll down a bit). 40% cash? Not really, that's cash or CP held as collateral against derivatives contracts.

Now, I'm not one of these ridiculous chicken little types railing against use of derivatives. Obviously Bill Gross has had plenty of success doing this. My question is why? Why do investors flock to this strategy when there are many more liquid and more transparent managers who are having just as much success? PIMCO and Western Asset Management and Blackrock and the like have become so big, who can say how liquid some of their contracts are? I mean, if you are the market, what happens when you want out of the market? Well, there is no market at that point, is there? The problem is not using derivatives per se, its a matter of being so large that you are the market.

Now, most people use more than one of these strategies. Particularly if they are doing the quasi-arb strategy, because you have to be using the derivatives to be making some kind of bet. But I'd say that every manager has a preferred means of adding alpha, and the good managers try to downplay the areas where they are less likely to add value. For example, I'm focused on MBS analysis first, sector weightings second, and credit analysis third. I spend time on interest rates, but I wait until I have a strong opinion before making a portfolio bet.

Saturday, December 16, 2006


So CPI comes out flat, below the Bloomberg survey of +0.2%. Core also flat. Take that, plus the fact that the market had been off sharply earlier in the week, and you knew a big rally was in the works. So the 10-year up 3/4 and the bond up over a point seemed about right to me.

Then something strange happened. The rally started to lose steam. By mid afternoon, the 10-year was only up 3/8 on the day. By 4PM, the 10-year was flat on the day. WTF? How does such a weak CPI print turn into an unch market?

The explanation I heard from dealer desks was weakness in European and Japanese bond markets. Seems kind of odd to me that Tokyo and Frankfurt would take the U.S. market lower during the late afternoon New York time. That means the sell off would have started around 8PM in Europe and like 3AM in Japan. Activity in those areas would be well known to U.S. Treasury traders before 8:30 New York time.

Anyway, I think it may be that PM's were all so anxious to buy on weakness earlier in the week, that by the time we actually got some bullish data, there was no one left to buy. Its a very bearish signal.

Thursday, December 14, 2006

Tomorrow's news today!

Hearing that the Federal Reserve may have accidentally released tomorrow's Empire Manufacturing number this afternoon. Its due to be released at 8:30 tomorrow. The figure displayed on the site was 23.13, which is a good bit higher than the Bloomberg survey of 17.7.

Who knows if the 23.13 number is accurate or not. I mean, if they are mistaken about what time to release it, the number could just as well be wrong too.

Anyway, they took the link down already. This might explain why the 10-year is about 3 ticks lower than it was for most of today. Also, we get CPI tomorrow, so even if the Empire Manufacturing figure is 23.13, the CPI result is really more important.


The Fed went ahead and released the Empire Manufacturing number, so the rumor was true.


Rumor #1: There was a rumor circulating around Wall Street yesterday that the out-sized retail sales figure was somehow erroneous and subsequent revisions would bear this out. Never heard what the error might be, and honestly, these rumors float around a lot. The rumor obviously was not widely believed, because the sell off got worse and worse all day.

Rumor #2: Asia is staying out of the U.S. bond market lately. I've heard this from several dealers over the last 2 weeks or so. Asia has been a major reason why interest rates have stayed low over this cycle, and its a popular theory to answer Greenspan's conundrum. So if Asian investors truly are diversifying their assets, this will result in a permanently weaker bid for the U.S. bond market. Its the kind of thing that will be impossible to see on any given day, and even hard to quantify after several years past. But if its true, IF, then there will be pressure on both rates and spreads.

Rumor #3: Money managers came in aggressively to buy on weakness yesterday, according to various desks I talked to. While this might seem doubtful at first, given that the Treasury market kept getting weaker and weaker all day, look below the surface. MBS, swaps, and corps were all tighter yesterday. Traditional money managers and bank portfolios are rarely overweight Treasuries, most make their living on spread product. So when spreads tighten in the face of a very weak Treasury market, it might be a sign that money managers are coming in.

