Federal Reserve Rate Rise Waiting Game

The anticipation over the Federal Reserve's likely target rate increase is approaching fever pitch, at least for a few thousand economists, bond traders, and analysts who are otherwise surgically attached to capital markets information systems. We can amuse ourselves with what-ifs while awaiting the Fed's formal announcement.

What if the Fed raises rates by only a notional amount, like 25bps? Money market fund managers will probably breathe a sigh of relief that they won't face extraordinarily large redemptions. We cannot say the same for fixed-income fund managers, especially those with actively managed portfolios skewed towards the long end of the yield curve.

What if the Fed raises rates more than the notional amount, like anything from 25bps to 100bps? Money market funds would scramble to meet redemptions if they own anything other than overnight paper. Some of the funds would have to lean on the Fed's emergency tools, making all of the dry runs up until now worthwhile. The US equity markets would likely suffer a severe drop as companies with the weakest balance sheets immediately face higher overnight borrowing costs.

What if the Fed leaves rates unchanged? Bond fund managers breathe a sigh of relief for another quarter and the US stock market gets a little bump. The market bump continues into January if Christmas sales are better than expected. The large investors moving markets, particularly hedge funds, will tend to ignore whether the holiday sales are better or worse than last year's numbers. They only notice the headlines.

The first scenario for a 25bps increase is the most likely one, but doing nothing is always an option. A larger rate increase is probably not an option given its consequences. The Fed needs to test its new emergency levers under real world conditions before it puts the economy on a path to a more normal yield curve. The end of the Fed's emergency lending policy for SIFIs changes one such lever significantly. Testing with minimal stress is always best, but the test must come at some point.

Financial Sarcasm Roundup for 06/16/14

Fixed income investors deserve some sarcasm today.  Low interest rates have lulled them into thinking that bond valuations can only go up.  The search for total return in the bond market is going to end with a bunch of sleepwalkers getting smacked in the face.

Central bank intervention has brought the world's fixed income markets into periods of illiquidity.  Bond owners can't sell if buyers won't buy.  The Fed is now considering imposing exit fees on bond funds to prevent panic selling that crashes the entire market and drives up real interest rates.  I fully expect the Fed to put an instant lock-up on bond funds in a crisis, with rolling exceptions for politically connected pension funds (read:  unions) that need to meet distributions immediately.  Lots of retirees will wail about liquidity.  Stanley Fischer is earning his pay at the Fed already.

I'm absolutely certain I'm going to get the last laugh at the expense of a whole bunch of fixed income investors.  I'll LOL even harder at money managers who bought derivative bets on low yields and high valuations that they thought would last forever.  I don't know if there's enough bond collateral in existence to cover those derivative bets.  If not, then a whole bunch of futures contracts will be worthless as bond investors try to exit the market in a panic.  The investment banks that wrote those contracts on future debt issues will be unable to make good on delivery if central banks continue to buy the lion's share of sovereign debt issuance.  Some banks and insurance companies will get to relive 2008 all over again.

The buy-side investment management firms would love rules preventing sudden exits from bond funds, up to a point.  The tipping point comes if high inflation degrades their bonds so much that their balance sheets are impaired and they face insolvency.  Central banks and finance ministries would face a multi-faceted crisis.  Should the Fed and other central banks stop buying sovereign debt, leaving inventory in the market to fill those derivatives?  If so, they would have to backstop their primary dealers anyway just to ensure those investment banks have the liquidity to buy bonds that will make their derivative exposure whole.  Or should the central banks buy bond holdings from the buy-side firms that may face uncontrolled liquidations?  The discussion of a policy freeze is just the first consideration for financial regulators facing a global bond market at its peak.

The handwriting is on the wall and so many investors don't want to read it.  Fixed income investors who start liquidating now can rotate their wealth into other assets that can still generate yield after the bond market freezes worldwide.  Hard asset stocks, REITs, and ETFs await their turn at end of the global fixed income bull run.  Bond fund managers can pivot to hard asset yields a lot faster than individual investors.  Chair Yellen probably knows this but she can't time the exit.  No one wants the secret to get out until individual investors are securely in their fixed income policy straitjackets.  The average folks got handed a pile of bull once again.

