Wealth International, Limited (trustprofessionals.com) : Where There’s W.I.L., There’s A Way

W.I.L. Finance Digest :: May 2009, Part 3

This Week’s Entries :


The bear market in Treasuries will worsen, because of a glut of government bonds. Instead, consider high-yielding mortgage securities and certain munis.

The extreme credit dislocations from late 2008 have largely disappeared, but this still leaves most fixed income investments looking good versus U.S. Treasuries, which still look expensive. 10-year Treasury yields are off their lows, but merely back those which prevailed June 2003 – when most of us wrongly thought the secular bond bull market which began in 1981 had finally topped out.

This article from Barron’s suggests bond investments which are more likely to generate a reasonable return for you than Treasuries.

The bubble has burst.

We are talking about U.S. Treasury securities, not housing. At the end of 2008, risk-averse investors poured into Treasuries, driving down yields to the lowest levels in decades. The 30-year Treasury bond fetched less than 3%, and short-term T-bills carried yields of zero.

Since then, the economy has shown signs of bottoming, the credit markets are functioning more normally, and the stock market has roared back from its March lows. Treasuries now are in a bear market, while bullish enthusiasm has taken hold in other parts of the credit market, including corporate bonds, municipals and mortgage securities, all of which had fallen from favor late last year. The 30-year Treasury, for instance, has risen to a yield of 4.10% from 2.82% at the end of 2008, cutting its price by 20%.

Barron’s called a top in Treasuries and a bottom in the rest of the bond market in an early 2009 cover story (“Get Out Now!” January 5). We were not alone in recognizing some of the nutty year-end developments. Warren Buffett highlighted the sale in late 2008 by his Berkshire Hathaway of a Treasury bill for a negative yield. Buffett wrote in Berkshire’s annual letter in February that when “the financial history of this decade is written ... the Treasury-bond bubble of late 2008” may rank up there with the housing bubble of the early to middle part of the decade. How does the market look now? Treasuries still look unappealing for several reasons. Yields are very low by historical standards, the government is issuing huge amounts of debt to fund record budget deficits, and the massive federal stimulus program ultimately may lead to much higher inflation.

“There are better values elsewhere among high-quality bonds,” says Steve Rodosky, an executive vice president at Pimco, which runs the giant Pimco Total Return fund (ticker: PTTAX), the country’s largest bond fund; it is besting its peers again this year, with a 4.8% return so far in 2009. Pimco’s chief investment officer, Mohamed El-Erian, was blunt at year’s end, saying, “Get out of Treasuries. They are very, very expensive.”

While holders of Treasuries ultimately will get their money back, prices could fall sharply in the interim, and repayment could be in greatly depreciated dollars. Treasury yields may rise further in the coming year, meaning that prices will fall as the economy strengthens. The yield on the 30-year bond could top 5% and the 10-year note could rise to more than 4%, from a current 3.15%.

If the bond-market theme of 2008 was a flight to quality, this year it has been flight from quality.

If the bond-market theme of 2008 was a flight to quality, this year it has been flight from quality, as lower-grade, more speculative securities generally have generated the best returns. Returns on junk debt and lower-grade municipals have topped 20%, while the rise in government-bond yields has become a full-blown global phenomenon.

Even after rallying in recent months, the corporate-bond market looks attractive (please see story, “Corporate Bonds Are Back”). The average junk bond in the Merrill Lynch high-yield index has fallen to a still-lofty 15% yield, from 19.5% at year’s end, while more highly rated corporates – those with triple-B ratings – yield around 8%, a comfortable four percentage points above long-term Treasury rates.

The municipal-bond market also has advanced in 2009, with the yield on top-grade long-term securities falling to about 4.5%, from 5.25%, while rates on lower-rated securities like tobacco-revenue bonds and hospital debt, which topped 10% at year’s end, have dropped more than a percentage point.

High-grade, 30-year munis now look reasonable. At the end of last year, top-grade 30-year munis carried double the yields of 30-year Treasuries, an off-the-charts relationship. Now, the 4.5% yield on triple-A-rated long-term bonds is slightly higher than the yield on the 30-year Treasury.

That spread remains generous by historical standards. It is hard to get too enthusiastic about intermediate-term bonds with maturities of less than 10 years. They are yielding 3% or less. Lower-grade munis could have more room to run.

The muni market could benefit if President Barack Obama succeeds in lifting the top marginal income-tax rate to 39.6% from the current 35%, because that would boost the appeal of tax-exempt interest income. State and local finances, however, are a mess throughout the country -- particularly in California -- due to a weak economy and the unwillingness of politicians to tackle the ballooning cost of pensions and health care for government workers.

It is a tale of two markets in the mortgage-backed sector. There is not much appeal in government-backed Ginnie Maes – or in Freddie Mac and Fannie Mae securities, which carry an implicit federal backing. These securities yield just 4%. That means funds like the big Vanguard GNMA (ticker: VFIIX), now carrying a 4.3% yield, could have disappointing returns.

The riskier – and more attractive – part of the market is the so-called non-agency sector of home- and commercial-mortgage securities. These yields still can top 10%. Funds with exposure to the non-agency mortgage market include TCW Total Return (TGMNX), which has a current yield of 10%.

The recent rise in rates has merely brought the 10-year Treasury yield back where it stood in June 2003, when the prior, multidecade low in rates was reached.

Amid the debate about the direction of Treasury rates, one thing is clear: The recent rise in rates has merely brought the 10-year Treasury yield back where it stood in June 2003, when the prior, multidecade low in rates was reached.

“Bear Market in Treasuries Begins” was the title of a report last week from Morgan Stanley economists Richard Berner and David Greenlaw, who wrote about the “main culprit: a changing balance between credit supply and demand that is boosting real rates.”

The Morgan Stanley duo thinks that Treasury rates are not apt to shoot up anytime soon, because so-called core inflation, which excludes food and energy costs, is likely to remain around 1% for the time being and because “the economy is turning slowly.” Fresh concerns about the economy prompted a 4% selloff in the stock market last week, and a rally in the Treasury market, which tends to move inversely to stocks.

It is no secret that the U.S. budget deficit is exploding this year from the combination of weak tax receipts and sharply increased spending. The government-bond glut is hardly confined to America.

Looking out a few years, Berner believes that the 10-year Treasury could hit 5.5% as investors seek a real, or inflation-adjusted, return of 3.5%, relative to what may be 2% inflation. It is no secret that the U.S. budget deficit is exploding this year from the combination of weak tax receipts and sharply increased spending. The Obama administration recently increased its deficit projection for the current fiscal year ending in September to $1.84 trillion, from the $1.75 trillion estimate made in February, and lifted its 2010 deficit estimate to $1.26 trillion, from $1.17 trillion. That compares with a $458 billion gap last year.

The result is a large increase in the issuance of government bonds. Total sales of government securities with maturities of two years or longer are expected to hit about $2.1 trillion in the current calendar year, up from $880 billion in 2008, according to analysts at Barclays Capital. Net sales – issuance minus maturing debt – could hit $1.55 trillion, up from $332 billion last year. The growth in bond supply is particularly pronounced in 7-year, 10-year and 30-year maturities. One sign of trouble was the poor reception in a recent sale by the government of 30-year bonds.

The government-bond glut is hardly confined to America. Combined issuance in the U.S., Europe, Japan, Canada and Australia could come to $4.2 trillion this year, according to British financial historian and author Niall Ferguson. Net government-bond sales relative to gross domestic product will be particularly high in the U.K., at 17.9% – well above the lofty 12.7% here.

The U.S. Federal Reserve is trying to sop up part of the bond deluge with a program to buy $300 billion of government debt through the end of September. It has already purchased more than $100 billion. The Fed also has a program to buy $1.25 trillion of agency mortgage securities as part of an effort to depress mortgage rates, now averaging around 5%.

The Fed may succeed in artificially depressing Treasury rates for the time being, but the Fed program will end eventually, removing a key piece of support for the market. The Fed could get stuck with sizable losses if rates rise, since its holdings of bonds and mortgage securities, now $1 trillion, could double by the end of 2009. If rates rise one percentage point, the Fed could suffer $140 billion in losses, calculates Sean Kelleher, a partner at JGC Management, a New Jersey investment firm.

Overseas buying of Treasuries appears to be waning.

Overseas demand, particularly from central banks, has supported the Treasury market in recent years, but that buying appears to be waning. China, for instance, sees sharply slowing growth in its foreign-currency reserves this year due to weakening exports, a development that reduces the country’s demand for Treasuries. Chinese officials also are worried about the country’s $1 trillion-plus holdings in Treasuries and other U.S. debt because of the risk of a weakening dollar and higher inflation.

One way to bet against the Treasury market is to buy the ProShares UltraShort Lehman 20+ Year Treasury ETF (TBT), which is designed to rise at twice the daily decline in the prices of in long-term Treasuries. This exchange-traded fund changes hands at around $50 a share, up from $40 at year’s end.

Treasury inflation-protected securities, or TIPS, appear to be a better bet than regular Treasuries, but they're not the bargain they were at the end of last year. The 10-year TIPS yield 1.62%, and the 20-year TIPS, just 2.25%.