Anecdotally, I talked to one dealer who told me that most of the money managers he talks to are short duration, but still came in to buy yesterday. Why? Its a little of the index conscious attitude I was talking about yesterday.

Let's say your duration is 85% of the index. If a month passes and you do nothing with the portfolio, well then your portfolio is 1 month shorter. Plus you've probably accumulated some cash from normal cash flow. So now instead of 85% you are 81%. What if the market is rallying? You didn't like where rates were before, but the market is going against you and you've allowed the portfolio to drift to an even lower duration than you really wanted. So ironically, many times PM's who are negative on the market are the most aggressive buyers on weakness, because they do not want to allow the drift factor to catch up with them.

Wednesday, December 13, 2006

Closet indexing or folding bad hands

I've mentioned my fascination with poker in this space before. While I don't play very much myself, I see so many parallels to successful trading and successful poker playing. One of these parallels is knowing which hands to bet, and which hands to lay down.

Let me back up and talk a little about the concept of benchmarking. Professional investment managers live and die by whether they beat an index. So much so that many in the profession decry certain managers as "closet indexers." That is, an investment manager who charges active management fees, but really is just trying to match the index.

Now, I'm not saying that some managers are acting as closet indexers in a cynical attempt to retain clients by staying around the benchmark. Most would agree that while outperformance is OK, underperformance gets you fired. Also, most IM's that I know get paid more on asset growth than on relative performance. So if producing returns that are around the benchmark is enough to bring in new assets, the manager may conclude that its not worth risking underperformance to deviate from the index at all. Obviously such a person is not serving their clients.

But many times the term "closet indexer" is over used. When large investors like pension funds or endowments hire investment managers, they do so in an attempt to fill various buckets. E.g., a large cap, small cap, venture capital, investment-grade bonds, high-yield, etc. These buckets are selected and weighted based on estimations of long-run return and cross correlation patterns. What do they use to estimate return/correlation figures? Indexes.

So if I'm hired to run a Lehman Aggregate strategy for a large endowment, but all I buy are MBS, then regardless of whether I'm outperforming or not, I am not serving my client. Then client asked me to manage a portfolio which would have a beta near 1 to the Lehman Aggregate. Same would be true if I held a very low duration or bought a bunch of high-yield bonds. The portfolio I was hired to create has to fit with various other portfolios, and if I ignore that then performance doesn't matter, I should be fired.

So let's say that I just have no view on rates right now. I've done my research and find arguments for both falling and rising rates to be compelling. But I'm running a bond portfolio, so obviously I'm going to have to make some kind of duration decision. No problem, I pick the index's duration. Am I being a closet indexer? No, because the client has asked me to run a portfolio with a beta to the Agg of around 1. So when I have no view on interest rates, I set my position such that my beta is near 1. It isn't a cop out, its good investment management.

I think of it like a poker hand. If I look at my cards and read all the other players and I just don't think I have a winning hand, I should fold. Too many investment managers want to make a bet just because they think its their job to make bets. Sometimes its just your job to wait for another hand or a different market environment.

Bull steepener??

Yesterday's market action has me wondering if I've misread the street's expectations. I had figured that a cut was priced in by June, and that any minor change in the statement now would only be a set up for a June cut. In fact, the only real change in the statement was to describe the slowdown in the housing market as "substantial."

But the market gave us a bull steepener, meaning that rates in the short end moved lower by a greater degree than in the long end. As I said last week, a bull flattener means that the market expects Fed cuts sooner rather than later. While I agree with the idea that the Fed may cut 1 to 3 times in 2007, I just do not see that the Fed is setting up a series of cuts in 2007. And having Bernanke's crew publicly state the obvious about the housing market hardly changes my mind.

One idea that I keep coming back to is that the curve will eventually steepen. I believe that will take most of the upside out of the 10-30 year part of the curve. If the market has correctly anticipated the Fed's actions, then the long-end will be priced right first, and the short-end will catch up. I'm building a short-end barbell, with some floating-rate positions and some 5-7 year positions. I'm light in the 20-year area. I have some positions in the 30-year area, as protection against a big bull flattener.