Financial Sarcasm Roundup for 06/02/14

Read my words and discover the contempt I have for humanity.  Stupid losers are everywhere.  They deserve nothing but my sarcasm.

Pimco's Total Return Fund is watching investor withdrawals whittle away its flagship product.  The trickles will turn to a deluge as investors realize the air is leaking out of the bond market bubble.  Chair Yellen can keep the plates spinning a while longer if the Fed has to restart QE purchases.  Everyone in the fixed income universe forgot about mean reversion while the fixed income party was going full steam.

The Administration's emission rules are going to put the coal sector in a world of hurt.  Climate change advocates have a religious fervor for reengineering our society, with or without a scientific basis.  The only thing dumber than blind faith in weak science is forcing others to pay for those beliefs.  Renewable energy stocks may get a small push from new rules on power plant emissions.  I doubt the Administration's push to convince other polluting countries in the developed world will bear fruit.  US coal companies will just export to China and India if the coal can't be burned domestically, and those nations will have no incentive to cooperate with US climate goals if they would otherwise lose access to our coal.  Way to go, Washington.

Ecuador is swapping gold for liquid assets, presumably some instruments denominated in US dollars.  Goldman Sachs took them to the cleaners and all the Ecuadoreans can do is lie about the deal.  It's obviously an asset swap but Ecuador's finance ministry and central bank both refer to it as an investment.  They must think the global financial community is as stupid as their own citizenry.  This swap only works for them if the US dollar retains its value for three years, a highly doubtful prospect if the US experiences hyperinflation.  A dollar devaluation means they'll only get back a fraction of the gold they're swapping out.  Goldman and other banks now have a case study they can use to liberate hard assets from other dollar-dependent countries before the party ends.  I'll remember that the next time I'm stocking up on stuff.

Humans run around like chickens with their heads cut off.  I exist to collect up the headless chickens and cook them for supper.  The brainless losers who don't read my blog might as well be headless.

SIFIs Make Double-Dumb Bet On Fixed Income

The biggest investment banks prove they are willing to follow the bond market to oblivion.  They have just doubled-down on reorganizations that commit to even more bond underwriting.  The comment at the end of that article shows some rare sanity in a financial sector gone mad.  These dumb banks are betting that huge sovereign debt issuance will continue as interest rates rise, and that said rising rates will entice investors back into fixed income.

I won't restate my long-held contention that central bank stimulus has driven global bond markets far past their natural equilibrium points.  Go read some of the World Bank's regular reports from 2013.  I sure did.  The end of this historic coordinated stimulus means the end of excess profits in bond underwriting.

It's even more amazing to see the SIFIs unwind their commodity operations to make room for bond desks.  Commodities are useful hedges in hyperinflationary periods.  Going long in fixed income with no commodity exposure was the kiss of death for investors who lived through hyperinflation in Weimar Germany.  I will not feel one ounce of pity for the spoiled preppie bond traders who are going to lose their shirts.  They all have it coming to them.  A run on the US dollar will not treat Wall Street kindly if this is what passes for strategy.  

Really Dumb Alternative Income Hedges

I frequently gripe about the nearsightedness of fixed-income portfolio managers and their investors.  It seems to me that the best they can do is eek out minimalist returns with ZIRP distorting credit markets.  Hanging on at the top of a bond market is dangerous when the only place interest rates can go is up.  Holding long-duration fixed income investments of any kind is suicidal on the cusp of hyperinflation.  Money managers look for alternatives to conventional credit products, like in Index Universe's ETF Report article on alternatives in fixed-income for October 2013.  They're not looking hard enough to impress me.

No way will I look at bonds, loans or notes that float with Libor.  That rate is still subject to manipulation and a few fines aren't fixing anything.  The World Bank should give me a call if it ever takes note of my GIBOR concept and wants to implement it worldwide.

