Category Archives: Hot Topic Commentary

Greece is the Word

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Yesterday Greece was a rock star, returning to public debt markets with a € 3 billion 5 year note priced at a yield of 4.95%. For a country with such a recent history of default, ratings still well below investment grade, which has not seen positive economic growth in over five years, the bond deal was pretty remarkable. As little as nine months ago, yields on Greece’s 10 year restructured bonds were over 11%.  As early as yesterday morning, a car bomb exploded outside the Bank of Greece in Athens, apparently in protest of the expected offering.  And yet investors could not get enough of the new deal, which was reportedly 8x oversubscribed. Yes, Greece was a rock star.

But maybe this is indeed a life of illusion.  A bond that had € 20 billion in demand only yesterday should probably be trading higher, as investors round up their positions. But no, the bond looked like it traded up a little, and then moved steadily lower throughout the day.

Back in the U.S., Investment Grade Credit seemed impervious for most of the past week to the global macro sell-off that’s been going on. Credit spreads have hardly budged – until today, when they finally showed some signs of weakness.  Total returns were positive through yesterday, driven primarily be lower interest rates, leaving the broad credit markets up nearly 1.0% for the week.  With rates down again, total returns should remain positive, but we expect excess returns for the week may dip into negative territory.

Supply was about $21 billion, about the same as last week, and dominated by global and 144a issuers, as U.S. Corporates enter their pre-earnings blackout periods.  Credit Agricole was one of the larger issuers, bringing $3.0 billion across a 5 year fixed, 5 year floater, and a 10 year.  The 10 year priced at +130 (which is tighter than Goldman Sachs current 10 year), and moved a few basis points tighter today in spite of the overall market weakness.  The market is much more comfortable with the safety of the French bank – perhaps in part since it disposed of its Greek subsidiary Emporiki in a transaction completed just a little over a year ago.

Was Emporiki a timely disposition? Or has Greece achieved sufficient reform to get its economy on track? We’ll see how it all pays out, but my guess is that it takes more than a coat of paint to turn an old jalopy into greased lightening.

Kubler-Ross and High Frequency Trading

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Back in high school I once took a class called “Death and Dying”. There I learned the works of Elisabeth Kubler-Ross and her “Five Stages of Grief”. These stages are Denial, Anger, Bargaining, Depression, and Acceptance. I have always thought markets went through some similar stages. The definitions are fairly close between the Investing and the Kubler-Ross versions. Except for #5, Investor Acceptance, defined as “where the strategy is adopted, copied endlessly, and mercilessly beaten into the ground until it breaks by the Street.”

Are we at that stage with high frequency trading strategies now that Michael Lewis’ recent interview on 60 Minutes brought this strategy to the mainstream and government organizations are investigating?

On one side of the coin it likely will take a while, if at all, for investor’s perceptions to change, Washington to hold hearings on the matter, and regulatory bodies to take action. Even then, there is a chance that the status quo won’t change. Many derivative strategies and concepts that were reviewed during the financial crisis a couple of years ago survived because there is a legitimate use of them in the marketplace and that investors may actually benefit as a whole. There are similar arguments for high frequency trading, usually invoking increased market liquidity and tighter spreads. Plus the pace of financial innovation often outstrips the ability of regulators to modify behaviors. Why should high frequency trading be any different?

However, eventually investors do come up with their own successful strategies to counteract something like high frequency trading. Perhaps we might even see a comeback of good old-fashioned block trading. Plus since other countries have taken measures to regulate high frequency trading, there is a precedent. Finally, regulators can move more swiftly and take sweeping actions that vastly impact financial markets more than investors anticipate, such as with Dodd-Frank and reforms such as Sarbanes-Oxley and Reg FD several years earlier in the wake of the internet bubble.

Is high frequency trading at #5 on the investor’s version of the Kubler-Ross scale or are we still at an earlier stage?  What do you think? Has the Michael Lewis interview brought high frequency trading to the fore and that investors will find ways to counteract it and regulators will eventually dismantle the strategy, or are we just at the beginning of a new revolution in algorithmic trading and artificial intelligence?

SEC Examination 2014 Priorities

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What Compliance Officers Should Expect from SEC Exams in 2014

If there is one thing that keeps compliance officers up at night, it is that dreaded message from the SEC, “We have decided to conduct an examination of your firm, and please do not treat this as an adversarial proceeding, rather we are here trying to learn about your firm, and we are here to help.” Hardly comforting given the many recent referrals from Enforcement, and the fact that Enforcement lawyers now routinely accompany SEC examiners to on-site inspections.

Recently, the SEC published its 2014 Examination Priorities giving broker-dealers and advisers guidance on areas of concern.

