Mullooly Asset Management

Fiduciary Fee-Only Financial Planner | Investment Advisor in Wall, NJ

Fixed income investments

Understand the Risks of High Yield Bonds

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Investors looking for income might be drawn to high yield bonds. High yield sounds like exactly what they’re looking for. However, their desire for yield often leads them to overlook the many risks that surround these investments. Tom and Brendan discuss the risks associated with high yield bonds on this week’s Mullooly Asset Management podcast.

High yield, non-investment grade, junk…all of these descriptions refer to the same type of investment. Bonds issued by companies with poor or shaky credit ratings. These bonds (rated below BBB) offer higher yields than investment grade bonds and treasuries because of the additional risks bondholders assume.

One thing to keep in mind regarding higher yields is that they’re relative. Meaning that when the long term US Treasury is yielding 3.25% (much like current conditions), junk bonds might be yielding 5-6%. Is the risk assumed worth the investment and the relatively higher yield gained? That’s a question investors and their advisors should be examining closely.

The different types of risks that junk bond investors should be considering are credit risk, price risk, and interest rate risk. Credit risk is based on the issuing company’s financial situation. Assuming you hold their bond to maturity, will they be around to pay you? What are their chances of defaulting? A lot of high yield bond issuers have poor or no credit history. That’s why their bonds aren’t investment grade. Price risk comes from the fact that bonds trade by appointment. Meaning that when you want to sell a bond, your broker has to find a buyer for it. This can lead to price volatility, meaning you might not get market value for your bond. Interest rate risk is assumed by any fixed income investor, regardless of whether their bonds are investment grade or not. Any time you invest in bonds you need to consider what fluctuations in interest rates will do to your investment’s value.

If you’re reading this post and you don’t know whether your bonds are investment grade or not (yikes!), look up their ratings online now! As previously stated, bonds rated below BBB are junk bonds.

There are many risks involved with high yield bonds. Their increased risk levels are comparable to those of some stocks, which is something a lot of investors don’t realize. Be sure to consult with your investment advisor about the risks involved with any type of investment before making a decision to buy or sell. Check out this week’s podcast to learn more about high yield bonds.

You can learn even more about high yield bonds here: http://www.sec.gov/investor/alerts/ib_high-yield.pdf

Warren Buffett’s Annual Letter To Shareholders

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Warren Buffett writes an annual letter to the shareholders of Berkshire Hathaway each year.  If you’ve never read them, you really ought to.  They are priceless gems.  Not a laugh a minute, but an interesting observation on what’s happening.

This year’s version is about 22 pages and he comments on Mark to the Market, derivatives, Bear Stearns and some of the other problems we’ve been exposed to the past year, thanks to our friends on Broad and Wall Streets.  The whole piece is worth your time if you care about the markets, but I’d pay particular attention to pages 15-18.

I also found Warren Buffett’s “prediction” about the possible bubble in the Treasury market to be very interesting.  You should too.

You can find it here: http://www.berkshirehathaway.com/letters/2008ltr.pdf

Modifications Needed For Mark to the Market Policy

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What is left in the governments bag of tricks to get the banks back on track?  One topic that I wrote about — 5 months ago — has popped up this past week with more and more frequency.  We are finally starting to hear more and more chatter about relaxing “Mark to the market” regulations.

What is mark to the market?

Suppose a house on your street went into foreclosure.  Previously, that home — and every other home on the street had a value of $600,000.  But the foreclosed property went through a sheriff’s sale and was sold for $250,000.  Does it mean every home on the street must suffer the same price cut?  Events like this can “dent” prices up and down the street.  But following market to the market regulations, every home on that street would now be worth $250,000.

Is that fair, or even realistic?

This is what banks and brokerage firms have been dealing with.  It’s absolutely glorious when prices are moving up.  But it is a nasty, vicious, life threatening downward spiral when prices are going down.  Let me explain:

In summer of 2008, Merrill Lynch desperately wanted to get out of a large investment ($31 billion) of mortgage backed securities.  Merrill, and many other brokerage firms were still carrying these bonds on their books at approximately $.80 on the dollar (80% of the face amount).  They received an offer of $.22 on the dollar, only a fraction of what they were carrying them on their books.  When Merrill completed the sale, all other similar investments — at Merrill Lynch and every other firm — had to be marked down to those kind of levels.

Here’s where bad news gets worse. Most banks and brokerage firms were choking on debt like this.  After all, Standard & Poor’s and Moody’s had rated these mortgage backed securities as high-quality investments.  This allowed banks and brokerage firms to hold these investments instead of treasury bonds (which had much lower interest rates), and these high credit ratings also gave them the opportunity to borrow against them. The benefit to the banks was easy to see.  But everyone else benefited too: somewhat higher rates were paid on CD’s and bonds, loans were available to many, and mortgages were created at lower rates.  We all drank from the well.  Some more than others.

