U.S. Debt Service Hits Historical Low

With low interest rates come historical low debt servicing costs. Granted, this is based on the history of The Fed tracking this, so it might have been lower in the days of sound money (gold and silver) when the common worker paid for stuff instead of having the neighbors pay for stuff on credit, but still, it might explain the strong stock market, if not why the bump in payroll tax isn't killing everyone. Check out the chart for yourself at The Fed.

The Democratic Process of Money Meddling

"...it is prudent of the central bankers to get a feel for where disappointment would actually set in."
(Source: E-piphany)

Our friend Mr. Ashton picked up the hints from a Bloomberg report. It is important to realize prices are never objective. It's true for houses, cars, and even U.S. Treasurys. So while one can despise the actions of the central bank, it's not exactly honest to claim they are stupid. As Bloomberg reports:

The New York Fed survey ... asks about expectations for the initial size of any new program of debt purchases and the time over which it would be completed. It also asks firms how often they anticipate the Fed will re- evaluate the program, and to estimate its ultimate size.

That appears to be a pretty good line of questioning! Before they make any announcement next week (or not) they better figure out what kind of a statement is least likely to create a panic. One might even consider the expectations are so strong, if they don't announce QE2 next week we'll have a clear and noticeable collapse in something on Wednesday afternoon and on into the week. It is the fall, after all.

So it looks like the fed is actually working out the plan by getting surreptitious "feedback". It's prudent to presume an event has already been priced in by the time it happens. Even if one is skeptical of that principle, given this kind of clear signaling, the pros obviously know and are already preparing their portfolios.

Therefore, the fundamental questions investors need to get right are these:

a) What prices will rise when this happens? Obvously Treasurys, except the inflation factor may counter the whole supply/demand factor.

b) If profit taking kicks in at the announcement, where have those profits been accumulating?

Without the results of the survey, we peons are at a grave disadvantage trying to get those answers right. The one thing we can be sure of though, is that at 2 pm EST on November 3rd, being at your terminal with fingers nimble and ready is the wise plan.

How's That Risk Curve Doing?

As our friends at Bespoke Investment Group point out, the market suggests we are not yet ready for higher-risk equity investments.

Compare that present influence with Pimco's Bill Gross discussion on market risks, namely how demand shifts toward the inner circle of safety during a crisis, then slowly back out the risk curve over time.

Note there are many risk vehicles not in Pimco's analysis; not because they don't exist or aren't relevant, but because there are so many layers and instruments. The key point is that bonds are less risky than equities, and preferred stock less risky than common stock.

The real rally is still taking place in risk circles inside of common equities, and the sell-off at earnings suggests we aren't yet ready to see a strong rally in equity.

There's No Place to Invest Capital

“If you look at financial markets, say, look at how much the Treasury is paying to borrow today, there is a lot of confidence, not just of Americans but investors around the world, that we’re going to find the political way to do it,” Geithner said. “There’s no alternative for us. We’ll be able to do that.”

So that's the optimistic spin on the U.S. Federal deficits and stagnating economy. Bloomberg spins the facts by beginning their title with "Deficits Don't Matter...".

From our point of view, the historical low yield on U.S. Treasury debt in the face of record high deficits indicates the investment world is saying the global economy is so bad there's no place to invest capital with any hope of getting a good yield -- might as well bury it in the back yard until some opportunity presents itself.

If you're unemployed, you better start thinking about how you can start your own business, because Corporate America obviously isn't going to do it for you.

Long End of the Treasury Curve May Stall

The yield curve appears to be hitting a ceiling.

For the rate to spread to narrow with long bonds rising, the short end would have to move fast and furious. With piles of excess reserves, it's unlikely short end is going to rise quickly in less than half a year.

The Fed's Report Card, by The Fed

The federal reserve put out their assessment of Ben Bernanke's helicopter ride in a report titled Large-Scale Asset Purchases by the Federal Reserve: Did They Work?

Presumably it isn't surprising they conclude what one expects when demand rushes in like a flood:

We present evidence that the purchases led to economically meaningful and long-lasting reductions in longer-term interest rates on a range of securities, including securities that were not included in the purchase programs. These reductions in interest rates primarily reflect lower risk premiums, including term premiums, rather than lower expectations of future short-term interest rates.

