Larry Hirshik is both a good friend of mine and our talented trader at SL Advisors. We’ve been friends for over 25 years. Larry and I both spent many years trading interest rate derivatives – eurodollar futures, interest rate swaps and government securities. Interest rate risk has been a topic that consumed much of our intellectual energy for close to three decades. Analyzing economic data, extrapolating growth prospects and assessing the likely path of the Federal Funds rate and interest rates in general was an important part of what we did.

So my friend Larry, who often possesses market insight, noted that there is no longer interest rate risk. Every fixed income analyst is really a credit analyst. As I considered this slap at orthodoxy, I realized Larry was on to something. The Fed has promised zero interest rates through at least 2013, and keeps coming up with new, innovative ways to lower bond yields. Almost every developed country has a policy designed to keep bond yields low enough to shoo away all but the least discriminating investor. The dominant issue affecting the cost of credit for almost the entire world is now its own creditworthiness. European sovereign debt yields are approaching or have already crossed high yield. And so it comes to this – 10 year Italian government bond yields, over 6%, are now competing with si,ilarly yielding leveraged loans. Given the choice between a portfolio of senior debt from non-investment grade corporations, or government debt from an issuer whose yields are now so far above nominal GDP growth as to ensure its debt load is unsustainable, investing in the former seems a wholly more sensible idea. Add this to the “Strange World” list.

I spent an interesting morning yesterday at the AR Symposium, a well-organized get together of hedge fund industry professionals. I had been asked to chair a panel titled “What do investors want and how do they want it”. A year ago I wrote an article pointing out that hedge fund investors in aggregate would have done better investing all their money in t-bills rather than hedge funds. It’s a controversial statement though not hard to prove and to my knowledge no one in the industry has since disputed it. The article was one of the most read on AR’s online site, and it served as the inspiration for my book, The Hedge Fund Mirage, available at the end of the year.

It’s not that I’m against hedge funds. There are many fantastically talented managers, and hedge funds have made enormous amounts of money. It’s just that the money hasn’t really made it through to the clients, in aggregate. I think hedge fund investors ought to do better than they have. I am pro-investor, not anti hedge fund. But not every hedge fund professional initially interprets my message in this way.

So I shared the stage with four charming and well-informed hedge fund investors yesterday. They deftly handled my mildly provocative questions, such as, “Since hedge fund investors have in aggregate not made money, what should they do differently?” Several useful suggestions were offered. I followed up with, “If hedge funds are to meet investors’ 7% return assumptions, this $2 trillion industry needs to generate $140 BN in profits annually, something they’ve never done (apart from the 2009 bounce back following 450 BN in ’08 losses). Why shouldn’t investors be concerned that the industry is overcapitalized?” This one was a little harder but the panel was up to the challenge and offered rebuttals. However, I do think this may continue to be a problem. And 2011 likely represents the 9th consecutive year that hedge funds have failed to outperform a simple blend of 60% stocks/40% bonds. The hedge fund faithful will continue to face such challenges, but most will persevere and new entrants will continue to arrive on the scene.

Another near death experience in equity markets avoided – at least for now. Kevin KAL Kallaugher’s cartoon in last month’s newsletter could scarcely have been better timed (if you missed it October’s letter is available on our website). Stepping back to examine levels of risk seems a reasonable place to start.

There is perhaps no more fundamental a question for bank regulators than knowing how much systemic risk exists, and its trajectory. Although it’s hard to believe looking back over the past few years, there is a well-established trend in the U.S. to increase the amount of equity capital supporting banks. The chart below from the St. Louis Federal Reserve shows that banks have reached 11% equity to assets with only a modest drop during the financial crisis. The numbers exclude companies such as Lehman Brothers (which was not a commercial bank) whose equity: assets was reported to be as low as 3% (i.e. balance sheet leverage of around 30:1) when they filed for bankruptcy in 2008. When Goldman Sachs and Morgan Stanley quickly converted to banks in the aftermath an immediate consequence was that they reduce leverage. But looking at the system as a whole and measuring common equity divided by total assets there is a clearly improving trend upwards. This analysis does not include any risk-weighting of assets, nor does it include any off-balance sheet instruments such as derivatives that might be altering, perhaps substantially, the apparent reduction in risk displayed here.

