Active bond managers have dazzled investors by outpacing the bond market in recent years. But it’s a simple sleight of hand, and the big reveal is coming.
The trick is that bond managers have been quietly loading up on low-quality bonds. They pay a higher yield than top-quality ones to compensate for their greater risk of default — in technical parlance, a credit premium.
When times are good, as they have been in recent years, there are few defaults because borrowers have little trouble paying their debts. Bond managers collect their credit premiums and easily beat the broad bond market indexes, which tend to be dominated by high-quality bonds.
When the economy slows, however, the defaults start to pile up, handing losses to holders of low-quality debt. And suddenly bond managers don’t look so smart.
It’s a worthwhile trade-off for managers. The booms normally last longer than the busts, which means that credit premiums are usually a boost to performance. And nothing attracts investors like a hot hand, or the appearance of one.
But it’s not great for investors. They often don’t realize that their bond manager is taking more risk until the losses show up. And investors who want riskier bonds can almost always buy them more cheaply through index funds. They would be better served by a closer inspection of bond managers’ tricks of the trade.
The unicorns are coming, and not a minute too soon for many investors.
As Bloomberg News reported recently, a flood of private companies are planning initial public offerings for next year, including behemoths such as Uber, Lyft and Slack Technologies. Airbnb may also add its name to the list.
Investors have been eager to get in, enviously watching humble startups morph into billion-dollar ventures. If only Uber and its cohorts had gone public earlier, investors tell themselves, they, too, could have profited from their rise.
Except it’s an illusion. For every Uber, there are many more startups that investors have never heard about. And even if they had, it would have been nearly impossible to pick the winners in advance, no matter how inevitable their success may seem now. The truth is, startups are doing investors a big favor by putting off IPOs until they’re more grown up.
Alan Greenspan, chairman of the Federal Reserve from 1987 to 2006, sent a shiver through investors last week.
In an interview on “The David Rubenstein Show: Peer-to-Peer Conversations” on Bloomberg TV, Greenspan warned that the U.S. may be poised for a period of stagflation, a rare combination of high inflation and high unemployment.
The U.S. last experienced such an episode in the 1970s and early 1980s, and the memory still haunts those who lived through it. The annual inflation rate jumped to 9.8 percent in 1980 from 2.9 percent in 1972, according to the core PCE price index, a measure of personal consumption expenditures excluding food and energy and the Fed’s preferred inflation gauge. Meanwhile, the unemployment rate swelled to 10.8 percent in 1982 from 3.5 percent in 1969, according to the Bureau of Labor Statistics.
For members of Generation X — which includes me — and subsequent generations, stagflation is ancient history. Annual inflation hasn’t topped 3 percent since 1993 and has averaged just 1.8 percent since then. And the current unemployment rate of 3.7 percent is the lowest since 1969.
Still, the implications for investors of skyrocketing inflation and unemployment come quickly to mind. According to lore, a surge in inflation would lift interest rates, causing bond prices to decline and thereby wrecking bond portfolios. Higher interest rates would also thump stock prices because future corporate earnings would be worth less when discounted at higher rates. And all of that would come when many investors would lean on their savings to offset higher living costs and possible bouts of unemployment.
It’s not clear, however, how much of that received wisdom is reliable. Yes, when inflation creeps up, interest rates tend to follow. The correlation between annual inflation and the yield on 10-year Treasuries has been strongly positive (0.76) since 1959, the first year for which numbers are available for the core CPE price index. (A correlation of 1 implies that two variables move perfectly in the same direction, whereas a correlation of negative 1 implies that two variables move perfectly in the opposite direction.)
A battle is brewing between Wall Street and stock exchanges. Wall Street says it’s fighting for ordinary investors, but don’t be fooled. Like everything else on Wall Street, this dispute is about the bottom line.
At issue is the cost of market data. Financial firms need price data to trade. They say the exchanges charge too much for that data and that ordinary investors get stuck with the bill. Consequently, they argue, exchanges should give investors a break by lowering fees.
It’s a clever but misguided argument. To see why, a bit of background is needed. Stock exchanges report the trades they execute and their best bid and offer prices to securities information processors, or SIPs, which consolidate the information into a real-time price feed. A group of exchanges and trading firms operates the SIPs, with oversight from the Securities and Exchange Commission, and financial firms pay a subscription fee to obtain access to the feed.
