Posts

Investing in Bonds? Do you know how they work?

/0 Comments/in /by

Over the past two years we have seen a significant rally in the bond market due to the Federal Reserve’s decision to keep interest rates low.  This run up in bond prices raises questions surrounding profit taking and tax management.  In this post I will walk you through an example of how bonds work.  In next week’s post, we will explore how bonds impact your taxes and what you can do to maximize your profits.

Advanced Yacht Builders

Advanced Yacht Builders needs to borrow money to buy supplies.  They would like to borrow $1,000 from you at 5% interest per year for the next 10 years.  You decide that this is a good investment and you loan them $1,000 by buying their bonds.  You will receive 5%, or $50, each year for the next ten years and at the end of the ten years Advanced Yacht will give you your original $1,000 back.

Bond

 

During this ten-year loan, the price of the bond goes up and down and you are able to sell it to someone else if you’d like.  This is how bonds are similar to stocks.  They can be bought or sold at any time and are different from U.S. savings bonds or bank CDs that only pay interest and never change in value.  The price that you are able to sell the bond to someone else is determined by its yield.

By lending $1,000 dollars at 5% interest, you are receiving a yield of 5%.  Calculating the yield of a bond can get a little tricky because there are three main things to consider: bond price, interest and the amount of time the money is borrowed.  I will not get into that calculation here, but the most important things to remember are:

  • The price of a bond is determined by its yield
  • When interest rates go up, the price of a bond goes down
  • When interest rates go down, the price of a bond goes up

Scenario 1:  Interest Rates Drop

Now lets say you’re a year into lending to Advanced Yacht and all of a sudden interest rates drop and they can borrow money at 1% interest instead of 5% interest.  After breaking out a financial calculator, you would find that the price of this bond would go from $1,000 to $1,340 because the yield of this bond went down, causing the price of the bond to go up (When interest rates go down, the price of the bond goes up).  You would still receive 5% interest AND have a gain of 34% in the price of the bond.

Scenario 2:  Interest Rates Rise

Alternatively, if interest rates rose to 9%, the price of the bond would go from having a price of $1,000 to having a price of $760.  Again, as interest rates increase, the price of the bond decreases.  You would still receive 5% interest, but if you needed to free up cash, you would have to sell the bond at a -24% loss.

The price of the bond decreases because investors do not want to buy the bond that you’re holding, which is only paying 5% interest, when they can buy a new bond from Advanced Yacht that is paying 9% interest.

Crane Paper Company in Dalton produces the pap...

Next Steps

The math to calculate the yield isn’t important here.  What is important is the fact that in the scenario where interest rates dropped from 5% to 1%, the price of the bond gained 34% and that requires your attention.  Your options are to:

  • Do nothing and collect your 5% interest, but watch the 34% gain decline over time because at the end of the ten years you will only be paid back the original $1,000 that you lent
  • Sell the bond that you purchased for $1,000 to someone else for $1,340 and lock in a 34% gain, but forfeit the future 5% interest payments

In the next post, we will answer the question of how taxes are impacted in either decision and which decision is right for you.

Ben Bernanke ready to act if Economy weakens further

/0 Comments/in /by

This week was full of economic data releases as well as some comments about the economy from the Federal Reserve Chairman, Ben Bernanke. To start the week, we had existing and new home sales fall well short of the 5 million annual run rate that was estimated.  The July 2010 sales came in at a dismal 4.11 million annual run rate, a 26% decline from the month before. Durable goods orders also missed estimates for the month of July.  It had been a bright spot in the economy but only grew 0.3% versus the estimate of 3.0%. Thursday’s initial jobless claims fell to 473k from last week’s revised 504k, although encouraging, the 4-week moving average edged up to 487k, the highest since December 2009.