Well of course! When demand for security jumps, so does the price. For a bond, rates fall when prices fall. And given the money to fund the purchase was created out of thin air, there was no decrease in demand for competitive instruments. The money that may have purchased those bonds was free to purchase others.

The reductions reflected lower risk premiums because it was made perfectly clear that there is no limit to the money available (since it doesn't come from finite pre-existing money) and hence no reason to expect lack of funding. It didn't reflect lower expectations of future short-term interest rates because it was also made clear it would end and the dilution effect was sure to increase the inflation premium in future markets.

One wonders if the authors actually expected any other conclusion. Imagine a rocket scientist being surprised that propelling an object at 200 MPH in an upward vector would make the object fly, but eventually fall to the earth as the applied acceleration source was stopped.

In spite of the humorous angle, it's a good piece of writing for one who wants to get a good look at how open market operations function.

Sector Analysis and Business Cycles

Faheem Gill has a nice analysis of the business cycle and equity sectors that do well in each. He focuses on energy, but the charts would be good for one to copy and mark with one's own preferred investments at each stage.

The only thing lacking is a note to shift out of equities into bonds at the peak of the interest rate cycle.

Treasurys No Longer Risk Free

It looks like this generation may be the one to see a new definition for "risk free interest rate".

From Bloomberg yesterday:

The bond market is saying that it’s safer to lend to Warren Buffett than Barack Obama.

Two-year notes sold by the billionaire’s Berkshire Hathaway Inc. in February yield 3.5 basis points less than Treasuries of similar maturity ... Procter & Gamble Co., Johnson & Johnson and Lowe’s Cos. debt also traded at lower yields in recent weeks, a situation former Lehman Brothers Holdings Inc. chief fixed-income strategist Jack Malvey calls an “exceedingly rare” event in the history of the bond market.

Wikipedia also has a good article on the importance of this to investment models.

How Can Stock Market Asset Prices Fall?

For the stock market to drop in value, something else has to be in greater demand. In the realm of paper assets, the only competition for equity is debt or debt-money, and the non-paper competition is commodities and real-estate. Let's look at each one, except real-estate, which should be clear without saying in the spring of 2010 is a non-starter.

It's been clear for about three years now that money does not flee to hard assets when paper assets are in jeopardy. Those hard assets experience a sell off, too, as money flees in a crisis for the stability of U.S. dollars. This should be expected for some of the reasons we pointed out in November. So if the stock market has a significant sell off, don’t expect a commodity price spike. Whether one thinks it should or shouldn't is irrelevant. That fact is it hasn't done so for the last three years. If you think it should, then take the sell-off as a chance to take a position at steep discounts. We address the fallacy of the counter-argument for deflation at the end.

We are then left with the realm of paper-assets: debt-money (currency) or debt instruments. Debt instruments can get very complicated because there are many types with a variety of risk and valuation models. However, we can simplify that into a few commonalities: short term and long term, corporate and government. There is another debt instrument that doesn't quite fit that simplification: debt derivatives. Of the collateralized debt types, they essential represent the same fundamentals as bonds, except risks are slightly lower as default risk is diversified among autonomous entities. The other common derivatives can be grouped as options, futures, or credit default swaps. Virtually all of those by definition are relativity short-term bets.

If one is worried about equity valuations (the theme of this writing) corporate bonds would be of interest to some as bonds receive the first-fruits of cash flows and stand ahead of stock in bankruptcy (government usurpation notwithstanding). But if equity prices are at risk, corporate default risks rise, too, so prudent investors won't flee to corporate bonds in a crisis. We find ourselves left with short and long government debt, or debt derivatives, competing with equity for capital investment.

Let's take debt derivatives now, particularly the CDS type. The only intelligent reason to sell equity for CDS is a credit crisis. This is in fact exactly what we saw in February. As the credit crisis that precipitated the change subsides, money flows back out of short term CDS instruments and back into longer term assets. While we don't have access to CDS price charts, we can certainly see the equity markets didn't stay low for long, which is consistent in fact and in theory with crisis of the past. So CDS competition is necessarily sudden or short lived, especially as CDS contracts are temporal by nature.