But the exchanges have a trove of other proprietary data that isn’t reported to the SIPs, such as volume and types of orders (market, limit, stop, etc.), and they can deliver it faster than the SIPs. That’s crucial for high-frequency traders and for banks eager to impress well-heeled institutional investors.
Don’t be so quick to believe the dirt you hear about brokers.
That’s the inescapable takeaway from research reported by Bloomberg News last week showing that false accusations of broker misconduct are disturbingly common.
Dynamic Securities Analytics, a securities litigation consulting firm, reviewed 82 arbitrated disputes between brokerage firms and their former brokers that took place between 2016 and the first quarter of this year. In roughly half of those cases, arbitrators concluded that firms had defamed brokers when reporting the reasons for their dismissals.
Leaving aside the irreparable damage to the reputations of falsely accused brokers — which is considerable — Dynamic’s research raises serious doubts about the reliability of brokers’ public employment records. Brokerage firms must disclose brokers’ comings and goings and any wrongdoing they commit along the way. That information is meant to allow investors to evaluate brokers’ backgrounds and dodge bad actors.
And if those disclosures are to be believed, then there is an alarming amount of bad behavior. Researchers Mark Egan, Gregor Matvos and Amit Seru reviewed brokers’ employment records dating from 2005 to 2015 for a study in the Journal of Political Economy. They found that 7 percent of brokers have a record of misconduct and that the number exceeds 15 percent at some of the largest brokerage firms.
One thing is certain: A U.S. recession will eventually come along. The question is what will cause it and when. Among the oft-discussed culprits is corporate debt. Bloomberg Opinion columnists Nir Kaissar and Noah Smith recently met online to debate whether companies have accumulated too much debt and if that poses a risk to the economy.
Noah Smith: More people are worrying about U.S. nonfinancial corporate debt, which is at an all-time high as a share of the economy. Bloomberg News looked into a bunch of big acquisitions and found that a lot of companies are so leveraged that they would have a junk label if credit raters weren’t being lenient (sound familiar?). The Federal Reserve is starting to watch the leveraged loan market carefully as these loans proliferate. Bank of America is on “recession watch,” modeling losses from a junk-bond crash. Bloomberg Opinion’s own Danielle DiMartino Booth believes that large amounts of so-called investment grade debt isn’t actually very safe, consisting of leveraged loans, junk bonds and BBB-rated bonds. Meanwhile, credit spreads have shrunk to levels that often presage a recession. And the Fed intends to continue raising interest rates.
Why shouldn’t we be worried about corporate debt?
Nir Kaissar: I don’t see much in companies’ financial statements to be alarmed about. For one thing, they don’t seem excessively levered. The Standard & Poor’s 500 Index represents roughly 80 percent of U.S. public companies by market value. Its debt-to-equity ratio is 113 percent. That’s lower than the average of 163 percent since 1990, and half as much as during the past two market peaks in 1999 and 2007.
Of course, some of that is related to deleveraging by banks since the 2008 financial crisis. The D/E ratio of the S&P 500 Financials Index is 158 percent, down from 563 percent in 2007 and 585 percent in 1999. But the numbers are no more concerning after excluding the banks. The D/E ratio of the S&P 500 Ex-Financials Index has climbed to a relatively modest 93 percent from 75 percent in 2007 and a post-crisis low of 68 percent in 2010.
Those numbers don’t suggest excessive demands on companies’ ability to pay their debts. The S&P 500’s EBIT margin — or earnings before interest and taxes as a percentage of sales — is 13.3 percent, which leaves lots of room for companies to absorb higher interest rates at current leverage levels. Yes, EBIT margins will contract during the next downturn, but interest rates would most likely decline, too.
There are things to worry about, but excessive corporate debt doesn’t appear to be one of them.
After the Federal Reserve raised the federal funds rate as expected on Wednesday, investors are no doubt watching how longer-term interest rates respond. But the stock market’s moves will be just as revealing.
U.S. stocks have been on a historic run since the 2008 financial crisis. The S&P 500 Index has returned 18 percent annually from March 2009 through August, including dividends, making it one of the best decades for stocks since 1926. It’s also the second-longest stretch without a bear market, as defined by a decline of 20 percent or more.