Last month Q2 2010 GDP was reported at an annualized rate of 2.4%, today it was revised down to 1.6%, beating more recent estimates of 1.4%.  The markets seemed to cheer the beat since all the other economic reports were misses.  At 10:00Am today the Federal Reserve committee met in Jackson Hole, Wyoming to discuss the state of the economy. With growth being too slow and unemployment being too high, Bernanke indicated that they will provide additional monetary accommodations to make sure the economy recovers.  This sent the market up about 1% and is so far holding onto those gains.  We’ll have to wait and see what’s in store next week to determine if the market will continue its brief rally. Next week’s economic indicators include Personal Income and Spending, Chicago Purchasing Manager Index, Vehicle Sales, and the most significant of all, Change in Non-farm payrolls & the August Unemployment rate. Any surprises in the payroll report will surely increase volatility and consumer sentiment.

Economic data shows economy still struggling

/1 Comment/in /by

Economic reports due out this week include new and existing housing starts, durable goods orders, and the revised estimate to Q2 2010 GDP.  Housing sales will  show about a 12% drop from June 2010 as the housing credits are now fully out of the system and natural market forces are coming back into play.  The annual unit sales rate will come in close to 5 million, the lowest since March 2009. One bright spot remaining in the economy is durable goods which should show an increase of 3% compared to June. Friday’s GDP report will show the economy grew at a  1.4% annual pace, much less than the 2.4% that was estimated just a month ago. This new information is probably the reason why Federal Reserve Chairman Ben Bernanke has stated that they will reinvest payments on their mortgage holdings back into long-term treasuries.

The economy continues to show both strengths and weaknesses, which is probably why the VIX is still elevated and the treasury yields are so low right now. People are confused and the conflicting data isn’t helping to ease their fears of another drop in the market. Uncertainty in the economy is still a large factor and until there is clarity, there will be more volatility.

Short and Sweet – Status Quo

/0 Comments/in /by

With the first quarter of 2010 now at a close, I am happy to say that there is not much to report. Certainly there were headlines that will persist for years and decades ahead, the healthcare bill and the potential for default from an EU country (Greece) being the most prominent. Yet from the perspective of the market, both viewing asset price movement and economic indicators, we plodded along just fine.

The stock market saw an overall rise of 5.4%. Halfway through the quarter we saw a 5% decline in the market before it rallied 10% for its finishing close. A 10% swing in one quarter may seem like a lot but to put it in perspective, a year ago we were seeing 10% swings in a single day. Most of the movement for this quarter, however, could be viewed through the prices of just a few firms. GE, the whipping boy of the recession, staged a very impressive rally in March (they hinted at dividend increases next year.) Rising 21%, GE was the leader of the S&P stocks on a weighted basis.

This growth though is surprisingly lacking in support. GE, Boeing, and banks drove the bulk of the movement in stocks this quarter accounting for a third of the increase in the S&P500. The Dow Industrial’s performance is even more unbalanced, with GE and Boeing together representing half of the increase this quarter.

If you parse it further, GE was driven by a projected increase in the dividend, Boeing by the first flight of the 787, and banks by their increased profits. While it is assuring to see the markets move ahead, the rally is restricted to a few discrete events. It is by no means an indication that we are headed into a bull market, or even that these gains will hold.

The fundamentals from the economy have stabilized but remain discouraging. Unemployment remains at staggering levels, nearly 10% as reported and 17% of underemployed/unreported. The good news here is that we are no longer loosing jobs, and managed to gain a few last month. I underemphasize this news, however, since the bulk of the gain was driven by temporary census workers. Net of those folks it was just enough new jobs to keep pace with the growing population and labor. That is why the unemployment rate did not change last month.

The bad news is that the same folks are still out of work. Without jobs growth the traditional driver of the US economy, consumption, will remain below levels necessary for a full recovery. Without consumption, job growth will lag. We are currently experiencing a negative feedback loop that the market hopes will just go away. As the Economist astutely points out, America needs to change from a consumption-based economy to a savings and investment-based one. No longer will an overbuilt, shoddily constructed home serve us well. Instead, we need to see consumer debt levels decline as folks need larger asset pools for retirement. It will be a long road ahead for America, one in which we could lose our economic dominance, but it is a road that we can no longer avoid.

The one bright spot in consumption and technology, is Apple. With their amazing balance sheet including over $25 billion in cash, raging iPhone sales, the prospect of opening the iPhone to Verizon this year with a 4G model, and the iPad launch this week, they have successfully avoided the slump in consumer consumption. And yes, I am clearly biased, having received my new iPad this weekend. In case you have any doubts, it is a game changer.

