Bonds 01 (May 08 - Aug 10)

[millionairemind]

SUPERTRADER CALLS FOR A BOND DECLINE by Brian Hunt

It doesn't take long for a great speculator to explain how he or she makes consistent money in the market. The whole art can be summed up in eight words: "Whatever the crowd does, I do the opposite."

i think in its simplistic form, this statement bears only 1/2 truth.... for a speculator (which is a latin word for "to watch"), risk and capital management are 2 other aspects that when combined with many other skills...

no one should believe that being a contrarian is the way to consistently make money.

To add to this, I would say the crowd is ALWAYS RIGHT on the trend until it bends. You want to be with the trend which the majority of the crowd is on until it breaks down.

It is the breaking down that hurts the crowd.

Eg, when Nasdaq was 3000, everybody was screaming it cannot go any further. How about 4000?? That was when everyone was jumping in.

At 5000, everyone was saying Nasdaq was on its way to 7000.... that was when the trend bends and broke.

Substitute Nasdaq for Shanghai Stock Exchange from 2004 to 2007 or Crude's meteroic rise ... and you get the same pattern.... cos' human beings never change.

[b0rderc0llie]

[
To add to this, I would say the crowd is ALWAYS RIGHT on the trend until it bends. You want to be with the trend which the majority of the crowd is on until it breaks down.

It is the breaking down that hurts the crowd.

Eg, when Nasdaq was 3000, everybody was screaming it cannot go any further. How about 4000?? That was when everyone was jumping in.

At 5000, everyone was saying Nasdaq was on its way to 7000.... that was when the trend bends and broke.

Substitute Nasdaq for Shanghai Stock Exchange from 2004 to 2007 or Crude's meteroic rise ... and you get the same pattern.... cos' human beings never change.

Agree to that. There are different ways to play it though.

I like to be on the other side of the crowd and opposite to the trend, so that when the trend breaks, I will benefit. I need to make sure that I can hold my positions until the trend breaks.

[kennynah]

that's timing the market and that's a entirely different angle altogether...

[winston]

The problem I have with stocks – and it is a very simple problem – is that while stocks are nicely priced, they aren't attractively priced relative to their own bonds.

The savagery of September, October and November was more drastic for bonds than it was for stocks. A 40% drop in stocks is big. A 20% to 30% drop in major categories of bonds is immense. So the take-no-prisoners market actually widened the opportunities on the bond side even more than on the stock side.

Investment-grade corporate bonds are a vivid example of that. The yield spreads over stocks is averaging about six [percentage points] right now. If you can get a 3.5% yield on stocks and 9.5% on the same company's bonds, which is going to give you the higher return?

– Rob Arnott, Founder and Chairman, Research Affiliates, as told to Barron's

[ucypmas]

I have been reading a number of articles on and off over the past few weeks about the flight to Treasuries and the resultant carnage in the markets for corporate bonds.

My question is that does anyone here invest in a bond fund especially those which invests in high quality (investment grade) corporate bonds?

Below is a sample from one of the articles. The full letter is at http://www.arpllp.com/core_files/The%20Absolute%20Return%20Letter%201208.pdf

Cheers

One final point – if you wish to take advantage of the opportunities currently presenting themselves, look at credit, not equities. Leveraged loans had an absolutely dreadful October, suffering from forced liquidations amongst hedge funds facing large redemptions and banks downsizing their balance sheets. At the beginning of the month, senior secured loans traded around 80-85. Four weeks later the average price had dropped to 60-65. The worst ever default rate for senior secured loans is about 8% and the average historical recovery rate in bankruptcy situations is 74%. If you assume a 35% annual default rate (!) and a 50% recovery rate, at current prices, the IRR to maturity is 22-23%, using no leverage whatsoever. John Reid at Deutsche Bank has calculated that the implied P/E ratio on senior secured loans is now less than one third that of equities. Either this is the investment opportunity of the century, or equity markets have seriously underestimated the economic downturn in which case things will get a whole lot worse for equity investors.

Some investors have asked us whether corporate high yield bonds offer a similarly attractive opportunity as they have also sold off. My advice is to stick with senior secured loans. First lien only. The typical capital structure of a leveraged company is far more complex today than it was in the last recession, and there is a great deal more debt on the balance sheet than there used to be. Historical default rates and recovery rates for high yield bonds are therefore meaningless. I wouldn’t be surprised if the average recovery rate on high yield bonds in this recession ends up being close to zero. First lien is the new high yield. Be content with the returns they offer. Don’t be greedy. It doesn’t pay in the long run as many investors have learned over the past few months.

Niels C. Jensen

© 2002-2008 Absolute Return Partners LLP. All rights reserved.

[kennynah]

ucypmas :

i dont single out bond funds to invest in...in fact, i probably never bought into an bond investments.. since u have read quite substantially, why dont u educate us in this forum about the basics of this investment... thanks.