In addition to this real yield, investors’ principal is indexed to U.S. inflation. If inflation runs at 2.5%, the 10-year TIPS will return 4.12% (the real yield plus inflation), and the 20-year TIPS will return 4.75%. The yield gap between the TIPS and ordinary Treasuries is called the break-even rate. That's the inflation rate that would result in similar yields on the two securities. The 10-year break-even rate is now about 1.5% (the 3.12% yield on regular Treasuries minus 1.62%), which is below the historical average of two points, but above the break-even yield of 0.20% at 2008's end, when TIPS were very attractive relative to ordinary Treasuries as investors figured there might be deflation.

TIPS are still good, because they protect bond investors from what they fear most: inflation. Investors can play TIPS through the Vanguard Inflation-Protected Securities fund (VIPSX), or an exchange-traded fund, the iShares Barclays U.S. Treasury Inflation Protected Securities fund (TIP).

The muni market has rallied sharply since March, helped by a new government program that allows state and local governments to sell taxable bonds for infrastructure and other needs while getting a federal subsidy for part of the interest expense.

Since March, some $9 billion of the Build America Bonds, or BABs, have been sold, including big deals from California and the New Jersey Turnpike Authority. BABs appeal to bond issuers because the all-in interest costs on the BABs now are lower than the cost of tax-exempt bonds after the federal interest subsidy of 35%. Estimates are that $50 billion to $100 billion of BABs may be sold this year, accounting for perhaps 25% of total muni issuance. The Obama-initiated program is due to last through 2010.

California’s BABS that are due in 2034 and 2039 now yield about 7.5%, versus a 5.5% yield on the state’s long-term tax-exempt bonds sold in March. The all-in cost to California for the BABs is roughly 4.9% (7.5% times 0.65), below the cost of tax-exempt financing. The Golden State’ general-obligation bonds carry some of the highest yields among state GO debt, due to the state’s huge deficit, recently estimated at $15 billion, and an economic mess evident in a jobless rate of 11%.

Other high-yielding munis include so-called tobacco revenue bonds, which were sold by states and backed by payments made by cigarette companies under the Master Settlement Agreement in 1998. A long-term issue from Buckeye Tobacco, issued by Ohio, yields nearly 10%, and carries barely investment-grade bond ratings of Baa3 from Moody’s.

The Build America Bonds program has bolstered munis by diverting new supply into the taxable market. Traditional buyers of corporate debt have bought BABs because yields are high relative to corporate issues with similar credit ratings.

There also has been a record inflow to muni mutual funds so far this year, with $4 billion to $5 billion a month entering open-ended funds.

The situation in the bond market is not as extreme as it was at the end of 2008. Still, investors ought to avoid Treasuries, buy corporates and high-yielding mortgage securities – and consider municipals.

Corporate Bonds: How to Ride the Bull

The rally in both investment- and non-investment-grade debt is likely to continue, even if corporate defaults rise in coming months.

“If any nuclear winter impends from coming debt defaults, it will not be corporate bonds and loans gone bad that topple the credit system,” asserts this piece from Barron’s which serves as a follow-on to the article immediately above. “If anything, corporate debt, whether investment- or non-investment grade, represents a first-class speculative opportunity, since corporate securities still sell at yawning interest spreads, or lower prices, than most other debt instruments.”

We agree with the assessment that corporate debt will not suffer the same losses as commericial and residential real estate-backed debt, and consumer loans. The question that should be asked before jumping in is what default rate assumptions are embedded in current corporate debt prices. Then you also should realize you are making an overall call on interest rates, inflation, etc. If you buy an individual bond issue you are also making a bet on a ratings (or default risk) increase or decrease (see article immediately below). Bottom line is that corporate bonds are a speculation, even if they do look attractive relative to Treasuries and other non-government debt.

The U.S. government has unleashed a barrage of measures over the past seven months to quell the credit crisis and get money flowing again, both here and abroad. And for the most part, these efforts are succeeding, through capital injections into banking institutions, direct purchases of securities by the Federal Reserve, and a panoply of special liquidity facilities.

Interest rates have dropped dramatically on all manner of credit-market instruments, from commercial paper and interbank loans to home mortgages and consumer loans.

But the one market the government has not directly addressed – bonds issued by corporations – has some folks worried. They paint baleful scenarios of companies unable to roll over their maturing debt because of usurious interest rates, and lenders reluctant to provide credit to dicey concerns at any price. And as corporate defaults mount in the months ahead, the four horsemen of the apocalypse – namely inventory cuts, job layoffs, capital-spending cuts and asset liquidations arising from bankruptcies – will be loosed on an already weak global economy.

“It could well turn out that the government has made a huge mistake by medicating every key segment of the credit market, save corporate debt,” avers Jim Bianco, a Chicago-based credit-market commentator. “I fear that a corporate-debt smash-up will bring on the dreaded second leg of the financial crisis.”

Barron’s does not share such saturnine views – for signs of a real thaw are accumulating quickly in the corporate-debt market. Most importantly, interest rates in the $1 trillion non-investment-grade, or junk-bond, market are starting to fall sharply. The canonical Merrill Lynch High Yield Master II Index has fallen from more than 20 percentage points over comparable Treasuries in mid-December to less than 13 percentage points. In terms of bond prices, that is a move from around 55% of par to more than 71% of par.

As a result, higher-rated corporate-junk issuers have been piling into the market with abandon, after months of inactivity. Among them have been the privately held hospital giant HCA; home builders Toll Brothers and Ryland Group ; Dole Foods; telecom outfit Crown Capital ; chemical concern Nalco ; and Canadian mining company Teck Resources, which sold $4.23 billion of debt in the biggest junk deal since last September, when the collapse of Lehman Brothers threw the entire high-yield market into the deep-freeze.

Moreover, there seems to be less risk aversion than even several months ago. Fund-flow statistics show that over the past nine weeks, new money is sluicing into high-yield mutual funds at 10 times the rate seen back in early March, hitting a weekly average of more than $1 billion in the most recent period. Also, April saw a spirited rally in the prices of the Merrill Lynch Index, with the lowest-rated triple-C bonds notching a 22% return, while the least-speculative double-B managed just a 7% gain. The junk market was clearly following the biblical injunction of the last being first and the first, last.

At the same time, debt issuance has been strong in the $6.7 trillion investment-grade-debt market.

Even major financial institutions such as Goldman Sachs and JPMorgan Chase have doffed their water wings of government support by issuing more-expensive, non-government-guaranteed debt, both to escape the pay strictures of the government’s Troubled Asset Relief Program [“TARP”] and to demonstrate their financial superiority to rival institutions in the bombed-out financial sector. Goldman, for example, earlier this month issued $2 billion of 5-year bonds, with a yield about four percentage points over the comparable Treasuries. This compared with a 3-year issue of bonds guaranteed by the Federal Deposit Insurance Corp. that Goldman sold in March at a 2.17-point spread over Treasuries.

Also, a perkier stock market figures to afford companies badly in need of liquidity considerably more refinancing flexibility. Many are now able to issue convertible bonds or preferred stock at far lower cost in terms of interest and conversion premiums than just a few months ago.

The rally in both investment- and non-investment-grade debt may be in its early stages, given the still-elevated interest-rate levels in both markets.

Says Michael Darda, chief economist at MKM Partners: “Folks are missing the fact that a full-fledged thaw is under way, not only in corporate debt, but also in smaller markets like municipal bonds and jumbo mortgages, which all augurs well. Rates are coming down fast on corporate debt from last fall, and credit spreads figure to really compress radically, once people sense – as I now do – that the slide in the general economy is about to trough. Then one will see a radical change for the better in the credit markets.”

There are myriad ways to play any rally in corporate-bond prices. Some investments that Barron’s suggested earlier this year still look attractive, including exchange-traded funds such as the iShares iBoxx $ High-Yield Bond ETF (ticker: HYG), open-end funds like Fidelity Capital and Income (FAGIX) and a host of closed-end bond funds that trade at a substantial discount to their net asset value.

To be sure, more blood will be spilled in the corporate-debt market in the months ahead. Moody’s expects the default rate of junk debt outstanding to hit a high of 16.4% by November of this year, while Standard & Poor’s expects defaults to crest in March of next year at 14.3%. Both of these forecasts far surpass the current default record of 12.54%, attained in July 1991, and the roughly 5% default levels reported by S&P for this March.

Likewise, the prospects remain grim for companies with bad business models, a paucity of attractive, unleveraged assets, or balance sheets encumbered with insensate debt burdens, say, as a result of private-equity buyouts. Already, the pain is mounting.

In a recent report called “Bondholders Get Buzzed,” S&P said that at least 28 corporate entities entered into deals with their lenders this year through the end of April to “either extend payment, convert debt into stock, purchase debt at a discount, reissue debt at more favorable terms, or a combination of the four.” These distress exchanges through April are nearly twice the 15 such debt haircuts that occurred in all of 2008 and seven times the four that occurred in 2007.

S&P’S 28 listed deadbeats include a number of well-known corporate names, and often involved haircuts by the lenders of more than 50 cents on the dollar.

Freescale Semiconductor, a once much-ballyhooed private-equity deal, was able to exchange $2.8 billion of debt for an aggregate $924 million face amount of senior secured debt. Ford Motor stiffed creditors by offering $1 billion in cash to retire $2.2 billion in secured term-loan debt, and another $1.1 billion to take out $3.4 billion of unsecured debt. Gaming concern Harrah’s Entertainment has gotten two bites at the apple by stiffing its creditors twice in the past five months. So much for the honor of its private-equity owners, Apollo Partners and TPG.