In the mean time, enjoy the spring and let’s hope that the Northeast has a chance to dry out.

Regards,

David B. Matias, CPA

A Year Never To Forget

/0 Comments/in /by

There isn’t much that I need to say to emphasize just how bad this year was in the financial markets. The world went through a capitulation, and in that process all the cracks and flaws within the financial system were exposed. From dismal company 401(k) performance to the complete collapse of hundreds of hedge funds, we learned first-hand that we need to focus on the basics.

For comparative purposes:

  • The US equity markets lost 37% as measured by the S&P 500 stocks
  • The European markets lost 42%
  • The Asian markets lost up to 68%
  • Once again, US stock mutual funds lost more than the overall market. In many cases the losses approached 50% (such as Fidelity’s Magellan Fund)
  • TIAA-CREF’s managed equity funds lost 35-40%. These are supposed to be well-managed long-term retirement funds
  • Investment in Commodities such as energy, metals and agricultural lost 46% • Investments in Corporate Grade bonds stayed flat
  • Investments in Corporate Grade preferred stock lost 32%
  • Investments in US Treasuries gained over 10% – the sole bright spot last year

I point all this out to make a few points:

1. Our financial system has for years encouraged people to use mutual funds and corporate 401(k) as methods to invest for retirement and diversify our risk. For those who followed this approach, they witnessed a loss of nearly half their investments. This is an astounding depletion of value, at exactly the wrong time as the country heads into a prolonged recession and enormous job losses.

a. I have for years been a staunch opponent of mutual funds for their lack of true diversification combined with elevated fees, both disclosed and hidden. With the stresses and dislocation we’ve seen this year, these flaws came to the forefront. Most funds lost more than the market this year – at a time when risk mitigation was critical to preserving family wealth.
b. The tax benefits of deferred tax accounts are dubious at best. Placing money pre-tax into a 401(k) makes certain assumptions regarding tax burdens in retirement and the benefits of growth of pre-tax assets. With such an enormous national debt generating in the past eight years and the manner in which income is progressively taxed, it is possible that the tax benefits of deferred accounts won’t exist.
c. Firms such as Fidelity are going to have much to answer to the investing public and lawmakers as they try to explain why so much of America’s retirement savings was wiped out in a single year.

2. There was no place to hide in the markets. The traditional notion of diversification did not work, such as international versus domestic investing. Any exposure to any risk results in enormous losses. Even the sole winner, Treasuries, has likely formed a bubble and could fall quickly in 2009. That, combined with the prospect of long-term inflation would make investing in the sole winning asset class of 2008 a risky and speculative investment in 2009.

3. Cash is Always king. I have used this mantra as cornerstone of our investment philosophy, and it is true now more than ever. Whether it is the cash flow off an investment (such as dividends or interest payments), or the cash flow going to the corporation, it is the first determinant in our investment approach.

Economic and Market View for 2009

By every measure, we are in a tough economic environment. Unemployment, the primary measure of a growing economy, is headed towards a 10% level – higher than we have seen in a generation. While the Obama stimulus plan could eventually generate the number of jobs that he is projecting, it will be at a steep cost. This cost will be in terms of an enormous budget deficit and a strong potential for dollar devaluation. The only mitigating factor helping the dollar is that every major economy across the globe is facing similar issues. It is a matter of who will recover first and at what cost.

The markets, however, will advance prior to the recovery in the market. Any sign that the worst is over will generate significant inflows into the general equity markets. The bond markets are already going through a rapid recovery: high-grade corporate bonds (AA and above) have rallied to pre-crash levels, many other investment grade corporate bonds have shown a similar recovery and preferred stock are showing strength as well.

The long-term prognosis for the US is difficult to determine. Unfortunately, it will largely rest on the incoming Administration and their policies, both domestic and foreign. Through years of indulgence and short sighted (aka greedy) policies, we have gutted the core of America. Our auto industry is in need of a shot of arsenic, we have exported a large part of our manufacturing base, and our primary growth industry – financial services – is in risk of permanent impairment. We need to find innovation, productivity and vision.