Examination Priorities for Both Brokers and Advisers

System-wide, the SEC will continue to focus on policies around fraud detection and prevention, corporate governance including the control environment and “tone at the top”, conflicts of interest, enterprise risk management, technology and supervision of IT systems.  The SEC will closely examine dual registrants and incentives to firms when customers choose to open accounts at dual registrants as an advisory client or brokerage client. The SEC also will scrutinize how advisers and brokers are addressing new laws and regulations, and sales and marketing practices related to retirement products such as IRAs and 401(k) plans. These broad areas affect nearly every adviser and broker-dealer, and all firms should be prepared for an SEC exam in these areas.

Examination Priorities Specifically for Investment Advisers and Investment Companies

Adviser Core Risks

Still stung by the failure to detect Madoff, for advisers, the SEC will continue to examine custody of client assets and compliance with the custody rules, paying particular attention to advisers that fail to realize that they have custody through non-conventional methods such as check-writing authority or powers of attorney.

Another core risk for advisers is conflicts of interest in business practices such as best execution, soft dollars, and agency/principal transactions. Examiners will scrutinize undisclosed compensation arrangements, allocation of investment opportunities, controls and disclosure when an adviser manages both performance-based accounts and traditional fee accounts, valuation of illiquid securities and higher risk products that are sold to retail and elderly investors. The SEC will review the accuracy of advisers’ performance advertising. Advisers that have wrap-fee programs should expect a review of fiduciary duties and controls to monitor wrap fee conflicts of interest, best execution and trading away from the wrap sponsor. Finally, the SEC will continue to review disclosure and compliance issues related to payments by advisers to distributors, solicitors and other intermediaries.

Areas of Focus for New Advisers Including Hedge Fund and Private Equity Fund Managers

New advisers that have not been examined in the last three years, including hedge and private equity fund managers, should expect a visit from the SEC in 2014. The SEC plans to look closely at new advisers’ marketing and sales practices, portfolio management including compensation methodologies, conflicts of interest and safety of client assets, and valuation particularly with respect to hard-to-value illiquid securities and their relationship to portfolio manager compensation.

Increasingly Aggressive Examinations

There is little doubt that the market and regulatory failures of the Great Recession has led to increasingly aggressive and skeptical examinations by the SEC. This creates compliance and reputational risks for firms. The 2014 exam priorities, although quite extensive, nevertheless provide a helpful guide for compliance professionals in determining where to devote finite compliance resources.

Optimistic Voices

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Investment Grade Credit finished the first quarter on a strong note, with spreads moving decidedly tighter during the last 2 weeks of March, generating total returns of nearly 3% for the quarter. With a few hours to go, that’s about 100 basis points better than the Barclay’s Agg, 135 basis points better than Mortgages alone, and 120 basis points ahead of the S&P 500. It’s even a little ahead of High Yield. IG returns were helped by both spread tightening and lower interest rates – definitely not the consensus call to start the year. It almost feels like we’re back in the Greenspan Goldilocks Economy.  Modest economic growth, reduced leverage, good equity returns, rising home prices…the domestic economy is almost like being in a fairy tale right now. Greenspans’s Goldilocks, meet Bernanke’s Dorothy. We’re out of the woods, we’re out of the dark, we’re out of the night….

Of course, the porridge is a lot sweeter this time around. We’ve had zero interest rates for five years now, while Goldilocks was only treated to 1% rates for about 9 months. With tapering firmly on its way and the first rate hikes seemingly just around the corner, will the exit for Dorothy be as smooth? Can we look forward to 3 years of low volatility and stable spreads? Step into the sun, step into the light….

Or will this turn out to be a horse of a different color? Is the whole market so addicted to sugar in its porridge that we go into insulin shock without it?

Maybe that’s a little dramatic. It certainly seems so right now. In addition to solid returns, low volatility and tighter spreads, supply has also been extraordinary, and a pretty good indicator of how eager everyone is to purchase IG Credit. We had the busiest March on record at over $110 billion, and supply for the quarter was up 15% from 2013 – both in a year when supply has been widely anticipated to move down for the full year by as much as 15%.