Yet a look at various measures of current corporate liquidity offer some hope, even with the U.S. mired in a deep recession. As noted in a recent report from the money-management firm Lord Abbett, the latest Federal Reserve data show that corporations’ ratio of cash and short-term securities to total debt in the 4th quarter of last year stood at around 20%, about the same as in 2004, well before the debt bubble inflated to lethal proportions.

Or take a look at corporate America’s debt-to-equity ratios in the 4th quarter. Lord Abbett points out that even after all the charges and other write-downs that decimated corporate net worth in the period, debt still stood at a reasonably muted level of 46.2% of total capital (debt plus equity). This compares with leverage ratios of more than 56% as recently as the mid-1990s. Nor is the current reading much different from the corporate leverage obtained in the mid-1980s, when Michael Milken and his Drexel Burnham junk-bond machine were in the early stages of their ascent.

Likewise, the low interest rates that corporations were charged during the debt surge from 2006 to 2007 as a result of collapsing risk premiums is now redounding to the benefit of leveraged corporations with lower-than-normal interest burdens. According to Moody’s Economy.com, net interest-rate payments in the fourth quarter of last year accounted for 18.8% of the total cash flow of nonfinancial U.S. corporations. While that was up from 14% in the 3rd quarter, largely due to the 4th-quarter economic collapse that sharply reduced corporate cash flows, it was not unusually elevated by historical standards. The interest-to-cash-flow ratio popped to over 30% from mid-1989 to the first half of 1990 as junk-debt mania hit its crescendo. Interest payments also consumed more than 25% of cash in the second half of 2000 and the first quarter of 2001, during the death and transfiguration of the dot-com boom.

“Clearly, a lot of crazy, high-risk corporate-debt deals were done in 2006 and 2007 that created terrible capital structures ... but people forget that the deals were often done at rock-bottom interest rates, which was certainly a plus for borrowers if not lenders,” observes Mark Zandi, chief economist of Moody’s Economy.com. “Also, the latest debt bubble lasted for a much shorter period than some manias in the past. As a result, I suspect that the current surge in corporate-debt defaults will be much shorter-lived than those that occurred in recent decades.”

Of greatest moment in any debt cycle are rollovers, whether occasioned by the maturing of outstanding bonds or renewal of expired bank-debt facilities. This is when the rubber meets the road, particularly in a debt market like today’s, in which continuing panic and risk aversion have stunted normal liquidity. Fortunately, on this score the calendar of impending rollovers in the junk-bond market looks somewhat subdued in the near term.

According to Moody’s, nonfinancial junk companies face debt refundings of about $190 billion over the next three years, out of their $1 trillion or so of outstanding bonds and bank debt. The bulk of that debt, $120 billion, will not roll over until 2011, compared with just $26 billion this year and $44 billion next year. And the refunding burden for the $6.7 trillion of outstanding nonfinancial, investment-grade corporate debt is a comparatively light $300 billion over the same three-year period.

“I know that the $120 billion of speculative-grade debt in 2011 is a shocking number, but the economic situation ought to be a lot better then than it is now,” says Kevin Cassidy, Moody’s senior credit officer.

Of course, defaults promise to spike higher in the next six months. Both S&P and Moody’s expect the percentages to push into the middle-teens. Still, defaults do not represent total losses. A significant value in defaulted bonds or bank debt can be recovered, depending on the seniority of the lender’s claim in the borrower’s capital structure. Value can be recovered through everything from debt restructurings and equity-for-debt swaps to asset liquidations in Chapter 7 bankruptcy proceedings.

It is unclear just how much might be recovered. “I do not expect recoveries to be as strong this time around as in past cycles, when recoveries were typically around 45 cents on the dollar,” says Diane Vazza, a managing director of S&P. “They will be hurt by the lousy economy, wounded banking sector, a lack of debtor-in-possession financing and the crummy leveraged deals done by the private-equity sector in 2006 and 2007. There will be more liquidations, in which recoveries typically suffer, this time around.”

Yet, according Economy.com’s Zandi, “lifetime” credit losses in the trillion-dollar junk market are likely to be limited to $200 billion. This would be small potatoes compared with his estimates of $716 billion in commercial-real-estate losses and around $1 trillion in residential-real-estate losses. In fact, even consumer loans will cost creditors more – $262 billion – than corporate defaults.

Most of the damaged junk debt resides in securitizations such as collateralized loan obligations, and therefore has already been written down to current “mark-to-market” values. So any losses eventually suffered will have minimal impact on the income statements and balance sheets of banks, insurance companies and other institutional holders.

In other words, if any nuclear winter impends from coming debt defaults, it will not be corporate bonds and loans gone bad that topple the credit system. If anything, corporate debt, whether investment- or non-investment grade, represents a first-class speculative opportunity, since corporate securities still sell at yawning interest spreads, or lower prices, than most other debt instruments.

In fact, investors might want to lavish on the corporate-debt market the very attention that the government has failed to lavish.

Bonds: Beating Treasurys

Treasurys are a bubble waiting to burst and corporates are risky. Maybe you should aim in between, with agency and other debt with various forms of government backstops.

Yet another approach to the bond market is suggested here by Forbes. The article author notes that even companies formerly viewed as rock-solid, like GE and Berkshire Hathaway, have lost their AAA credit ratings – so perhaps one should look at fixed income investments with less risk than corporates. The alternative suggested are debt issues with some form of government backing which nevertheless yield decidedly more than similar maturity Treasuries.

If you were heavily into Treasurys at the outset of 2008, pat yourself on the back. The Merrill Lynch Treasury Index ended up 14%, its best annual performance since 1995. These days, however, Treasurys are risky. The recent flight to safety has sent prices up and yields to the lowest levels in four decades. In February Warren Buffett even called the phenomenon a bubble, on a par with the Internet bubble of 1999 and the housing bubble that burst two years ago.

The alternative? Investment-grade corporate bonds offer rich rewards; at six percentage points over Treasurys, yield spreads on 10-year, BBB-rated corporate issues are wider than they have been in six years, says Standard & Poor’s. High-yield debt, with yields approaching 20%, is even more enticing – except that Moody’s expects default rates to hit 15% this year versus 4% in December 2008. Corporate icons that a year or two ago looked rock-solid, like AIG and Lehman Brothers, have collapsed. Survivors General Electric and Buffett’s Berkshire Hathaway have lost their AAA credit ratings.

If you think Treasurys are toppish but corporates bear too much credit risk, consider the middle ground: agency and other debt with various forms of government backstops.

At the safest end of the spectrum are entities whose debt, like Treasurys themselves, is explicitly guaranteed by the U.S. government. Ginnie Mae does not borrow money itself; rather, it makes securities out of mortgages originated by the Federal Housing Administration, Department of Veterans Affairs and other federal agencies. Ginnie Mae charges investors 0.06% to guarantee – with Uncle Sam’s support – that interest and principal will be repaid. The only risk is from fluctuations in interest rates (similar to, but not as great as, the rate risk built into Treasurys).

Vanguard’s Ginnie Mae fund (with an average maturity of 1.7 years) yields 4.4%. That is better than the 2.4% yield on the firm’s intermediate-term Treasury fund (average maturity: 6.4 years).

Fannie Mae and Freddie Mac buy mortgages and package them into securities as well as issue debt. The government placed both inept giants under conservatorship last September, promising to buy up to 80% of their preferred stock and to extend protection to holders of their securities and debt.

This implicit guarantee is slightly less airtight than the pledge on Treasurys, but the difference is probably academic. It is hard to imagine the feds letting the two mortgage buyers welch on obligations in all but the most dire circumstances.

Among Fannie and Freddie offerings, Susan Schiff, who runs the Eaton Vance Government Obligations fund, likes pools of their seasoned securities. One of Schiff’s holdings, a pool mainly of adjustable-rate mortgages originated by Washington Mutual and packaged by Fannie in late 2004, has an average loan age of 15 years and yields 3.2%. These securities will not mature on average for 21 years, but they behave more like lower-yielding one- and 2-year Treasurys because of the speed with which the principal is paid back on the bonds.

One thing you must remember with corporates and most mortgage securities is the “call risk.” This is the risk that principal will be returned at an inopportune moment for you. Whether calls in fact damage you depends on unpredictable events, but in probabilistic terms callability usually slices at least a quarter-point off your expected return. Almost all Treasurys are noncallable. Also, coupons on Treasurys are exempt from state income tax, while interest on corporate bonds and Ginnie Maes is not. That tax difference is worth as much as another quarter-point (in a taxable account). All in all, a Ginnie Mae or Fannie Mae should offer a yield at least half a point over the comparable Treasury before you even give it a second look.

Another quasi-government security is a bank bond with a guarantee from the Federal Deposit Insurance Corp. The FDIC guarantees the bonds through maturity, but after June 2012 it reserves the right to call them. Three-year Goldman Sachs bonds with FDIC backing are paying 1.8%, or 0.5 percentage points over comparable Treasurys. Similar issues from Bank of America and JPMorgan Chase yield 1.9%.

