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Friday, May 31, 2013

Short Term High Yield Instead of Intermediate or Long Term Bonds: The Strategy Holds Up During the Bond Selloff

I have written several times about avoiding intermediate and long term bonds in portfolios and concentrating on short term high yield etfs (SJNK yielding 4% and Hyld yielding 8%) as a major part of bond portfolios and as a place to park cash along with lower risk GNMA and Short term investment grade bond funds and etfs.

While many non market watchers may not have been looking, May saw a major increase in medium and long term interest rates. The ten year treasury yield went from 1.6% to over 2.1% a one year high (in conjunction with the move of 30 year mortgages to a high of 4%). As bond yields move up bond prices for longer term bonds move down. Below are charts of the intermediate and long term treasury bond ETFs compared to the short term high yield bond ETF (sjnk) as you can see the fund has remained steady meaning the investor picks up the yield while the investors in longer term and intermediate term bonds suffered price losses that well exceeded the yield making the total return negative.

While I cant predict the future of interest rates, this does show the advantage of the strategy of moving from intermediate and longer term bonds to short term high yield.. When rates move up longer and intermediate term bonds will show a loss while short term high yield ihas been shown in this case to hold its value.

1. Intermediate term treasury bond ETF (IEF dark line) vs  SJNK short term high yield bond price chart.

2. Long term Treasury Bond ETF TLT  vs SJNK Term High Yield Bond (brown)

Wednesday, May 22, 2013

Harvard Economist Gregory Mankiw Says" Stocks may be an especially good deal today"....Color Me Skeptical

In the Sunday NYT Harvard Prof. Gregory Mankiw admits that he is not much of a stock picker and correctly advises investors to steer clear of stock picking and diversify broadly through indexing...some good basic advice.

But then he makes a statement that indicates he isn't much of a market timer either. He makes reference to the equity risk premium and some recent research ".(my bold)

In 1985, Rajnish Mehra and Edward C. Prescott, both now at Arizona State University, published a paper in the Journal of Monetary Economics called “The Equity Premium: A Puzzle.“The Equity Premium: A Puzzle.” They pointed out that over a long time span, stocks have earned, on average, about 6 percent more per year than safe assets like Treasury bills. This large premium, they said, is hard to explain with standard economic models. Sure, stocks are risky, so you can never be certain you’ll earn the premium, but they are not risky enough to justify such a large expected return.

He then notes the following recent study as an indication that stocks may be a good value at present:

Stocks may be an especially good deal today. According to a recent study by two economists at the Federal Reserve Bank of New York, given the low level of interest rates, the equity premium now is the highest it has been in 50 years.

I think the study indicates quite the opposite...perhaps Prof is a poor market timer as well as self admitted poor stock picker.

First off at least in recent history the average equity premium is lower than the 6% cited above. As the NY Fed study notes 

he chart below shows the weighted average of the twenty-nine models for the one-month-ahead equity risk premium, with the weights selected so that this single measure explains as much of the variability across models as possible (for the geeks: it is the first principal component). The value of 5.4 percent for December 2012 is about as high as it’s ever been. The previous two peaks correspond to November 1974 and January 2009. Those were dicey times. By the end of 1974, we had just experienced the collapse of the Bretton Woods system and had a terrible case of stagflation. January 2009 is fresher in our memory. Following the collapse of Lehman Brothers and the upheaval in financial markets, the economy had just shed almost 600,000 jobs in one month and was in its deepest recession since the 1930s. It is difficult to argue that we’re living in rosy times, but we are surely in better shape now than then. 


It seems to me the authors show a profound misunderstanding of stock market performance in their above analysis. The best stock returns come when the market recovers from periods of deep pessimism When there is "blood on the streets" and doomsday forecasts are the conventional wisdom. That is the whole point of the equity risk premium, For those willing to take the risk of owning equities during that period they are most likely to get compensated for the risk 

Future returns from stocks are highest when valuations are low...and that of course coincides with periods of pessimism. 

It makes sense to look at the equity risk premium number in conjunction with current valuations

The valuation indicator that has the best predictive power is the Shiller p/e ratio which is charted below.

Over at analyst Samuel Lee a fellow fan of the indicator writes:

...My favorite valuation metric, Shiller P/E, averages real earnings over 10 years to smooth out the effects of the business cycle. At the S&P 500's current price of $1,600, Shiller P/E is 23, about 40% higher than its historical average. According to AQR co-founder Cliff Asness, the stock market's average 10-year real return from this P/E ranged from negative 4.4% to 8.3% annualized, and averaged 0.9% annualized. The low average reflects the fact that Shiller P/E tends to be mean-reverting.

The equity risk premium according to some shows stocks a "good value" relative to bonds, but the valuations seem to tell a different story.

