Monthly Archives: November 2013

Love Me Tender

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Credit had a much better week, pushing month-to-date excess returns solidly into positive territory. Spreads held in even as Treasury bonds sold off following the release of Fed minutes on Wednesday. Supply has continued to be very heavy, with over $33 billion of new investment grade offerings. Deals also seem to be performing better this week than last. For example, Coca-cola Femsa (the largest Coke bottler globally) brought $2,150 million of a 3 part deal; the 10-year tranche priced at a spread of +135, and is trading 10 basis points tighter on the bid side.

The interesting question for us is why? After languishing for two weeks, in the midst of a week where taper fears were re-ignited, and when spreads are already trading at the tight end of their post-crisis range, what is pushing spreads tighter? While it is possible that regular readers of the weekly credit wrap noted that we called the end of the financial crisis a few weeks ago, and are responsible for driving spreads tighter, we think there is more at work here.First, volatility (as measured by VIX) has moved lower, and even with the move higher in rates, credit spreads generally respond favorably to a lower-vol environment.

Second, corporations have been active in tendering for outstanding debt, and this reduces net supply. There have been about $15 billion in tenders so far this quarter, and this provides a nice boost for the market. This week, Mondelez announced an offer to purchase up to $1.5 billion of outstanding high coupon debt, at spreads inside of where bonds were trading.  Companies will engage in tender activity in order to reduce high coupon debt, which will generate a loss in the current year, but reduces interest expense going forward. For total return investors, it is just a gift. You want to pay how much for my bonds? Ummm…okay. We love tenders. And we always will.

Credit had a much better week, pushing month-to-date excess returns solidly into positive territory. Spreads held in even as Treasury bonds sold off following the release of Fed minutes on Wednesday. Supply has continued to be very heavy, with over $33 billion of new investment grade offerings. Deals also seem to be performing better this week than last. For example, Coca-cola Femsa (the largest Coke bottler globally) brought $2,150 million of a 3 part deal; the 10-year tranche priced at a spread of +135, and is trading 10 basis points tighter on the bid side.

The interesting question for us is why? After languishing for two weeks, in the midst of a week where taper fears were re-ignited, and when spreads are already trading at the tight end of their post-crisis range, what is pushing spreads tighter? While it is possible that regular readers of the weekly credit wrap noted that we called the end of the financial crisis a few weeks ago, and are responsible for driving spreads tighter, we think there is more at work here.

First, volatility (as measured by VIX) has moved lower, and even with the move higher in rates, credit spreads generally respond favorably to a lower-vol environment.

Second, corporations have been active in tendering for outstanding debt, and this reduces net supply. There have been about $15 billion in tenders so far this quarter, and this provides a nice boost for the market. This week, Mondelez announced an offer to purchase up to $1.5 billion of outstanding high coupon debt, at spreads inside of where bonds were trading.  Companies will engage in tender activity in order to reduce high coupon debt, which will generate a loss in the current year, but reduces interest expense going forward. For total return investors, it is just a gift. You want to pay how much for my bonds? Ummm…okay. We love tenders. And we always will.

Lutefisk Buyback

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The holidays are rapidly approaching. Unfortunately for us in the Upper Midwest, holidays often equal lutefisk. Lutefisk in our view has to be the worst holiday food tradition in the region, even worse than receiving a fruit cake. At least fruit cake can be re-gifted, often for years at a time—kind of like a culinary chain letter.  When it comes to lutefisk, we would rather perform open heart surgery on ourselves than eat this alleged food. Some hearty souls claim to like lutefisk. In fact several years ago there were lutefisk microwave entrees. For most of us, the less lutefisk—the better.

On the opposite end of the scale, there are stock buybacks. The more we get, the happier most investors are. Usually for growth-oriented stocks we are not fans of stock buybacks. While we think it can be an effective way to return cash to shareholders in a tax-efficient manner, the timing and the amount of the buyback can dramatically impact the return on the company’s (and ultimately the  shareholders’) investment. For instance, most share buybacks undertook during the 2006-8 timeframe likely did not deliver a good, if any, return for shareholders. Additionally, while a share buyback can grab headlines, oftentimes stock options and grants can dilute or even undermine the earnings per share impact of a buyback.

Furthermore, U.S. based companies usually use cash domiciled in the U.S. for a buyback—all from the same pile of cash used to pay dividends, U.S. based pensions, U.S. employee health care costs and many other expenses. This can leave far less cash for growth-oriented activities especially here in America. These activities can include additional property, plant and equipment that can lower costs in the long run or increase productivity and/or capacity, additional investments in research in development, U.S. based acquisitions, new marketing channel development and sales force enhancements. The expected return of the buyback has to outstrip all of those other potential uses for cash in our view to be worth the risk and potential long-term growth opportunity costs.