Yet another option is debt issued by the Federal Home Loan Bank or the Tennessee Valley Authority, with maturities reaching out to 2038. Yields are a bit better than yields on comparable Treasurys and are exempt from state income tax. But many of these bonds have call risk.


RidgeWorth Intermediate Bond Fund manager’s Jim Keegan says any recovery is still a distant hope, given the pitiful state of the U.S. consumer’s balance sheet.

Intermediate Bond Fund manager Jim Keegan believes we are only part way through a major consumer retrenchment, which will see the consumer portion of U.S. GDP fall from its recent peak of 70% down to its long-term average of 60%. The corollary is that any hopes for a quick recovery in the overall U.S. economy are misguided.

Keegan has 40% of his fund portfolio invested in investment-grade corporates, but he favors issuers in defensive sectors such as regulated utilities, health care and pharmaceuticals. It took years for the consumer imbalances to build up, says Keegan, so correcting the imbalances will not happen overnight. Structure your portfolios on that assumption.

Jim Keegan does not have much use for what he calls the “green-shoots-and-glimmer camp” that sees optimistic signs of economic stabilization when more than a half-million people lose their jobs. Instead the RidgeWorth Intermediate Bond Fund co-manager, who headed for safety way ahead of the pack in 2007 and 2008, is waiting out what he sees as a long-term readjustment by the U.S. consumer.

To buy into the consensus view that stabilization will quickly lead to recovery, “you have to believe that this is a normal business cycle,” Keegan says.

He does not. “This is not a normal inventory adjustment cycle,” says Keegan, who leads a team of portfolio managers including Perry Troisi, Adrien Webb, Michael Rieger and Seth Antiles. Keegan is also chief investment officer of Seix Investment Advisors, which sub-advises RidgeWorth funds.

The $1.1 billion RidgeWorth Intermediate Bond Fund has returned almost 9% employing a defensive strategy in the year through May 13 – Keegan’s first year managing RidgeWorth funds after coming over from American Century Investments. That puts it in the top 1% of its peer group, according to Morningstar, which rates it five stars overall. Over the past three years, the fund has returned 7.61% annually on average. Institutional shares (ticker: SAMIX) comprise the vast majority of the fund. It has two other classes: A shares (IBASX) for the retail market and R shares (IBLSX) for the retirement market.

Keegan actually saw the financial crisis approaching as far back as early 2007. He told the Wall Street Journal in April of that year he was worried about the collateralized debt obligation “phenomenon.” He predicted, back then, a vicious cycle of ratings downgrades, forced sales and valuation issues. “Who knows where that will end?” he asked.

That question remains unanswered, he says today.

Still, reflecting his cautious outlook emphasizing the safest corporate debt, Keegan’s fund has lagged a bit so far in 2009. April, Keegan explains, was “a month of high beta,” meaning big rewards for taking risk. Junk bonds, for instance, posted record monthly gains.

“I would not characterize our portfolio as high beta,” Keegan says. “We think the high-yield market has really run like the equity market: too far, too fast.”

The core of Keegan’s strategy is retrenchment by U.S. consumers as they go from their debt-enabled buying binge of the last decade to balance-sheet repair. He figures the process will not stop until the consumption portion of GDP shrinks from more than 70% now back to its long-term average around 65%.

That process may already be occurring. According to the Federal Reserve, consumers slashed borrowing in March by the largest dollar amount since the government started keeping track in the 1940s.

A few percentage-points worth of spending relative to GDP does not seem like a lot, unless you are talking about a $14 trillion economy. “I have always been of the theory that if you get the consumer right, you are going to get U.S. GDP right and you will get the trend in global GDP right,” Keegan says.

He favors the debt of staples like regulated utilities, health care, pharmaceuticals and other defensive sectors. Though he is overweight investment-grade corporates – almost 40% of his portfolio – they do not show up among his top individual holdings (see chart), a reflection of just how diversified his fund is.

In February, RidgeWorth added Roche Holdings, the Swiss pharmaceutical giant. Keegan likes its strength in oncology and low patent-expiration ratio. “From a bondholder’s perspective, the cash flow tends to be very stable, and you have very predictable servicing of debt,” Keegan says. He bought the new debt at a spread of 345 basis points (or 3.45 percentage points) over 10-year Treasury yields.

In addition to Wal-Mart Stores, he also holds bonds of U.K.-based Tesco , the world’s 3rd-largest retailer after Wal-Mart and France’s Carrefour.

As part of his retrenchment theme, Keegan recently bought Time Warner Cable , whose roster of subscribers grew in the first quarter. Keegan figures that even with less discretionary income, consumers will not fiddle with their TVs; they may even spend more on cable and less on going out.

Another holding is Australian energy company Woodside Petroleum. Keegan bought some of the company’s 10-year debt offering in late February at a little over 600 basis points above comparable Treasury yields. He likes the market for liquefied natural gas because of strong Asian demand and Woodside’s contracts with Japanese and Korean utility companies.

Keegan has favored new issues in the recent credit environment. Even high-quality companies faced a significant price concession compared to their outstanding issues, at least until very recently. And the very fact that companies were able to bring new debt to the market at all was a reflection of underlying strength.

Keegan, 48 years old, got his start with a summer job at Dreyfus in the late 1970s. He moved on, after graduating from St. Francis College in his native Brooklyn, to Republic National Bank in 1982. He got an MBA from Fordham in the late 1980s.

The Dow Jones Industrial Average traded at about 700 back when he graduated college, Keegan recalls, making the decision to go into the credit side an easy one. Experiencing the high inflation/interest rate 1980s gives Keegan some perspective on what is happening now.

Even when banks got into trouble in the late 1980s, there was still cash flow and underlying assets associated with loans. So while that period was tough for financials, “you could get 10 or 20 people, or funds, or private-equity guys, to sit in a room and put a bid on those loans.”

“We can all put a bid on an office building in New York City, but we cannot do that for a leveraged tranche of a CDO,” he says.

Keegan also has a watchful eye on Wall Street: not just its balance sheet, but layoffs. He reckons the U.S. economy has had a couple of seismic shifts in recent decades: first from a manufacturing to a services-based economy and then, a greater orientation toward financial services.

That could make this downturn sting even more. “The multiplier tends to be very high,” he says, citing estimates pegging it as much as three nonfinancial jobs lost for each financial one. So the mantra that unemployment is a lagging indicator no longer holds, and it will be a coincident or even a leading indicator this time, he says.

That is a wake-up call for investors who bid up stocks even after the government reported another 539,000 jobs evaporated in April (40,000 in finance). With wages only up one cent on average, it is hard to imagine households being able to earn their way to better balance sheets.

“I am sitting here scratching my head” at how investors saw a silver lining in the employment data, he says.

And Keegan does not worry that the Fed’s overworked printing presses will spur inflation anytime soon. He remains in the camp that says deflation is the bigger risk. “The velocity of money is just so low,” he explains. Against that backdrop, the Fed should be on hold with interest rates near zero well into next year, he says, keeping a lid on Treasury yields that have crept back above 3% in recent weeks.

His pessimism is surely being tested. Despite the latest uptick, initial jobless claims are still well below their March peak, leading some to suggest the recession is in its final stages, and surveys point to stabilization, if not recovery.

Keegan’s message? “It took years to build up [imbalances], and people should not be surprised that it is not going to be done in months or quarters,” he warns. In fact, “I don’t think we are any more than halfway through.”

That is a sober message for the Beta guys already gearing for the post-game party.


Are speculators to blame for price spikes that have helped some stocks gain entry into the Russell 2000 – or are more sinister forces at work?

Stocks which gain admittance to indexes used by index funds with large amounts of funds in aggregate under management benefit from a jump in price, however temporary, on the day the stock joins the index. Index funds care more about tracking the index exactly than overpaying for a stock on a price spike. Since the price spikes are most pronounced on small stocks whose index weight is very small (in capitalization-weighted indexes, which is almost all of them), investors do not really care about the phenomenon.

Speculators can obtain a gain by guessing correctly about a stock moving from index outsider to insider. (We are unaware of any scandals involving advanced information of index composition changes leaking out of the selection committees.) Emphasize “guess.” But the widely tracked ($2.87 trillion in investments) Russell indexes, notably the Russell 1000 and 2000, use out-in-the-open criteria for index inclusion: The market capitalization on the close of trading on a given date – May 29 this year. Some suspicion souls have found evidence that traders unknown are gaming the system by driving up the price of stocks on the threshhold for Russell index inclusion on the given date. They are then able to sell the stocks to the indexers who pile into the stocks.

If true is this a big problem? Not really. A Russell Investments spokesperson said that last year’s additions to the indexes amounted to just 0.47% of the total weight, even as she praised the study revealing possible manipulation. But it would not exactly involve the purest of ethics either, and it would be very easy to change the entrance criterion to dispose of the problem, e.g., instead use the market capitalization averaged over several days.

The Russell spokesperson says such ideas are “worth considering.” You’re dang tootin’ they are.

Dale Rosenthal made money in grad school playing the Russell 2000 Index’s reconstitution. The small-cap benchmark’s spring shuffle is a favorite bet for quants like Rosenthal, who now teaches finance at the University of Illinois at Chicago. Over three months in 2004, he made 23% on a portfolio of about a dozen stocks.