The Economist  ran a piece on the same  study from the NY Fed  (my comments in parentheses) they wrote :

Is it possible to square the absolute(high risk premium) with the relative measures (high valuations and modest increases in profits) ? Equities may perform much better than government bonds, but only because those bonds will provide dreadful returns. The New York Fed researchers found that the main reason for the high risk premium was the exceptionally low level of yields. In America, 
Britain, Germany and Japan, ten-year bond yields are all below 2%

Even using current 10 year treasury yield of under 2%(instead of the t bill rate) with the current equity risk premium of 5.4% on gets a 7.4% expected return for equities. Measured against the extremely low current inflation rate of under 2% that would put expected equity returns right within their long term average range of 6-8% above inflation.

The Exonomist article  concludes as follows:
Still, because of the unappealing nature of likely bond and cash returns, it would probably take a shock to derail the equity rally in the near term. Such a shock could be economic (a sudden surge in inflation that prompted a change in monetary policy, say) or geopolitical (a wider war in the Middle East, for example). But for now, the bulls see no need to worry.

That may be a decent argument for no imminent crash but not a rationale for 18% return over the course of the 4 1/2 months year to date.

 Even if one accepts the equity risk premium and the rationale for stocks being attractive to bonds because of low interest rates one gets to an expected annual return for stocks of  5.4% (based on t bill rates of zero). That means returns for 2013 year to date are more than 3x the expected return for the year. It's hard for me to conclude that "stocks are an especially good deal today".

When the main reason for an asset rally is that "there is no place else to put your money" makes me nervous. In my view at a minimum it makes sense to review ones asset allocation and if necessary sell some US stocks to put allocations back in line buying some short term bonds and non US stocks. 

Valuation matters.

Sunday, May 19, 2013

I think this is the 21st Century Version of the Famous Shoeshine Boy Story

The well known story about Joseph Kennedy (father of JFK and RFK):

Allegedly, Kennedy knew to get out of the stock market before the crash in 1929 when he got a stock tip from a shoe shine boy. His thinking was that if a shoe shine boy is giving you stock tips, then the market is too popular (or overvalued) for its own good. ....

Against my better judgement I found a clip on cnbc in which this young lady was explaining on national business television "her very first option trade" 

Her blog is here
The description of the blog:
Rachel Fox is a successful 16 year old actress who also happens to be a very successful stock trader in her free time. This blog offers her perspective on the stock markets as she learns to trade, as well as provides education for those wishing to learn more about investing. 

You can catch the debut of Ms. Fox's first option trade "more exciting than a first kiss" gushes the CNBC talking head here
Here is the transcript of the intro:
well there's a first time for everything, isn't there? the first day of school, the first car, even a first kiss. but none of those experiences are nearly as exciting as what our next guest is about to do. well, you may know her as ee lynnette's evilstepchild on desperate housewives. but rachel fox is also thefounder and editor of the hit blog fox on and you want to read it, because just last year, she made more than 30% on the market doing over 300 trades and her very big news today, folks, she's going to make her first options trade.

It reminded me of why I haven't watched more than a few minutes of cnbc for many years (and wish I had stopped much sooner)

And over at
This young investing wizard is  ranked #1 on income investing strategy and #2 on Portfolio Strategy and Asset Allocation

Law student with B.A. in American History, Political Science, and British Literature from Washington & Lee University.

Tuesday, May 7, 2013

While You May Not Have Been Looking...European Stocks Are Outperforming the US and Emerging Markets Have Turned Up

The two major European stock etfs VGK and FEZ have now outpaced the US market performance over the past 12 months and Germany (EWG) which strongly outperformed the US in 2012 is not far behind over that same period .

Below is a chart with SPY (S+P 500) and total US Market (VTI) comparison (colors for labels are the same is on bar chart and the top graph which is growth of $100,000)

Emerging markets are way behind but have turned up of late with EEMV which I have written about outperforming IEMG which I mentioned in the same article as an alternative to VWO has outperformed over the last 12 months.I wrote about adding IEMG and EEMV to portfolios as an alternative to VWO here.

IEMG EEMV, VWO  and VTI below, return and volatility in bar chart below growth of $100,000 in line chart.

I have written about the relative valuations of US and international stocks in my review of the first quarter.

Friday, May 3, 2013

An Unusual ETF That Looks Interestng

Readers of this blog know that I am not a fan of hgh management fees and not much of a believer in active management....

Yet a relatively new ETF that carries high fees and is actively managed looks quite interesting to me.

The ETF is HYLD the Petrius High Yield Bond ETF , it is an actively managed high yield bond fund with a management fee of (ouch) 1.35%.

One reason I am not a fan of actively managed bond funds is that they are often "go anywhere bond fund" like Pimco's Total Return which makes macro bets (positioning) across maturities and types of bonds. Even with Mr. Gross' admirable management record I don't like the fund because in building a bond portfolio one never knows how the fund is positioned. Thus it is impossible to structure a bond allocation with particular targets in terms of credit quality and duration with such a fund. Other funds, even when labelled for a particular part of the market, can drift away from the prospectus title and have a poor record of consistently outperforming the benchmark.

