As we’re all being reminded, 1996 was the last time the Federal government was forced to shut down, the result of a budgetary dispute between then House Speaker Newt Gingrich and President Bill Clinton. It didn’t last that long, was economically inconsequential and was generally believed to have worse consequences for the Republicans than the Democrats.

Politics has become generally more partisanship since then and at least according to many participants far less collegial. Disputes over the budget have become more frequent in recent years, with the last crisis over raising the debt ceiling in 2011 causing investors to contemplate the unthinkable, that the U.S. might miss a debt payment. The Federal government is currently operating under automatic sequestration, the result at the end of last year of the calculation by both parties that automatic spending cuts were preferable to a negotiated agreement.

In fact much of what the rest of us regard as dysfunction in Washington DC can be traced to the power of incumbency and the reduced turnover of elected officials. The House of Representatives in particular is increasingly unrepresentative of mainstream Americans and more reflective of the more liberal and conservative wings of each party. Gerrymandering, that process by which congressional districts are drawn as if by a blind chimpanzee, are intended to create electoral districts full of like-minded voters. While an original intention was to assure that racial minorities would be represented by one of their own, an unfortunate consequence has been to steadily reduce the number of Congressional seats that turn over. In last year’s election 90% of the House and Senate were re-elected.

While that might sound as if our legislators need not care much about what voters think given their success at retaining their seats, a great many of them are acutely tuned to the elections that really matter; the primaries through which each party selects its candidates to run in the general election. The polarized politics we watch is because of the increasingly powerful role played by primary voters. House seats that will reliably return a Congressman of a certain party are uncompetitive in the general election and therefore the primary of the dominant party becomes ever more consequential. It forces House members of both parties to be ever more sensitive to their party activists or risk being outflanked by an even more extreme candidate that better appeals to the “party faithful”. As a result, the centrist voter is increasingly marginalized. There doesn’t appear to be anything to reverse this trend, at least for now. In fact, if anything there’s some evidence that it’s further exacerbated by internal migration of Americans to districts and states that they perceive to be “red” or “blue”. I write about these developments in my book, Bonds Are Not Forever – The Crisis Facing Fixed Income Investors.

This analysis is intended to be non-partisan. For investors of either party or no party, the future is likely to include more frequent disputes that require one side to blink as the protagonists perform for their hard-core constituency. America’s challenges require compromise, and regrettably we are electing representatives for whom total victory is all that counts. It will become a more familiar landscape.

 

Fed Chairman Bernanke’s press conference on Wednesday was more interesting than usual. The decision not to “taper” (never a word the Fed has actually used) caught market participants by surprise. The Fed will continue to buy $85 billion of bonds every month until further notice. Perhaps the low interest rate bias of the presumptive Chairman Janet Yellen colored the debate. Those FOMC members keen to begin the Fed’s exit strategy might reasonably have felt it poor timing to taper when in just a few months Chairman Yellen might have to defend a policy moderation with which she did not agree.

Perhaps even more striking was the answer Bernanke gave to a question on when the Fed might reach its equilibrium interest rate of 4%. The FOMC publishes its members’ rate forecasts and from those you can derive what they think the yield curve out to about five years should look like. Bernanke noted that the consensus among members was that rates would be at around 2% at the end of 2016. He then added that it might take a few more years for rates to reach the Fed’s neutral rate of 4%. It was a quite extraordinary assertion, and even though Bernanke will not be around at the Fed for much longer, he bluntly told bond investors that it’ll be many years yet until yields are freed of government distortion and allowed to properly compensate investors for the risks of inflation and the costs of taxes. Holding bonds at current yields is unlikely to leave you better off in real terms than you are today.

Many large asset managers and brokerage firms have an enormous stake in seeing retail investors continue to plow their savings into this return-less asset class. Bond pricing is far more opaque than for equities. There’s no ticker tape that shows where a bond just traded. The typical individual investor buying a municipal or corporate bond is doing so through a broker with limited information about where the wholesale price is. In fact the inefficiencies of the municipal bond market are well known. In July 2012 the SEC issued its Report on the Municipal Securities Market and provided strong criticism both of the disclosure practices of issuers as well as the market structure itself. They described pricing to investors as “opaque”, noted the general unavailability of firm bid/ask quotes, and pointed out that price transparency available to the brokers was not similarly available to the clients.

Bond brokers like it this way because uninformed clients are more profitable for them.  For many years the tailwind of the secular bull market in bonds has deflected attention from transaction costs incurred by retail investors that are far too high.

