6 Pieces Of Immortal Financial Wisdom

I was digging around in my old notes on my GDrive just now and came across these 6 juicy peaches from an old friend at CreditBubbleStocks.com. I’m deleting the note as I am reorganizing my GDrive, but I still wanted to hold on to stuff like this.

All observations are, in their own way, profound. Here they are:

  1. There’s two ways to learn things– the easy way, and the hard way. And surprisingly, most people pick the hard way.
  2. Stocks are for selling, bonds are for buying.
  3. As I always say, “You can’t fix stupid.”
  4. Real men don’t hedge; they know.
  5. I only “Texas Hedge”.
  6. What a world we live in.
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Doing The Hugh Hendry

Below is some commentary from Hugh Hendry I found in an FT.com editorial I since can not access as I don’t have a login. But I thought it was interesting when I first read it awhile back and I still think it’s interesting now. I meant to post it earlier. Rectifying my mistake:

For the moment, let us forget the chances of a hard landing in China. Forget the drama of Europe’s circus of politically inspired economic incompetency. Forget that the good news of the US economy’s succession of positive economic surprises is really bad news as fixed income managers have sold copious amounts of too cheap volatility and because it has made equity investors turn bullish, sending stock market volatility back to 2007 levels. This is dangerous. Improved US data may represent a classic short-term cyclical upturn amid a profound global deleveraging cycle.

Such moves have been commonplace for the past three years and have yet to prove a harbinger of any structural upswing. I worry that the pathological course of the last several years will see volatility rise sharply once again. Even so, there exists, in terms of my parochial world of hedge fund investing, a bigger issue.

I fear that my no longer small community has been compromised. Last year was generally very tough for long/short strategies and I commiserate with all concerned. But last year world class funds lost more than 15 per cent in just two months. Today they are celebrated again for making double digit returns in the last quarter even though they still languish below high water marks and their reputation for risk management, at least to those clients who have poured over their copious due diligence statements, has been sorely compromised.

You can probably live with that if you are a pension scheme or a large, sophisticated fund-of-fund because you have a global macro sub-sector that can benefit from short-term shifts in volatility. But the unfortunate thing is that this group exercised its stop losses somewhere between the great stock market rallies of 2009 and 2010. That is to say, they honoured the pact they had with clients. They adhered to the terms of their risk budget: they lost money and they reduced their positions. I fear that owing to this nasty experience the financial world is in danger of harvesting a monoculture of fund returns that could prove less than robust should the global economy suffer another deflationary reversal.

To my mind the situation has parallels with the plight of the banana. Today the world eats predominately just one type of banana, the Cavendish, but it is being wiped out by a blight known as Tropical Race 4, which encourages the plant to kill itself. Scientists refer to it as programmed death cell destruction. In stressful situations bananas fortify themselves by dropping leaves, killing off weaker cells so that stronger ones may live to fight anew. They operate a stop-loss system.

But modern mass production of single type bananas has replaced jungle diversity with commercial monocultural fields that provide more hosts to harbour the blight. The economy keeps producing stressful volatility events. Good managers keep shedding risk and monetising losses and are duly fired, leaving us with a monoculture of brazen managers who will never stop loss because they are convinced central banks will print more money.

Diversification has proven the most robust survival mechanism against failures of judgment by any one society, hedge fund manager or style. But what if we are now a single global hedge fund community afraid to take stop losses and convinced of an inflationary outcome to be all short US Treasuries and long real assets?

This is pertinent as I have always been fascinated by that second rout in US Treasuries in 1984, long after the inflation of the 1970s was met head on by Paul Volcker’s monetary vice and a deep recession. How could 10-year Treasury yields have soared back to 14 per cent and how could so many investment veterans have been convinced that a second even more virulent inflation wave was to hit the global economy?

Psychologists tell us the explanation is embedded deep in the mind. They refer to the “availability heuristic”. Goaded by the proximity to the last dramatic event, investors overreacted to the news that the US economy was pulling out of recession in 1984. They saw high inflation where there was none.

With this in mind, I would contend that it may take several more years before the threat of debt and deflation can be successfully exorcised from investors’ minds, even if the global economy were not set on such a perilous course. Such is the potency and memory of 2008’s crash that anything remotely challenging to the economic consensus could be met by a sudden and severe reappraisal to the downside.

Should such an event send 30-year Treasury yields back to their 2008 low of 2.5 per cent, we believe enlightened investors might better be served by thinking the opposite. Only then might it prove rewarding to short the government bond market and embrace what may turn out to be a much promised once in a lifetime buying opportunity for risk assets.

