Recently a client of mine called me and asked me about a bond fund that his other broker was telling him about. When I researched the fund, the actual way the fund works, it is almost laughable that this type of security exists. If you went to a store and bought a pair of jeans and the sales person told you that these are the best type of jeans but if (or when) they fall apart we'll give you another pair and if that pair falls apart we'll just give you another one, would you buy the jeans? I say probably not because how is this jean company going to have the money to keep replacing your decayed jeans when you only bought one pair to begin with? This is the same idea when dealing with securities. If you don't understand how an investment is going to pay you, or it doesn't make sense logically, then it's simply not a solid security. When you invest in a security whether it be stocks or bonds, your broker should be able to tell you exactly what will be paying your dividend/interest. If he or she can't explain it in terms that you understand, don't buy it.
This particular fund was supposed to pay out 2.65% and was rated AAA. When I looked at the individual bonds that made up the fund, nearly all of them were no where near AAA quality, in fact, 20% of the fund were bonds that were rated below minimum bank investment grade (Baa3/BBB-). I called the company that put the fund together and asked how this fund had a AAA rating. The woman I spoke to explained to me that the fund starts out with a AAA rating, if it gets downgraded to AA, the payout instead of being 100% of 2.65% it will be 110%. She then told me that if it gets downgraded again to A the fund will pay out 125% and then 150% if it gets downgraded to BBB and then it will pay 200% with a BB rating meaning instead of paying out 2.65% it will pay 5.30%. I asked how this was possible because if the fund gets downgraded, it probably means that one of the bonds within it went bad, and therefore is not paying so where are they going to get the money to pay the holders the extra yield promised? It simply doesn't make sense. As an example, if there are 10 bonds that make up a fund and they each pay $10 so the investor is making $100 off the fund and one of these bonds goes bad and the fund is only collecting $90, how is it going to pay the investors $110? Where is the money supposed to come from?
This is exactly what got the securites industry in a mess to begin with, people were buying these Collateralized Debt Obligations (CDOs) and Collateralized Mortgage Obligations (CMOs) without a clue as to what was paying their interest. Even the brokers didn't know exactly what they were selling! The broker that presented this fund probably only knows that it's a bond fund and rated AAA, that's it. Everyone thinks finance is an area that's very confusing but that's only true when your broker doesn't understand the security they're presenting and therefore can't explain it to you.
The moral of the story is if you don't understand how a company is going to continue to give you new jeans to wear when the ones have keep falling apart and you only bought one pair, then what's probably going to happen is the company will go out of business and you will be left pants-less.
Monday, January 25, 2010
Thursday, January 14, 2010
When in Doubt, Run the Other Way
When our entire economy came crashing down around ours ears, the only businesses that were shaking in the boots more than the real estate companies, was the retail industry. Between Barneys, Saks, Bloomies, and Bergdorfs sales have been running rampant. Nearly every brand that these stores carry took the approach of marking down their covetted items. I loved the sales but the problem was as a buyer I started thinking, if I can get these shoes 50% off, then why not wait to buy them until they're marked down to 70% off? So while there were great deals out there, the companies that were in competition to mark down their product more than the next company, didn't realize that they were devaluing their product. If I can buy a $500 pair of shoes for $200 or $300, why would I ever again spend $500 on this type of shoe? Nearly every single one of these companies that took the frantic mark down approach had dismal earnings last year. The only company that stood out among the rest was Hermes. Instead of focusing on marking down their items, they kept their prices the same and produced ads about how well made their lines of clothing and bags are instilling an idea how buying a product of theirs is an investment. Since it's so well made, the product will stand the test of time and therefore be worth whatever extravagant price. As a result, Hermes was one of the only high end brands whose earnings didn't tumble in 2009. As an investor, you should take a note from Hermes and not follow the crowd as they franticly buy super short term investments for fear of inflation.
Right now short term municipal bonds are yielding incredibly low. The reason for this is that since everyone thinks there's going to be massive inflation, they don't want to have long term investments where their interest won't be worth much so the demand for short term bonds is through the roof! The only problem is, there isn't actual inflation happening and there won't be until our employment figures start to turn around. Traditionally when inflation happens, the price of lets say milk goes up so the worker tells their boss they need another dollar in their paycheck to pay for this milk, the boss raises the salary causing wage inflation which in turn causes true inflation. What's been happening now is when the employee asks the employer for another dollar in their paycheck to afford the rising price of 'milk' the employer can't give it because then the company won't be competitive with all the other companies worldwide. Moral of the story is the employer closes up shop, letting all the employees go and opens up a shop in China, Vietnam, or wherever else he or she can for less money. This has been happening for the past 10 years and until we figure out a way to get employment on the rise, inflation is not a serious concern. My advice is to be like Hermes, go the other way. Invest in medium term bonds (10-15yrs out) to take advantage of what yields you can while not going out too far so you'll be prepared for when inflation does actually hit.