“You could have a hedge fund,” says the professor, “where you walk in during April and work until August, then turn the lights off.” Since 1984, the indexes run by Tacoma, Washington-based Russell Investments have intrigued mathematically inclined traders, nicknamed quants, because Russell membership is an objective function of a stock’s market cap on the last day of May – as opposed to the inscrutable committee decisions that fill indexes at Standard & Poor’s or Dow Jones (which is also known as Barron’s publisher).

Russell’s market-determined composition also exposes it to predatory traders who can manipulate a stock into the Russell.

But the Russell’s market-determined composition also exposes it to predatory traders who can manipulate a stock into the Russell – hurting investors in Russell-indexed mutual funds and angering experts like Rosenthal. Indeed, a continuing study by a pair of researchers at State Street Global Advisors has found evidence of trading that seemed designed to rig the Russell’s membership through a surge of buy orders on the index marking date. Russell Investments praises the study and tells Barron’s it will seriously consider making changes.

More than $2 trillion in investments are indexed or benchmarked to the Russell 1000 Index of the 1000 largest stocks by market cap. Another $870 billion tracks the Russell 2000.

The game of anticipating additions and deletions has a long and respectable history among brokers who service index funds, as well as hedge funds and proprietary trading desks that take positions they hope to unload to rebalancing indexers. More than $2 trillion in investments are indexed or benchmarked to the Russell 1000 Index of the 1000 largest stocks by market cap. Another $870 billion tracks the Russell 2000, the next two thousand stocks by market cap after the Russell 1000. To the dismay of Wall Street back offices, Russell makes its annual changes on a single day – June 26 this year – and the index funds’ stampede can be a Pamplona-type spectacle.

But a less-noticed intrigue occurs on the date when Russell measures stock-market caps to determine index membership. It is May 29 this year. Working as a trader at Morgan Stanley some years back, Rosenthal noticed stocks that surged suspiciously up the ranks on the day Russell took its snapshot. “People actually forced stuff in ... that is just evil,” says the finance prof. “It isn’t like you figured something out, but that you made it happen.”

Among the stocks that just squeaked above the Russell 2000 threshold, a disproportionate share of the gains for May occurred on that measurement date – indeed, in the last minutes of that day.

Those suspicions seem borne out by the data of Zhan Onayev and Vladimir Zdorovtsov, researchers at State Street who studied the past 9 years of Russell reconstitutions. Among the stocks that just squeaked above the Russell 2000 threshold, a disproportionate share of the gains for May occurred on that measurement date – indeed, in the last minutes of that day.

The State Street researchers noticed the disturbing trades in the course of another study when they charted the order flow of stocks entering the Russell 2000. That chart, excerpted at lower left, showed a measurement-day spike in buy-order imbalances (defined as buys minus sells, divided by total orders) for all Russell additions, large and small. And over eight years, the imbalances for the smallest entrants averaged three times higher than for the largest entrants. Zdorovtsov and Onayev think that is possible evidence of traders trying to push stocks over the Russell threshold.

“That chart was the ‘Aha!’ moment for Zhan and me,” says Zdorovtsov. Last year, about 200 new additions made it over the Russell 2000 threshold, which was the market cap of the 3000th stock at the close of May 30, 2008 – or $167 million. In this year’s still-recovering market, analysts like Citigroup’s Lori Calvasina predict the cutoff will be down around $72 million. A would-be manipulator might hoard illiquid stocks with market caps under that level, in hope of pushing them up on May 29. The table at upper left illustrates some of the thinly traded, non-Russell names now hovering around the $70 million level. Barron’s would not recommend buying any stock based on its market capitalization.

Russell’s head of index-client service, Lori Richards, praised the State Street study. “We highly value this kind of research,” she says. “Over the past nine years, we have made multiple changes to our methodology to preserve its ability to be transparent and to reduce market gaming.” Russell now adds initial public offerings throughout the year and has a “buffer zone” on the border between the Russell 1000 and Russell 2000, so that a stock does not move back and forth between the indexes unless its size changes significantly. If mischief takes place at the bottom of the Russell 2000, says Richards, the problem is small. Last year’s additions to the indexes amounted to just 0.47% of the total weight.

With $3.5 trillion tracking the Russell indexes, that is still $170 billion of assets exposed to manipulation.

The Russell measurement-day imbalances may possibly result from honest speculators, Zdorovtsov notes, and not necessarily from stock manipulators. Still, he and Onayev suggest that Russell put a buffer zone at the bottom of the Russell 2000 as well. Better still, Russell should stop using a single day’s price to rank stocks; an average over several days would be harder to manipulate. Russell index executive Richards says those are ideas worth considering.

Finance professor Rosenthal thinks Russell has disrupted the market’s operation – however innocently – with its one-day-a-year fracas. “It is like showing up at the supermarket,” he says, “to buy 1,000 gallons of milk.”


If you seek the safety and yield of fixed income but don’t want to miss a rebound in equities, convertibles may be the answer.

Richard Lehmann, who is primarily an income-oriented analyst, recommends convertibles for those who want to be more aggressive than buying a pure bond but are too chicken to buy stocks.

The lingering pain of 2008’s market meltdown has investors understandably skittish about getting back into stocks. They seek the safety and yield of fixed income, but they do not want to miss a rebound in equities. Convertibles may be the answer. Usually they provide more income than stocks (albeit less than the coupon on straight debt). As the name implies, they can be (sometimes must be) exchanged into common equity. However, if the market should nose-dive again, these hybrid securities will not fall as much as the company’s stock.

It would be of course naïve to think that converts could consistently keep up with a bull market while proving safer in a bear market. It is a simple mathematical fact of the stock market that if you want to protect against losses you have to give up some gains. That said, convertibles provide a good balance of virtues, and the time is especially ripe for buying these because two things have driven down their prices. One is that the stock market crash has lowered the conversion values (value of common into which the bond or preferred can be exchanged). The other is that yields are high, and therefore prices are depressed, especially on debt issued by the sort of companies that are most likely to have converts outstanding. In other words, the pure bond value of a convert is low. With stock prices low and junk bond prices low, prices of hybrid stock-bond securities are low.

Another way of looking at a convert is to examine its “conversion premium” – the percentage amount by which a convertible’s price exceeds its conversion value. At the moment, conversion premiums are low. By buying when conversion premiums are low, someone who buys the convert rather than common shares pays a low fee for the enhanced yield and safety of the hybrid security.

The classic convertible is exchangeable, at the option of the holder, into a fixed number of common shares. Nowadays you will see a lot of converts with a variable number of common shares that they are good for. If the common sinks, the convert holder is entitled to more shares. Another variation is mandatory convertibility. The convert pays a nice yield for a few years, then is forcibly converted into common. I find a number of mandatory converts to be attractively priced at the moment.

One is the Freeport-McMoran Copper & Gold convertible preferred stock (70, FCX-M) with a 100 par value and a $6.75 dividend. A year hence it automatically converts into between 1.3654 and 1.6327 shares of common, with the number a function of how well the common is doing. If the stock stays stuck at its recent $44, you get the higher number of shares, at an effective cost of $42.87 each. Meanwhile, your convert is yielding 9.6%. Look carefully and you will see that there is no free lunch here. If the stock takes off the convert will not quite keep up (because the number of shares you get will fall). But this is a very fair tradeoff.

Another winner is the convertible bond of Archer Daniels Midland, a big agricultural firm that is a major ethanol producer. The $50 par unit (36, ADM-A) has a 6.25% coupon, which means that it currently yields 8.7%. In June 2011 it converts into between 1.0453 and 1.2544 shares of ADM stock, which at the moment is trading near $26. The conversion premium is 10% (compare 36 with 26 times 1.2544), well worth it to get the fat yield for two years. ADM common yields only 2.2%. Your main risk here is that Congress could adopt a rational energy policy. That risk is low.

Among classic converts (where the exchange is voluntary), I like the 4.875% perpetual preferred stock, par value $100, issued by Bunge Ltd. (78, BGEPF). Like ADM, Bunge processes and ships grain. The stock is down 61% in the last 12 months. This convertible can be exchanged at any time for 1.085 shares of common stock. With the common at $57.50, your conversion premium is 25%. For that premium you buy both a nice yield (6.25%, as opposed to 1.6% on the common) and some downside protection if Bunge’s stock falls further. It is unlikely that Bunge will get into financial trouble, given its relatively strong earnings and balance sheet. Bunge and my other two picks are also great inflation hedges. As I explained in my last column, the government’s stimulus plan will probably get the economy going again, but it will also ignite a serious bout of inflation. These converts should provide protection and profit.


Stocks of land-rich companies are back in the dustbin. For patient investors they are worth a look.

Land stocks can be great value investments – if bought right. A lot of the time they languish, sitting on extensive amounts of acreage and selling at deep discounts to a conservative appraisal of their land holdings. Net income is usually low and P/E ratios high during these fallow periods. Then when housing goes through one of its periodic booms the market will suddenly recognize those values.

One is well-advised to place one’s bet on companies with no or low leverage, otherwise they may not survive to see a revival in their fortunes. Another factor that should not be ignored is how effective company management is in realizing the underlying values when the opportunity arises. Often it would be well to have land development subcontracted to those who are good at it – which is not necessarily those who have been passively managing the land holdings for years.

Here is a quick and dirty starting list of land-rich stocks from Forbes.