 

Notes – David Merkel On Corporate Bonds

David Merkel, author of the AlephBlog, has an extensive background on Wall Street and is something of a value investor when it comes to his money management principles. There is a lot of good content on his site in various disciplines within the investment analysis and money management domains so this will likely be the beginning of a multi-part digest series. This one deals with his lessons about the corporate bond market. To read the entire original discussion, please click the title heading of each section.

The Education of a Corporate Bond Manager, Part I

How I learned the basics, and survived 9/11.

  • “Bond swap”– trading away an older bond of a company for a new issue
  • New deals almost always came cheap
  • Think about bonds as a put option on the equity
  • When selling a bond, look at what investment banks ran the books of the deal
  • Never make it look like there are two sellers (by working with two banks) or bids will vanish; bad etiquette to employ two banks without telling them they’re in competition with one another

The Education of a Corporate Bond Manager, Part II

How I learned to trade bonds, and engage in intelligent price discovery.

  • If you want to buy a bond not presently offered, find out who brought the deal and made a market in the bond issue
  • Price discovery toolkit:
    • Comparable bonds in the same industry
    • Credit spreads across rating categories
    • Credit spreads across the maturity spectrum within rating categories
    • Spreads on CDS on the same name
    • Value of scarcity vs cost of liquidity
    • Proper spread tradeoffs on premium vs discount bonds
    • Calculate spread on last few trades
  • There is a price to gain liquidity that the issuer pays
  • “One-minute drill” creditworthiness check on Bloomberg:
    • GPO, how has the stock price moved over the last year?
    • HIVG, how have option implied volatilities moved of late?
    • CH6, how is operating cash flow?
    • DES, what industry is it in?
    • DES3, major financial ratios of the company
    • CH2 or ERN, earnings declining?
    • CRPR, credit ratings?
  • If these tests are passed, odds of company doing badly while waiting for a credit analyst’s opinion are slim

The Education of a Corporate Bond Manager, Part III

What is the new issue bond allocation process like, and what games get played around it?

  • Speed of decision process when buying new bond issuance based upon:
    • complexity of deal
    • creditworthiness of issuer
    • speculative nature of market
  • When market runs hot, odds rise that the syndicate will overprice a deal and deliver losses to those asking for overly large allocations
  • Dealing in the gray market has taint, you don’t want to be seen doing it lest your allocations be reduced
  • Syndicates want to place bonds entirely with long term holders if they can, implies they priced it right, leaving little money for speculators

The Education of a Corporate Bond Manager, Part IV

On the games that can be played in dealing with brokers.

  • Poker aspects of the bond market:
    • be honest, keep your word on trades, don’t weasel out once you say “done”
    • have a fair reputation, that you don’t try to pull fast ones on the broker community
    • reputation for fairness should be reinforced by other actions
      • if ibank quotes price/spread out of market context, let them know what you know; only trade against them if they insist they’re right
      • if risk control desk comes to you with a trade to cover a short and you own the bonds, help them; make them pay a little more than the ask but don’t gouge, then they might offer you the long cross-hedge bond at a nice price
    • have an “openness policy”; reveal 80% and conceal 20%, the most critical 20%
    • your broker at the ibank is proud of his best clients; he doesn’t want to lose you if you’re bright, trade a lot, run a big account
    • never tell your whole story to any broker; break up your business among many brokers, with no overlap
    • it’s good to have a reputation for being bright, or at least not a pushover
  • It’s freeing to not think about whether a particular trade will generate a gain or a loss but rather how the portfolio can be improved

The Education of a Corporate Bond Manager, Part V

On selling hot sectors, and dealing with the dirty details of unusual bonds.

  • It takes time and effort to farm, but financial products can be whipped up in any season
  • If I am underweight, someone else must be overweight versus the index; someone has to absorb all the paper of a hot sector, don’t let that be you
  • Credit analysts understand the creditworthiness of bonds; what do PMs understand?
    • portfolio composition vs needs of the client
    • trading dynamics of the marketplace, whether good bonds might temporarily be mispriced
    • dirty details of the bond; covenants, terms, etc.
  • A lot of value is added by document review; in a time of panic, those insights are golden because other managers toss out illiquid bonds they don’t fully understand

The Education of a Corporate Bond Manager, Part VI

On dealing with ignorant clients, and taking out-of-consensus risks.

  • Optimal strategy for life insurers: interest spread enhancement with loss mitigation
  • Defaults are a fact of life; if you run with such a thin capital base that you can’t survive a few modest defaults, you’re running your insurance company wrong

The Education of a Corporate Bond Manager, Part VII

On the value of credit analysts.