Monday, December 11, 2006

Continued flattener as we wait for the Fed

The 2-10 slope flattened 2bps today, and has now flattened the last 4 days except Thursday when the curve was unchanged. The 10-year rallied almost 1/4 point, which should encourage the bond bulls after Friday's rout. I'm hearing that many foreign buyers came in on weakness, which has been a recurring theme for most of the last year or so. I'm sure volume was light with the Fed coming out tomorrow.

The rally gives a bear room to work tomorrow. Had we sold off today, I would have bet on a rally tomorrow just based on technicals. However with the 1/4 point rally on no news, I'm suspicious that today's rally is exaggerated by light volume, and I'm inclined to sell it.

The traders I've talked to are chattering about the Fed scenarios for tomorrow, but when you get down to it, most people expect little change in their language. If that happens, then I doubt the market moves much. If anything, it will disappoint some of the "Cut Now!" crowd and touch off a bear flattener.

But like I said, it sounds like most traders expect no change in statement. I agree with that, so if that's what happens, don't expect much market movement.

Friday, December 08, 2006

Homebuilders headed for doom? Bond market doesn't think so.

On Wednesday, Toll Brothers released earnings, posting a 44% decline in net profit. CEO Robert Toll expressed some optimism, saying that "we may be seeing a floor in some markets..." Toll was panned in some spots for their optimism.

But those who bet on corporate solvency for a living are betting with the home builders. I took a look at YTD change in asset swap spread for the 7 major investment-grade home builders. In each case I used a 10-year issue. The source is Merrill Lynch. A positive number means the bonds have increased in spread, indicating the market thinks there is more risk in the name. A negative number is the opposite, the market thinks the company is a safer bet today than at the beginning of 2006.

Toll Brothers (Baa3/BBB-): +11bps
Pulte Homes (Baa3/BBB): -24bps
Lennar (Baa2/BBB): -3bps
DR Horton (Baa3/BBB-): -9bps
Ryland (Baa3/BBB-): +12bps
MDC (Baa3/BBB-): No Change
Centex (Baa2/BBB): -2bps

So we have two wider, four tighter and one flat. None have moved in a big way YTD, although all are much tighter than where we were in June. Here is a graph of the net change over the course of the year in each.

Here is some perspective. Based on a 6% coupon and 40% recovery, a 10bps widener implies a 1.5% increased chance of default over the course of the next 10-years. So the worst performing home builder in this group, according to the bond market, has only a slightly higher probability of defaulting today than it did at the beginning of the year. Further, most home builders have improved in credit strength in 2006.

What does this say about the larger economy. Maybe not too much. The bears will tell you that housing will drag the economy down because of reduced consumer spending via cash out refis as well as reduced construction-related employment. Credit spreads on home builders aren't saying anything about the cash out refi effect. The bond market is saying that home builders will be able to maintain positive cash flow, but that could be because of a massive reduction in spending.

What the credit spreads are telling you is that the bottom is near. If home builders were going to be unable to sell off their inventory and/or take large losses on inventories, spreads would be wider. If there were to be no market for newly constructed homes for several years, spreads would be wider. The credit market has neither of these views.

Thursday, December 07, 2006

Not your daddy's bond daddy...

Consolidation on Wall Street has pushed out a lot of smaller brokerage firms. Right here in Baltimore, we used to have multiple prominent regional brokerage firms such as Legg Mason and Alex Brown. Both are gone. Today it is difficult to compete with the cost advantages that firms like Merrill Lynch or Morgan Stanley enjoy.

But there remains one area where regional firms have the advantage over the big shops: municipal bonds. Not necessarily the big billion dollar state deals, which do exist in the muni market, but in the smaller deals which make up the majority of the market.

A firm like Merrill Lynch isn't set up to do a $20 million muni deal. There isn't enough in it to make a difference in the bottom line. Enter the smaller dealers, for whom $10-$50 million deals are just the right size.