The end of falling rates and eventually the beginning of rising rates should cause retail buyers of individual bonds to take a much closer look at how much profit their broker is making from their business. The SEC’s report found transaction costs of up to 2% were common for retail investors. Brokers don’t have to disclose their profit on a trade if they acted as principal, which conveniently is often the case. If clients had to write a separate check for such amounts they would no doubt be shocked into demanding far greater transparency.

Meanwhile, the challenge is on for new and more creative ways to convince clients that they should maintain a significant allocation of their portfolios in fixed income, in the face of a Fed that intends to drive all the yield-based return out of bonds and a market structure that provides a good living to brokers who have access to much better price information than their clients.

In recent weeks, I’ve heard one firm argue that bonds have never delivered a negative return over any two year holding period over the past thirty years; this ignores the current very low level of yields from which the next two year holding period begins. Another firm acknowledged the poor return prospects in bonds but claimed they were still needed for diversification – in other words, losing money unpredictably is somehow helpful.

Many investors hold “low-risk” investment portfolios which are substantially in fixed income. This includes a friend of mine whose taxable trust yields 1.5%, coincidentally the same as the annual management fee charged by the trust company. While the IRS and the trust company are both benefitting from this arrangement, my friend regrettably is not.

The Fed’s interest rate policies of recent years have so far turned out to be far more enlightened than many of their critics assumed. A slow but steady economic recovery has taken hold, and inflation has for now remained low. However, interest rates that are maintained at artificially low levels for an extended period should also spur investors to reconsider the appropriate allocation of their savings to fixed income and the significant drag that transaction costs represent.

In recent weeks I’ve heard quite a few people comment that they’re looking for “rising rate strategies”. It’s a seductive concept; interest rates are almost assuredly headed higher. The debate about tapering rages on, and clearly the bull market in bonds is over. Serial Quantitative Easing will transform to the Fed’s exit strategy from its $3.5 trillion balance sheet.

Unfortunately, it’s not that simple. Long positions in a bond bull market have several sources of return. In addition to the capital gain that falling rates create, the holder of a leveraged long position further benefits from positive carry in that the cost of funding the position through the repo market is less than the interest rate earned on the bond. There’s also “rolldown”, in that a ten year security held for a year will be priced as a nine year security, and with a positively sloped yield curve the lower nine year rate causes some additional drop in the yield. Three sources of return make a bull market with a positive yield curve a great environment for leveraged investors.

By the same token, bond returns in recent years have been very strong.

Rising rates present a significant challenge for investors. The past four years’ return on the Dow Jones Corporate Bond Index (all investment grade bonds) is 18%, 9%, 9% and 12% respectively (from 2009-2012). Since each year has provided investors with a return substantially above prevailing interest rates, a significant portion has come from capital gains through bond yields falling and the rolldown effect described above. Clearly, since yields are now rising, capital losses will eat into interest income and it’ll be challenging for investors to break even. So far this year the Dow Jones Corporate Bond Index is -3.7%.

But just because bonds are likely to be a poor investment doesn’t mean they’re a good short. It’s a tempting proposition, but being short means that positive carry becomes negative carry and rolldown also works against you (since a shorted bond will roll down the still positive yield curve to a lower yield over time, notwithstanding the effect of generally high rates).

Here’s an example. Suppose an investor shorts a $1million ten year security with a 4% yield, and expects to hold the position for a year. Short term rates at 0% mean that the short will pay away the 4% coupon on the bond with no meaningful offsetting credit from cash (since cash rates are so low). This will cost $40,000. The slope of the yield curve is around 0.20% per year, so the ten year security’s market yield can be expected to fall by approximately this amount over the course of a year, absent any overall shift in rates. This will cause a further loss of about $15,000 to the short.

The net result is that yields need to rise to around 4.55% over a year for the short position to be profitable. Anything less, and the combination of negative carry and rolldown will render the position unprofitable.

This is the significant hurdle facing any strategy that seeks to profit from rising rates. They’re already expected to rise, so profiting from a forecast of rising rates requires that they rise more than is already priced in to the yield curve. If rates move irregularly higher, it’ll be very hard to profit from that. A better approach is to look for investment strategies across all asset classes that ought to be robust during a rising rate environment, but that don’t require rising rates to work.

