BONDS
Investing for the long, long, long term
MARTIN MITTELSTAEDT

From Tuesday’s Globe and Mail
Published Monday, Nov. 08, 2010 5:16PM EST
Last updated Wednesday, Nov. 24, 2010 11:37AM EST

Goldman Sachs (GS-N167.60—-%) just issued a 50-year bond. The Government of Mexico, U.S. railway giant Norfolk Southern Corp. (NSC-N62.44—-%), and Dutch banking conglomerate Rabobank Group did one better: They all recently issued bonds with the stupendous term of 100 years.

The clamour from investors for these ultralong bonds is raising eyebrows in the capital market. The Goldman issue is slated to return investors their money way off in 2060, while 100-year bonds won’t pay back their principal until a century from now.

Bonds are basically just a way to lend money, but until recently it was unusual for any investor to be so trusting as to lend money for up to a century. During such an extended period, bond issuers can run into revolutions, depressions, bankruptcies and all manner of other reasons for non-repayment. Up until now, normal terms for long bonds were considered to be 10 and 20 years.

Despite the risks, yield-hungry investors are snapping up these superlong-term securities. While 10-year government bonds are yielding around 2.75 per cent, Goldman and the other issuers of long, long bonds are offering the tempting inducement of rates around 6 per cent.

The high yields explain the popularity of the offerings, but the bonds’ terms are so extreme that many market pros believe they are a signal that the long-running bull market in fixed-income securities has reached the limits of rationality. Investors fixated on finding a good yield are ignoring the dangers that go along with investing in bonds that won’t mature for a couple of generations or more.

Going ‘Very, Very Wrong’

“Some of these deals are going to go very, very wrong,” frets Ric Palombi, a fixed-income portfolio manager at McLean & Partners Wealth Management, who oversees approximately $1-billion in assets.

Mr. Palombi isn’t buying the bonds for his clients, and is surprised they’ve become a hit. “I never thought they would be so prevalent.”

The Goldman issue is a poster child for the continuing frenzy in the capital market for long-dated instruments. The Wall Street bank originally hoped investors might have the appetite for $250-million (U.S.) worth of the securities, according to market chatter at the time of the issue last month.

But Goldman sold more than five times as much – $1.3-billion. Ordinary ma and pa investors were the target buyers, signified by Goldman chopping the bonds into minuscule $25 amounts. This is an unusual size. Bonds typically trade in minimum multiples of $1,000.

How They Work

It’s not clear how many of the small investors who bought Goldman’s bonds realize the fine points of the deal. According to the prospectus, Goldman has reserved for itself the right to redeem the bonds at their face value of $25 on five days’ written notice any time after Nov. 1, 2015.

If interest rates stay low, Goldman, which didn’t respond to a request for comment, will likely call the bonds and pay off investors. Those seemingly high yields will then vanish.

Meanwhile, if market interest rates return to more normal levels because the economy recovers or inflation resumes, it’s likely that the cost of borrowing for extremely long terms could rise well above the 6.125 per cent that Goldman is paying. In that case, Goldman won’t redeem them, and buyers will be stuck with losses because bond prices move inversely to interest rates.

It’s telling that, while Goldman has the right to redeem, buyers weren’t given the same right to force Goldman to buy back the securities if interest rates surge.

While investors in any long-term bond face the risk of the issuer defaulting, any strong uptrend in interest rates also poses a problem.

Bond prices are in the midst of the longest bull market on record, having rallied in the United States for the better part of 29 years. Back in 1981, when the bull run began, 10-year U.S. Treasuries were yielding about 15 per cent and were shunned as “certificates of confiscation” by investors. Now the yield is a tad under 3 per cent and investors are snapping up bonds.

What Goes Up…

Nothing goes up forever, some analysts caution.

“Within a couple of years, the bond market probably is going to be entering some kind of [long-term] bear market,” says Frank Hracs, who compiles the Canadian Mutual Fund Analyst, a publication that tracks fund inflows and has found the hottest area is currently in bonds.

Mr. Hracs worries that the “long-term outlook for bond capital gains is negative.”

The losses owing to any rise in rates could be devastating. If rates revisit their 1981 levels, the 50-year and 100-year bonds will collapse in value by about 60 per cent.

• Bubble alert: Where risk lurks in 2011
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Bullbear Stock Investing Notes

October 25, 2010

In Bond Frenzy, Investors Bet on Inflation

By CHRISTINE HAUSER

At a time when savers complain that they are earning almost no interest from their bank accounts, some investors on Monday bought United States government bonds that effectively had a negative rate of return.

Bizarre as it sounds, that is correct. In an auction of a special kind of five-year Treasury bond, investors paid $105.50 for every $100 of bonds the government sold — agreeing to pay the government for the privilege of lending it money.

The reason is that these types of bonds offer a guaranteed protection against inflation. So, if inflation soars — as some economists worry might happen, with the government seeking to give the economy a boost by flooding it with money — the value of the bonds would go up accordingly.

The investors who took part in the $10 billion auction are betting that inflation, now at about 1 percent annually, will rise to a level that more than compensates for the premium they paid.