Systemic banking risk may be lower by one measure, but it’s obviously an imperfect yardstick based on recent history. The chart below shows the standard deviation of GDP (from the U.S. Bureau of Economic Analysis) and the S&P 500. Economic swings have been fairly consistent for most of the past couple of decades while equity market volatility has been at times breathtaking. So is systemic risk really coming down or not?

The now soggy and cold Occupy Wall Street crowd may not yet articulate a coherent set of views, but one might speculate that the financially literate amongst them would favor still less risk rather than more. Measuring equity as a percentage of bank assets is a crude and obviously out-dated tool, in addition to which some of the biggest losses occurred outside the banking system (such as AIG and the Federal housing agencies FNMA and FHMC). The broader socialization of credit risk and a recognition that some banks are too big to fail have been necessary precisely because the banking system is (or at least was found to be in 2008) undercapitalized.  And even with  11% equity: assets, there can be little doubt that banks are in a class of their own when it comes to making their equity capital work hard. No other industry operates with anything like the leverage that banks employ. Companies with far more stable earnings incur far less balance sheet risk. To select a few by way of illustration: Bristol-Myers Squibb (BMY) has 34% equity: assets and Johnson & Johnson (JNJ) 36%. These calculations exclude goodwill from assets and therefore use tangible common equity to be more conservative. As a result no adjustment is made to these and many other companies that own operating assets whose value has increased  substantially since they were acquired but which have not been written up in value on their balance sheets. Financial services companies rarely own assets worth more than their stated value. Loans and bonds are hopefully worth their face amount, but doing much better than getting your money back is hard unless such assets were acquired in distress and while banks often hold distressed assets they rarely acquire them as such. Even within the financial services sector Travellers (TRV) gets by with almost 21% equity. Not coincidentally, these are all holdings in our Hedged Dividend Capture Strategy, which seeks to offer better returns than corporate bonds through a hedged portfolio of equities of steadily growing and prudently managed companies. As regular readers know, outperforming high-grade bonds is not simply a reasonable objective it’s most likely imperative in order to avoid a loss in after-tax real wealth.

Banking leverage is definitely good for banks and is necessary at some safe level in order to allow credit creation and economic growth. While leverage has come down, financial risk has not and there may be a link between increasing compensation and higher levels of risk since the two have grown together. Reducing bankers’ bonuses shouldn’t be an objective of public policy, but further increases in capital would result in a greater share of profits to the providers of capital rather than labor and a safer system too. I’ve long felt banks were much better places to provide labor than capital, which is why I worked for a bank for a long time but have never invested in one beyond the requisite restricted stock employees receive. But since society bears much of the downside of banking catastrophes, it’s reasonable to ask whether society is receiving commensurate benefit. The financial system is measurably riskier over the past twenty years. Who else has this helped beyond the financiers?

It’s a complex question. The global economy has become more linked, and of course there’s only ever one version of history to evaluate. We can’t know how things would have turned out with even lower bank leverage but an otherwise unchanged script. There is no “control experiment” with which to compare, so it’s probably a question that will never have a satisfactory answer. There may be many problems with the Basle III capital guidelines, but directionally the shift towards even greater capitalization seems uncontroversial. If Greek sovereign debt hadn’t been assigned a risk weighting of zero under previous rules, French and German banks who suspended critical thought wouldn’t now hold so much of it. We wouldn’t have a semi-annual Euro crisis. As banks strenuously debate every increase in regulation, their attitude to systemic risk should be part of their response.

What could be more appropriate than Greece delivering a lesson in democracy. The word itself is derived from the Greek language. Democracy began in Greece and is returning there. How very appropriate. The enduring weakness of the EU has been its management by technocrats with often scant regard for popular opinion. The beauty of a referendum is that the Germans and the French, having increasingly taken sovereign decisions over the Greek people will now be in effect negotiating directly with the Greek population itself. Few observers can doubt either the political judgment or the basic fairness of pursuing this route. The French and German banks that recklessly bought so much Greek debt with scant regard for the risks deserve little sympathy. Perhaps they’ll revisit the revised 50% haircut recently agreed on Greek bonds as a smart campaign move as the referendum date moves closer.