[ucypmas]

To the extent I understand bond price movements - take for example a treasury bond with a fixed coupon of 4% for a 10 year treasury (which was about 2 months ago), the yield has now been pressed to very low levels of 2.5% thanks to the Fed's continuous cutting of their target funds rate. At the same time the face value would have rallied by 60% (4/2.5). Not surprisingly if you check with fundsupermart, quite a number of bond funds (those holding large amounts of US treasuries) are up by 10% since the past month or so. Which is superlative compared to most equity funds...

Of course this is a pretty simplistic view, there are other complexities such as length of time to maturity, current interest rate environment, default risks etc all of which affect the value of a bond. If someone knows the mechanics better, please post an article or feel free to add to the examples.

On bond market, most of the articles I read have about the same story; after Lehman failed in Sept and the credit markets got into a bit of trouble most large institutions and funds are no longer keen on holding corporate paper as a place to park their cash and get some yields at the same time, preferring to hold Treasuries to ensure that the $$$ will still be there a couple of months down the road when they want to reallocate/access their capital. They don't want to be stuck holding some debt paper (e.g. on some Indonesian company) that they can't sell off to raise cash when they need it. So presumably this phenomenon is pretty widespread. And coupled with the selloff in Oct/Nov, it seems that bonds (company bonds, not US treasuries) are where the undervaluation is.

So using his example and simplifying further, let say that you buy 100 different bonds with zero coupon (no interest) with a maturity value of $100 each at $65 per bond, incurring a capital cost of $6500. And lets say they all are due to be redeemed after one year. If 65% of the bonds make it and the remaining 35% go bust due to the underlying companies going bankrupt, you will still have $6500 (your capital back less the time value of the money). If you have bought "senior" paper which stands at the front of the queue when a company is liquidated for recovery of assets, and assuming the recovery rate is 50% of face value, you will still get $1750 from the bonds which have "gone bust" (after they sell off the office microwave etc). Total return is therefore $8250 vs $6500 spent purchasing the bonds in this scenario, in one year.

He also mentioned that for investment grade stuff (i.e. senior secured notes from good companies) in the worst ever experienced defaut rate is 8% (based on history), and the bankruptcy recovery rate in such instances is 74%. So if we use his assumptions, then you will get back $9200 from the 92% of bonds that make it to maturity, and $592 from recovery after liquidation; total $9792, which is 50% gain. In bond funds the law of large numbers will result in some kind of average default / recovery being played out (and returns are of course lower due to diversification of those funds). And of course the current recession may be different and we may experience much higher default rates etc. But still...

Anyway out of curiosity I was nosed around bond funds at fundsupermart - the worst performing bond funds over the past 3 months are what they call "high-yield bond" funds, or "below investment grade bonds" aka "junk-bonds". Most of the funds are off about 25%, or more. Some of them I probably wouldn't touch as they have large exposures in Latin America and the ex-Soviet Union states - if things go bad these countries will be among the first to default. High yields / junk bonds are also lower down the feeding chain when it comes to recovery of assets.

The writer below made the point that to invest only in senior level bonds will stand the highest chance of recovery. He thinks historical default and recovery rates for high yield bonds are no longer usable in this environment, so the apparent low price in high yield bond funds could be a red herring. So again my question - if anyone here has knowledge of bond funds available in Singapore which focuses on the corporate sector bonds (globally), appreciate if you could share your experience and knowledge.

And while we are on bonds, on wider scale if the credit markets remain in this state there will be lots of damage to the economy. The credit markets need to go back to some kind of normalcy before a proper stock market recovery can take place.

[kennynah]

ucypmas : thanks for this informative post.

as i mentioned, i have not invested in bonds and bond related instruments. my additions below would hence not be from experience but merely just my minuscule knowledge.

a) Fed Funds Rates - given that they are now at almost rock bottom, the only directional move for them will be upwards through time. Since these Fed Fund rates are inversely correlated to T Bill prices, I would imagine that it might be a little too late to be considering T Bill investments. That is, going forward another 1 year, the maximum that Fed can do is to lower their lending rate down by a max of 1/2%... there's not much downside to this anymore. Hence, the rallies in T Bill prices would have upside limitations.

b) Corporate Bonds - whether they are classified as "senior notes" or otherwise, these ratings dished out by rating agencies. In the last months, rating agencies were seriously criticized for their lack of objectivity when evaluating companies' earning/solvency status. A point that Winston has stated time and again is very relevant here. If these entities, whose Bonds they issue, are not located where you are living/.staying, it is even harder for any good assessment of their business viability, except to make some best guess efforts. Eg, it probably is easier for us to evaluate if it is safer to buy Bonds issued by United Engineers, than for us to determine if General Motors Bonds, will be redeemable successfully at maturity.

c) If i am not wrong, there's management fees that needs to be paid to purchase Bind Funds from fundsupermarket or any of such houses. This "commission" must be determined in advance to factor the eventual rate of returns from an investment viewpoint.

