High Yield Bonds dilemma

From my friend David Kotok:

High Yield Bonds in a Quantum Universe
August 16, 2012

Michael Lewitt is a portfolio manager and heads the opportunistic credit section of Cumberland.  His bio can be found at www.cumber.com.  His email is michael.lewitt@cumber.com.

Zero interest rate policy has created a quantum universe in which bonds and other financial instruments are, more than ever, difficult to value.  Traditional value metrics are no longer sufficient tools for investors seeking to protect their capital and still generate reasonable risk-adjusted rates of return.


The high yield bond market is currently trading at its lowest yield in history.  At 6.84%, the Barclays High Yield Index is trading at 604 basis points (one basis point equals 1/100th of 1%) more than 5-year Treasuries.  Spread represents the risk premium that investors demand for owning these bonds, and it is measured against the yield on what are considered to be riskless Treasury securities.  It is important to recognize that spread measures relative values while yield measures absolute values. Investors who pay too much attention to spread and not enough attention to yield leave themselves vulnerable to large losses when the market reverses, as it inevitably will.


The manner in which most high yield investors rely on spread and Treasuries as a riskless benchmark is flawed.


Spread is a fixed income measurement tool being applied to a hybrid debt/equity security: a high yield corporate bond.  The weaker a bond’s credit quality, the greater risk of loss it poses.  Lower rated bonds pose a risk of loss that is more akin to equities than to investment grade bonds.  For that reason, spread becomes less useful as a risk measurement tool as one moves from BB-rated bonds down to B-rated and CCC-rated bonds.


Treasury securities are considered riskless because the world believes that the United States will never default on its debt.  This belief persists even after last year’s loss of America’s AAA rating.  But today’s low interest rates on Treasury instruments point to the fact that the economy is extremely weak.  Moreover, while the U.S. will certainly not default, it actively engages in the process of “disguised defaults” through policies that encourage inflation and currency devaluation.  For these reasons, Treasuries may not be risk-free in the way that they used to be, and using them as the benchmark understates the risks associated with below investment grade bonds.  Because high-yield bonds are priced off Treasury rates, they offer an unduly low yield that is lower than justified by these types of bonds and the economic environment.


Today’s spreads are about 300 basis points wider than they were in May 2007, when the high yield bond market traded at its lowest spreads in history (+238 basis points).  Yields, however, are about 50 basis points lower.  The reason for this is that 5-year Treasuries were trading at 4.85% in May 2007 while today they are roughly 0.70%.


In order to earn appropriate risk-adjusted returns in high yield bonds – and to avoid succumbing to the trap of focusing on relative returns – an investor must seek out bonds that are trading at appropriate absolute valuations.  This requires a greater focus on yield rather than spread.


Interestingly enough, some of the best absolute values in the high yield bond market are in short maturity lower rated bonds that remain low rated due to high leverage but that are otherwise unlikely default candidates.


One example of this type of bond is First Data Corp., a credit card processor that was taken private by KKR prior to the financial crisis.  First Data Corp. 11.25% Subordinated Notes due 3/31/16 pay more than a 12% yield despite the fact that most of the company’s debt matures after 2016, KKR is heavily invested in and strongly supportive of the company, and the business is slowly but steadily improving.  These bonds are rated Caa2/CCC+, yet the odds of the company defaulting and not repaying them are extremely low.  In this case, as in many cases, the low rating is attributable to the company’s high leverage but drastically overstates its default risk.


The lesson is that investors must learn to think for themselves and not blindly follow conventional valuation measures or credit ratings.   Thinking like the rest of the market only allows an investor to see what everybody else sees.  The key to successful investing is seeing what nobody else sees.  The path to higher risk-adjusted returns and the ability to avoid the large losses that are inflicted on high yield bond investors with near biblical regularity requires the ability to think differently than the consensus.  This is particularly important in a quantum investment universe in which zero interest rates are distorting the value of all financial instruments.




Michael Lewitt, Vice President and Portfolio Manager



Report from Maine

My good friend David Kotok has a :

TAG – An Interim Report from Maine
August 1, 2012


What will banks do when they get $1.3 trillion in free money? Sometimes, they misbehave.


That’s the point made by Chris Whalen in his latest post at Zero Hedge. Thank you, Chris, for permission to put the piece on our website for others to see. Here is the link: http://www.cumber.com/content/special/cwhalen.pdf.