We’re inclined to stay on the yellow brick road for now. We know how risky it can be to follow a different path. March up to the gate and bid it open…

Open…

CFA Minnesota Insight Series Notes, “Where to Invest in a Rising Rate Environment”. March 25, 2014

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Ben Emon, PIMCO

  • Zero bound rates are a huge issue and have been a chronic problem for countries like Japan
  • The private sector is still deleveraging
    • It’s still with us, and there is still $11.5 trillion in nominal consumer debt
    • We need to increase leverage to increase growth, so we need to decrease rates
    • Will increased rates increase the risk of deflation?
  • We have full employment, but what kind?
    • There are lots of temporary workers
    • Many have dropped from the labor force
  •  Interest rate outlook: 4% ceiling off of a 0% Fed funds rate
    • 1.0% impact of Fed bond purchasing program and forward guidance
    • 0.8% impact on GDP due to demographics, global debt and political uncertainty
    • 2.2% fair value, fluctuating between 2.5%-3.0% until clearer economic picture evolves
  •  Thinks that there will be a 2.5% to 3.0% spread between the Fed funds rate and nominal interest rates for now, with a probable gradual increase in interest rates over time
  • Fed’s projection of 2.5% policy rate at the end of 2016 contrasts sharply with the past, which has been nominally faster. The tightening cycle was two to perhaps three to four years. The challenge is how to communicate the change and Yellen may have interjected some uncertainty, and the Fed is not clarifying how it will behave.

 

  • Where to invest?
    • Long U.S. duration not a great place to be right now
    • Overweight European duration may be a better place to be
    • Overweight emerging duration may be better than it was last year
    • Some emerging markets look attractive

Panel Discussion, Different Perspectives: moderated by Paul Doane, St. Paul Teachers’ Retirement Fund; Phil Nelson,NEPC; and Greg Zick, Xcel Energy

  • Don’t want to exchange interest rate risk for credit risk
  • Monetary policy in the U.S. is diverging with the rest of the world
    • Possible tightening cycle
    • Lots of uncertainty with timing and other factors
  •  Increasing rates by the Fed will be data dependent, e.g. GDP level
  • Credit spreads are low and credit quality is good, but we are paid on spreads
    • Tail risk with low yielding assets?
    • Many are forced to buy low yielding assets
    • Be wary of bank loans which carry a high yield but people don’t realize they are callable and sometimes sell above par very close to call price so the total return is not great right now
  •  Still a place for durations
    • Risk mitigating tool
    • Need liquid, non-correlating assets, especially with equities
  • Looking at a range bound market
  • Look at total return, be more flexible and nimble and explore variable rate products
  • Adding additional diversification via investments in a broader array of bonds and equities can be beneficial in the overall risk / return of a portfolio as evidence by the actual portfolio returns presented.
  • It took 14 years to break 4% interest rates in the post WWII cycle, will it take that long this time?

 

Thomas Coleman, Wellington Management Company:

  • As he sees it there are four strategies now
  1. Staying the course
  2. Shift form interest rate exposure to credit exposure
  3. There is a high price for liquidity, and how to use it
  4. Being more opportunistic
  • Expect low rates or a low growth world.
  • Staying the Course
    • Legitimate strategy
    • If rates unchanged, a possibility for 8% cumulative return the next five years
    • Rates abruptly rise, perhaps a negative return in the early years then quickly recover
    • Rates gradually rise and slowly drift higher, comes in at 40 bps /year for this scenario
  • Other scenarios
    • Nominal government bonds do well in decreasing growth and inflation
    • Corporate spreads and high yields do well in increasing growth and decreasing inflation
    • Developed market ILBs do well in decreasing growth and increasing inflation
    • Emerging market currencies and ILBs do well in increasing growth and inflation
  •  It’s not until the Fed is done tightening historically do markets determine if the Fed has overshot or not, perhaps as long as one year plus after the fact
  • Duration hedged credit is like a synthetic bank loan, which can help create a floating portfolio.
  • Think like a lender, own what you want to own
  • Diversification works, but less so on a market cap weighted basis, equal weighted offers more diversification

 

Panel Discussion, Investment Advisors: Josh Howard, Advanced Capital Group; Mark Book, Sit Investment Associates; Neil Sheth, NEPC; Justin Henne, Parametric Clifton

  • One of the panelists was exploring European middle market lending
    • 30% of loans are funded by banks in the U.S. compared with 80% in Europe
    • More shadow banking in the U.S.
    • Bigger corporations are in the middle market tier in Europe compared to the U.S.
    • Default rates in Europe are less than the U.S.
    • Recovery rates in Europe are better than the U.S.
    • Therefore active management works well here
  •  One of the panelists was taking an absolute return strategy
    • Earn more while waiting for rates to rise
    • Use this strategy in conjunction with an existing portfolio, which would include the use of futures and options
  • Another used treasury futures most often to remove rate risk and keep credit risk; this can be an advantage in that you don’t have to sell out of the funds you like and incur transaction costs and/or taxes.
  • Use a rules based approach, as rates increase, increase duration for example.
  • One said the key is how to generate income and return as opposed to gauging the Fed and inflation
  • Clients went from caring about mitigating risk to looking for return, with another person mentioning that he’s seen a big shift to that view in the past three to six months.
  • Absolute return strategy doesn’t work well in the short term, it takes time to implement

If you are interested in reviewing the slides from the event you can view them here