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Monday, May 3, 2010

Want German Bonds With That Greek Crisis....I Don't

Pimco guru Mohammed el Arian gives good overview of the Greek and European crisis in this week's Barrons:(my bolds , my comments in blue)


Barron'sThis week we saw Greece's credit rating cut to junk status, Portugal and Spain downgraded and the head of the OECD liken the debt crisis to the Ebola virus. What happens next?
El-Erian: This past week the market came under pressure from late sellers, people who recognized that Greece isn't interest-rate risk but a volatile credit risk and thus needed to trim positions. It blew out spreads significantly and made the market highly illiquid. That led to a scramble among the International Monetary Fund, the European Union and Greece, and we had the image of [IMF Chief] Dominique Strauss-Kahn and [European Central Bank President] Jean-Claude Trichet going to Germany, where all the decisions are being made, which was very reminiscent of [Federal Reserve Chairman Ben] Bernanke and [former Treasury Secretary Henry] Paulson going to Congress. We enter the weekend with the Germans considering how much of a bailout they can finance. I suspect that behind closed doors, the other question is how you involve the private sector, whether it's willing to buy new Greek bonds and treasury bills, or whether it's involuntary, where the private sector contributes not by putting in new money but by not being repaid. Nobody in Europe wants to talk openly about this. Greece isn't just a liquidity problem; it's a liquidity and solvency problem. Greece alone can't resolve its solvency issue. The longer the delay in putting together both domestic adjustment and external financing, the higher the probability of a debt restructuring.
It's important for investors to have Plan A and Plan B. Under Plan A, ultimately, the Germans will need to finance most of this large bailout package and cover Greece for two to three years. That would give a bid to risk assets. Under Plan B, the Germans will be reluctant to write large checks for so long that it would make restructuring a higher probability. This would shock the risk markets, spread the problem to European countries, contaminate European banks, reduce liquidity in the system. So you plan for both, scale your positions so they can adjust quickly to either scenario. The market on average has bet on Plan A.
The delay in solving Greece has disrupted Spain and Portugal. It's a real possibility that Spain and Portugal may need to receive a bailout from Germany. It's a low-probability scenario that Germany will sign up for that bailout, so that's why getting Greece right is so important. Otherwise, the number of attractive options for Europe diminishes. Germany is able to financially write these checks but unwilling to be the funder of a three-year bailout for these three countries.
If the issues for the peripheral European countries aren't resolved, it's a bigger problem for Europe-wide issues, including the euro. Next, you ask the question of what happens to the euro zone itself. What happens to the euro zone should be taken seriously as a risk scenario. This is about 10 steps away from what the market is willing to recognize.
For too long, markets have priced in what we called at Pimco an immaculate recovery for Greece -- this notion that the private sector would continue to buy into artificial growth and long-promised fiscal adjustment on the part of Greece and would provide so much financing that it would lower Greece's borrowing costs to such low levels that you could get both fiscal adjustment and growth. We sold Greek holdings early on and stayed on the sidelines rather than participate in the various bond issuances that Greece has made and that have subsequently gone down in value. 
El Arian notes that Pimco holds no positions bonds of Greece, Spain or Portugal

But interestingly later in the interview he states:(my bold)


What do you like these days in the emerging and developed markets?
At Pimco, we have been and are going up in the capital structure, migrating up the quality side in corporate paper. I like equity and credit exposure in Australia and Canada, interest-rate exposure in Germany. In the U.S. and U.K., I'd look to add inflation exposure on attractive pricing.
El Arian is responsible for managing far more money than me but I can't see how holding any German paper follows from the analysis he gave of the European situation. (top Pimco honcho also indicated a preference for German bonds in his april commentary) The only possible situation for holding German interest rate risk would be a bit of a perverse one: a massive decline in German growth and the need to bailout German banks would lead the ECB to flood the market with liquidity. Of course the consequences to the Euro would be dire leaving dollar based  investors in euro denominated paper with large currency losses. What are the prospects for a bank bailout in Germany ? the nyt gives an estimate of German exposure to the weaklings of Europe

German Banks Have Big Investment in Greece

April 28, 2010, 5:20 PM
There may be a good reason why German taxpayers are so unhappy about having to lend money to Greece. In effect, they already have. Germany’s financial institutions hold some 28 billion euros, or $37 billion, in Greek bonds, Barclays Capital estimates, extrapolating from International Monetary Fund data,  Jack Ewing of The New York Times reports from Frankfurt.
A quick survey of Germany’s largest banks on Wednesday indicates that probably half of that debt — rated “junk” by Standard & Poor’s since Tuesday — sits on the balance sheets of institutions that are owned or controlled by the government. The percentage could be much higher, but outsiders have no way of knowing for sure because bank regulators and many of the banks refuse to disclose precise numbers.
Germany’s existing exposure to Greek debt easily exceeds the 8.3 billion euros that the country would lend to Greece as part of a European Union plan to help the country avoid default on its debt — though not the 24 billion euros that may eventually be needed from Germany. Hypo Real Estate Group alone holds 7.9 billion euros worth of Greek debt. And, after a bailout last year, the taxpayers own Hypo Real Estate.
Germany’s direct exposure to Greek debt provides another reason  the country’s problems are very much Europe’s problems. “It’s not just a question of paying for Greece’s luxury pensions. There are intrinsically strong German interests as well,” said Alessandro Leipold, former acting director of the I.M.F.’s European Department.
In my view this peek into Pimco's thinking points out a more fundamental issue related to Pimco's active bond management and use of their funds.