We are in Maine. By tonight, about 30 people will gather in the dining room. The early birds are already in discussion about banks, Europe, and the FDIC TAG program, which expires on December 31, 2012. We will debate this tonight with Whalen and others.


Whalen makes a very important point. The big banks funded over a trillion dollars of zero-cost money. If you read his piece carefully, you can see the degree to which it encourages speculative activity. What happens on December 31, when this program expires?


Will depositors, in US dollar terms, worry about safety and return to other forms of placement? Without the FDIC’s (read: federal government’s) guarantee of unlimited amounts of non-interest-bearing deposits, will deposits reflow elsewhere? Will this interfere with the pricing in the repo market? Is this distracting the Federal Reserve from policymaking? There are more questions than answers when it comes to this program.


So far, officialdom at the FDIC in Washington DC, the Fed, and elsewhere has been silent. There will be lively discussions of this and other topics in Maine.



David R. Kotok, Chairman and Chief Investment Officer


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For Cumberland Advisors Investment Portfolio Styles: http://www.cumber.com/styles.aspx?file=styles_index.asp
For personal correspondence: david.kotok@cumber.com

Twitter: @CumberlandADV


A good analogy from my good friend,

Janice Dorn, M.D., Ph.D.





We’re not two peas in a pod.
We’re two fingers in Chinese handcuffs.
The more we pull we stay,
The more we stay we pull apart this wicker toy…
“Chinese Handcuffs” by Matt Kadane


Most of us are taught from a young age that “winning isn’t everything; it’s the only thing.” When we lose, we feel ashamed and humiliated– which is why we do everything possible to prove to our families and the world that we are winners.

Coaches encourage their teams to “Go out there and win, win, win!” That is how we keep score in athletics. Winners win, losers lose and numbers don’t lie. This type of thinking shows up in every area of our lives, including our jobs, relationships and trading.

The bottom line is this: We all want to win and succeed because it is ingrained in our collective psyches.

If we are winning, we are “on a roll” and give ourselves positive messages to keep winning. If we are losing, we try harder and harder, but a subtle shift occurs.  We morph from trying to win to trying not to lose. Ironically, the more we try not to lose and tell ourselves that we must stop losing, the more we lose.

Winning traders feel happy, confident and good about themselves. Contrast this with the losing trader who is constantly trying not to lose. These traders have a tendency to dig themselves deeper into losses because they do not yet understand a fundamental tenet of trading success: It is both necessary and natural to lose

The beginning trader believes every trade must be a winner. She/he goes from newsletter to newsletter looking for the Holy Grail of trading that promises the highest number of winning trades. In trading, the highest number of winners tells you nothing unless you know the percentage gained on the winning trades relative to the drawdown percentage on the losing trades.

Trading is a game of probabilities; thus, it is paramount to understand that is it perfectly natural to lose. Successful traders always make more money than they lose. One major reason for this is that they understand the game they are playing. They also do one critical thing that losing traders do not do — they embrace and manage risk. In other words, they identify the risk involved in every trade and they quickly cut losses when the ratio of risk to reward is no longer favorable. At the same time, they hold on to profits and may even increase position size if the risk/reward remains favorable. Winning traders do less of what is not working and more of what is working. They are trying to win, rather than trying not to lose.

The Chinese Finger Cuff is a woven wicker straw with an opening at each end the size of a finger. Once you put a finger into each end of the straw, you are in a losing position. When you try to pull your fingers out of the straw, it tightens around them. The more you try to pull out, the tighter the straw becomes. The emotional brain feels trapped wants out at any cost and so it orders you to pull and pull, causing more constriction around the already trapped fingers.

After struggling a while, the rational brain takes over and tells you that the way to get your fingers out of the straw is to relax and stop pulling.

The same applies to trading. The more you resist taking a loss, the larger the loss becomes and more desperate you become not to lose. Once you totally relax into the trade, let your rational brain take over from the grasping, clutching emotional brain, you see that the best way to win is to let go.

The takeaway from this is simple. Winning is not the same as trying not to lose. Great traders may struggle, but not to the point where they are in the vise of the Chinese Finger Cuffs. They know and understand completely that losing is often the only way to win. They have learned to surrender, accept and move on. Once you practice doing this with your own trading, you will find a new sense of freedom and a new happiness. Moreover, you will preserve your capital to play the game another day.

Perhaps my number one rule is: Don’t try to make a profit on a bad trade. Just find the best way to get out…Linda Bradford Raschke,



Janice Dorn, M.D., Ph.D.