 

Barron’s published a panel discussion on MLPs this past weekend. The panelists debate whether MLPs are still attractively valued or not and their sensitivity to rising rates. Although MLPs have been very strong this year, with our MLP Strategy +23% year-to-date, we continue to think that distribution yields of 5-6% and conservative growth prospects of 4-6% (implying a total return of 9-11%) make this a good asset class for the long term investor.

It’s important to pick the right names though as in any investment strategy. Because MLP investors are driven in part by the tax deferral treatment of the distributions, this is also not a sector that lends itself to much trading or switching out of names. Indeed, a well-managed MLP portfolio should be the most parsimonious user of brokerage services, because it should have minimal turnover. Selling an MLP typically triggers a taxable gain, and as time goes by the hurdle a new investment must clear in order to justify the tax bill incurred by selling an old one can become almost insurmountable. Earlier this year one friend suggested MLPs were due for a correction and noted a well-regarded MLP investment manager was selling. In our analysis we found that for some long-standing accounts it would have required that the cash thereby raised be reinvested at prices 20% lower simply to break even on the taxes incurred through selling in the first place. Meanwhile, the manager’s track record would not show the after-tax return. His clients could be worse off even while his track record looked as if timing had helped them. As it turned out though, this Spring correction was only around 2% so not worth the trouble.

Some MLPs offer very high but fluctuating yields. Petrologistics, LP (PDH) is an example. They convert propane into propylene, and so their earnings are highly sensitive to the price spread between the two. Their current distribution yields is 9.8%. Their 2011 S-1 registration statement warned of wide fluctuations in their distributions depending on business conditions. Their most recent 10K noted that, “We may not have sufficient available cash each quarter to enable us to pay any distributions to our common unitholders.”

It’s not just that LP investors are typically looking for stable yields and that PDH does not promise that. The additional challenge is that there are probably times to own PDH and times to be out of it. More frequent buying and selling reduces the amount of capital available for an investor to deploy because of taxes.

The Barron’s article mentioned other MLPs with more volatile business models, such as CVR Refining (CVRR). Refining can be a feast or famine business depending on margins which fluctuate widely. CVRR’s current distribution yield is an eye-catching 20%, although there’s clearly some doubt about its sustainability since management recently lowered its guidance.

There was also an interesting piece on Seeking Alpha this morning on StonMor Partners, LP (STON). STON is not in the energy business at all, but is in “deathcare”. They operate cemeteries and funeral homes. For historical reasons they operate as an MLP. The 9.6% distribution yield is attractive, although we’ve never invested because we found the financial structure overly complicated. Managing cemeteries is somewhat similar to running an insurance business, in that you get to invest the float. In STON’s case, people buy cemetery plots with cash and the maintenance costs of the cemetery are spread over many years.

The Seeking Alpha article notes the absence of much insider ownership or even institutional ownership, and asserts that distributions are persistently funded with issuance of debt, rather than out of profits. The writer believes a distribution cut is likely.

If any of these names mentioned above cut their distribution because of insufficient cash, as a friend of mine has said in the past, “Down’s a long way from here.”

Later this month John Wiley will release Bonds Are Not Forever; The Crisis Facing Fixed Income Investors. Some might say that one book is enough for anybody to write, but I must confess the experience following release of The Hedge Fund Mirage in late 2011 was sufficiently positive that I decided to indulge my audience’s patience once more. Recent sales and media coverage related to The Hedge Fund Mirage have no doubt been supported by continued mediocre hedge fund returns delivered at great expense. The industry remains a soft target.

Bonds are harder to criticize. For one thing, bond investors really have done well for a very long time. There is no “Bond Mirage” to be written. Bill Gross may have had a hand in more wealth creation for clients than anybody. However, as comfortable as it is to invest in what’s been working well, the math of current yields represents a substantial constraint on anything like past performance repeating itself.

The most important step to getting a book published is a business plan which should include an assessment of other books on the topic. Although ruinously low interest rates are a topic on which millions of savers can quickly commiserate, Amazon’s offerings of bond books are heavily biased towards telling you how to buy bonds and which ones. The view that fixed income deserves a radically small portion of an investor’s assets is not one that has many proponents. As with hedge funds, much of the continuing support for owning bonds comes from those with a self-interest to maintain. In the last few months we have come across some extraordinarily poor advice.

