The Curve Flattener

Sometimes I feel horribly worthless looking at fixed-income investments when turmoil in the Middle East and disaster in Japan are creating tense shocks to equity and commodity markets, something that would be so interesting to dive right into. At the same time however, these events also emphasize the value of making wise fixed-income decisions and how desirable these investments can be once a rate has been locked up long term.

Leveraging and interest-rate spreads (difference in interest rate between a products of different durations or for different purposes) are basic financial ideas which banks rely on as a foundation to their revenue.

If you lend long term (i.e. 30 years) and borrow short term (1 year), you will earn the spread between these two rates. This is an introduction to the [Strategy #2] “carry trade”.

Source: U.S. Department of the Treasury – Resource Center (3/15/2011)

Normally, yields are upward sloping, and while there are many theories regarding this, I prefer the ‘Liquidity Premium Theory’. Liquidity Premium says that investors are paid a premium for sacrificing liquidity in addition to the expected returns on investment lifetime (also notes that bonds of different maturities are partial substitutes). This theory explains the term structure of interest rates, mainly:

• interest rates on bonds of different maturities move together
• yield curves are upward sloping when short-term rates are low, downward sloping when short-term rates are high
• yield curves almost always slope upward.

While this strategy may seem harmless initially, it is not without its flaws: inflation fears and default risks, which can seriously hinder the maneuver long term.

Stairway to Heaven

The thing about fixed-income is that if you get it right the first time, you’re golden. If you’re wrong, time passing by feels like the seething pain of a Castle-Beckett, Leonard-Penny, Bones-Booth relationship you hope for, but takes eternity to come to fruition. Actually, it’s worse than that cause at least those relationships keep you wanting more. This pain drains you.

When building the base of a portfolio, look at CD’s (certificate of deposits) because any investment in this product under $250,000 at a bank is insured. If you have more moolah, mix and match and revolve more banks into your merry-go-round to create an endless amusement park for secure deposits and returns. But only the longest rides receive the best rate of return- so how do you solve this liquidity problem if you find yourself stuck on a ferris wheel?

Let’s say you’ve decided to place $100k in CD’s. Instead of throwing it all in a 5-year CD to take advantage of top bracket rate, splitting the sum into five allocations results in – let’s call them “rungs” – of $20k each. Distributing each rung into five different CD’s, one for 1, 2, 3, 4, and 5 years, gives you five different maturity rates.

With this strategy intact, you sacrifice midterm return for immediate liquidity. When each CD matures, you can either use the funds to reinvest in better opportunities, or push it back to the end of the line with another 5-year CD. After four years, you will have the full fund gaining 5-year rates with 1-year liquidity advantages. In other words, you will then be receiving 5-year rates with only a 1 year wait for each rung. The key advantage here is spreading out interest-rate risk by presenting more opportunities to you as each rung matures, allowing you to assemble your [Strategy #1] CD ladder. Of course, this planning idea can be transposed to bonds and other fixed-income products with customized duration and amounts. Laddering fixed-income investments has become largely popular today with interest rates expected to rise and ambivalence in the equity market. Its overall advantages are providing diversification and immunizing the portfolio from interest rate fluctuations.

As you can see, even in the long run, the sacrifice is very minimal.

(Top: Fund value for CD allotment strategies | Bottom: Difference in overall return | Rates determined by Ally Bank at time of writing, given constant interest rates)

PIMCO’s Perceptive Paradigm

Class started back up today and I actually feel thankful I’ve spent many hours on this blog seeing as I was able to get through the majority of my studying for Money & Banking. I’ve really only discussed 4 or 5 chapters so I’m excited to share the notes I’ve taken on the rest of the material. Many of my readers reminded me I would present my thoughts on trading strategies and portfolio ideas by the weekend, but I really feel like the PIMCO investment decision is worth analyzing first (well, it is an investment scheme nonetheless). I promise tomorrow I will start looking at the first of a few trading tactics and their theories.

My blog mentioned PIMCO trashing their investments in U.S. Treasuries (>1 year) earlier last week when the decision was first announced. Now that we’ve discussed the environment of interest rates and partially because there was a large discussion in my Business Insurance course today on investors backing off fixed-income products, this is an opportune moment to find takeaways from a real-life situation of interest rate expectations.
_____

PIMCO, Pacific Investment Management Company, was founded by its chief investment officer William H. Gross. The Total Return Fund, its prized asset, has been historically successful, beating 84% of competitors with a +7.43% return last calendar year. The TRF houses in the range of $230-250b.

Illustration: Michael Mucci (WAToday) – Bill Gross of PIMCO

In its basic motive, Gross believes that interest rates will increase dramatically in the future (enough to reduce government bond holdings from $147b in June 2010 to 0). When I spoke about what determines interest rates in my previous entry, long-term rates are an expectation of average rates over that duration. It seems too obvious right? The discount rate set by the Federal Reserve has been from 0 to 25 basis points during this recession that there seems to be no direction but up for interest rates to go. Furthermore, rising inflation has pressured the Fed to raise their rates soon. In fact, this drain on U.S. bonds may very well just boost up rates going into the future.

