Why corporate bonds are still expensive

Think fast: what yields the most, municipal bonds or corporate bonds?

It used to be the case that munis yielded less, since they have the benefit of being tax free -- Federal and oftentimes state too. So investors typically pay more for them, which then brings their yields lower. Also, many muni bonds are backed by state taxes, and the state can always raise taxes to cover their interest expense. Which mean munis in general are a lot safer than corporate bonds -- in general, there are many exceptions of course.

These days, for reasons that I don't understand, Muni bonds in California are yielding a lot more on an after-tax basis than corporate bonds, when comparing similarly-rated credit scores and maturity.

In fact, the spreads are so out-of-whack that I can get a safer (higher credit rate) Muni right now for a much better after-tax yield than a corporate bond with similar maturity.

Just for fun, I checked out a few high-yielding California Munis. Consider this:

California St Var Purp, 2034 (CUSIP:13062R3Y2) was recently seen trading for $80-$89 for an yield of 6.13-5.4%. Not bad for a tax-free return.

A few more:

San Gorgonio Mem Healthcare Dist Calif Go Bds, 2031 (CUSIP: 13062R3Y2) $80-89 6.13-5.4%, rated A3 by Moodys.

California St Go And Go Refunding Bds, 2036, (CUSIP: 13062TSB1) $83.454 5.684%, rated A2 by Moodys and A by Fitch and S&P.

To get a 6% yield after tax, one needs an yield of at least 6/(1-.28) = 8.33% pre-tax. And that's only considering a moderate tax bracket of 28% and no state taxes.

A more reasonable tax bracket for a California investor in the upper tax brackets would be 33% + 9.3% = 42.3%. So, to get an after-tax yield of 6% on that basis one would need to find a bond yielding upwards of 10%.

But let's be conservative and require a 9% yield. What can I find with that kind of yield?

Well, mostly only financials. Here are some issues:

Citigroup Inc, 2012 86.631 9.187 A3/A
Viacom Inc, 2036 77.03 9.191 Baa3/BBB
Bank of America, 2013 84.498 9.202 A3/A-

So, while it's not impossible to get a good deal on corporate bonds, one needs to be really careful to:
  1. Pick a maturity that you're comfortable with. Don't expect the market to fully value your bonds soon. If you can't wait for maturity, don't buy it!

  2. Be wary of credit ratings of financials. Financials are really a black box these days. While the Fed is currently backing them up, they may not do so forever. Or they might split banks apart and you may end up owning the debt of the "bad" part.

  3. Stick with G.O. bonds. As I mentioned before, General Obligation bonds are backed by state taxes and hence are generally safer. Be careful with some kinds of non-GO bonds which are not even issues by the state, but merely use the state as conduit to reach the bond market. These are the worst, usually not backed by anything.

  4. Avoid insured munis. There are issues that are backed by some private company (MBIA, AMBAC, FGIC, etc). Why is this bad? Because if the state is going to default, it will start with those it knows someone else is going to pick up the tab for them.

  5. Avoid low-quality for long-term bonds. Anything below BBB+ (Baa for Moodys) is probably too dangerous to own beyond a year or two, unless you have insight into the company's financial position. Which brings me to...

  6. Do your homework. Look at the terms of the bonds, its seniority, the terms of any sinking fund, call terms, etc. Look at what else the company owes and who the creditors are (if there are lots of more senior bonds than yours you may not get paid in the event of a default). Check the details on the MSRB website.

To summarize: Munis are offering higher yields than corporate bonds, for higher-quality issues and with the backing of a tax authority (for G.O. bonds). No one should invest in corporate America today unless they can find a much better deal with much larger margin of safety.


Off-topic: How much do we know what we don't know?

At the risk of alienating all four of my faithful readers, I'll discuss something off-topic that I happened to have thought about randomly and found intriguing enough to write down. Please bear with me while I get philosophical.

How much do we know what we don't know? And how has this changed over time?

I mean, as human beings, we discover new things all the time, through science, experiments and by accident. And we also often discover things that we can't explain. For example, we know we don't know if P=NP. We know that we don't know if the universe is infinite. Or if string theory is true. Or if there's life on another planet.

So, how much do we know now we don't know, say, in relation to what we do know? Is it a 2-to-1 ratio of known unknown to known? Or is it more like 1.5-to-1? Or 1-to-1? And how has this changed over time?