Bulls attribute much of that success to lower interest rates. It’s no coincidence that stocks skyrocketed soon after the Fed dropped rates in late 2008 in response to the financial crisis, they argue, and that the market kept moving higher while the Fed held rates low for years.
The gist of the argument is that investors expect a premium for owning risky stocks rather than safe bonds — in technical jargon, an equity risk premium. When bond yields decline, stocks can pay less, too, provided that the premium stays roughly the same. But there’s little evidence investors are paying attention to the premium.
Investors may be betting on marijuana in all the wrong places.
Enthusiasm for pot stocks reached a fever pitch last week when investors piled into British Columbia-based Tilray Inc., a developer of cannabis medicinal products, doubling its stock price over three trading days through Wednesday. Volume for Tilray’s stock had averaged 7 million shares a day since it went public on July 18. Last week, that average spiked to 20 million.
Investors were already plenty high on pot stocks before Tilray came along. Three of the biggest by market value, Toronto-based Cronos Group Inc., Vancouver-based Aurora Cannabis Inc. and Ontario-based Canopy Growth Corp., are hugely expensive. None are profitable, but their average price-to-sales ratio based on expected revenue for the 2018 fiscal year is a stunning 185, or 50 times that of the S&P 500 Growth Index’s P/S ratio of 3.6.
The U.S. stock market is dominating again this year, and money managers may soon face some unpalatable choices.
It’s not even close. The S&P 500 Index is up 9.9 percent in the eight months through August, including dividends. Meanwhile, overseas stocks, as measuredby the MSCI ACWI ex-USA Index, are down 3.2 percent. U.S. bonds, as represented by the Bloomberg Barclays U.S. Aggregate Bond Index, are down 1 percent. And hedge funds, as tracked by the HFRI Fund Weighted Composite Index, are up a modest 1.7 percent.
It’s too soon to know how private assets, such as venture capital, private equity and real estate, have done because their results are generally reported on a multi-month lag. But it’s not likely to matter. Even the most ardent admirers of private assets, such as elite university endowments, allocate only a portion of their portfolios to them. So the results, however good, are unlikely to make up for the drag from other assets.
Bloomberg Opinion marks the 10th anniversary of Lehman’s bankruptcy with a collection of columns from around the world. Read more.
A decade after the collapse of Lehman Brothers Holdings Inc., there are still arguments about who was responsible for the 2008 financial crisis. But it’s also worth revisiting who paid for the crisis and who profited from it.
Any discussion about winners and losers, of course, must start with the bank bailouts. The centerpiece of that rescue was the Troubled Asset Relief Program, or TARP, an October 2008 federal law that authorized the U.S. government to “invest” in banks and their toxic mortgage-related assets. The U.S. Treasury invested $426 billion and ultimately recovered $441 billion when TARP ended in December 2014.
While it’s true that TARP turned a profit, the reward was laughably inadequate for the risk. The program bought assets that were deeply distressed — assets that ought to pay above-market returns when prices recover. Instead, TARP generated a return of less than 1 percent a year from October 2008 to 2014, while the S&P 500 Financials Index returned 5.3 percent and the S&P 500 Index returned 12 percent, including dividends. The difference amounts to hundreds of billions of dollars.
The Federal Reserve threw banks a lifeline, too, by holding interest rates near zero for years. The average effective federal funds rate dropped to 0.16 percent in December 2008 and remained below 0.25 percent through the end of 2015. That allowed banks to borrow money cheaply. It also sapped savers of badly needed income.
Those moves were undoubtedly necessary to keep the financial system and the larger economy from collapsing. But banks bore too little of the burden, and it’s difficult to view the bailouts as anything other than a massive wealth transfer from ordinary Americans to financial firms.
But there was another — arguably bigger — wealth transfer during the financial crisis between ordinary investors and more sophisticated ones. As the stock market tumbled from November 2007 to February 2009, retail investors pulled a net $152 billion from U.S. stock mutual funds, according to data compiled by Morningstar, including adviser and retirement share classes. More than half of those redemptions, or $78 billion, were during the market’s lowest points from September 2008 to February 2009.