It still seems for now that being short the € has many ways to provide a return. Surprises keep cropping up, and in addition there is growing evidence that gap between U.S. and Euro-region GDP growth will widen in favor of the U.S. A cut in short term rates by the ECB seems likely by the end of the year. We are short the € through owning EUO in our hedge fund as protection against falling equities which would hurt other positions. However, the focus of Merkel and Sarkozy on the issues should ensure that the tail risk of a complete disaster will be averted. They will muddle through – it won’t be pretty but that is the most likely outcome. Consequently, we’ll use € weakness to reduce the position.

Senior loans continue to be attractive. The improved GDP outlook in the U.S. should keep a lid on potential defaults among leveraged borrowers. We are invested in PPR and BHL which both have good portfolio management and are attractively priced. Both securities yield close to 6% and are at around a  7% discount to NAV. They represent a solid component of a yield seeking portfolio and are in our Fixed Income Strategy.

Disclosure: Author is Long EUO, PPR, BHL

It’s not just the last decade that’s been harsh on stocks. A report from Jim Bianco’s eponymous research company calculates that for the past thirty years treasury bonds have outperformed stocks. It’s the first thirty year period since 1861 that this has happened according to research on the topic by Jeremy Siegel.

What could be safer than to bet on a continuation of a thirty year trend? Most of the people working on Wall Street have lived the majority of their careers during a time when safe, stodgy investments have been the place to be – though it should be added that the relatively long duration of thirty year bonds makes their price moves more perky than shorter maturities. But the very success of bond investing makes it that much harder to repeat the performance. Just as stocks had impossibly high P/E ratios in the late 90s as the internet bubble climaxed, ten-year treasury notes yielding 2.2% can only return 2.2% over the next ten years. Thirty year bonds returned 11.5% over the past thirty – the yield on thirty year bonds thirty years ago was 14.68% (according to the Federal Reserve’s H-15 report) which accounts for their subsequent return. Today’s thirty year bond yields 3.25%. As mysterious as is the Math of fixed income to some, even Bernie Madoff couldn’t conjure up past returns out of today’s yields.

No doubt for some time to come bonds will be the beneficiary of investors. The world remains a financially risky place, and the latest EU crisis measures increasingly appear to be short of what’s needed. Wilbur Ross was on CNBC this morning noting that a 50% writedown in all EU peripheral sovereign debt (i.e. the GIPSI countries) would require an additional €400BN in bank capital compared with the EBA’s current stress-test estimate of €100BN (of which €30BN is for Greek banks). Other analysts are increasingly finding fault with the absence of detail in the plan. There continues to be plenty for investors to worry about. And yet, stocks don’t require much dividend growth to outdeliver bonds. $20 in 2% yielding stocks with 4% growth provides the same return as $100 in 2% yielding ten year treasuries, leaving $80 to be held in cash or invested elsewhere. Stocks have had a great October and cheaper entry will be available. But the math is compelling.

There have been many times when the ultimate high in the bond market could have occurred – however, one can be certain that past performance will not predict future returns. One can be reasonably sure that future returns will be very low single digits. And there’s a decent chance that today’s bond investors will lose money. Safety comes with a price.

What exactly is a Credit Default Swap (CDS) on Greece worth? It seems likely that the International Swaps Dealers Association (ISDA), the industry body that rules on such things, will soon confirm that the 50% write-down on Greek debt accepted by the banks does not constitute a credit event, because it was accepted voluntarily by the banks and not forced upon them. Although the EMEA Determinations Committee has not yet met, ISDA’s website posts a press release that says, “…it does not appear to be likely that the restructuring will trigger payments under existing CDS contracts.”

Analysts have been predicting as such for weeks. But if a 50% loss doesn’t trigger an insurance pay-off, what does? And if Greek insurance doesn’t pay off, will CDS contracts on Italy, Spain or even France ultimately ever have any value? A sovereign default is a political decision, and quite possibly the insurance contracts owned will ultimately not protect their holders. It reminds me somewhat of the market for perpetual floating rate notes. Many years ago these instruments used to be priced as if they would eventually mature and traded at spreads comparable to finite-lived instruments. Then in 1987 investors realized that these instruments shouldn’t be priced as if one day the issuer would repay them and the market collapsed.