On the other hand, I have felt that there is potential for success in active management of bonds within a defined level of credit quality and duration. After all bond market prices (on a relative basis in the same sector and duration) are determined by the issuer's creditworthiness. This is determined by slower moving and less volatile factors : major changes in income, changes in balance sheet rather than the more volatile  earnings and revenue that determines stock prices.  The ultimate risk to a bondholder is bankruptcy and even in bankruptcy bondholders will receive something and are senior to holders of equity.

 So good credit analysis/active management does have the potential for outperformance.

That is why HYLD looks interesting. It confines itself to a specific sector of the credit market: short term high yield. As I have noted in my credit market review, this sector offers an attractive risk reward profile. The low duration reduces interest rate risk and also diminishes credit risk . While credit spreads have indeed declined already the lower interest rates reduce debt service costs.

Should economic conditions improve that wouldwould increase the debt issuer's cashflow and ability to service debt..effectively reducing the credit risk of high yield bond. While the narrowing of credit spreads between high yield and treasury bonds has raised some warnings of a "bubble" the truth may be that short term high yield has extremely attractive risk/reward characteristics compared to the rest of the bond market.

The index ETF for short term high yield (SJNK) looks attractive and HYLD may be an attractive addition to short term high yield allocation in a bond portfolio.

Petrius explains its methodology here. Essentially it is value investing within the short term high yield sector.
As the manager explains it: in a paper on alpha and beta in bond investing.

What is important for investors to understand about value investing in bonds versus stocks is that we have a natural exit strategy
in that we have a maturity date with a price of par ($100). Value investing in the equity business means that you can own a cheap
stock and it can stay cheap forever. Most importantly, the analysis on bonds is entirely different than stocks. Why? Our returns don’t
depend upon beating expectations or earnings growth or great stories or any of that nonsense. What we care about is the company’s
ability to pay its bills, including our interest payment, until that maturity date, or an earlier refinancing or call. So our analysis centers
on our core philosophy: CREDIT IS EITHER AAA OR D! What we mean by this is that if we believe that the company can pay all its
bills for the foreseeable future, then it is an AAA credit to us. If we believe it cannot, we put it in the “D” camp, which means we feel
it has a high likelihood of default and we will choose not to invest in it

In other words if they can locate a bond with an attractive yield short maturity and good credit prospects as long as the bond is paid back (the exit point) the active market selection will be profitable.

So far so good for HYLD.

Here is a comparison of HYLD  and SJNK

HYLD                                                                  SJNK
Duration                            3.1 years                     1.99 years
30 day SEC Yield                8.1%                         4.07%
% of assets rated below b-  17%                           19.2%

One Year Performance and Volatility are listed below . Clearly on a risk/return basis HYLD looks quite attractive. Interestingly and not surprisingly the outperformance of hyld vs sjnk is almost identical to the yield differential of 4%.

The high total return which is in excess over the yield is capital appreciation due to compression of credit spreads. But going forward an investor in either of these ETFs would be happy with no fluctuation in price and simply  collect the yield of investment grade short term bonds of around 2%. And looking at the relative yields investors in SJNK could tolerate some reversal in the credit spreads and declines in price and still have a total return above that of investment grade bonds. That cushion vs investment grade is even greater for HYLD.

Of course the caveats remain: the fees are .95% above that of SJNK, the fund has been around only since Nov 2010 so the track record is short. Liquidity is not great , a good rule of thumb is never to enter market orders and to always use limit orders, this would particularly the case for this ETF.

Using HYLD in a bond portfolio:
 I have written before about the concept of a credit barbell as opposed to the more common barbell strategy combing long and short maturities to modify interest rate risk.

In a credit barbell one would remain in the same duration but lower the credit risk by combining high and low risk.

A simple and  risk averse strategy would be to combine SJNK, HYLD and the short term treasury ETF SHY.  SHY pays virtually no interest and this point, but it gives a bit of a crisis hedge. Should a serious crisis like in 2008 occur, SHY will likely increased in value.

In 2008 SHY increased in value by 6.6%, short term high yield etfs were not available, but as a bit of a point of comparison intermediate term high yield declined by 24.7% and short term investment grade declined by 6.6%. I would expect short term high yield to show a decline somewhere between that number. Using a conservative number of 20% decline for HYLD that would mean a 50% SHY 25% SJNK and 25% HYLD   portfolio would return somewhere in the are of -7%. Not terrible for a disaster scenario considering the current yield on the portfolio would be that would carry 3%  compared to 1.1% for short term investment grade bonds (VCSH).

And high yield has a strong reversion to the mean. In 2009  JNK returned over 37%