I am sick and tired of hearing about variable demand rate obligations (VRDOs).  Those instruments were among the first to freeze in value during the 2008 financial crisis and most investors sold out of them in frustration as soon as they could.  I tried pitching them when I was a financial advisor in 2005-6 and none of the so-called fixed-income experts at my firm could ever give me consistent answers on how they were priced or how they paid interest.  Brokerages were labeling them as "cash alternatives" simply because they were subject to auctions that had not failed . . . until 2008.  The fine print of a VRDO prospectus mentions that the instruments' viability in auctions is backed by a credit facility known as a standby bond purchase agreement.  If an investment bank is unwilling to lend in support of such an agreement, the VRDO auction fails and the investor is stuck holding what becomes de facto a long-term bond.  That will be dangerous during the onset of hyperinflation.

International bonds might work if they originate in countries that have a strong rule of law orientation, a significant hard asset sector, and a low propensity to hyperinflate.  That rules out anything except bonds from Australia, Canada, New Zealand, and Switzerland (which lacks the hard assets of the other three, unless you consider Swiss chocolate).  I tune out the remaining China bulls who think dim sum bonds are China's ticket to reserve currency status.  That makes me LOL.  Investors who ignore China's debt-laden shadow banking system deserve what's coming if they love dim sum bonds so much.

I've blogged about BDCs before.  They work great in normal times by providing asset-secured loans to companies that can't qualify for low-interest bank loans but aren't in such distress that they need investment banks to underwrite high-yield debt.  These aren't normal times.  Hyperinflation will enable debtor companies to repay BDCs with less valuable future currency.  I expect the market value of BDCs to plummet in hyperinflation unless they supplement their loan portfolios with standby equity distribution agreements.

Fixed-income investments remain a minefield for many reasons.  Rising US interest rates will lower bond valuations.  Hyperinflation will destroy bonds altogether.  Fiscal cliff wrangling makes non-US institutional investors more likely to dump US dollar bonds at any moment.  Very few coupon-based securities are going to tempt me to chase yield under these conditions.

The Limerick of Finance for 07/17/13

Fed can't keep inflation away
Spike in real rates can't be kept at bay
Debt investors beware
So much risk is out there
Hard assets await their big day

Fixed Income Facts and Fancy When Staring Down Inflation

An acquaintance got me thinking about the fixed-income universe.  I haven't thought about it much lately for good reason.  Fixed-income investments are wiped out in high-inflation economies and the Federal Reserve's implied policy of monetizing US sovereign debt dramatically increases the chances of high inflation.  The fixed-income universe is much broader than sovereign debt.  I ought to see if any income-generating instrument can survive high inflation.

The Dividend Yield Hunter lists multiple categories of fixed-income instruments that go way beyond bonds.  I was not aware that exchange-traded debt existed in forms other than preferred stock (not really debt, but acts like it) and funds.  The Tennessee Valley Authority, for example, lists its bonds on exchanges for the public to trade (TVC and TVE are examples).  The usual cast of characters like MLPs, royalty trusts, and REITs round out exchange-listed offerings.  I've never considered business development companies (BDCs) as fixed-income investments because they are unique ways to invest in undercapitalized small companies, sort of like VC firms but publicly traded.  Dividend Yield Hunter lists BDCs as fixed-income, presumably because they must pay out their earnings like other pass-through entities.  BDCs are also searchable over at QuantumOnline, and that site also lists exotic things like income deposit securities.

Fixed-income investing is a fine stabilizing element for a diversified portfolio in normal times when interest rates are at their long-term historical average and the national debt-to-GDP ratio is manageable.  Americans are not living in normal times any longer.  Most fixed-income investments will see their principal destroyed when high inflation reduces the dollar's value to nothing.

These are the types of fixed-income investments I have decided to avoid due to their vulnerability to inflation.
US sovereign debt of any kind.  The Fed is going to swallow these things whole when foreign central banks sell them in a panic.  The QE needed to absorb the world's outstanding stash of Treasuries will have to be monstrously huge.
Coupon debt of any kind.  This includes any corporate debt or municipal bonds that pay a fixed coupon based on the bond's face amount.  That face amount will be worth less than nothing after hyperinflation ends.  Say goodnight, internotes.
BDCs.  I don't care how generous the cash flow from repaid loans looks right now.  BDCs are highly sensitive to short-term interest rates and real rates will skyrocket at the onset of high inflation.  Their funding is unsecured, which means investors have little recourse to recover assets after bankruptcy.  No thanks.  Finally, their assets are loan portfolios.  High inflation is a debtor's dream come true because it allows them to pay existing debts with future dollars that are worth less than current dollars.  Inflation will destroy BDC loan portfolios.  These are the crucial differences between BDCs and other private equity vehicles.
High yield debt.  No way, ho-say.  This was the first debt category to crack when the market turbulence of 2007 became the crisis of 2008.  Junk bonds are always the first to be wiped out in any market downturn because their issuers have weak earnings or troubled business models.