Such may be the fate of developed market sovereign CDS.

To list three credits of note:

Source: ISDA; CNBC.com

The table above takes most recent net and gross CDS outstanding from ISDA, combines them with current CDS prices and assumes four-year average maturity to estimate the approximate net and gross mark-to-market positions among participants from these three names. Although it should be a zero-sum game (i.e. gains for sellers of protections are losses for buyers) the table seeks to estimate the range of P&L swings among participants in the market. The true figures for these three are probably closer to the low end of the two totals above (i.e. $7.3BN) and even that assumes the swaps are worthless which is an extreme outcome. But the same analysis could be applied to other developed sovereigns, perhaps emerging market countries and even corporations deemed too big to fail. Indeed, it appears as if an important element of the negotiation between the banks and the EU was to ensure CDS contracts did not pay off. Avoiding contagion, but perhaps avoiding further losses (if the banks were themselves net sellers of CDS protection) were important consideration. A further step in the socialization of credit risk has been taken.

So buyers of CDS protection are confronting a brave new world. Perhaps selling protection on an EU  sovereign credit is suddenly the easiest money out there.

The Federal Reserve’s wealth transfer strategy of shifting purchasing power from savers to borrowers has other unintended consequences apart from plundering the thrifty in favor of the profligate. If you run a fixed income fund, ten-year treasury notes with a 2% handle doesn’t create much raw material from which to manufacture some income for your clients. The inadequacy of the yields jumps out, and many thoughtful bond managers have been drawn, or even forced, to reject such poor compensation and to adjust their positions in anticipation of fairer, higher yields.

Thus has the Pimco Total Return Institutional Fund (PTTRX) missed this year’s rally in bonds. Having concluded earlier in the year that U.S. treasury yields offered scant return for the risk, they shunned them publicly and completely through the debt ceiling crisis and into the most recent bout of risk reduction in the third quarter. It was a completely reasonable view to take – they may not have drawn comfort from the fact that we shared their outlook, but we did and so this article is not about bragging that we outperformed Bill Gross. Pimco’s long track record speaks for itself. The point here is that artificially low yields perhaps added urgency to the quest for better fixed income outcomes than were on offer for a passive investor. Positive real yields of, say, 2% (which would require interest rates 1-2% higher) at least afford the plausible option of passively investing and taking what’s on offer. But since today’s yields reduce purchasing power after taxes and inflation, any red-blooded bond manager is virtually required to shop around for alternatives. For a bond fund as big as PTTRX the bets are necessarily big. Their boycott of the U.S. treasury market caused them to miss a fall in yields from simply ruinous to ridiculous.

Just because a view has been wrong is not sufficient reason to change it. That statement doesn’t apply to traders with leverage, since holding one’s convictions too strongly can lead to bankruptcy. But for the unleveraged, new information is the only thing that’s really important. Bond yields have fallen this year and being underinvested has been wrong – so far. But the new bond yields are less attractive than the old ones, and while economic growth has moderated in recent months  the long-term outlook is scarcely that much worse than in the Spring. Active government involvement in the bond market is designed to drive other investors away. Ben Bernanke could as easily hold up a sign during his regular testimonies before Congress saying, “Savers, We Don’t Want Your Money”. What can be more eloquent than the active competition of the government with private savers for its own debt? How loudly should the message be broadcast? If the government wants bonds that badly, let them take the lot. Go elsewhere – senior loans, Master Limited Partnerships, dividend-paying stocks. The government wants savers to consider such alternatives, and will continue to drive them out with derisory yields until they get the joke.

Meanwhile, Bill Gross wrote a rare mea culpa. Well put, and you’ll find no criticism of his past actions here. Pimco have more recently completely switched gears on treasuries and now own them – in fact, if anything based on the aforementioned letter Pimco’s economic outlook is more negative than consensus. Retaining the mental flexibility to move 180 degrees from bearish to bullish is extraordinarily difficult. Most people can only manage moving back to neutral, so kudos to Bill Gross for not letting a few dropped fly balls cause him to lose his nerve. I can’t claim such dexterity – or more accurately, I continue to believe far better alternatives to bonds exist.