When I raised my opinion that interest-rate risk is more of an “opportunity risk”, this example has clearly proven my point. PIMCO has allocated its assets from Treasury bonds to cash and short-term holdings so when rates do start climbing again, it will be in a strategic position to repurchase. Duration is a bond’s sensitivity to interest rate fluctuations, and going short duration is an investment strategy when rates are expected to rise. Shying away from safety seems unusual considering what is happening in Libya, the disaster in Japan, China’s real estate bubble, and the stale economy domestically. Some have even hinted that because of these uncertainties, bonds are on the buy side now, but it would be foolish to agree to this in the 10-30 year range.

If you think about it, buying long-term Treasuries today will be just as painful as buying an Isgro’s chocolate cake and not being able to touch it, taunting you for years. I can only imagine having a 10-year bond and in 2020, be receiving coupon payments that are only 25% of what I could be making if I had waited. I would be knocking myself on the head for every payment I received and not knowing if  I should sell my asset or not because its value has declined so much in said future. Serious props to those who bought bonds in the early 1980’s when rates were in the teens and have recently beat inflation three/fourfold with no risk. How bitter they must be that these grandfather bonds have all but expired or are soon to be.

“It’s not a question of dissing the United States or questioning the credit of the United States, but simply a maturity reflection,” Gross said. And I agree with him that bonds are “mispriced”. I briefly acknowledged in my previous post that bonds and equities together are substitute goods; with the Dow Index up ~26% from June last year, the only question left in relevance is how much bonds are mispriced by.

Ceteris Paribas

I’ve always thought interest rates were determined by some arbitrary combination of economic data and government decisions calculated on a supercomputer hidden somewhere deep within. On the contrary, interest rates, like all other prices, are manufactured from the omniscient supply & demand framework. Indeed, even a rudimentary understanding of S&D models can allow us knowledge and opportunities of limitless ends if we have the ability to anticipate behavior of interest rates changes.

Demand Side
Long-term bond price is a reflection of expected prices in the future. Thus, if there are grandiose expectations for future returns, investors will pull out of bonds today, thereby decreasing the quantity demanded for bonds today. Also, the inherent nature of specific bonds can determine its demand; investors shy away from risk (decreasing demand) while embracing liquidity (increasing).

Supply Side
Many of the variables associated with the supply side of the bond markets are positively correlated. These include government deficit, expected inflation, and profitability on other investments. In regards to investor profitability, bond prices tend to swim against the flow of other markets. Because bonds are seen as safe investments, uncertainty in other markets decreases the price of bonds (increases interest rate). In general, I look at bonds and equities as substitute goods- if the stock market is booming, interest rates tend to move upward to attract more buyers. Most importantly, each factor change in the demand and supply of bonds hinges on the assumption of “other [factors] being equal”. It is then that we can pinpoint accurate interest rates at equilibrium.

(Figure: Supply & Demand framework in the bond market -> determination of interest rates)

Money S&D (alternative model to bonds S&D)
We invest in bonds because they are the most viable replacement for plain money. This “Liquidity Preference Framework” (equates S&D of bonds to S&D of money) acknowledges that income and price level are the main factors positively correlated to money demand. On the same side of the coin, the quantity supplied is positively correlated with money supply, arguably resulting in a lowering of interest. I say arguably because indirect consequences occur from money supply changes. If money is gloriously pumped into an economy, doesn’t income, price level, and expected inflation all rise as well? Doesn’t that lead us back full circle to adjusting the money demand curve? The idea here is to analyze the lag of secondary effects from money supply changes to realize absolute shifts in our money S&D model.

Consequences of Interest Rate Changes

The Federal Reserve Bank decides to buy $600 billion worth of U.S. bonds. Now that’s something I actually might have heard on the evening news two years ago. As simple monetary policy rules apply, investors can expect interest rates to drop in an attempt to stimulate the economy. So how does this affect debt-investing strategies?