But should one be venturing into non US and especially non dollar bonds at all? I don't think so. Pimcos fixed income managers are confined in their holdings to fixed income yet unrestricted within that category and as their largest fund title indicates they are looking for the greatest total return. But is that really the purpose of the bond part of most investors' portfolios ? I would argue no.

The fixed income portion of a portfolio consisting of equities, bonds and perhaps alternatives like commodities is to provide the anchor of a portfolio. I like very much Peter Stanyer's concept in his book of umbrellas and ..... To me this is the purpose of the bond part of the portfolio. Steady extremely low risk earnings with emphasis on capital preservation and tbills held for liquidity more than earnings.

The ideal holding for the umbrella part of the portfolio would be TIPS which carry US sovereign risk and no risk of loss of real return due to inflation.While in is true that perceptions of sovereign credit risk has declined I reject the idea that there is meaningful risk of a US bond default. If such an event would occur the magnitude of the financial crisis would make 2008 look mild and would leave no room to run for cover. Short term treasuries and highly rated investment grade bonds might be a part of the portfolio for the slightly adventurous.

 International bonds in my view belong on the other side of the asset  allocation that is in the risk asset section along with equities, reits and commodities. A good comparison would be with domestic high yield bonds which may have risk rather to yield characteristics that at time merit additions to a portfolio but they are not part of the bucket and umbrella part of the portfolio. Pimco's managers may be quite skilled at moving things around with freedom to roam anywhere around the world and around the the yield curve, credit spreads and types of issuers, But is that what one really wants for the defense side of ones portfolio in the bond allocation ?

Nevertheless Pimco promotes its flagship total return bond portfolio as a core fixed income holding and puts its new Global Advantage Bond Fund with a 30% allocation to emerging market bonds in the same category of core bond holding. I'll pass using those for that purpose.


 But it seems that some of my well known colleagues look at things differently. Here's the bond allocation from a firm highlighted in today's WSJ. I would say only the Pimco Low Duration fund provides anything clost to the "liquidity "bucket" or "umbrella" to withstand financial storms that I look for in my bond allocation


BONDS: There is a 36% allocation to bonds, primarily through bond powerhouse Pacific Investment Management Co., whose funds the advisers have used for more than a decade.
Mr. Voicu allocates 9% to Pimco Total Return, which primarily buys high-quality medium-term bonds, and 6% to Pimco Low Duration, which buys bonds of shorter maturities. The portfolio has two multisector funds that can buy various types of bonds, including risky low-quality bonds. They are Loomis Sayles Bond, at 4%, and Pimco Unconstrained Bond, at 9%. The portfolio's 8% foreign-bond allocation is in Pimco Emerging Local Bond, which buys medium-term bonds of governments and companies in developing countries.
Interestingly the same month end investing in funds section of the WSJ prevents a glowing review of another bond fund that I would never hold as part of my bond allocation for the same reasons outlined above.




Michael Hasenstab has led the Templeton Global Bond fund to the top of Morningstar Inc.'s world-bond category over the past decade. He got to No. 1 partly by saying no. No, that is, to strictly modeling his portfolio after a bond index, ...
Mr. Hasenstab is more than willing to own big slugs of bonds from countries that have virtually no representation in the fund's benchmark, the Citigroup World Government Bond Index, as long as they have strong fiscal policies and healthy economies. That's a move that in most fund companies would have marketing executives complaining about "style drift." For Mr. Hasenstab it has meant stakes in Brazil, Australia and South Korea.
I took a little peek under the hood of the fund  at the Franklin Templeton website and found a couple of things that caused me further pause. The fund carries a 4.25% initial sales charge and a .96% management fee. According to the website that chops the funds effective one year return from an impressive 26.23 to 20.89. Still very impressive but still, fees cut the net return by 1/4.


The fund's top ten holdings include Korea, Poland and Russia t fee and depending on share class a front end or deferred load, meaning the fund must outperform an index by more than 1.5% before yielding any net benefit to the investors. The fund also owns California munis, venezuelan and mexican govt paper.


A possible holding for people that believe in aggressive active management for part of their portfolio ? I guess so. But it is certainly not something for the bond part of any portfolio I would manage.









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