Imagine that, in the beginning of times, we didn't know anything. But we also didn't know we didn't know anything either -- we were totally ignorant of what we didn't know. So this situation might look like point A in the graph below: a little knowledge of something and no knowledge of anything else.

With time, we discovered fire, but we didn't know how to make it. Then we did. And we knew there was day and night, and phases of the moon. But we didn't know why. Maybe that was at point B in the graph. That one took a long time to solve, I suppose.

Throughout history, we learned a lot of stuff and a lot more that we knew we couldn't (yet) explain. With science and technology, we discovered so much new stuff, I believe our knowledge has grown exponentially in the last 100 years.

Why did it take us so long to achieve such growth rate? I don't know for sure, but I believe it has to do with science, technology, prosperity and the nature of discoveries. Each breakthrough led to a new baseline that benefited everyone, exponentially.

For example, by learning how to grow our own food, not only everyone benefited from having more and better quality food, but we also benefited from not having to worry so much about getting the food, which in turn freed us up to discover new things -- say, how to build better houses, or treat a disease.

But, going back to the point, how much new stuff have we discovered that we can't explain?

My guess is that what we know we don't know has grown at least twice as fast as what we do know. For each new DNA sequence we studied we probably found at least another two that we can't yet explain. And for each new molecule, another two have been found by accident. And for every theory explaining something, two conjectures arose trying to explain something else.

My guess is that the graph of human knowledge about the known and the unknown has grown like this, with exponential recent growth, and at least double that rate for the known unknown.

What do you think?


Accounting Shenanigans at Closed-End Mutual Funds

I had a position a while back in PCN -- PIMCO Corporate Income Fund -- a bond fund. It appreciated 60% in a matter of weeks and I sold it. It dropped and it hasn't recovered since. Nonetheless, it still trades for a whopping 18% premium to NAV.

Today, I took another look at it to see what's going on and whether or not it still is a good investment, despite the ugly premium. Its yield is certainly attractive: 14%.

My first concern about it was whether or not it was eating into principal in order to support its high yield. Many closed-end funds do that. Of course, that's not a sustainable strategy nor is it profitable for the investor.

So I took a look at its most recent quarterly report (note: I only trust the report on the SEC website). And as usual, I also went back to its previous quarterly report.

I was flabbergasted by what I found out.

Care to take a wild guess why? Search on both reports for "Fair Value Measurements". The fund recently adopted FAS 157 and switched the bulk of their portfolio fair value estimation to Level II.

Level I determines that securities are valued on the basis of market prices (mark-to-market, if you will). Level II uses "other significant observable inputs" and Level III is pure witchery.

Why would they adopt FAS 157?

One reason is the market dried up for corporate bonds. However, is this really true? There are still bid and ask prices out there for almost all securities, certainly more than 0.97% of their portfolio, which is the amount they claimed they could use Level I quotes for, and 98.6% for Level II and the rest for Level III.

Does this seem reasonable to you?

My brokerage still shows me quotes for most of PCN's portfolio, including widely traded bonds such as those of GE, C, F, GS.

Even worse is the fact that they report $33 million in Treasury Bonds which accounts for 5.5% of the portfolio. How can treasury bonds not be quoted at Level I?

Something smells fishy.

To be sure, using Level II doesn't mean the securities became more risky, it only means they became harder to value. And while I can believe that the current market environment doesn't make things easy, I strongly doubt using Level II for 98% of a corporate bond's portfolio is warranted, especially when there are such large positions in very liquid securities.

I also checked IQC, a California Muni fund I currently own. They too adopted FAS 157 recently and switched the bulk of their portfolio to Level II. CIF, another popular corporate junk bond fund, has been on Level II for a few quarters now.

Given that I don't understand why the radical switch nor why Level I quotes are impaired, I prefer to stay away from these funds for now. I will need to make a decision about my IQC position soon.


Short Interest -- Mid April 2009

The NYSE periodically lists the top 100 open short positions. This list is interesting because it shows which companies the market believes are overpriced.

Sadly, the NYSE list only shows total shares sold short, not what percentage of shares outstanding these are. The handicap is obvious: it's hard to compare companies and to gauge just how much short interest there really is. One needs to look at the short interest as a percentage of the shares outstanding.

Another interesting metric is to look at the days-to-cover number. As it says, this number indicates how many days it would take for short sellers to unwind their positions. This number is interesting both as a short seller perspective and as a contrarian one. It shows how willing short sellers are to short the stock given the danger of a long and painful short squeeze.