Sometimes you feel as if you’d like the world to stop right where it is. For most investors, arriving at work and checking their portfolios over coffee this morning should be one of the most pleasant beverages they’ve consumed in many months. After the misery of the third quarter culminating in September’s testing of every reasonable investment thesis, sanity is finally returning. The Europeans have avoided disaster; the Germans have crammed voluntary losses on the banks (who have only themselves to blame for owning so much Greek debt in the first place). The banks say they will recapitalize through retained earnings rather than dilutive secondary offerings. The EFSF will be stretched as needed (although details are still sketchy). Life as we knew it can resume, and risk assets are cheap. Enjoy the view, like gazing across a beautiful vista on a sunny day. Touch the moment and savour it. Of course there are problems, and the moment won’t last. But for now, just look and let September’s nightmare recede.

So having done that, what’s next? Well, having engineered a voluntary loss of 50% on holders of Greek debt and thereby avoiding an actual default, the market for sovereign credit default swaps (CDS) appears superfluous. Cautious buyers of Greek debt (were there ever any?) who bought credit insurance (i.e. CDS) have found it a waste of money. Sovereign defaults are at the end of the day as much political as credit events. Rating agency assessments of countries are political judgments, and maybe we’re witnessing the end of one corner of the CDS market. Bankers have warned that reduced hedging opportunities will reduce the appetite of banks to extend credit – that may not be a wholly bad outcome given the amount of poorly conceived credit they’ve extended in the past. But reduced credit in the near term combined with Europe-wide fiscal retrenchment will stifle growth.

For our part, the main challenge to investors remains finding a fair alternative to the paltry yields offered in fixed income. Senior loans continue to be an attractive sector. The ING Prime Rate Fund (PPR) yields close to 6% and closed at a  7% discount to its NAV. When I spoke to one of the co-PMs a couple of weeks ago he felt fairly sanguine about defaults barring a European disaster which, at that time couldn’t be ruled out. Meanwhile, high-grade corporate bonds at around 4% with no growth require conditions close to but just short of deflation to turn out well. The gap between the 8% earnings yield on the S&P500 and 2.25% ten-year treasury bonds is somewhat narrower than a month ago but still historically wide. Today is probably not the day to jump into equities, but at a calmer moment they still look like a more attractive long-term investment than bonds. The after-tax return on $100 in ten year treasuries can be beaten by a combination of $80 in 0% cash and only $20 in 2.2% dividend yielding stocks assuming as little as 4% dividend growth. Bonds are at yields that only a QE emboldened government could love.

In equities we remain fully invested. Natural gas E&P names continue to represent the more volatile sector of our Deep Value Equity portfolio. Devon Energy (DVN) is barely above the value of its proved reserves. We continue to believe Gannett (GCI) is very cheap at 6X earnings or less than five times free cashflow. And Microsoft (MSFT) remains attractive at less than 7X earnings net of cash (less debt) on balance sheet. MSFT has been cheap for many, many months. It’s not exciting to be an investor – far from it. But it continues to be reliably profitable.

Disclosure: Author is Long PPR, DVN, GCI, MSFT

The FT notes in an article this morning how M&A activity in the shale gas arena reached almost $50BN during the third quarter, a 135% jump on a year ago. Some deals were large and notable, such as Kinder Morgan’s (KMP) purchase of El Paso. Others took place out of the spotlight, but what is clearly taking place is a growing acknowledgment by the major energy companies that domestic natural gas in the U.S. will represent an increasingly important source of energy production. It’s here in the U.S., it’s cleaner than other fossil fuels (though global warming is yesterday’s story) and it’s persistently cheap. They very success of so many E&P companies in drilling for natural gas has depressed its price, helping consumers but hurting profitability. When Petrohawk sold their business to BHP Billiton  it confirmed CEO Floyd Wilson’s oft-stated belief that the assets Petrohawk owned better belonged within a larger company with a lower cost of capital. That statement really is the key to the natural gas story. In a time of abundant and cheap natural gas, the company that has the lowest overall cost structure (including the cost of financing the necessary capex) will win.