These are the types of fixed-income investments I am open to considering, given the caveats mentioned.  Their common denominator is their basis in a hard asset sector.
MLPs.  I like pipeline MLPs as a play on hard asset servicing.  Oil and gas are energy hard assets whose demand will be price inelastic during high inflation.  My concern is whether FERC regulations will prove to be so onerous during hyperinflation that they destroy the pricing power of MLPs and their pipeline operating companies.  I cannot rule out regulatory risk with pipeline MLPs.  I may have to wait until renewable MLPs are active.
Royalty trusts.  These are collections of orphaned oil and gas wells whose owners do not need to spend capex to upgrade them.  They pass their earnings through to trust holders as the wells' reserves run down.
REITs.  These are the trickiest to consider.  Some residential REITs will fair poorly during hyperinflation if their holdings are concentrated in urban areas that are hostages to rent control ordinances.  Those will not retain their pricing power during hyperinflation.  Commercial REITs will fare better but many REITs own a mix of properties.  The best sector bet for me may be iShares Dow Jones US Real Estate (IYR), an ETF of REITs, but based on its dividends it's currently trading more than twice what it should be worth.

I feel like restating my enmity for actively managed funds of any kind, including fixed-income.  Bond mutual funds are no longer needed now that index funds and ETFs exist.  Active management of fixed income portfolios is for institutional investors and corporations who must immunize their portfolios against interest rate moves or match durations to liabilities.  They have specific goals in liability-driven investing.  The larger investing world doesn't need to constantly fine-tune a fixed-income portfolio.

I must also reiterate my disdain for the superficial analysis some fixed-income investors use to evaluate the attractiveness of securities.  I've heard some investors claim that MLPs and REITs trading for less than book value are bargains, but if those same entities have low ROEs then there's a reason they trade at such discounts.  The market is discounting their ability to generate cash flow because a low ROE indicates they use capital inefficiently.  They may be paying too much for debt because of past negative credit events or committing capital to operating payouts (like lawsuit settlements or regulatory fines) instead of facilities maintenance or improvements.

Finally, it's worth noting that rising volatility hurts the valuations of fixed-income investments.  The VIX is currently trading below its historical average of about 20.  Any rise in the VIX hurts fixed-income securities, with or without hyperinflation.

I'm staying the heck away from fixed-income investments.  I'll keep my eye on only those few types that generate cash flow from hard assets like commodities or real estate.  

Alpha-D Updates for 11/19/12

This month's portfolio update was extremely simple.  All of the options I wrote last month expired unexercised.  I renewed the short covered calls I typically write over GDX.  I tried to execute some other option plays but for whatever reason they wouldn't take in the system.  Perhaps that is just as well.  I won't try again until after next month's options expiration weekend.  I expect the U.S. equity markets to become extremely unstable as the eventual effects of quantitative easing, the fiscal cliff, and the eurozone's insolvency become obvious.

I remain long GDX, FXA, FXC, and FXF, with no other equity positions.  I have the rest in cash.  I have no fixed income exposure because I don't want inflation to destroy my net worth.

Thoughts On Master Limited Partnership ETFs

The prospect of hyperinflation demands due consideration of hard asset alternatives in a portfolio.  I've been exploring master limited partnerships (MLPs) to see if they fit my investing style.

I spend my daylight hours hearing roadshow pitches from oil and gas prospectors who explore producing wells one property at a time.  These wells are difficult enough for a small company with limited finances.  Pooling single wells into MLPs aggregates their production and enables partners to allocate capital where it can add the most to production.  Pipeline MLPs are intriguing for a related reason.  Their cash flow is the result of amalgamated production in large regions, regardless of how poorly a single well may be performing at any time.