One large firm acknowledged the poor return prospects in fixed income but still valued their diversification qualities (i.e. they’ll lose money when your other investments are profitable, which is supposed to be helpful). Another published a chart showing the uncannily strong relationship between the yield on ten year treasuries and the subsequent ten year holding period return (yes, really!). The author of that particular insight probably also marvels at just how reliably bond yields rise when prices fall (and vice-versa). Whether fixed income returns after taxes and inflation are modestly negative (the most likely outcome) or worse, the originators of the insights listed above will work hard to present the results to clients positively. They’ll need to avoid numbers though, because that’s unlikely to help. Adjectives such as “decent”, “acceptable under the circumstances” or “OK” will be favored over more measurable assessments.

One friend showed us a taxable trust for which she’s the beneficiary that retains a substantial fixed income holding yielding 1.5% — coincidentally the same as the management fee charged by the trust company (pun intended). The U.S. Treasury and managers of the trust are both doing well out of this arrangement, although unfortunately my friend is not.

While there’s plenty wrong with low interest rates, the approximately thirty year bull market in bonds has coincided with two other evolutionary shifts. One is that debt outstanding has, by any measure, soared to levels that until recent years would have been believed unsustainable. When other significant public obligations such as Medicare and unfunded public pensions are included along with consumer debt we collectively owe more than twice the size of the U.S. economy. The second is the steady growth in financial services, including securities trading, money management and banking of all kinds. Since the peak in inflation in the early 1980s we have a substantially bigger banking sector and far more debt, but approximately unchanged median per capita GDP. In short, there’s not a lot to show for all this borrowed money and frantic trading.

How this all resolves itself is unclear, but the Federal Reserve sees ultra-low interest rates as part of the solution. Indeed there is so much debt and so many borrowers that providing a return above inflation would seem to be against the public interest, a needless waste of money. To the extent that the Fed, and by extension the U.S. government, can control it they’re likely to side with borrowers over lenders and maintain low rates. The evidence so far is that they can pursue such a strategy indefinitely. Inflation is a time-honored solution to excessive debt. Combined with financial repression, a regime of rates maintained artificially low, this can allow debt to be repaid at a negative real cost. Whether rates and inflation move up together or remain low together, yields below inflation plus taxes appear inevitable.

The growth in financial services supported the growth in debt, through financial engineering that sliced up obligations to meet every conceivable investor’s taste. Markets developed for derivatives of all kinds from interest rate to credit risk and complexity combined with leverage in a profitable waltz until the music stopped in 2008. Although the benefits of this bigger financial sector are hard to identify in the rest of the economy, banks were hardly to blame for the financial crisis. Government policies that subsidized debt and promoted overinvestment in housing were a significant factor. However, the aftermath which included the TARP program created a popular perception that Wall Street nearly blew up Main Street.

The public policy response against banking is well under way, justified by the imperative of avoiding a repeat. Under such circumstances it’s hard to imagine a return to the pre-2008 interest rate regimes that generally provided reasonable returns to lenders. A “better bargain for the middle class” for which President Obama recently called, probably excludes interest rates high enough to compensate lenders for inflation and taxes. Bonds Are Not Forever does not take political sides. Saving for the future transcends politics, and both blue and red investors need to coolly assess the populist shift in Washington’s policy response to banking.

The question facing bond investors is, how to respond to this steady transfer of real wealth from savers to borrowers. Three central banks (U.S. China and Japan) own almost $6 trillion of U.S. government debt and they remain significant buyers. In addition, by maintaining short term rates at virtually 0% the Fed keeps additional downward pressure on longer term rates. Their motivation is not commercial, but low benchmark rates tug most other rates down, limiting the opportunities for a commercially driven bond investor.

Hence, the radical advice to abandon the bond market as irretrievably distorted by government activity. If the Fed wants to own bonds so badly, let them own the lot! Take your ball and go elsewhere, to a place where the rules of private sector supply and demand still operate. The Equity Risk Premium, often reproduced on this blog, is a simple visual explanation of our bond-free investment philosophy at SL Advisors as well as the inspiration for the book. Bond yields are highly unattractive compared with the earnings yield on equities. The odds of bonds beating stocks over the long run are extremely poor. Meanwhile, the need for stable investment income is as strong as ever. Bonds Are Not Forever explains why investors should have low expectations for fixed income returns, and SL Advisors runs strategies designed to meet the need for stable investment income without using fixed income. Quite simply, the book explains the philosophy behind our investment business but also seeks to entertain the reader along the way. Clients of SL Advisors can expect to receive their autographed copy within a few weeks.