Perhaps the product of both numbers is even more interesting to look at since it combines both equally.

A word of caution though is to be careful when shorting low-priced stocks, since they tend to be more volatile and show larger swings, forcing a short seller into margin calls and big losses.

Without further ado, here's the list, with the extra fields mentioned above added.

(if the table doesn't load, click here)


Why Dividends? And Why Not?

In modern finance theory, there is no difference between valuing a dividend-payer stock versus a non-dividend payer. In theory, both kinds of stocks will be worth the sum of their future free cash flow, discounted at an appropriate rate.

In the figure below, we represent a money flow from a company's earnings to you, directly into your pocket. Assume the company earns $15 per unit of time, say per quarter. Upon earning money, the company declares a dividend of $10 (a 67% payout ratio). At time zero, let's say you have zero dollars and the company has $30. It then decides to pay $10 dividend. After paying the first dividend the company now has $20 and you have $10.

Then, the company earns another $15 and pays you $10. You now have $20, and the company has $25. And so on. At the end of 5 quarters, you've accumulated $50.

For simplicity, let's say that the company ceased to operate and the cash remaining in its coffers went to pay debt. You would get nothing else at liquidation, but you kept your $50.

How would you value this company at time zero?

Well, I would sum up all the cash flows to me and discount it at some rate. For simplicity, let's say the discount rate is zero. So the total worth of this stock to me is exactly $50, since that's what I will get out of it.

Now, assume the same company didn't pay you a dividend, but instead kept it in its savings account. The figure below illustrates the cash flow, just this time you get nothing all along, until the company liquidates, pays you the same 67% payout , in excess of what it owes, and uses the rest to pay the creditors.

You would get your same $50 and the company would keep $55, which it would use to pay creditors. So the valuation of this company must be the same as the one before: $50 (again, ignoring the discount rate).

So, in theory, the value of a company is independent of whether or not it pays a dividend. Some would even argue that dividend payers should be valued even a little lower, since you as a shareholder have to pay taxes on the dividends you get, while the company gets to keep it tax free (well, not quite tax free, it pays corporate taxes, but you as the shareholder get to keep more money in the company's coffers if it doesn't pay a dividend, due to the double-taxation system).

But what's the problem with this reasoning? There are many. The most important one is that unless you know and trust management, how can you be sure you will eventually get money out of a company? You don't. In many cases, management sees a pile of money and decides to expand their empire and buy other companies -- at usually very unreasonable prices. Other examples of malinvestments abound, such as throwing money at losing product lines, paying out huge bonuses to themselves, blatant theft (see Financial Statement Analysis for how to spot "cooking" of books by crook managers).

Cash, inventory, patents, equipment and market share can all go away quickly. A company's attractiveness can vanish due to poor management or adverse economic times. Having a history of dividends can help an investor put a value on a stock and get paid while he holds his investment.

On the other hand, paying out a dividend when the company can't afford it is a bad idea and one should avoid buying companies that need to borrow to sustain their dividends. Moreover, the dividend can be cut and vanish just as quickly as the company can be mismanaged, so be careful not to over-emphasize dividends in your evaluation. As we've seen, the potential to pay a dividend in the future is almost as valuable as having one now, as long as your confidence in the company not destroying what it has built is very high.

In conclusion, dividends provide an interim return, which I see as the price I should be paid to invest in a company. Whenever two securities are roughly equally attractive to me, the one with the dividend will always win. However, limiting oneself to only dividend payers is a mistake. One should invest in sound companies with sound management and with decent prospects of earning money.


Lessons from the 20's

I just came across this snippet below, from Saj Karsan's excellent summary of the famous Security Analysis book, by Graham & Dodd. Apparently banks didn't learn the lessons from the 20's. I wasn't aware of these things either -- if only I had read this book more carefully when I first read it, a few years ago.

Saj writes (emphasis mine):
A popular type of guaranteed security is common in the real-estate mortgage market. A bank will sell investors a mortgage, and will guarantee payments on that mortgage. Unfortunately, for this type of self-guarantee to be worth anything, the following principles must be kept:

1) Loans must be conservatively financed
2) The guarantee must come from a company well-diversified

If loans are not conservative, then declines in real-estate values will result in deterioration in loan values. If the guarantor is not diversified, a general decline in real-estate values will serve to place the guarantor in receivership, which makes for a most dubious guarantee.