The unusual auction on Monday “reflects a condition in the Treasury market that has been in place for months, chiefly that yields on shorter maturities have moved below the inflation rate,” Anthony Crescenzi, a senior vice president at the bond giant Pimco, wrote in a research note.

Guy LeBas, the chief fixed-income strategist for Janney Montgomery Scott, said there were about $28 billion worth of bids for the notes. About 40 percent were foreign buyers, 57 percent dealers and the rest were possibly retail investors, he said. The prediction is for a 1.58 percent rate of inflation, as measured by the Consumer Price Index.

“It was good demand considering the negative yields,” he said. “They are counting on the Fed to be successful in generating inflation.”

As strange as all this may seem, these investors were actually going along with conventional market wisdom. Many economists are concerned that if the economy continues to stagnate, there is a danger of deflation, or a decline in prices, that would be difficult to reverse.

Most analysts expect that the Federal Reserve, which has already lowered interest rates to near zero and bought Treasury securities in efforts to reinvigorate the economy, is about to pump even more money into the system. Such a move would probably increase the rate of inflation.

Fed officials have hinted at such action in recent appearances. In a speech in Boston on Oct. 15, the Fed chairman, Ben S. Bernanke, said that “there would appear — all else being equal — to be a case for further action.”

The markets interpreted that and other statements as unmistakable signals that the Fed was poised to act at its next meeting, on Nov. 2-3.

Mr. Bernanke couched his argument in terms of the Fed’s mandate to keep prices stable and maximize employment. He said that inflation had been running well below the implicit target of about 2 percent and that unemployment, at 9.6 percent, was too high.

Inflation-protected Treasury securities have already been trading at negative yields on the open market for some time, as professional and institutional investors have sought to hedge their portfolios against the risk of inflation. But Monday was the first time since the government began selling these so-called Treasury Inflation-Protected Securities in the 1990s that new ones were sold at a negative yield.

Buyers “believe we have reached the bottom of the inflation cycle and the next move is higher, not lower,” said Kevin H. Giddis, the executive managing director and president for fixed-income capital markets at Morgan Keegan & Company.

A growing aversion to risk has produced all manner of investment oddities in the last two years. At the height of the financial crisis, for example, the yield on ordinary short-term Treasury bonds turned negative for a brief time as people flocked to safe investments.

Even now, big investors are buying gold at levels unseen in decades, to protect against fluctuations in the value of currencies. Small investors are fleeing the stock market in droves, favoring bonds and even cash over equities. Companies have managed to sell bonds that do not pay off for 50 or even 100 years.

The remarkable auction occurred as stock indexes on Wall Street edged higher, buoyed by recent strong corporate earnings and a month-to-month rise in housing sales.

Sales of previously owned houses increased 10 percent in September from August, to a seasonally adjusted annual rate of 4.53 million units, above forecasts of 4.30 million, but they were still down 19 percent from September 2009. The National Association of Realtors said about a third of the sales last month were related to foreclosures.

On Monday, the Dow Jones industrial average rose 31.49 points, or 0.28 percent, to 11,164.05. The broader Standard & Poor’s 500-stock index gained 2.54 points, or 0.21 percent, to 1,185.62.

The Nasdaq composite index climbed 11.46 points, or 0.46 percent, to 2,490.85.

Bond prices fell, with the yield on the 10-year Treasury rising to 2.56 percent from 2.55 percent late Friday.

As equities advanced, the dollar declined over the weekend after promises by the world’s 20 biggest economies to avoid a currency war.

It was the latest sign that financial markets are positioning for a rise in inflation. Economists point to the fall in the dollar as a sign of budding inflationary pressures. Another is the recent sharp rise in the price of some assets, including commodities like gold.

Graham Bowley and Sewell Chan contributed reporting.

http://www.nytimes.com/2010/10/26/business/26bond.html?ref=business&src=me&pagewanted=print

Health is Wealth

CHENNAI: Equities, mutual funds and FDs can longer satiate the super rich. Instead, they are channelling their wealth into start-ups, unlisted companies, realty-focused private equity funds, gold ETFs and art. The burgeoning breed of HNIS, or wealthy people, are exploring and investing in a whole new range of asset classes.

According to a recent report by Karvy Private Wealth, the wealth management arm of the Karvy Group, individual wealth in India stands at Rs 73 lakh crore and this is expected to double to Rs 144 lakh crore within the next three years. While the bulk of investment is still in direct equity (31.1%) and fixed deposits and bonds (30.3%), private bankers said there is a growing preference for alternative investments. Most HNIs have ridden on the mutual fund and equity wave as they went into the market early. They are now looking at different asset avenues, said Nitin Rao, executive vice-president (private banking group and third party products), HDFC Bank.

HNIs are classified as people with an investible surplus of at least $1 million . Over the years, the profile of HNIs has also rapidly undergone a change.

• Older HNIs largely comprised members drawn from business families. 
• Today, nearly 45% of private clients are first-generation entrepreneurs or self-employed, 15% comprise professionals, 20% are senior salaried executives, 5% are young celebrities, with property inheritors accounting for remainder.