The good news is that we have an incoming Administration that is addressing these very issues. Alternative energy, energy independence and the related innovation will be a crucial first step in these policies. America’s focus on savings and breaking the addiction with consumption are the other necessary steps. Frankly, as a consumer-oriented society we need to go on a 5-step recovery program and stay in that support group for some time to come. The recovery will bring a good amount of pain, and we’ll be prone to frequent relapses if the entire situation is sugar coated.

While it may sound like doom and gloom, as are still the leading innovators of the world, with our research institutions and entrepreneurialism unlike anything in the history of civilization. Most of our institutions will survive, including the corporations that produce good stuff and have strong intellectual property. The ones who produce poor goods and don’t innovate (i.e. the auto industry) are going to ultimately fail, or at the least be unrecognizable in the future. Those in between will struggle to find their place in the next economy.

Portfolio Positioning

At Vodia we had a number of successes and failures during 2008, the most destructive of which was the government take-over of the GSEs, Fannie Mae in our case (I am still pissed-off at the Treasury for this one). But to our credit, we also took many steps in advance of this crisis: we realized some impressive gains earlier in the year, we were already positioned with low equity exposure, our cash positions were high, we avoided the emerging markets and commodities collapses, and most of our investments were based on strong cash flows.

As a result, we were able to reduce the damage by half, give or take depending on your risk profile and account specifics. This is great news. With a horde of cash to invest at this market bottom and the prospects of an eventual recovery we are well positioned going forward, we can ride up with the markets at an accelerated pace, making back any losses and then some as the recovery takes hold.

For 2009, we are repositioning the portfolio as follows:

  • We have increased equity exposures over 2008’s lows. While we are not going to our long-term equity allocation level, we have found a mid-point between the low equity allocation from 2008 and your long-term target. We will be reassessing this exposure as more economic news unfolds, with the eventual goal of reaching long-term levels when we feel that the downside risks have mitigated.
  • To increase the equity allocation, we have used a combination of individual companies as well as a non-US ETF that is a composite of the global equity markets. This allows us to hedge against a declining dollar while gaining exposure to the world’s recovery.
  • Our focus will continue to be on health care, manufacturing, global sustainability and technology
  • We have been using corporate bonds as well, to take advantage of the greater yields (as high as 10%) with the protection of asset securitization and blanket liens against corporate assets. Many of these instruments have variable interest rates dependent on metrics such as yield curve steepness and inflation.
  • We have introduced a small level of commodities into many of the portfolios. With energy going through a bubble-burst, and the long-prospect for global population growth, we believe that commodities such as oil, metals and agriculture represent a solid lower-risk long-term investment.
  • Our cash positions will still remain elevated as we hunt for additional opportunities.

As usual, please call or write with questions or comments. A detailed performance report will be emailed or mailed separately. We also have our annually updated Form ADV available in print and electronic version. Feel free to write clemail@vodiacapital.com or call 978/318-0900 for a copy of it. Best wishes for a healthy winter, David B. Matias, CPA

Best wishes for a healthy winter,

David B. Matias, CPA

The Perfect Storm

/0 Comments/in /by

There is nothing pretty about the past three months. While the positives regarding the global economy remain, such as growing populations, growing demand and a phenomenal explosion around international trade, the US has entered the witching hour. Namely, our economy here has been battered by three concurrent forces that are creating what may prove to be the perfect storm.

The first of these factors is the ever-present subprime debacle. I have already explained this in length, but it is worth noting the situation in review and how it is still affecting us today. With grossly overinflated home prices and a lending practice that placed unrealistic demands on borrowers in a declining home price environment, the mortgage industry created an explosion of defaults and foreclosures during the first half of this year. The effects have been felt globally since these mortgages were repackaged into supposedly safe investments and placed into everything from bank portfolios to money market funds. To date, the reported losses by the financial institutions related to these subprime securities have reached $400 billion, and could still be climbing by some estimates.