When casual investors think of fixed-income returns, the first things that usually come to mind are U.S. Treasuries, largely because they are safe havens backed by the freedom and liberty of Barack Obama (and the full faith of the United States government). I wonder what the public is supposed to do when the largest bond fund trashes all their U.S. securities…

Let’s discuss the consequences (today) and behavior (tomorrow) of fixed-income variables and hopefully touch on asset-protecting and trading approaches by next week. Maybe then can we see why PIMCO believes U.S. Treasuries are “overvalued”.
_____

To casual investors, U.S. Treasuries are as safe as cash. To entrepreneurial investors, risk abundantly seeps through every trade and keeps them up at night. No, not so much the risk of default, but interest-rate risk. To me, it’s like buying the new iPad 2 (I swear I’m not an Apple rep) at full price only to have them come out with a better, flashier, state-of-the-artier iPad 3 the next day. Now I hate my iPad 2. I don’t like my 10-year Treasury Note at 3% anymore either if one year later, it’s risen to 3.5%. That may not seem like a fortune, but for me to lose half a percent every year for 9 years, maybe more…? In this regard, interest-rate risk is associated with the idea that prices and returns are more volatile for long-term bonds. This also explains why in an economy with shallow interest rates, shorter-term bonds will allow you to use liquidity as an advantage to realize higher returns from future opportunities. From my perspective, interest-rate risk is more of a loss of opportunity, although casual investors may lose out if inflation persists.

This leads me to the second major consequence of interest rate changes. While that 10-year Note I bought before might be at 3% (nominal), if inflation creeps up on me at 5%, I’ll actually be in the red, -2% (real)! Inflation is like an invisible thief; with the right goggles, you can set up sufficient defenses (TIP Securities). Inflation above a healthy level is something that plagues everyone, and a weapon governments utilize to tax citizens through its money supply control. // Because low and middle-income citizens hold more cash than the rich, they’re the ones suffering when money is relentlessly pumped into our economy! There is no reason high-income individuals should be lobbying for budget cuts while pushing against raising tax rates in the top bracket! But, I get carried away // Back to my main point: there are greater incentives to borrow with low real interest rates, and vice versa.

In summary, the two direct effects of changing interest rates on fixed-income investing are

• fluctuating returns (obviously)
• borrowing and lending incentives.

By understanding the immediate consequences, maybe we can uncover the indirect impacts in connection to other assets such as commodities and foreign currencies in future posts.

Shakespeare Capital

Page 1 – “On the evening news you have just heard that the Federal Reserve is …” I’m already dosing off. I want to skip to the juicy stuff so I read the PowerPoint summary my professor posted online instead of the textbook for Ch. 1: Why Study Money, Banking, and Financial Markets? Most of this information (GDP, unemployment, price level, calculating growth) I’ve seen from beginning Econ classes. Afterwards, I skim through the chapters of the textbook (first time all semester, I must confess) to get a grasp of the content I should be preparing for on the test. The majority of the chapters deal with interest rates, foreign exchange, and some equities so you’ve been warned – these are the heavy topics for the beginning of this blog.

By the time I’ve finished the first 3 chapters of the book, I pretty much just plowed through the tedious functions & structures of financial markets and money. Takeaways: (1) markets allow surplus money to flow toward those with shortages to (2) promote economic efficiency. Got it. Hopefully I don’t get tested on much more than that from these intro chapters.
_____

I’m going to cook dinner tonight (Mexican) so this is my last chapter (Understanding Interest Rates) today before reading about the consequences of interest rates and what drives interest rates.

If you’ve ever taken an intro finance or economics course, you probably understand that time literally is money. In Hamlet, Shakespeare famously claimed “Neither a borrower nor lender be,” but clearly he didn’t appreciate the anatomy of capitalism. Borrowing/lending drives economic growth and the time value of that money is interest. Obviously, interest rates change perpetually and differ depending on who the money is borrowed to.

Say I decide to purchase roundtrip tickets to China today with my Ivyfund ($900) instead of keeping it in the CD; my monetary opportunity cost is the $23 of interest the fund would have earned in 1 year. In essence, is it worth $23 to me to travel this year as opposed to next? If I extrapolate this theory further and let my 2.5% APY CD mature, I will have $1018 before I leave to Asia. I like everything ASAP because who knows what will happen 5 years down the road (no time to travel, inflation, etc). My CD is worth less to me today because I enjoy the gratification of consuming today. Same with life – everyone wants to eat their dinner while it’s hot, be the first in line for the new iPhone, or watch American Idol as it airs and not the rerun.

[FV – Future Value, PV – Present Value, t – time, i – interest]

I wanted to dedicate a whole post on the time value of money because of the influences it has on fixed-income investing. In fact, how to evaluate present and future values is the foundation of fixed-income. Having a strong grasp of this concept helps determine liquidity, rate of return, and overall cash flow in a business or portfolio. So, when you think it’s harmless to wait 6-8 weeks for that $200 rebate on your new computer or a half month to receive your delayed paycheck, think again: time just cut open a hole in your pocket full of change.

The credit market includes simple loans, fixed payment loans, coupon bonds, and discount bonds. Key facts to remember:

• When coupon rate = yield rate, bond price = face value and vice versa
• Bond price and yield rate are negatively correlated.

Historically, fixed-income securities have always been the low-risk low-yield components in a portfolio, although they now have wary investors on their toes in regards to munis and sovereign debt. Good thing we didn’t let playwrights run this country.