Of course, municipal deals and corporate deals are very different. In a corporate deal, the corporate executives have a personal financial incentive to minimize interest cost. In a municipal deal, the municipality's finance people may be morally obligated to seek the best deal, but they have no personal incentive. Which opens the door for unscrupulous bond dealers to use political donations, entertainment, and outright bribes to influence how business is awarded.

There used to be a cadre of smaller dealers in the south referred to as "bond daddies," which were known for operating in a "mutual back scratching" fashion. For me the term conjured images of muni investment bankers and local politicians sitting around smoking giant cigars and sipping mint juleps. At some point the banker offers a generous campaign contribution to the politician and says "Now, don't you think this road needs repaving? I'm sure we could float a bond issue to cover the costs..."

If you talk to anyone at Stephens or Morgan Keegan, they will probably laugh at your quaint story about the old "bond daddy" days. But I hear tell stuff like that still goes on in the muni market. Yes, according to the Wall Street Journal and federal regulators, some bond dealers are still willing to spend money to make money, even if the spending money part involves bribery. And it may be that firms north of the Mason-Dixon line have learned a thing or two about garnering new business the old fashioned way.

Federal regulators are not well equipped to deal with this problem for the same reasons that Merrill isn't well equipped to sell $10 million bond issues. The Feds like going after big targets, but the big boys don't make enough money in the muni business to bother with underhanded dealings. Its the small firm with 10 offices scattered across one state that are more likely to be doing something untoward to win deals. Does the IRS or SEC want to sent investigators out to the 1,000 firms like that to find the 2 or 3 that are guilty? If you are a Federal prosecutor, you don't make your career by going after corporate criminals no one has ever heard of and are guilty of a crime no one cares about.

Here is the bottom line. The muni market is a dank and sometimes seedy place. More retail customers get ripped off when buying munis than any other single product. The fact that each bond is so unique and trades occur in small sizes means that the market is far less efficient than other areas of the bond market. In terms of the whole bribery thing, its a classic example of what happens when you give someone power but no financial incentives. This occurs in all sorts of governmental posts all over the world.

Wednesday, December 06, 2006

Bear flattener

The ADP report came out strong today: +158k vs. expectations of +100k. Its spooking the bond market, and I think that's a sign the market was out of breath when the 10-year was at 4.40%.

We're also 2bps flatter between 2's and 10's. Its interesting to think about what various combinations of market direction and curve slope direction mean.

Bull Flattener: If yields on the long end are falling more than those on the short-end, it means the market is pricing in more Fed cuts, but is not pricing in the first cut any sooner.

Bear Flattener: If yields on the short end are rising more than those on the long end, this means the market is delaying the expected first Fed cut, but still expects the same or a similar number of cuts eventually.

Bull Steepener: Here, the short end is rallying more so than the long end, which implies the first cut has been moved forward, but the number of cuts has not changed.

Bear Steepener: If the long end is leading a sell-off, this means that while the Fed may still cut soon, the number of eventual cuts has been reduced.

Tuesday, December 05, 2006

Range notes

I've recently got a couple questions about non-inversion and range notes. First, some background.

A range note is a bond that pays interest if a specified interest rate remains above or below a certain level and/or remains within a certain range. Most of the ones I've seen lately are structured something like a 6% coupon so long as 3-month LIBOR doesn't go above 8% or some such. Any day where the LIBOR rate is above 8%, no interest accrues. That's just an example, I haven't pulled up a specific issue. I've also seen range notes involving currency exchange rates. Normally the range note is issued by a large bank or other financial institution whose credit is behind the principal payment.

Valuing a range note is fairly straight forward. In the above example where there is a fixed coupon, you have two simple pieces. One is a 6% bullet. The other is a modified 8% LIBOR cap. Instead of a normal cap, this is more of a binomial cap, where you pay 6% every time you are above the cap strike. Either way, normal binomial tree methodology could be used to value the modified cap.

I don't own any range notes of this type. If I wanted to enter into a cap or floor transaction, I could. It almost has to be the case that entering into the derivative transaction yourself is cheaper than doing it via the structured note. I say this because the investment bank doing the range note is, in effect, selling the derivative to you. They wouldn't be doing this unless it was profitable for them.