I am stand to be corrected for all the above i stated...so, please educate me even more...

thanks.

[ucypmas]

Hi kenny

You have made some very good points and I fully agree with the things that you have said.

a) Investors not vested since Sep would have missed the T-bill rally. The train has left the station and its too late to join now. Outsiders have now said that there is a "bubble" in T-bills and one should be short. The Fed is determined to keep rates where they are and the treasuries could hold at these levels for some time yet, but countering that is a bond's future income is well known in advance (the coupon rate is fixed) and it is very difficult to hold bond rallies. Unlike the way equity markets can go on and on due to investors continuous hope that future earnings will be higher, and other new investors (or speculators) will be willing to pay even more than what they pay for their stock.

b) You have a point with regards to the degree of competence (or incompetence) of these rating agencies. My thinking on the corporate bonds is that as an asset class they have been bashed down so badly, that buying as a basket (i.e. through a fund) would see limited downside. This however also means that any returns would be somewhat "diluted" due the inherent nature of these funds (through management fees, trading attrition, lack of concentration in very good securities etc).

c) Buying through online houses such as POEMS and Fundsupermart gets you somewhat lower entry fees. In most cases the fund will quote a sales charge of 5%. Financial advisers peddling funds they represent (e.g. Income, Great Eastern, AIA, Prudential etc) may quote a fee that is somewhat lower, and some may also offer a range of fees (from 3-5%) which include "advice" from the FA. Online houses such as POEMS however charge only 1.5% front end sales charge. I would consider the online house cost (1.5%) to be ok, instead of the prohibitive 5% charge quoted on most brochures.

I see unit trust funds as a way to access markets/asset class that I cannot do on my own. And only in cases where there is a clear proposition for long term gain in relative to other opportunities that I have. For example I would never want to buy a UT invested in the Singapore market as it is a place I can understand, can do some research on my own (e.g through places like Huatopedia) and I am able to purchase individual stocks in myself.

[millionairemind]

Published January 9, 2009

Distressed bond numbers surge
Perceived credit risk pushing up yields of corporate bonds in Latin America and Asia
(NEW YORK) The housing and credit crisis in the United States has created an eight-fold worldwide growth in distressed bonds, which are now cracking new frontiers in Latin America and Asia.

Distressed corporate bonds, defined as debt whose yields trade at levels of more than 1,000 basis points higher than those of benchmark government bonds, were confined almost exclusively to US shores a year ago.

Now, credit risk is rising in emerging markets.

In Asia a year ago, only bonds of China's largest tyre maker GITI Tire traded at levels suggesting rising default risk.

Today, the perceived risk as judged by bond investors is growing fastest in Asia, where 32 corporate bonds have reached distressed levels, according to Moody's Investors Service data.

In Latin America a year ago, only Mexico's Industrias Unidas, a metals and mining company, had debt that traded at distressed levels. Today, the list has grown to 18 Latin American corporate bonds.

Bond prices are reflecting concerns that a wave of expected US corporate bankruptcies may be repeated elsewhere.

'Everything started here, the US was the epicentre, and now it's moving on to Asia and other developing markets,' said Martin Schulz, an international fund manager at Allegiant Asset Management in Cleveland, Ohio.

Distressed debt trading does not necessarily always lead to default or bankruptcy, although such risk is increasing.

'The perceived risk is high but the actual risk of default may not be that high,' said Peter So, head of research for CCB International, a subsidiary of China Construction Bank.

Globally, there are nearly 650 companies with corporate bonds trading at distressed levels, compared to 82 companies a year ago. They include hundreds of companies in the United States, ranging from Ace Hardware to Zions Bancorporation.

Chinese developer Shimao Property's bonds now yield about 20 per cent, and spreads on South Korea's SK Energy and LG Electronics, Japan's Softbank Corp and India's ICICI Bank Ltd are all trading at distressed levels of more than 1,000 basis points above their respective benchmark government bonds.

In October last year, the yields on many corporate bonds around the world were even higher. But yields fell rapidly in recent weeks, after governments around the world took action to provide more liquidity to financial markets and banks loosened some lending standards.

'Many banks are willing to support large property companies as they believe the prospects are good and demand is buoyant,' Mr So said. 'Many banks are willing to extend loans and the bankruptcy risk on Chinese property companies is less than perceived.'

Standard & Poor's analyst Diane Vazza said that defaults will climb this year. US high-yield default rates may rise to 7.6 per cent in the next 12 months, double the 3.15 per cent observed in November last year, she said.

Through December, 108 companies globally defaulted, impacting US$302 billion of debt in 2008, nearly five times more companies than in 2007, according to S&P.

Of the 108 defaults, 86 came from the US, seven from Europe, five each from Asia and Canada, three from Latin America, and two from Russia. -- Reuters