  • Credit analysts are a corp bond mgrs best friend
  • Provide a necessary check on a PM trying to play “cowboy” and be a yield hog
  • Native tendency is to reach for yield:
    • a portfolio with more yield earns more
    • a higher yielding credit will rally, due to mean-reversion
  • The second is true about 50% of time, but rewards are asymmetric; gains are small, losses are large– it doesn’t pay to be a yield hog
  • All analysts have biases; to overcome, give them a list of spreads for companies they cover and ask them to rank the credits in that sector
  • For Mr. Yes, ask him about risk factors; for Ms. No, ask what are the best names she’d invest in
  • Every investment shop tends to create a monoculture modeled off the PM at the top; to avoid bias:
    • have multiple analysts look at a conviction idea
    • have PM take it home and analyze it
    • look at Street research to find bears, and circulate the opinion to the team

The Education of a Corporate Bond Manager, Part VIII

On price discovery in dealer markets, and auctions gone wrong.  I never knew that I could haggle so well.

  • There may be 7000 actively traded stocks in the US but there are nearly 1,000,000 bonds, the last trade of which may have been a week or a month ago
  • After adjusting for default risk, the number one predictor of portfolio return is yield
  • Default risks are lower after the bust phase of the credit cycle, rise as the credit cycle gets long in the tooth
  • David does a trade: “But how to come to the right price/yield/spread?  I had a few trades, but they were dated.  I knew the spreads then, and used the spreads of more liquid similar credits to adjust it to a likely yield spread today.  I put in a fudge factor because illiquid bonds are higher beta, and then studied which of my brokers might have a bead on the bonds in question.  I would ask them their opinion, and if they were in my ballpark, I would back up my bid some, and bid for $1 or $2 million of the bonds.  The response would come back, and I would have a trade, or nothing, but maybe some color on where they would be willing to sell.  If a trade, I would back up my bid a little more, and offer to buy more.  If no trade, I would offer 50-70% of the distance between our bid/offer, and see what they would do.”
  • How to have a successful auction of bonds you own:
    • limit auction to dealers who have most interest
    • say you’re just raising cash, eliminates information risk, makes them willing to bid
    • cover level is the second place bid
    • can’t come back begging for love
    • ties are fine; no love, both brokers get half
    • not enough bids, cancel it
  • Limits to haggling: when you’re already getting an unreasonable deal, smile, say thanks and move on; it’s more important to be invited back
  • Bid/offer fewer bonds than wanted by the seller/buyer at the level, and ask for better terms at their size; makes them more willing to deal
  • Always pay your brokers, it makes them more loyal to you
  • Trading is an amplified version of character; try to be fair everywhere you can while still making money for the client
  • Playing for the last nickel costs 95 cents in the long run

The Education of a Corporate Bond Manager, Part IX

On the vagaries of bulge-bracket brokers, and how a good reputation helps on Wall Street.

  • You aren’t supposed to act like a market-maker; if it’s known you aspire to risk-free profits, they might use their power to hurt you:
    • lower allocations on new deals
    • tougher in haggling
  • Reputation matters
  • Gravitate secondary trading business to those who “walk the walk”

The Education of a Corporate Bond Manager, Part X

On how we almost did a CDO, and how it fell apart.  Also, how to make money in the bond market when you reach the risk limits.

  • You can only do deal #2 if you’ve done deal #1
  • Macro theme: stability usually triumphs over discontinuity

The Education of a Corporate Bond Manager, Part XI

On my biggest mistakes in managing bonds.  Also, on aggressive life insurance managements.

  • Bonds are asymmetric
  • Paid to be cautious regarding failure
  • When in doubt, sell
  • Don’t always take your broker at face value

The Education of a Corporate Bond Manager, Part XII (The End)

On bond technical analysis, and how to deal with a rapidly growing client.   Also, the end of my time as a bond manager, and the parties that came as a result.   Oh, and putting your subordinates first.

  • On timing purchases and sales:
    • the large brokers generally know who is doing what
    • be nice to sales coverage, you’d be amazed what they’ll tell you
    • keeping the VIX on screen helped accelerate or slow down purchases and sales in a given day; yield spreads lag behind option volatility
  • On time horizons:
    • Three horizons
      • daily
      • weekly-monthly
      • credit cycle
  • On scaling:
    • moving in and out of positions slowly, as market conditions warranted, is useful
    • “Never demand liquidity unless it is an emergency and you meet the strenuous test that you know something everyone else does not. But, make others pay up for liquidity where possible. You are doing them a service.”