Now, there may well be cases where you're willing to pay up for the derivative exposure the range note allows. First, it might be a situation where legally an entity can't use derivatives. This is pretty common among public authorities and municipalities. The range note may allow the entity to hedge certain interest rate exposures they would otherwise be unable to. Second, a small investor may not be able to buy the derivative due to size constraints. However, most small investors are not going to be able to properly value the pieces embedded in the structure, so there is considerable risk that small investors get plain ripped off.

A non-inversion note is basically a range note but where the "range" is the slope of the yield curve. I've seen them done based on LIBOR and Treasuries and usually the slope is 2-10 years. So as an example, the non-inversion note would pay 8% any time the slope between 2-10 years is positive, zero when its negative. The ones I've seen usually have a 1 or 2 year fixed period, meaning that the bond cannot be called and the 8% coupon is paid no matter what. After the fixed period, the 8% accrues every day the slope is positive, whereas nothing accrues on days where the slope is negative. So if the bond pays quarterly with a 30/360 accrual schedule, and the slope was negative one day during the quarter, you'd be paid 1.978% for that quarter or a 7.91% annual rate.

I view this more favorably than the straight range notes. First of all, the derivatives needed to reproduce a non-inversion note are not standard, widely traded structures. So to reproduce these bonds you'd need to buy something custom created anyway. Second, I believe there is a natural tendency for the yield curve to be positively sloped, and this is a tendency which will persist over time. That makes betting against inversion an easy call. Has recent foreign purchase activity caused the slope to be flatter than it might have otherwise been? Maybe, but remember that as recently as 2004 the 2-10 slope was over +200bps.

The issues are usually callable anytime after the fixed period is over. In all likelihood, the issuer will call the bonds as soon as they can if the curve has reverted to a normal slope. The bonds will only stay outstanding as long as the slope is negative or close to zero. Take that as a warning for anyone considering buying one of these.

Why are these issued? Most of the non-inversion deals have been done by investment banks or commercial banks. These are entities that abhor an inversion because it compresses their profits. I believe banks view issuing non-inversion notes as an insurance policy against long-term inversion. While historically, periods of inversion are usually less than a year, the banks just cannot afford a longer period of inversion, and are willing to pay for some amount of protection.

Monday, December 04, 2006

Blog roll...

While waiting for a meeting to start, I found two great blog posts worth sharing.

First is David Andrew Taylor from Dismally wrote a detailed response to a question yours truly posed to him. David does great work at his blog, which I read daily. Most blogs run by real traders are focused on stocks or commodities which are all fine and good but don't have a lot to do with my area of focus. Currencies, which is what Dismally is all about, have a lot to do with interest rates and inflation. So David's blog and my blog might seem to be worlds apart, but we actually deal in the same topics quite often. David also has more of a Keynesian viewpoint, which serves as a check on my own monetarist views.

Second is a post from Econbrowser on how much foreign flows might be impacting interest rates. The research quoted claims the 10-year is 100bps lower than it would be with zero net foreign purchases. The problem with this kind of research is that zero net purchases isn't too realistic. So the headline of 100bps is a little misleading. For what its worth, I believe that the foreign purchase effect is quite large, I just don't think foreigners are going anywhere anytime soon.

Reader comments and other rarities

One reader had the following to say about Friday's steepener post...

"When do the Fed's Governors quit talking up the inflation fears and finally talk about the weakening economy ..... when it's too late ? It seems as if they're putting themselves into a non-winning position by yelling "fire" so often "

Here is my thought. I'm assuming by "fire" the reader means warning about inflation. I think the Fed faces a real conundrum. There were two major "mistakes" in the Fed's history. One was in the 1930's, decreasing the money supply at a point where the economy was already weak, thus causing the Great Depression. The second was the 1970's stagflation, where the Fed allowed the money supply to grow to help economic growth while allowing inflation expectations to become entrenched at a high level.

Stagflation is a real risk here, and the Fed knows it. The bursting of the housing market bubble is (and will) weighing on the economy both because of job losses and consumer behavior. But the economy is still awash in liquidity owing to the 1% Fed Funds rate of 2003-2004. Inflation measures continue to creep up, the dollar is weakening, etc.