If you think real estate is near a bottom, you should buy some land. But do not feel you have to acquire a deed. Shares of stock are an attractive alternative in valuation terms, and very liquid. Brokerage commissions are a whole lot smaller than title insurance premiums and lawyers’ fees.

There are some intriguing real estate investment trusts that own lots of raw land. On average, says Green Street Advisors, REITs are priced at 75% of their liquidating value. Other companies operate businesses and just happen to sit on lots of acreage [see table in article]. A non-REIT, Tejon Ranch [TRC] of Lebec, California, owns 270,000 acres of high desert in northern Los Angeles County.

Buy when housing is a wreck, land prices are plunging and such companies’ stocks are priced at a discount to the underlying value of their dirt. Then sell once housing recovers, the stock-market discount disappears or land values jump. Ideally, the three factors will coincide. They did so in mid-2005, when shares of landowning companies reached their zenith. Since then they have fallen 60% to 90%, offering an attractive entry point.

At least 10% of Tejon’s acreage is developable. It is a 90-minute drive to downtown L.A. and so no commuter’s paradise. But it is heaven for retirees and others seeking nice scenery. These days blocks of Tejon’s acreage are used as farms, which generated $13 million in revenue for the firm last year. A small industrial park and grazing fees from ranch lands added another $27 million.

Company managers have also applied to build two residential developments. Tejon won the crucial backing of environmentalists in May 2008, when it agreed to put its 240,000 undevelopable acres into a conservation land trust. (Tejon has retained the right to ranch, farm and prospect for oil on these lands and even sell large chunks, most likely to the environmentalists.) Full approval would enable Tejon to put up 26,000 homes on the 30,000 acres not included in the deal.

Tejon’s $23 share price puts a value on those developable acres of only $15,000 each. They will probably be worth several times that when home building comes back to life. Before the bust, raw land in the city of Santa Clarita, 40 minutes farther south on Interstate 5, was going for $200,000 an acre. The $15,000 figure, moreover, assumes that the 240,000 acres of farm and ranch land are worthless.

“We have owned this for 11 years, and it has never looked cheaper,” says Michael Winer, manager of the $1 billion Third Avenue Real Estate Value mutual fund. Winer’s fund owns a quarter of Tejon’s shares, and he sits on its board. He has vetoed efforts to lever up Tejon’s balance sheet, which is virtually debt free.

“The key to owning these stocks is to invest in the ones that are free of debt,” Winer says. “They cannot service it.”

“Florida land” is all but synonymous with “underwater.” But take a look at St. Joe Co., whose $24 share price is down from $80 during the housing bubble. The former papermaker, with headquarters in Jacksonville, owns 586,000 acres, 90% of it developable and most within a few minutes of Florida Panhandle beachfront. St. Joe has taken the next step to development on 49,000 acres by having land “entitled.” That means obtaining permission from all the relevant governments to put 45,000 homes and 13 million square feet of commercial space on the acreage.

To be sure, there is much more to be done before the land turns into cash. Utility lines and roads have to be installed and builders have to step up to the plate with a development plan. Still, St. Joe looks like a bargain. Its enterprise value (market capitalization plus debt, minus cash) is $2.3 billion. That means you are buying entitled land for $30,000 an acre and the remaining developable land at $1,500 per acre. Icing on the cake: The coming Panama City, Florida airport will be smack in the middle of St. Joe’s territory.

Forest City Enterprises, a Cleveland, Ohio developer with offices in New York City, owns 10,800 acres, mostly in urban and suburban areas, and has options to purchase another 8,900 acres. Forest City also owns office, residential and retail buildings that produced $1.3 billion in rental revenue last year.

Before the economy collapsed, Forest City was eager to develop 22 acres of industrial land in Brooklyn, New York, dubbed Atlantic Yards. It had planned to spend $4 billion building 16 office, residential and civic properties, plus a new arena for the National Basketball Association’s Nets. The project is in cold storage at the moment.

Forest City’s balance sheet is a concern. It owes $8.9 billion against assets appraised last year at $11.5 billion. The stock market is valuing the $2.6 billion in equity at around $600 million. Of course, it would take only a 23% fall in the assets’ value to make the equity worthless. Consider this stock a lottery ticket that pays off if the city does not go bankrupt.


Hazard: Inflation gets really bad in a few years, and/or the dollar weakens. Guard against both risks with shares of some overseas commodity producers.

We have all heard the story countless times by now: All the “money” being “printed” by the U.S. Federal Reserve will eventually find its way back into the market for real goods and assets, driving inflation through the roof. The scenerio is credible enough, but the devil is in the timing and magnitude details.

In line with old friend Peter Schiff, who is quoted in the article, this Forbes piece suggests the idea buying of commodities stocks with major sales outside the U.S. as an inflation/U.S. dollar hedge. You get exposure to agricultural and industrial commodities, which are reliable hedges against rising prices in general, while also making sure you are not overexposed to the U.S. dollar and economy (and government).

Walker Todd has a sobering message for you: A tidal wave of money is headed your way, and it is going to soak the global economy in a sea of rising prices.

Since last summer the U.S. government has committed $8.1 trillion to domestic bailouts, figures Todd’s American Institute for Economic Research in Great Barrington, Massachusetts. Part of that commitment is through loan guarantees that might not be needed. Even so, says Todd, “the authorities have lost control of the expansion of money.”

The danger is that after the economy hits bottom, all the money sitting on the sidelines – including $3.9 trillion that households have in money market mutual fund accounts and the $7.5 trillion held in interest-bearing bank accounts – will come rushing out. As it does, consumers and businesses will have to vie with government for a finite amount of goods and services. If the Federal Reserve has not already begun applying the brakes to the money supply, prices will shoot higher. Even before inflation sets in, there could be devaluation – a fall in the dollar’s value against other currencies.

“People who own U.S. assets, whether real estate, stocks or U.S. Treasurys, are going to lose substantial wealth in the next 5 to 10 years,” says Peter Schiff.

“People who own U.S. assets, whether real estate, stocks or U.S. Treasurys, are going to lose substantial wealth in the next five to ten years,” says Peter Schiff, president of Connecticut’s Euro Pacific Capital. “They need to move their money abroad.”

Unfortunately, if you buy Schiff’s argument, traditional inflation hedges provide less than airtight protection. Stocks tend to gain against rising prices but only if you have a decade or more to smooth out their volatility. Treasury bills pay next to nothing in real terms over the long haul. The same is true even of Treasury Inflation-Protected Securities, unless held in tax-sheltered accounts.

It is also apparent that gold and silver, time-tested stores of wealth, are better hedges against wars and other crises than against inflation. In the 34 years since Americans were once again allowed to own gold, its purchasing power has climbed 2.7% a year, barely enough to cover insurance and assay costs for hoarders. Gold is also susceptible to bubbles of its own, warns Liam Halligan, chief economist for Prosperity Capital Management in London.

Here is a concept: Consider commodity producers with significant foreign sales as an alternative that offers something of a double-hedge. They can give you exposure to agricultural and industrial commodities, which tend to fare well in times of rising prices; on top of that, they are a hedge against the dollar.

Each company in our table [see article] has revenues in excess of $1 billion, manageable debt, positive cash flow from operations and an enterprise value/sales ratio below historic norms. All generate at least 2/5 of revenue outside the U.S.

If you believe a world recovery is near, copper, uranium, oil and agriculture products are worth a look because they tend to perform well early in expansionary cycles. That is according to Krassimir Petrov, an economics professor at the American University in Bulgaria. Gold, by contrast, tends to perk up in a later, more overheated stage, he says.

Southern Copper is a $4.9 billion (sales) Peruvian miner with American Depositary Receipts listed on the New York Stock Exchange. It boasts the largest copper reserves of any publicly listed producer in the world. Despite copper’s fall in the past 12 months from $8,700 a tonne to $4,400, Southern recently said it will still pay a 12-cent-a-quarter dividend and keep buying back stock.

Cameco is a Canadian uranium miner trading for a 4.1 enterprise value to sales versus a five-year average of 7.4. Titanium Metals’ ratio of 1.0 is less than half its 5-year average. The Dallas firm derived 41% of its $1.2 billion in sales abroad in the past year and has no debt.

Undeveloped land and agricultural commodities are two other sound inflation hedges, says Walker Todd. Viterra is Canada’s largest grain handler and has revenues of $5.5 billion and debt equal to 23% of total capital. Alternatives include Bunge and Archer Daniels Midland, both U.S.-headquartered, NYSE-listed firms with assets across the globe.

If your broker does not handle foreign stocks, or charges an arm and a leg, consider Interactive Brokers or E-Trade. Interactive will execute trades on 80 exchanges in Asia, Europe and North America. Commissions on electronic transactions for European stocks run around 0.1%. Trades are executed on hometown exchanges, so investors pay the same spreads as locals. The currency conversion charge is just $2.50 for any trades below $50,000.

On more exotic exchanges, such as Argentina’s, say, a trade handled by Charles Schwab & Co. confronts a round-trip cost as high as 1%; on big exchanges, like London’s, the bid/ask spread is going to be more like 0.1% to 0.2%. Schwab’s minimum stock commission for an overseas trade is $100, but the currency conversion charge is already bundled into the execution price.

A number of exchange-traded funds also own producers of hard assets, including S&P Global Materials (fee, 0.48% a year) and the Van Eck Market Vectors Agribusiness ETF (fee, 0.65%.)