Here’s where worse news becomes a catastrophe. Many banks and brokerage firms were leveraged 30:1 or 40:1.  Meaning, if the value of these bonds dropped by 5%, they had a serious problem.  This is why they started creating, buying and selling these additional “bets” or “side contracts” known as credit default swaps.   Most of these mortgage backed investments had already been marked down to about 80%.  But the bar was brought down to 22 with that Merrill deal.  Yikes.

I am completely against bailing out incompetent management.  Wall Street and the banks have taken some really dumb risks and made terrible decisions.  Indeed, some of these executives need to be shot.  But the problem is that the banks provide “the grease” that keeps the economy moving.  So something needs to be done.  Mark to the market needs to be modified.  Yes, it means changing the rules in the middle of the game, which really isn’t fair.

There’s more (much more), but that’s enough for now.

Are you Receiving a 0% Yield For Your Treasury Bills?

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It was reported this week that the Treasury Department sold $32 billion in T-bills at a yield of 0%. Yes, that’s NOT a misprint: zero percent yield.  These are treasury bills which mature in four weeks. Yields on these kind of investments have dropped from 1.75% this summer to zero in December 2008.

Clearly, investors are more concerned about return OF principal then return ON principal. Another important point to keep in mind is many money market mutual funds invest in short-term treasury bills as the primary component for their investment portfolio. If the current average rate on Treasury Bills is now 0%… what kind of rate should you expect to receive on money market funds over the next few months?

This is just another reminder that money markets are an unusual investment. They’ve been a terrific place to hide for most of 2008. But most of the time they are not — and should not be — considered an investment. Most times, money market mutual funds are merely short-term parking places while you are in between other investments.

Nationalizing Banks Could Be The Key To End The Recession

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The Treasury announced they will begin to inject capital (money) into banks, under terms created under the bailout bill.  This article will try to walk through, in English, what this all means.

As part of the bailout bill (or TARP: troubled asset recovery plan), one provision that was mostly overlooked during the congressional hearings and rollout was the feature that permitted the Treasury to inject capital directly into selected banks.

A general understanding that most people had of the bailout bill, was that “troubled assets” would, essentially be “traded” to the Treasury for treasury bills.  That feature still is in the bailout package, but is mired in the developmental stages.  Working out the details of which assets (and from which banks) to trade may take a long time to figure out.

And time is the one precious commodity that no one has.

So the Treasury is proposing to take an “ownership stake” in some banks.  They will “buy” part of some banks in return for preferred stock.  They will receive dividend income and be able to make money by selling those shares in the future.  Probably right back to the banks themselves.

What do the banks get?  Well, when you sell stock, you get cash.

Now…here’s where the plan works: When a bank receives equity (cash) it can turn around and lend that money, practically overnight.  However, banks don’t lend money on a dollar for dollar basis, it’s always leveraged.  Not that 30:1 or 40:1 leverage like what sunk the fat cats. So, for illustrative purposes only, think in these terms: $700 billion could turn into $7 trillion worth of loans and financing.  If that doesn’t get banks moving again, we are all dead.  For perspective, consider that the entire mortgage market in the United States is approximately $14 trillion.

This feature was widely overlooked by most folks when the bill was introduced and signed into legislation by President Bush.  But this feature may indeed be the “master stroke” (or “magic bullet”) that gets the wheels turning again.  It’s a dangerous precedent, and it IS risky (if it doesn’t work, it is game OVER).

But understand THIS as well: getting the banks to lend money again, is not the end of a recession.  But it will certainly re-ignite the flame, and can very likely accelerate the economy.  So, while I’m not an economist by profession (but I am an optimist), in my humble opinion I feel this will be a short, but very severe recession… followed by recovery.

You truly are living in interesting times.  I don’t believe we will see this kind of action again for years and years.  Maybe generations.  And this is a “magic bullet” (or atom bomb) that we need to insure we will never need to employ again.  Seriously…never again.

I’ve read many different reports about the mortgage mess.  No one really seems to have accurate data.  But if 80 or 90% of all mortgages are current, I have to believe the federal government has made a good investment with this bailout bill.  I believe the government will make money on these mortgages.  And now that they are injecting capital into selected banks, they will have “preferred stock” in these banks.  Meaning, as the banks get back on their feet, the government will make money on these investments as well.  They are negotiating great terms and getting in near the ground floor.

The immediate impact will be the re-opening of the banks, and the credit markets.   We’ll see that right away in our local economy.  But the entire process may take several years to completely unwind.  But the Treasury has the deepest pockets in town.  Whoever is President of the United States in five or six years will certainly try to take credit for the “economic miracle” that occurred on “their watch.”

You can count on that.