The next type of debt instruments we look at are short term parking places: short-term government bonds, and short-term derivatives other than CDS. All are havens for capital in times of uncertainly. All are temporary parking places where one then reallocates into something of greater risk with more reward potential as the precipitating event subsides. The certainty of that movement is assured by monetary low-interest rate policies of central banks. No serious money manager can sit on ROI assets below 2% for long unless in fact the world experiences price deflation of all asset classes across the board. The Austrian theory of inflation arising as a consequence of money creation suggests in this season of 2010 that is an absurd expectation. The arguments to the contrary are addressed below.

Like real-estate, it should go without saying that holding long term government bonds in an era of Keynesian expansion with extremely low interest rates as one of the most high risk (to asset price) low-yield investments of capital. Just as rolling short term bond holdings into short term bond holdings for an extended period is only sensible in an era of broad-based systemic price deflation, holding fixed rate long bonds when currencies are threatened by increasing debt, and interest rates have no where to go but up, is asking for capital loss.

Finally, the last paper asset vying for attention of investor and speculator capital is currency. In a crisis, even after all the liquidity measures and deficit spending in the U.S., the U.S. dollar is still the target of those fleeing for safety. Again, we aren't concerned about whether that is a long term good bet, but simply recognize it as the status quo. If indeed one believes such moves are unwise in the long run, take it as an opportunity to buy more reliable dollar based assets at a discount if it should transpire. But keep in mind, when this flight to safety takes place, money that isn't secured in currency derivatives will be parked in government bonds of the currency of choice, and we’ve demonstrated those arguments only have temporary extremely short value propositions. So the fundamentals of holding "cash" (pseudonym for currency), is really just another name for a bond position, and hence currency moves will follow the fundamentals of bond investments. Since bonds of all substantive nations are basically in the same boat, we don’t expect significant changes in currency price ratios as much as we’ll see in equity positions, and of course foreigners’ demands for equities ultimately translates into foreigners’ bias for currency price ratios. We covered that topic to some degree in our September piece titled "Where is the Next Bubble?"

Given the choices money managers have in allocating capital, there appears to be only one reason to expect any kind of significant decline in equity prices in the near term, and that's a flight to safety. Just as the financial crisis of the past faded into history, there's every reason to believe this one will play out the same. We pointed out some of those reasons in November under the title "Contagion: Been There, Done That"

In that piece we also point out how the latter sub-crisis had less effect than the instigating crisis. We've seen this take place recently with Greece's crisis, where there was some quick and noticeable reaction to flee to dollars and push down equities and commodities, but it was short lived and of little significance. Many have tried to build the case that "this time it's different" and pull some data out of a hat that appears different. Typically what we find is that they simply were unaware of similar data that did appear last time, or they miss the similarity of essence and difference only in nomenclature of the old and new data.

So we are left with the only variable that could explain a protracted equity bear market - positive or negative inflation. Positive inflation usually gets improperly discounted by the established world view in one of two ways -- they pick a measure of money that hasn't grown well and then conclude we'll see tame inflation or deflation, or they pick a secondary influencing factor (velocity is popular these days) and argue that it will overcome the creation of money. We've provided some links on the velocity argument back in July '09 and revealed how money supply and velocity can take some interesting forms. It is our belief that the contradictions between the Austrian school theory that inflation is a monetary phenomena, and the new school that it is a velocity issue, is simply missing the point that the Austrian school theory carries with it an inferred premise that the time between the money hitting the street and the prices showing up at retail are delayed by several months to a few years. In order for monetary inflation to not eventually show up in price inflation (either consumer or capital asset price increases), one has to permanently and systemically keep the velocity low. For nations whose people have consumer goods in abundance, inflation most likely appears in financial asset prices. For nations whose people have a higher portion of earnings going toward basic goods and services, inflation most likely appears in consumer goods.