Ken Fisher believes that when the stock market recovers it will recover quickly. You cannot wait for the bottom and invest at your leisure, then; you have to get in before you are sure the bottom is in. This prognostication does have the virtue of being consistent with the market’s performance of the last few months.

Investors battered by the bear market are asking: “How long will it take to get back up to where we were when the bear market began?” My answer: I don’t know. There is no way to really know. Just guess. But when the recovery comes, it will come much faster than you expect. Bear markets are almost always followed by bull markets in a pattern with a V shape, as detailed in my February 16 column. The steeper the descent, the steeper the ascent. We had a steep descent.

Worried investors are thinking that the pattern will be different this time, that it may be a decade or more before the S&P 500 is back to its 1,565 high. The really worried ones think that this recovery may not occur in their lifetimes. But the grim notion that a crash is different, worse and near unique has been ubiquitous late in every bear market.

There are the endless comparisons with 1929-32, a crash that was followed by a partial recovery and then another bear market (with another economic downturn) in 1937. I do not think that comparison is at all valid. Next month I will detail why. The key point is that investors fear a 1930s-like L-shaped bottom with stocks going nowhere for years. But the 1930s had no L. There were, rather, several Vs in succession. In the first three months after 1932’s bottom the market was up 92%. We should be so lucky now.

If March 9 was the bottom, and that is an “if”, then at the recovery rate seen between June 1932 and March 1937 we would reattain the November 2007 peak in March 2010. The gloomsters pondering comparisons with the Great Crash just do not contemplate this fact. If stocks rebounded at a slower pace – in line with the average during recoveries over the past century – then we get back to the S&P 500 at 1,565 in May 2012. Think about buying stocks now that you will want to own in 2012, ones like these.

Sweden’s Sandvik (6.6, SDVKY) fell 70% in the bear market as the recession whacked sales of its metal-cutting, mining and construction tools as well as specialty alloys based on titanium and zirconium, used in thousands of applications like boiler tubes and flanges. This diverse vendor of industrial supplies has 50,000 employees in 130 countries. It sells at 70% of annual revenue, 7.5 times depressed earnings and 5 times what I expect for 2010 earnings.

Timken Co. (17, TKR) supplies bearings and specialty steels to markets that scare investors – including transportation, mining and aerospace. The worriers assume that it will be killed by Chinese competition. It will not be, any more than it was put out of business 25 years ago by cheap Japanese steel. Why? First, half of what Timken does is marketing. Second, it already operates globally, in 26 countries, including an upcoming factory in Xiangtan, China supplying parts for windmills, for instance. At 30% of annual revenue, at five times my estimate of 2010 earnings and with a 4.75% dividend yield, Timken is too cheap.

Owens Corning (19, OC) cannot get a break. This producer of fiberglass and other building products was sent into bankruptcy by asbestos lawyers. It emerged in 2006 just in time for housing to head south and the stock to tank 85% top to bottom. But it is more than holding its own in its markets. Two years from now investors will look back at 2009’s valuation – 40% of revenue, 80% of book value – and shake their heads.

Olin (13, OLN) is number three (behind Dow and PPG Industries) in the U.S. chlor-alkali business, which means splitting brine into chlorine, caustic soda and hydrogen. Olin also makes Winchester ammunition. Industrial chemicals are a good antidote to inflation. Olin is cheap at 56% of sales and six times earnings with a 6% dividend yield. It would be better if Olin bit the bullet and sold Winchester, but you have got a buy even if it stands pat.

China is growing despite the recession. A winner is Aluminum Corp. of China (18, ACH), at 3.25 million tons a year the world’s number four maker of this metal (behind Rio Tinto Alcan). ACH sells at six times trailing earnings and 90% of sales. The yield is 2%.

With the worst of the credit market crisis behind us, global yield curves are steep. That means that lending yields fat interest margins. Under the circumstances Spain’s largest bank, Banco Santander (9, STD), is worth a whole lot more than its recent one times revenue and six times likely 2009 earnings.


Now is not the time to bunt. Aim high, not recklessly or nervously, but in a studied, calm and controlled manner.

Value investor John Rogers claims that faint heart will not win fair maiden today. It is time to buy stocks at deep discounts and hold on. Typically, Rogers suggests some picks we do not quite get, e.g., department store chain Nordstroms after it has tripled off its low and is selling for a fairly small 20% discount to his estimate of intrinsic value. But maybe that’s just us.

Business news is everywhere, and following it these days is enough to give you an ulcer. I am beginning to hear investors say that the best way to beat this volatile market is by trading – anxiously moving in and out of securities as the market ebbs and flows. In my view there is no surer path to the poorhouse. Long-term investment success is not about making little decisions. It is the big decisions that matter.

These big decisions in periods of hyperoptimism or pessimism (like now) are what separate outstanding investment managers from the pack. No player ever made it to the Baseball Hall of Fame for his distinguished bunting record. Now is the time to swing for the fences, not recklessly or nervously, but in a studied, calm and controlled manner.

I will admit that there is a bit of luck involved here. But as the chemist Louis Pasteur once said, “Chance favors only the prepared mind.” An investment manager’s big decisions are not a coin toss; they come from years of relentless reading, studying those who have excelled and those who have fallen short, dissecting one’s own successes and failures, networking with those who can shed new light on a stock or industry and teasing out contrarian points of view. This is the style of investing practiced today by Warren Buffett and half a century ago by his teacher Benjamin Graham.

I spend five hours seven days a week just reading and analyzing, trying to ferret out good stocks and make sure that the stocks I already own are still worth owning.

Retailing is on its heels, but I like department store Nordstrom(22, JWN). It has a stellar brand built on its unparalleled customer service and a massive, enticing shoe department. But two issues hang over the stock. First, there is the well-known tightening of purse strings in the recession. Second, many believe department stores have a grim future – or none at all. The recession will end, inevitably, and I think department stores with a sharp edge, such as those that sell luxury wares to the well-heeled, have the opportunity to thrive. The stock has already tripled from its November 2008 lows, but it is still on the bargain shelf, trading at a 21% discount to my estimate of its private market value.

Admittedly, I have made some big mistakes in the media business. My Journal Register pick last year was a disaster. However, I always look forward, never back, and think the pessimism has gotten out of hand. So I am buying newspaper firm Gannett (4, GCI), publisher of USA Today. I am well aware that newspapers are suffering a deep secular decline as advertisers flee traditional media for cheaper, easily measurable advertising on the Web. But remember that a significant amount of the drop has been because of the troubles of automakers and home sellers. When a company with strong franchises like Gannett sells for one times trailing earnings and three times expected 2010 earnings, I step up and swing. In 26 years I cannot remember such an opportunity to invest at historically low levels in companies that are generating cash flow, earnings and real profits.

I am also a big buyer of Aflac (29, AFL), a leader in supplemental insurance (for example, to cover cancer care) in Japan and, to a lesser degree, in the United States. Geico has its gecko. Aflac’s mascot is a white duck. For 17 years Aflac’s earnings have increased 15% annually while peers have struggled to cover their cost of capital. As Buffett will attest, there are few better business models than insurance. Companies like Aflac collect premiums, invest them wisely and pay claims when necessary. It is like running an investment fund where the insurance company gets to keep all of the profits it makes after paying claims.

Among insurers, Aflac takes a conservative approach. It invests only in investment-grade bonds. The shares have declined with those of other financials because Wall Street is fretting about a small slice (less than 15%) of its bonds that are long-dated or perpetual hybrid securities (meaning they combine debt and equity components). The hybrid bonds were issued by European banks, and some analysts are panicking over the possibility of nationalization. I think, however, the earnings power of the insurance franchise will overcome any losses on these bonds. The stock trades at a 58% discount to my estimate of its intrinsic value.


If your assets are barely sufficient for your own needs, stiff your heirs. Put your money into an annuity.

When you buy life insurance you are betting that you will die sooner than the insurance company thinks. On the flip side of the same actuarial coin, when you buy an annuity you are betting that you will outlive the insurance company’s expectations. It turns out that for most retirees this later bet is a good one, the main exception being that you are so well off that you can self-insure your own longevity risk.

Forbes informs us here that economists who study the retirement market have long been frustrated by consumers’ apparently irrational aversion to annuities. A plausible theory given is that like most investments annuities are sold as well as bought, and fixed annuities which start paying out immediately are not very profitable for the salesperson – the commission is low, and the customer will probably not be needing too many other investment products in the future. Into this gap steps Forbes with this useful article, which covers the basic considerations in the buy-an-annuity-or-not decision.

As a purely financial matter, it is difficult to die at just the right time. Pop off unexpectedly young and you could rob your family of paychecks it was counting on. Hang on too long and you could exhaust your savings, impoverishing your family or consigning yourself to a decrepit retirement home.

One unexpected side effect of the recent financial crisis: A boom in sales of fixed immediate annuities, which dispense guaranteed income for life. Sales at New York Life, the largest issuer, hit $425 million in the first quarter, up 82% from last year.

Annuity Payouts For most clients those new annuities are likely to be a good deal. A 65-year-old man who pays New York Life $100,000 today will receive $650 a month for life. That is equal to taking out 7.8% of the total each year, which is double what long-term Treasurys yield. (Because of her longer life expectancy, a woman of the same age would receive $600, or 7.2%.) Wait longer to buy an annuity and the payout is, of course, higher (see table).