In order to avoid the mistakes of the 1970's, the Fed will continue to talk very tough about inflation. What they want to avoid more than anything else is a loss of credibility. If the public continues to believe that the Fed is still primarily concerned about inflation, and will do whatever it takes to avoid accelerating inflation. As long as this credibility remains, the Fed can afford to just leave rates where they are and allow a weaker economy to solve the inflation problem.

Once their credibility is lost, they become forced to embark on a 1980's style series of painful rate hikes. No one wants that. So even if they think there are serious risks to the economy, as long as the level of inflation remains elevated, they are going to continue to emphasize the inflation risk.

Friday, December 01, 2006

The cut is coming... or so the market thinks

The 2-10 slope is 6bps steeper (less inverted) on the day, which is the biggest single day move in that slope since September 20, 2005. The slope is currently -10bps after trading as low as -19bps at various points in late November.

A bull steepener (which is where rates fall, but short rates fall faster than long rates) indicates cuts from the Fed will happen sooner than later. To understand this, think about why the curve inverted in the first place. It was because the market believed that a period of economic weakness and Fed cuts would eventually come to fruition. Therefore investing in longer-term rates would allow one to lock in attractive coupons. So while shorter-term bonds are more closely related to the current Fed Funds rate, longer term bonds anticipate cuts. Hence, short-term bonds carry higher rates than long-term bonds.

When the curve steepens, something about the above situation has changed. If the curve is steepening and rates are falling, then it must be that the eventually from above has turned into soon.

Is this right? I've been arguing that the economy is on better footing than the market is indicating. Today's weaker manufacturing numbers don't convince me otherwise. In order for me to be convinced, I'm looking for weaker consumer spending/income figures. Yesterday's initial claims figure isn't encouraging, but I think we need more data points to be worried about a recession.

Then again, I've argued that the downside potential for rates (upside for bond prices) is much greater than the upside for rates. If we do enter into a recession, I believe that the Fed will be forced to cut rates very aggressively, possibly down into the 2% range. This would create a major rally, particularly in the front end. That's why I'm positioned duration neutral and for a steeper yield curve.

KKR inquiry into a bathroom remodel gets blown out of proportion

Rumors are swirling that Home Depot is in the sights of private equity buyers, and that the bid might not be friendly. While Home Depot stock was only up marginally yesterday, the bonds were getting killed. HD '16's were trading in the +75 range last week, now over +100.

In many ways, a buyout makes some sense. First, you've got a languishing stock. Weighing on Home Depot stock is obviously the housing situation, but the stock had been languishing before this year. There are questions about management, highlighted by the near riot at the most recent annual meeting. If a private equity buyer could wait out the housing downturn and remove the current management group, they might earn a nice profit.

On the other hand, this would be an extremely large transaction, likely over $100 billion. I'm also surprised to hear this deal might be done as a hostile take over. I can't think of any major private equity deals done recently as hostile. I'm sure there was one or two, but not any of the really big deals.

Does that make Home Depot bonds a buy? There are two likely paths for this bond. If there is no buyout, the bonds probably tighten to +80 to +85. They won't make it all the way back to +75 because there will remain this lingering doubt over whether the buyout idea could come back.

If there is an LBO, the bonds could go out another 100-200bps. It all depends on what the new company looks like, which we can't know at this point. Given that Home Depot is rated Aa3/AA, so if they were to move into junk territory, +300 or so, that's +200 from here.

So you have 15-20bps of tightening potential and 200bps of widening potential. In percentage terms, that's upside of around 1.5% and downside of 16%. Some investors would stop right there, unwilling to take risk that is so negatively skewed. But for traders it becomes a question of odds. If you think the odds of the buyout actually coming to fruition is 1%, its a buy. If its 10%, its a push. If its 20%, its a short-sell.

For my money, there are plenty of A-rated corporate names with a little hair on them that have 15bps of tightening potential and offer better odds against widening.