“We believe that individuals in India are under-invested in alternative assets. We believe this will be a huge area of investments in the next decade. PE, real estate funds, realty investment trusts and global investments are expected to be popular among HNIs,” said the Karvy report.

Even with debt and equity, HNIs are exploring options that are offshoots in such classes. “They are looking at investing in unlisted equities, PE funds and in debt,” said Rajmohan Krishnan, senior V-P, Kotak Wealth Management.

Read more: Now, super rich look at alternative asset classes – The Times of India http://timesofindia.indiatimes.com/business/india-business/Now-super-rich-look-at-alternative-asset-classes/articleshow/6680959.cms#ixzz11R1yExbE

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The 10 year U.S. Treasury yield has been greater than the S&P 500 Index dividend yield since 1958. However, in November 2008 the roles reversed when the S&P 500 yielded more than 10 year Treasuries. The chart above compares these yields from November 1993 to November 2008. Why do stocks, as represented by the S&P 500 Index, now yield more than bonds, as represented by the U.S. 10 Year Treasury?

Experts differ on the reasons, but one reason is simply market forces. The 10 year U.S. Treasury yield has been driven down as investors have moved out of stocks and into the safety of U.S. Treasuries, driving bond prices up. Bond yields go down when bond prices go up. The S&P 500 dividend yield has increased due to the recent sharp declines in stock prices. Dividend yield represents the trailing annual dividend per share divided by the current share price. Current stock prices have dropped at such a sharp rate that when dividing trailing annual dividends by current price, the dividend yield increased.

http://www.icmarc.org/xp/rc/marketview/chart/2008/20081212SP500DividendYield.html

Health is Wealth

We saw Warren Buffett put forth his views on the concept of ‘economic goodwill’ and why he prefers companies that have a high amount of the same. Let us now see what the master has to offer in terms of investment wisdom in his 1984 letter to the shareholders.

While Buffett has devoted a lot of space in his 84′ letter to discussing in detail, some of Berkshire’s biggest investments in those times, but as usual, the letter is not short on some general investment related counsel either. In a rather simplistic way that only he can, the master gives his opinion on a couple of extremely important topics like ‘investments in bonds’ and ‘corporate dividend policies’. On the former, he has to say the following:

“Our approach to bond investment – treating it as an unusual sort of “business” with special advantages and disadvantages – may strike you as a bit quirky. However, we believe that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessman’s perspective. For example, in 1946, 20-year AAA tax-exempt bonds traded at slightly below a 1% yield. In effect, the buyer of those bonds at that time bought a “business” that earned about 1% on “book value” (and that, moreover, could never earn a dime more than 1% on book), and paid 100 cents on the dollar for that abominable business.”

Berkshire Hathaway in 1984 had purchased huge quantities of bonds in a troubled company, where the yields had gone up to as much as 16%. While usually not a huge fan of long term bond investments, the master chose to invest in the troubled company because he felt that the risk was rather limited and not many businesses during those times gave as much return on the invested capital. Thus, despite the rather limited upside potential, he went ahead with his bond investments. This is further made clear in his following comment:

“This ceiling on upside potential is an important minus. It should be realized, however, that the great majority of operating businesses have a limited upside potential also unless more capital is continuously invested in them. That is so because most businesses are unable to significantly improve their average returns on equity – even under inflationary conditions, though these were once thought to automatically raise returns.”

Years and years of studying companies had led the master to conclude that there are very few companies on the face of this earth that are able to continuously earn above average returns without consuming too much of capital. Indeed, such brutal are the competitive forces that sooner or later and in this case, more sooner than later that returns for majority of the companies tend to gravitate towards their cost of capital. If we do a similar study on our Sensex, we will too come to the conclusion that there are not many companies that were a part of the index 15 years back and are still a part of the same index. Hence, while valuing companies, having a fair judgement of when the competitive position of the company, the one that enables it to consistently earn above average returns is likely to deteriorate. This will help you to avoid paying too much for the company’s future growth.

After touching upon the topic of bond investments, the master then gives his take on dividends and this is what he has to say:

“The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios – inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let’s call these earnings “restricted” – cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas:

•  its ability to maintain its unit volume of sales, 
• its long-term competitive position, 
• its financial strength. 

No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.”

While the master is definitely in favour of dividend payments, he is also aware of the fact that not all companies have similar capital needs in order to maintain their ongoing level of operations.

• Hence, in cases where businesses have high capital needs, a high payout ratio is likely to result in deterioration of the business or sooner or later will require additional capital to be infused. 
• On the other hand, companies that have limited capital needs should distribute the remaining earnings as dividends and not pursue investments which drive down the overall returns of the underlying business. 
• In a nutshell, capital should go where it can be put to earn maximum rate of return.

He then goes on to add how his own textile company, Berkshire Hathaway, had huge ongoing capital needs and hence was unable to pay dividends. He also further adds that had Berkshire Hathaway distributed all its earnings as dividends, the master would have left with no capital at all to be put into his other high return yielding investments. Thus, by not letting the operational performance of the company deteriorate by retaining earnings and not distributing it as dividends, he was able to avoid a situation in the future where he would have had too put in his own capital in the business.

http://www.equitymaster.com/detail.asp?date=8/16/2007&story=1

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