As simple as these principles are, in practice problems have arisen. In the roaring 20s, new and aggressive firms provided loans at levels so as to leave very little equity in the mortgaged property, despite the fact that appraisals were made at dubiously high levels. In order to compete with these firms, reputable ones would be forced to lower their standards. The industry spiraled out of control, and guarantees turned out to be useless in the ensuing carnage as firms were forced into receivership.
All this sounds exactly what happened recently. Last year, an ex-Lehman mortgage trader I know, talked about how investment banks had to lower their standards or lose business to more aggressive banks. The result we all know: rule number 1) above was violated and when RE prices declined (even though they never decline!), things went haywire. Many loan guarantors (AIG included) weren't well-diversified enough, violating rule 2).

All hail Ben Graham, the new Nostradamus.


S&P 500 Fair Value

Estimating the fair value of a stock is an exercise in predicting the future. Estimating the fair value of an entire index, such as the S&P 500 is not any easier. Luckily for us, it doesn't involve estimating the future of 500 companies simultaneously. We can treat the entire index as a single company (sort of like a conglomerate, with multiple divisions).

Many people like to predict future earnings and then apply a multiple (such as the P/E multiple) or forecast free cash flow year over year, apply a discount rate and add up the values. Others, like me, prefer to value a stock using the stream of dividends it will provide in the future, using the Dividend Discount Model (DDM).

Whatever method one uses, it boils down to three things:
  1. Predicting future growth g (of earnings, cash flow, dividends)
  2. Setting an appropriate discount rate r
  3. Applying the appropriate model.
In this case, I will use:
  1. A dividend growth rate inline with smoothed historical rates.
  2. Use a discount rate that provides a reasonable historical fit, which a priori should be between 7 and 20% (another option is to use the risk-free rate of return, such as that of treasury bonds, but I don't like that option for various reasons that I won't discuss right now)
  3. Use the Dividend Discount Model (DDM)
The DDM states that value = dividend / (discount rate r - growth rate g)

So, what is a good historical dividend growth rate? Let's look at the past to estimate that. The raw data can be found here.

Since 1960, the dividend rate has grown on average at 5.68% over the years.

The discount rate has varied a lot as investors took more or less risk depending on their perception at the time of risk, inflation and future growth. Fitting the DDM over the years to get a good approximation yields a 7.5% rate of discount (see the figure). This is the return rate an investor should demand for exposing his money to market risk. 7.5% seems appropriate as a long-term rate, even if it seems low right now, since times won't always be bad in the future, nor will they necessarily be good, like they were in the late 90's, when investors were demanding very little rates of return (even negative!).

Now, all we need is a starting point for the dividend the S&P500 index will pay an investor this year. Well, let's make an educated guess. In 2008, the dividend was $28. Since then, many companies have cut their dividends, suspended them or gone bankrupt. Very few have raised their dividends. If we assume a 15% drop in dividends for 2009, the fair value of the S&P 500 should be 681, not the current 870.

See the figure above for a plot of the estimated fair value versus the real value since 1960 (2009 numbers are measured year-to-date and estimated are year-end).

Can it fall more? Of course. Can it go up more from here? Sure. The best bet is to buy companies that are undervalued based on the Dividend Discount Model and for which future prospects look solid.

As for the S&P 500, I wouldn't bet on a continued rally from here.

How banks are hurting good payers

No, I'm not going to talk about how the government is bailing out those people who shouldn't have bought a house in the first place. That's unfair and wrong alright, but I'm talking about what banks are now doing to people like you and me, who bought their homes with real down payments.

If you bought your home with a nice 10-20% down payment and your house depreciated in value, enough to eat into your whole equity, you're now under water. And once you're under water, your options to refinance are few, if any. First, you're locked in with your current lender, since no other banks will lend you money, since the loan would be higher than the current price of your home.

If your bank sold you loan to Fannie Mae or Freddie Mac, you may still refinance if the loan-to-value ratio is not above 105%.

But otherwise, if your bank is still holding your loan in their books, you're locked with them. That's how they're hurting people in the first place: you can't go anywhere else and you can't benefit from the new government program for those with up to 105% loan-to-value loans. Once locked in, banks will not refinance unless you stop paying.

Now, how insane is that? If you're a good payer, then you don't deserve to refinance. But if you default, then you're allowed the benefit of a refinance or a loan modification!

By encouraging bad behavior, banks will get more of what they've already gotten: bad debtors.