Applying some Boglehead theory to MLPs leads to the conclusion that MLPs arbitrage away risks specific to single wells and pipelines.  It follows that an ETF of MLPs would arbitrage away risks of local geography and single MLP structures, leaving an investor with broad exposure to a flow of hard assets.

I will posit that the cash flow generated by an MLP ETF is a rough substitute for the cash flow generated by fixed income investments.  One crucial difference can make all the difference in a hyperinflationary environment.  Inflation gradually destroys the principal value of a fixed income security and reduces the real value of its coupon payments.  Even TIPS may not be immune to this destruction if their principal resets are not frequent enough to keep pace with inflation, or if the resets are based on artificially suppressed CPI calculations.  A hard asset ETF such as an MLP ETF may not suffer such a deficiency.  Its cash flows are derived from the nominal value of payments made for resource flows, so its value should theoretically hold during hyperinflation if it is rapidly marked to market.

The only MLP ETF I am currently considering for this role in my portfolio is the Alerian MLP ETF (AMLP).  I have not purchased it yet for several reasons.  First, it trades at a multiple of 22 times earnings, pretty pricey given the economy's long term average P/E of 14.  Second, its expense ratio is frighteningly high at 0.85%.  Finally, it has only been around for two years, and has not paid enough coupons for me to find its value using something like my REIT ETF valuation methodology.  I believe that methodology is applicable to an MLP ETF because REITs must pass through their cash flows as dividends to shareholders, just like MLPs.

I like that AMLP is optionable, so that if I did own it I could write short puts under it while inflation drives it up.  Other MLP substitutes like ETNs don't have that flexibility.  Come to think of it, I may decide to buy into it despite my reservations above if inflation really does get going.  Bargain or not, hard assets that generate cash flows bring the best of many worlds when hyperinflation starts destroying the value of everything else.

Full disclosure:  No position in AMLP at this time; this disposition could change with the onset of high inflation in the U.S.

Money Market Fund "New Rules"

Comedian Bill Maher popularized the catch phrase "new rule" to describe some cultural truism that cries out for instant change.  Maybe financial regulators are trying out some material from his script.  The SEC is thinking out loud about some new rules for money market funds.  You may remember those funds from 2008 when the inability of the Primary Reserve Fund to maintain its NAV north of one dollar almost brought commercial activity in North America to a halt.

The only proposed rule that makes sense to me is to make the share price a floating value.  Such a fund isn't cash if it's invested in securities that have some kind of maturity, even an overnight maturity.  Money market funds belong in the general category of actively managed fixed income funds but brokerages are reluctant to break this bad news to clients.  It will mean one less cash management tool in a toolbox already bereft of yield thanks to the Fed's zero interest rate policy.  Wealth management firms had better quickly find some other place to sweep overnight balances if they want to avoid an MF Global kind of collapse in the next surprise credit crunch.

I'm more than willing to use Bill Mahr's method here.  "New rule: A money market fund is no such thing if it doesn't hold money (as cash) and can't be exchanged on a market (due to illiquidity)."  That wording should be easy enough for the SEC to implement.

Full disclosure:  No position in any money market funds at this time.

Updating The Alpha-D Portfolio For Nov. 2010

Here's what I didn't change this month.  I maintain my long puts against LMT (hedging the defense bubble) and IYR (hedging the housing sector). 

I also maintain my long holdings of GDX (gold sector bull), FXI (China bull), TDW (energy services bull and compelling fundamental value).  My covered calls on each expired unexercised and I refreshed them.  I also sold short puts under those three securities.  If they remain range-bound, I keep the cash.  If they drop in a flash crash, I pick up more of what I like at a discount. 

Here's one significant change. For the first time in over two years, I wrote a small number of short puts under EFA.  I do not have a long position yet in EFA but I'm willing to risk acquiring some.  I don't mind a Euro currency crisis or Asian capital controls as the trigger.  I consider EFA to be a way to own non-U.S. markets I can't track myself.  I'm not quite ready to take the same approach with SPY because I'm waiting to see whether a bond market dislocation puts the S&P 500 on sale. 