Having said that, there are times when buybacks are worthwhile and we need to incorporate the potential for them into our investment analysis. For instance, for companies with a cyclical bent, there may not be any worthwhile investments for the company’s cash other than purchasing their own stock at that point in the cycle. Additionally we also know that if the buyback is timed properly, it can enhance shareholder returns. It is also nice to have the company conceivably buying stock on pullbacks, potentially supporting the stock. Finally at the end of the day, an investor should be concerned with generating an abnormally good return over the investor’s investment horizon. Buybacks certainly play a role in that regard. Therefore, when there is a buyback announcement one may have a percentage of float number in mind that would make us take notice of it being material to the stock’s shorter-term potential investment attractiveness.  Do you have such a number? What do you think?

Thrift Shop

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For weeks we have been complaining about the lack of supply in corporate bonds, while spreads continued to grind in. We take it all back. Supply has returned to the credit market, with about $60 billion issued over the past two weeks, and month-to-date returns are negative – both total returns and excess returns. Intermediate Corporates have outperformed; they are closed to flat on both metrics. Long Corporates have gotten crushed. Most of the performance has been driven by changes in interest rates, but long credit spreads are wider too.

On top of that, the new deals are not even performing that well. There are some exceptions, of course, like the Thompson Reuters Deal that came this week. They brought $1.5 bill across three tranches, and it was priced to move. The company is engaging in debt-financed share buybacks, which is the bane of the credit world, so they had to price it well to entice buyers.  30 year bonds (the smallest tranche) are 10 basis points tighter, 10 year bonds are about 15 basis points tighter, and even the 3 year did well. Those bonds priced at Treasuries +90, and are trading about 13 basis points tighter. No, the credit market doesn’t like debt-financed share buybacks. Unless the bonds are expected to perform. Then maybe we’ll wave ‘em in.

Even though a few new issues have done well, most of the deals from the past couple of weeks are trading at spreads flat to new issue, or wider. Demand is still strong for a well-priced deal, but concessions have all but disappeared in much of the market.

So forget about supply, right now we’d rather be poppin’ tags in the thrift shop of the secondary market for corporate bonds. I’ll buy your granddad’s bonds. They look incredible.

To Hold Cash or Not to Hold Cash That is the Question

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Lissa Rurik, CFA, CAIA

One of the central tenets in money management is that cash is not the place for money that is not earmarked for transactional purposes.   Not only does a cash position lose its real purchasing power over time, but the opportunity cost of holding cash is quite apparent in times of good market returns.  We’re all familiar with the studies that illustrate the drag on returns to the extent an investment portfolio doesn’t participate in the market’s best performing days.

However, data as to the impact of avoiding the market’s worst days is less widely touted in the investment community (although it is easy enough to search out and offers a compelling argument at that).  Certainly there is value in avoiding exposure to a market decline.  Additionally, there has to be value in the opportunity of being able to put cash to work during times of lower market multiples.

A recent article in the Wall Street Journal’s Money Magazine reported that the well-known investment firm GMO LLC had built up cash levels in its mainstream investment portfolio to 50% of assets earlier this year.  According to James Montier, a member of the firm’s asset allocation team, they had concluded that most other investment opportunities – particularly in the western markets – were too expensive and investors were likely to lose money after inflation from current valuation levels  (http://online.wsj.com/news/articles/The Case for Cash 9202013 ).

Montier published a white paper on this topic in November, 2012, and it’s an interesting read (The 13th Labour of Hercules: Capital Preservation in the Age of Financial Repression  — James Montier).  Before diving in however, it’s important to appreciate a couple of key premises in GMO’s intellectual framework.  First, risk is understood to be less about volatility and more about the permanent impairment of capital.  Second, GMO’s models are developed within the context of mean reversion; i.e., the forecast period incorporates a return to “normal” conditions. Continue reading →

Dazed and Confused

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This is going to date us, but we are Led Zeppelin fans. One benefit we here in Minnesota had over our pastoral neighbors to the east is that Zeppelin would not play in Wisconsin. Rumor had it that in 1969 Zeppelin did not sell out a show in Wisconsin and never wanted to play there again.

Channeling Zeppelin, we are “Dazed and Confused” about the industrial sector. Like most that follow the sector we monitor Institute of Supply Management (ISM) data on a regular basis. The data from ISM has been good lately—seemingly across the board. In our view Philadelphia Fed data echoes that sentiment. European and Chinese data are generally pointing toward expansion. Usually these data are a leading indicator of industrial health so that’s good news for the sector, right? Well, usually, but not so fast. Copper prices are also considered a leading indicator of industrial demand and prices are down notably since the beginning of this year. That’s not good for future industrial demand because money talks, right? Other data such as the National Federation of Small Business survey also shows conflicting trends in our opinion. Additionally U.S. and global GDP figures may indicate that we are just plodding along—no real change. Of course, there are some subsectors that are doing better than others—aerospace doing better than mining equipment, in our view. However, our question is where is the industrial sector going to perform as a whole over the next six to twelve months? What do you think?