Right now short term municipal bonds are yielding incredibly low. The reason for this is that since everyone thinks there's going to be massive inflation, they don't want to have long term investments where their interest won't be worth much so the demand for short term bonds is through the roof! The only problem is, there isn't actual inflation happening and there won't be until our employment figures start to turn around. Traditionally when inflation happens, the price of lets say milk goes up so the worker tells their boss they need another dollar in their paycheck to pay for this milk, the boss raises the salary causing wage inflation which in turn causes true inflation. What's been happening now is when the employee asks the employer for another dollar in their paycheck to afford the rising price of 'milk' the employer can't give it because then the company won't be competitive with all the other companies worldwide. Moral of the story is the employer closes up shop, letting all the employees go and opens up a shop in China, Vietnam, or wherever else he or she can for less money. This has been happening for the past 10 years and until we figure out a way to get employment on the rise, inflation is not a serious concern. My advice is to be like Hermes, go the other way. Invest in medium term bonds (10-15yrs out) to take advantage of what yields you can while not going out too far so you'll be prepared for when inflation does actually hit.
Thursday, January 7, 2010
Do Bonds Die?
While usually my posts have been silly and fun this one touches on a bit of a more serious topic. This week a close friend that I grew up with lost her Mother to brain cancer. The saddness and frustration I feel can't be put into words on how this insulting disease took a vibrant woman from our world. When thinking about how to cope with this, I realized the best way is to think about how Anita Friede is still with us. Her certain nuances, sense of humor, way with words and style savvyness live on in her daughters. Also the memories from people who's lives she touched keeps her with us. While the feelings an investor will feel when losing an investment cannot compare to losing a loved one, when a bond defaults it usually ends up sticking around in the same way that Anita will.
The default rate on municipal bonds is extremely low to begin with but if you look at the default rate on general obligation bonds that are rated minimum bank investment grade (Baa3/BBB-) the default rate is less than 1%. The only state general obligation bond that has defaulted in the past 100 years was the state of Arkansas during The Great Depression. Typically when a bond defaults, it will miss an interest payment or two and then will end up paying off in arrears meaning that the bond will pay it's interest late and will also pay interest on the lapsed time. Basically more often than not once a bond has "hit the D" it still lives on and pays off in full just a little late. This was the case with Arkansas in the 1930s.
A number of small towns default on bonds every year. Mainly these towns are unrated because the issue of bonds was so small they didn't want to pay for a rating. The reason some of them default is usually due to the fact that the town had an unexpected expense that it had to pay off first and then could continue paying it's interest.
The moral of the story is when a bond defaults, don't panick, it's likely that you will end up getting all of your principal and interest back just a little later than expected. I can only compare this to Anita because she left such a mark on the world that even though she has phyisically left us, those who knew her will benefit from their time with her in the years to come.
The default rate on municipal bonds is extremely low to begin with but if you look at the default rate on general obligation bonds that are rated minimum bank investment grade (Baa3/BBB-) the default rate is less than 1%. The only state general obligation bond that has defaulted in the past 100 years was the state of Arkansas during The Great Depression. Typically when a bond defaults, it will miss an interest payment or two and then will end up paying off in arrears meaning that the bond will pay it's interest late and will also pay interest on the lapsed time. Basically more often than not once a bond has "hit the D" it still lives on and pays off in full just a little late. This was the case with Arkansas in the 1930s.
A number of small towns default on bonds every year. Mainly these towns are unrated because the issue of bonds was so small they didn't want to pay for a rating. The reason some of them default is usually due to the fact that the town had an unexpected expense that it had to pay off first and then could continue paying it's interest.
The moral of the story is when a bond defaults, don't panick, it's likely that you will end up getting all of your principal and interest back just a little later than expected. I can only compare this to Anita because she left such a mark on the world that even though she has phyisically left us, those who knew her will benefit from their time with her in the years to come.
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