I didn't add much to my fixed income holdings other than buy a one-month Treasury with my cash proceeds from selling options.  The sickeningly low yields on Treasuries reduce the effectiveness of this yield-enhancement approach.  I just need to stay in the habit of rolling cash into F.I.  It will pay off when interest rates rise after the U.S. is forced to live within its means. 

More Junk Bonds For A Junk Economy

Corporate borrowers with nary a chance of repaying debt are taking advantage of record low interest rates to sell junk bonds:

U.S. companies issued risky "junk" bonds at a record clip this week, taking advantage of keen investor appetite for returns amid declining interest rates and tepid stock markets.

The borrowing binge comes as the Federal Reserve keeps interest rates near zero and yields on U.S. government debt are near record lows. Those low rates have spread across a variety of markets, making it cheaper for companies with low credit ratings to borrow from investors.

Fixed-income investors are so desperate for yield that they're willing to clear the junk bond market of any and all inventory.  The last time I recall seeing stories like this was Spring 2007, just months before the first panic attacks started hitting credit markets.  We can thank the Fed's gamble on QE2 for returning us to this precipice.  Not everyone at the Fed is happy to gamble with America's solvency:

The Federal Reserve is undertaking a "dangerous gamble" by keeping rates at near zero for so long, and must start raising rates or risk damaging the nascent U.S. recovery, a top Federal Reserve official said on Friday.

Helicopter Ben will stay the course despite dissenters like Thomas Hoenig.  China isn't waiting for any further quantitative easing and is diversifying away from dollar holdings in advance of more Fed purchases of debt.  If only American investors could do the same.  Alas, it's too late for many Baby Boomers to diversify, and what little they have left in U.S. assets won't see them through their retirement years. 

America's hard times will last a long time.  Prepare for long, lean years by spending less and saving more. 

Want More Yield? Look Outside U.S.

Fixed income investors fed up with the Fed's ZIRP may wish to look elsewhere for additional yield, like Down Under:

Australia’s central bank raised its benchmark interest rate for the fifth time in six meetings, dismissing warnings that higher borrowing costs are already eroding consumer spending.

Governor Glenn Stevens increased the overnight cash rate target to 4.25 percent from 4 percent, the Reserve Bank of Australia said in a statement in Sydney today. The decision was predicted by 13 of 23 economists in a Bloomberg News survey.

Hey, 4.25% isn't bad compared to darn near zero Stateside.  Professional bond managers are beginning to come around too:
 

Pacific Investment Management Co., which runs the world’s biggest mutual fund, favors currencies in China, Brazil, Canada and Australia on expectations they offer attractive returns amid an uneven global economic rebound.

 
 
Earth to Fed:  Indefinitely holding the target rate at zero will hurt the U.S. whether or not there's a recovery.  Indeed, U.S. Treasuries are no longer considered a safe haven due to the U.S.'s increasing sovereign default risk.  Unattractive yields may be the trigger that sparks a run on the dollar if foreign investors decide they've had enough of holding dollar reserves that earn nothing. 

Crime Doesn't Pay . . . For Some People

Note to fraudsters: You can't always get away with ripping off your clients:

After months of secretly working with the FBI, Bernard Madoff's right-hand man emerged in federal court on Tuesday and pleaded guilty to conspiracy and other charges, contradicting claims by the disgraced financier that he acted alone.

Now if only we can jail the bankers being paid to fraudulently hide junk assets on their balance sheets. Nah, forget that, regulators would rather just ask them to be more discreet when cashing their chaecks:

Bonuses are already set to rise next year, according to New York-based pay consultant Johnson Associates Inc. The incentive compensation for employees in fixed-income divisions of banks may jump 40 percent to 50 percent from last year, the New York- based firm said. Bonuses at asset management firms may fall as much as 35 percent, the report showed.

Last time I checked, mortgages are considered to be fixed-income instruments. That's how they're rated, packaged, and marketed to CMBS buyers. The co-conspirators (banks' fixed-income credit analysts) in hiding the banks' fictionally performing mortgage assets are thus planning to pay themselves even more next year.