The effects of the subprime debacle that we are still feeling are quite pervasive. In the US, it has accelerated foreclosures in many situations where it would not have occurred under normal circumstances, even with declining real estate prices. And second, it has erased the profits of the financial sector, dragging down the overall equity markets. Third, with so many aftershocks past and present, the bond markets are still reeling; and in the case of municipal bonds, go through fits and spasms, eek out some gains, only to be gripped by another seizure when more bad news is revealed.

This in itself would be enough to cause tremendous distress in the financial markets as we have seen starting exactly a year ago this month. The conventional belief just two months ago was that these issues would work through the system in time and after a correction in the markets we would resume with growth in the markets and economy, albeit anemic for some time to come.

Now enter factor two. While it may seem more like an inconvenience than a financial crisis, the US government deficit has grown astronomically during the past eight years (yes – read, Republican out-of-control spending). The effect has been singularly devastating-the rapid decline of the value of the US dollar. From 2001 to today, the dollar has lost over half its value and the decline could continue. I’ve been writing about this topic for four years now as a priority for our political and economic policies. Unfortunately, we are now here.

The follow-on effects are pervasive. In a simplistic view, it makes it more expensive to purchase international goods or to travel abroad. The opposing argument, that our manufactured goods are now cheaper and more attractive stimulates the US economy, is true to some extent. The larger issue is that we import far more than we export, including the bulk of our energy needs and many raw materials.

And now the third factor and the great behemoth that pervades our headlines: the price of oil. Unfortunately, or perhaps fortunately, oil is traded in US dollars. And we buy a lot of oil from overseas. For our cars alone, we spend $1.3 billion dollars a day on oil to convert to gasoline, more than half of which comes from overseas. Because of growing demand from growing economies such as China and India and the deteriorated value of the dollar, we are spending twice as much for our foreign energy sources than we did just two years ago. Viola – inflation.

So we have a dismal real estate market with increasing foreclosures, the prospect of real inflation for some time to come, and a recession that would have been a slowdown if it were not for these factors. Put it all together, and you have one of the worse financial markets that we have seen in decades.

That is the bad news. The good news is that our world is about to change. Gone for good is the era of cheap gasoline, and good riddance. While we may feel the enormous pinch today, the impact of the mighty buck will accelerate changes that have been needed for quite some time. Americans are driving fewer miles (by close to 10% according to some estimates), SUVs are no longer in demand, and energy conservation in every aspect of life is on the tips of EVERYONE’s tongue. These are good changes. We will use less, we will waste less, carbon emissions will decline, and in the long run we will be a more efficient and conscientious society.

While it would have been nice to do this at our own pace and in our own time, that luxury has been squandered. The time is now, and the pace is immediate-at least as immediate as humanly possible.

Going Forward

Prospects for the remainder of the year are a haze for all. We have officially entered a bear market, with the major US indices down 20% from their highs. The question is, do we recover to close out the year where we began (our initial forecast), or do we continue a decline and remain in this quagmire. In either case, it could be at least two years before we revisit a bull market with annually rising values. For the immediate term, we are waiting to see and gathering as much information as possible. The primary factor we’re watching is the price of oil: if oil remains stable or declines, then we will make it through this in short order; if oil continues its rise, then I fear the bear market will deepen.

Our investments have continued to emphasize the same principles we have held for the past few years – cash generation augmented by well-researched growth opportunities focused around technology and demographic changes. While we performed extremely well in the months of April and May, June was the worst month on record, leading to an overall loss for the quarter. Surprisingly (or maybe not, given the market), it was our cash generation portion of the portfolio that suffered the most, from stable defensive stocks such at United Technologies and GE to very high income, tax-efficient global preferred stock.

Our approach to weather this storm is going to be grounded in the fundamentals. Historically, even stronger bull markets follow bear markets, placing tremendous emphasis on riding this out while positioning ourselves for the recovery. While it is tricky to predict the bottom of the market, it is important to look for buying opportunities on undervalued equities and hold onto those positions that will survive and ultimately thrive in the next cycle.

Reports regarding your individual accounts will be going out in the coming week, with a brief analysis of what worked and didn’t work for the year to date. Depending on your investment profile, we may include research notes on companies that we are strongly considering as we look to boost equity positions in the coming months. As always, please write, call or simply stop by with questions and concerns.

Best wishes for an enjoyable 4th,

David