Part of the sales surge is because of the crash. Fixed-annuity buyers sailed peacefully through the recent market turmoil with monthly checks intact. Another factor: Many older Americans now find themselves planning for retirement with shrunken portfolios. Instead of living off dividends and leaving the principal to heirs, they need to consume the whole sum for their own needs.

Annuities offer the best way to lock in guaranteed lifetime income, argues Christopher Blunt, who runs New York Life’s retirement division. Retirement income generated from a stock-and-bond portfolio requires keeping plenty of assets in reserve in case they are needed to fund a long life or contend with a nasty bear market. Blunt’s pitch: Get the same retirement income as you could from a stock-and-bond portfolio, with 25% to 40% less principal.

Annuities’ ability to generate superior retirement income is conjured by pooling risk. The annuities transfer savings from people who do not need it (because they're dead) to those who do.

Economists who study the retirement market have long been sold on the merits of annuities and frustrated by consumers’ aversion to them.

This ability to match assets to future liabilities sends academic hearts aflutter. Economists who study the retirement market have long been sold on the merits of annuities and frustrated by consumers’ aversion to them. U.S. vendors sold a piddling $6 billion worth of immediate fixed annuities last year. The 2008 figure will likely be around $10 billion. This in a country with $2.7 trillion tucked away in 401(k)s.

One explanation for poor sales is that immediate fixed annuities are not very profitable for the salesperson. A 70-year-old client who plunks down $500,000 for an annuity and cashes a $3,600 monthly check probably does not need much else.

Another impediment to sales has been crummy marketing by insurers. Fixed immediate annuities have gotten a bad rap in part for sharing an association with their deferred-annuity cousins. These are complex vehicles that promise a tax deferral but subject buyers to a multiyear “accumulation phase,” during which assets are subjected to all manner of surrender penalties, commissions, fees and insurance charges, before paying out a dime. Most are great deals for the sales reps and lousy ones for clients.

Unlike fee-laden deferred annuities, immediate annuities are likely to be a square deal for buyers.

Unlike fee-laden deferred annuities, immediate ones are likely to be a square deal for buyers. The typical buyer receives a string of payments worth (at discounted present value) 95 cents for every premium dollar he pays in. The obvious reason for the efficiency in the pricing is that prices are easy to compare. Someone with $1 million to put in gets quotes from several vendors and takes the best payout.

Insurers do the best they can to make the product more opaque and complicated. Responding to customers’ fear that they will get a really bad deal (by dying young and leaving heirs nothing), vendors offer such features as a guaranteed minimum payout. A 65-year-old man who buys an annuity with a “10-year period certain” feature has the right to checks for 10 years, even if his heirs are the ones to cash them. For this he cuts his annual payout from 7.8% to 7.5%. That might seem like a small price to pay, but the drop-off is so tiny only because the guarantee is unlikely to cost the insurer much. Almost all 65-year-olds live at least into their early 70s.

Assuming you are in good health and keep your product features simple, there are not a lot of downsides to fixed immediate annuities.

Assuming you are in good health and keep your product features simple, there are not a lot of downsides to fixed immediate annuities. One to think about is the risk that the insurer will go bust in your lifetime. However, there are segregated asset pools as well as state-run guarantee funds to make a loss unlikely. In the bankruptcy of Executive Life, some annuity holders lost 20% of their payout. Try to buy from a company with a rating of double-A or better from A.M. Best. New York Life, TIAA and Northwestern Mutual qualify.

A bigger risk is inflation. New York Life offers a rider that increases payouts at a set rate of between 1% and 5% annually but is not pegged to actual price rises. More in keeping with the buy-it-and-forget-it philosophy are payouts linked to the Consumer Price Index, which are available from Lincoln Life Insurance and others. For a 65-year-old man an inflation-indexing feature would cut his initial annual payout from 8% to 5% of his original principal. If inflation averages 4%, the indexed payout would surpass the conventional one in year 12.

Do you want to protect a spouse? That will cost you. If our hypothetical 65-year-old man is married to a 60-year-old woman, he will cut the annual payout to 6.3% if it has to last until they are both dead.

Immediate annuities are not a great fit for everyone. If your annual retirement living expenses (including income taxes) come to less than 3% of your assets, you should be able to safely fund your lifestyle by owning a conservative mix of securities, without effectively handing over 7% to an insurer to cover your longevity risk. For everyone else the standard advice is to annuitize the portion of your nest egg you will need to cover living expenses, including supplemental health insurance. The rest you can invest as you please.

One way or the other, an immediate annuity is an investment you are unlikely to regret buying. If it turns out that the insurer got the better deal, you will not be around to fret about it.


Lofty Stock Values in Asia Stir Jitters, for the Short Run Anyway

If you want to see something scary, cast your eye on the dollar-adjusted returns for Asian markets.

Since the March bottom, India is up 57%, Korea 60%, Taiwan and Hong Kong both 48%, China’s Shanghai Composite 25% (it is up much, much more from its low) and Japan’s Nikkei 36%. Having missed much of that gain, foreigners in recent weeks have plowed money into emerging markets, particularly Asia. This month, HSBC Global Research concluded: “Valuations are starting to look stretched.” The 12-month forward price/earnings multiple for the MSCI Asia ex-Japan index is 15.8, above its long-term average of 14.5, while price to book is 1.8, near HSBC’s fair value. Citigroup strategist Elaine Chu says holding periods are at an all-time low: “The risk is that investors are too complacent and forget about the fact that flows could reverse as quickly as markets roll over.“

There is plenty of cause for concern: An election and the prospect of a hung parliament in Japan, political uncertainty in India and lots of other places, institutions unloading shares of Chinese banks. And it looks as though China may grow less rapidly than people think. New-loan growth is slowing, despite ample liquidity. Fixed-asset spending is up sharply, meaning capacity is growing when sustained improvement in global demand remains uncertain.

“We are skeptical,” says Hugh Young, managing director of Aberdeen Asset Management Asia. “The outlook is cloudy for business as a whole.”

Thus, even those bullish over the long haul believe the rally could stall out. “There may be a correction ahead” in China, says Guang Yang, manager of Templeton Global Opportunities (ticker: TEGOX). Still, Yang adds, “I don’t think it is a bubble. ... Valuations are still cheap. You can still buy for under 10 times earnings in Hong Kong.”

Look for Miners’ Shopping Spree

Those with cash are king.

In Aesop’s tale of the Ant and the Grasshopper, the studious ant saves in good times while the grasshopper dances in the summer. In the recessionary winter, the ant’s larder is full and the grasshopper is starving.

In this case, the ants are a number of copper miners in developing markets such as China, Brazil, Chile and Poland, flush with cash and eagerly scanning maps for potential targets to be gotten on the cheap. There is a lot of potential as the winners and losers of the credit crisis emerge, says Juan Carlos Guajardo, the executive director of the Santiago, Chile-based copper-and-mining studies center, Cesco. “Those that made big buys and took on a lot of debt have a problem, while those that have cash can take advantage,” he says.

On [May 15], Comex copper closed at $2.0175, down 6% on the week. Although copper prices are half of what they were in 2008, when they rose to more than $4 per pound, the red metal is up about 65% from its 2008 settle of $1.325.

Tight liquidity and credit conditions could discourage major acquisitions, said Freeport-McMoRan Copper & Gold (ticker: FCX) Chief Executive Richard Adkerson, in a recent interview. However, many companies that banked the earnings from the commodities bonanza last year are not worried.

Polish copper miner KGHM Polska Miedz (KGH.Poland) plans to buy a U.S., Australian or Asian copper operation during the fourth quarter of this year, according to CEO Miroslaw Krutin. “We are a cash-rich company that did not participate in the mergers and acquisitions [last year], when the market valuations of mining companies were at very high levels,” Krutin says. “We are in quite a competitive position in comparison to our peers at the moment.”

Chilean miner Antofagasta (ANTO.UK) is also flush, and seeking out opportunities to buy advanced projects or existing operations, CEO Marcelo Awad said last month at the business-analysis-and-consultancy-group CRU’s 8th Annual World Copper Conference in Santiago.

Earlier this year, Brazil’s Companhia Vale do Rio Doce (VALE) snapped up the Corumba iron mine in Brazil, the Potasio Rio Colorado potash project in Argentina, and Regina exploration assets in Canada from Anglo-Australian miner Rio Tinto (RTP) for a combined $1.6 billion.

China, too, has emerged as a deep-pocketed investor looking to secure strategic supplies, particularly in Australia, through its state-owned miners. China Minmetals has overcome concerns about the large size of China’s stake raised by Australian authorities, who recently approved the $1.7 billion purchase of Australia’s OZ Minerals’ (OZL.Australia) assets.

In February, Aluminum Corp. of China (ACH), known as Chinalco, offered $19.5 billion to Rio Tinto in a bid to raise its stake to 18%. The deal, which is being evaluated by the Australian Foreign Investment Review Board, would increase its pricing leverage for iron ore from Rio’s mines. China’s Nonferrous Metal Mining (8306.Hong Kong) is also moving to purchase a majority stake in Lynas (LYSCF) for 252 million Australian dollars (US$184 million).