What are the crooks rewarding themselves for? Cooking their books, of course. Analysts and auditors who falsely portray non-performing mortgage loans as high-quality assets succceed in delaying inevitable home foreclosures. That gives a whole bunch of unemployed homeowners the impression that the economy isn't getting worse. Does it feel like a bottom? A lot of people are fooling themselves into thinking so:

Optimism on U.S. equities climbed the most since April, according to the Bloomberg Professional Confidence Survey. Investors expect equities to rise during the next six months in a record seven countries, with indexes in Brazil, Italy, the U.K., France, Mexico, Japan and Switzerland forecast to advance.

Good luck, folks. I'm not one for self-delusion. There is no economic recovery. Commercial real estate harbors the next set of defaults to hit the economy. When those hit, we'll be right back in a credit crunch.

I'm staying short.

Taking Risk at the Wrong Time

The small investor is jumping on the wrong bandwagon at the wrong time:

Lately, however, as stock and bond markets have rebounded, mutual-fund investors have had a split personality.

They’re back to buying relatively safe investments like high-quality corporate bonds. But they’re also pouring money into the riskiest investments.

I don't need to go into the disadvantages of actively managed mutual funds here. Consider John Bogle's arguments against active management if you need reasons to know why mutual funds are a worse deal than index funds and ETFs. I also take issue with the article's assertion that high-quality corporate bonds (rated of course by the same credit rating agencies that completely misread MBS risk) are a "safe investment" in an era when public and private sector debt is over 300% of this country's GDP. Oh well. Some people are going to learn the hard way, over and over again. That lesson is coming soon as we head into earnings season for Q2 with some pessimistic estimates:

The year-over-year profit slide for Standard & Poor’s 500 Index members may narrow to 21 percent from July through September, after declines of an estimated 34 percent in the second quarter and about 60 percent in the year’s first three months, according to data compiled by S&P and Bloomberg. Earnings may rise by year-end based on comparisons to late 2008, which was roiled by the meltdown in financial markets.

This is why I'm short the markets, folks, while uninformed investors are busy chasing past performance.

Nota bene: Anthony J. Alfidi is short uncovered calls on SPY and IWM.

Swensen Model Jumps On Inflation Bandwagon

Some of the smartest money managers in the business haven't looked so smart since last September. Maybe now they're getting smart again:

David Swensen, the top-ranked college endowment manager in the past decade, said individual investors should own inflation-protected Treasuries because U.S. economic recovery efforts may lead to an increase in consumer prices.

Mr. Swensen is an original thinker, which is rare among portfolio managers. His Yale portfolio has performed badly since 2008, so perhaps recognizing the inevitability of inflation will help restore his model's reputation. The only disadvantage of using TIPS instead of gold as an inflation hedge is that TIPS are subject to default risk. This is low now, but then again no one thought the U.K. would be in danger of losing its AAA rating for gilts.

I don't own TIPS. I do own IAU and GLD (with covered short puts).

Rebalancing the Alpha-D for May '09

I added to my long holdings of FXI and GDX as further signs of my conviction that China and gold are the best things to own in Great Depression 2.0. I sold puts under both but sold covered calls only on FXI; it's not as volatile as GDX. I wouldn't mind owning more of either involuntarily but I'm not about to risk my GDX from being called away. I'm holding onto my long position in IAU and writing puts under it.

I refreshed my uncovered calls against IWM after they expired at a profit this past Friday. I'm still quite happy betting against an economic recovery in the U.S.

I also bought a 3-month CD as part of my cash management strategy. I'm not at all fond of fixed income in general right now but I'm willing to seek a little extra yield on my idle cash.

The Haiku of Finance for 11/26/08

A few random thoughts
On fixed-income ETFs
Become one long post

Fixed Income Bond Funds Might be as Dumb as ETFs

I'd like to continue my train of thought from yesterday about the difficulty of using instruments like ETFs to actively manage exposure to the bond market. BTW, I may not have been clear in my post yesterday that potential exposure to additional volatility through FI ETFs would come from hedge funds and individual investors who actively trade these instruments. Such volatility would less likely originate with the trading activity of the ETFs' fund management companies (BGI, SSgA, etc.) because their corporate size gives them the ability to buy bonds in bulk to fit their products' maturity ranges.