As an investor, you have to choose carefully though, and definitely avoid companies that use too much leverage. As a result we’ve never invested in Chesapeake (CHK). Aubrey McClendon is a great cheerleader for the industry but has exhibited a wholly different risk appetite in the past than we would like. We continue to like Comstock (CRK) a name that’s fallen too far. We also think Devon Energy (DVN) is a solid investment trading as it does close to the value of its proved reserves (providing a cheap option on likely but not yet proven assets) and with half its revenues now coming from crude oil production. It’s also all onshore, having divested its offshore and non-U.S. assets in recent years.

But Master Limited Partnerships (MLPs)  also allow an interesting angle on the development of shale gas assets. Once the gas is extracted it needs to be processed, refined, transported and stored. This is to a large degree what drove KMP’s acquisition of El Paso; positioning for the huge infrastructure investments required to move natural gas from under the ground to the U.S. consumer. I found it interesting that earlier this month JPMorgan initiated research coverage of MLPs. They used to cover them but the analyst left several years ago and they dropped their emphasis on the sector. But JPMorgan estimates $130BN in capital investment over the next ten years as the industry responds to a shifting mix of fuels to provide energy. The tax status of MLPs precludes them from retaining much of their earnings, so new projects are usually funded with freshly raised debt or equity capital. For an investor this imposes discipline on management, since a poorly conceived project won’t easily attract cheap financing. JPMorgan no doubt sees an attractive long term fee opportunity. Meanwhile, there are ways to participate in shale gas development for the equity investor through E&P companies and the income seeking investor through MLPs. The sector has also recovered strongly from the sell-off in equity markets through September – the Alerian MLP Index (AMZ) is back within 5% of its high reached in April. 6% distribution yields and steady growth help.

So says Don Sturm, owner of two community banks in Colorado. And Mr. Sturm’s complaint is not that he’s been amply paid (although he may have), but that depositors are flooding in at a rate that outstrips his banks’ ability to usefully redeploy the money. This is QE2 at ground level. Investors fleeing the treacherous equity markets are selecting safe bank deposits, but are receiving nothing in return. In some cases banks are actually charging large clients for the privelige of being depositors.

Banks are still struggling to find enough good places to put the money they have. Although the system is awash with liquidity that other necessary component of inflation which is velocity (in other words, how quickly money gets recycled) is notably absent. Hence the ballooning money supply is not yet translating into inflation. But M2 is growing at an increasing pace – according to figures from the Federal Reserve its annualized growth has quickened from 10% over the past year to 24% over the past three months. Still no sign of a problem, and yet ten year treasury notes yielding 2.25% or high grade corporate debt at just over 4% provide scant protection should money velocity reappear and link up with already ample money creation.

On a different topic, how exactly does an investor in Greek debt get comfortable with a “voluntary” 60% loss? To accept any negotiated settlement there needs to exist a worse alternative, and it’s hard to imagine what that might be. Since the purpose of a voluntary loss is to avoid triggering a payoff on CDS contracts, it’s a stretch to see why any holder of Greek debt who also owned such CDS insurance would accept an uninsured 60% loss rather than endure a bankruptcy and so retain the ability to claim on their insurance coverage. Maybe there are very few holders of CDS who use it to insure against risks they already have. It increasingly appears as if most buyers of CDS protection were smart enough to avoid actually needing the insurance. It’s as if most homeowners insurance was owned by people on their neighbour’s house rather than their own.

We continue to be short the Euro through a long position in EUO. Although Europe’s leaders are clearly focused on the issues at hand, the latest recapitalization needs are being dismissed by analysts as simply covering the loss from a mark-to-market of existing bond holdings at current levels rather than simulating a more stressful scenario than currently exists. The EU’s leaders are getting there but at a painfully slow rate, and southern Europe is most likely already in a recesson. As is often the case, it looks as if the economic cycle in  the U.S. will be ahead of Europe’s, which should provide support for the $ against the €.