Anyway, let's see what happens when fund management companies offer actively managed bond funds, rather than ETFs. PIMCO stated today that one of its muni bond vehicles may have trouble delivering dividends to its investors:

PIMCO California Municipal Income Fund II (the "Fund'') may be required to delay the payment of the declared November dividend and the declaration of the next scheduled dividend on the Fund's common shares.
(snip)

Continued severe market dislocations have caused the value of the Fund's portfolio securities to decline and as a result the Fund's asset coverage ratio has fallen below the 200% Level.

If the 200% Level is not met on December 1, 2008, the Fund would have to postpone the payment of the previously declared November dividend and the declaration of the December dividend until the situation is corrected. Depending on market conditions, this coverage ratio may increase or decrease further.

The fund's stated objective is to provide current income; failure to make a dividend payment means it has failed this objective. I am not a securities attorney, so I cannot say whether this exposes PIMCO to some kind of liability. I would say, as a private investor, that any fixed income fund that can't meet its performance objectives because of market volatility, and not for reasons such as asset impairment or fund company bankruptcy, is not worth my personal consideration. If an investor holds a comparable bond portfolio as individual securities and not as part of an actively managed fund, the investor would receive the coupons on schedule.

This isn't just a problem with PIMCO's Cal muni fund. Some of their other funds have hit the same snag:

PIMCO Corporate Income Fund and PIMCO Corporate Opportunity Fund (each, a "Fund'' and collectively, the "Funds'') today announced that each Fund will redeem, at par, a portion of its auction rate preferred shares ("ARPS''), beginning December 15, 2008 and concluding on December 19, 2008. The Funds also announced that they may postpone the payment of previously declared November dividends for common shares and postpone the declaration of dividends for common shares, currently scheduled to occur on December 1, 2008.

But wait, there's more! Other PIMCO funds had problems just last week that will prevent them from paying declared dividends:

The Boards of Trustees of PIMCO High Income Fund, PIMCO Floating Rate Income Fund and PIMCO Floating Strategy Fund (each, a "Fund'' and collectively, the "Funds'') today announced each Fund will redeem, at par, a portion of its auction rate preferred shares ("ARPS''), beginning December 8, 2008 for PHK and PFN and December 10, 2008 for PFL and concluding on December 12, 2008 for all Funds.

PIMCO is regarded (by those same market "experts" who told us securitization of debt was a great innovation) as a firm chock full of bond expertise. If this vaunted expertise couldn't anticipate a volatility-induced payment stoppage in several bond funds, then what exactly are investors getting by paying PIMCO to actively manage their bond money? PIMCO sure has a snazzy website for press releases, which curiously doesn't feature the releases noted above. Any asset redemptions (sales) PIMCO has to make to meet that 200% threshold may come back to investors as taxable capital gains distributions from the funds! Aw, that's just great (sarcasm filter off).

Here's my approach to fixed income investing. I currently use some fixed income securities (CDs, Treasuries, corporate notes, and others with short-term maturities) as my cash management strategy for the proceeds I collect from selling options. I buy them and hold them to maturity. It's that simple. At some future date I'd be willing to buy long-term bonds to protect my principal and get some form of interest rate immunization, but once again I will hold them to maturity. I am not going to waste my time or money actively trading bonds to try to outguess the Fed's interest rate changes. I have a life, you know.

Oh yeah, PIMCO is yet another firm that never responded when I sent them my resume. Now they're having problems. Coincidence? I don't think so. ;-)

A Brief Comment on the Pointlessness of Fixed-Income ETFs

Here's a repost of something I posted to Seeking Alpha now that I've expanded my reach there:

Fixed income ETFs make little sense to me. The point of having FI in a portfolio is to generate a regular cash stream and smooth out volatility through diversification. Throwing an FI ETF into the mix may actually raise portfolio volatility because hedge funds and day traders will be tempted to time FOMC moves. Also, if you're a covered call writer (like me), the option chains are so thin on FI ETFs as to be useless. In this market a buy-write strategy can easily see you position called away. No thanks to fixed income ETFs!

I'll have more to say on ETFs as time goes by. I am conquering the world wide web of finance, one pithy post at a time. ;-)