One could achieve low monetary velocity with an economic collapse, but no substantial and influential market participant in the global economy is working toward that goal. Every policy choice and operation is designed to get people to dump their cash for something that will provide a return. All policies are designed (intentionally or accidentally) to make holding cash a losing proposition. It's the essence of both kinds of capitalism; traditional theoretical capitalism and corrupted modern capitalism. The former objective is to use one's financial capital to produce value in goods and services to reap a return on investment. The latter objective is to use one's financial capital to make other people's money work for you. The latter is the fundamental basis of the debt-money system used by every nation on earth: leverage. With every segment of every population save a few fringe radical thinkers working toward the same objective (i.e. maximum return on investment) something global and earth shaking will have to occur to put everyone off their agenda. We aren't suggesting that can't happen, just that the most likely expectation is that it won't happen until this next round of business cycle expansion pops sometime in the teens of the 21st century.

For the stock market to drop in value, something else has to be in greater demand. At this juncture in 2010 it goes without saying that real-estate and long bonds are non-starters. Other hard assets have proven themselves unattractive as replacements (albeit good co-equals) for equities. Being left with nothing other than short-term non-performing parking places and short term quick gains made attractive by temporary sudden shocks, there simply isn’t any real long-term asset class competition to distract the global investment community from demanding more equity positions. The prudent scholar, historian, and investor should be prepared for another cyclical equity bull market in the coming few years.

Credit Spreads Expected to Narrow

This Time Is Not Different

The business cycle is alive and well. If you read the blogs and mainstream media you'll see a lot of bearish sentiment about the destruction of the American economy. Certain things won't be exactly like they were, but the interesting thing we see often is those bearish pessimists keep trying to discredit the optimists by pointing out the fallacy of "this time it's different", meaning this bubble isn't going to thrive any more than the last one.

Well, they're right on one count. The bubble won't thrive better than the last. But the one guilty of clinging to a fallacy are the bears. The "this time it's different" fallacy really points back at them. See, the bears are trying to sell us on the idea that "this time" the business cycle isn't going to happen. No sir, this time we've really shot ourselves and the stock market is just going to go right back down until the entire economic system of the world resets.

Well, maybe we exaggerate their point of view a little, but the essence is there. We contend the business cycle is alive and well and the prudent person will plan accordingly.

So how then do we interpret the budget deficits in light of the business cycle? For background on the business cycle of boom and bust one should go dig around at some of our favorite economic sites:

The Mises Institute
The Foundation for Economic Education
Cafe Hayek

Budget Deficits For Fun and Profit

Budget deficits necessitate a rise in interest rates. To attract money to Treasuries, the price has to fall since people will be competing for better returns in riskier assets. A lower price for Treasuries will attract that money to that instrument along some continuum of risk/reward which differs from one person to another. Meanwhile, the supply of Treasuries is going to be growing. To attract buyers then, the market has to push down the price of Treasuries.

On the off chance (slim as it is) that the government can’t attract buyers from the open market, the central bank will have to monetize the debt to prevent failed auctions. Hence, gold would be a good buy against U.S. dollar dilution by the central bank. This is not only true because of the recent past liquidity measures, but even more so for potential future liquidity efforts, if they arise.

Nevertheless, even if there are no more waves of quantitative easing, the last stimulus will be enough to create a wave of price inflation in the next five years. The recent sell-off in gold was simply profit taking and flight to cash on fears of Euro defaults, accentuated by program trading on the momentum and short term hysteria. Now that has subsided, we can get a wave of movement back toward long-term fundamental expectations based on centuries-old historical expectations of the boom-bust business cycle.

The beauty of this setup is that it implies higher risk in Treasuries than historical norms. Higher risk between Treasuries and corporate bonds means the spread between Treasury and corporate will narrow to the extent that businesses still know how to run a sound business. This translates to basic business-cycle fundamentals acting in opposite directions on the two sides of the spread.

Even though Keynes may not have had the big picture well understood when it comes to long term health of the economy, he was not wrong that government deficit spending stimulates demand for goods and services in the marketplace. Demand for goods and services in the marketplace is good for “business”, which translates into improving business credit default risk as cash flows improve for them.

Given then improving business credit default risks with degrading government credit default risk, we have a nice scenario that translates into narrowing credit spreads between so called "risk free" Treasuries and business risk corporates.

We're not trying to sell the value of the business cycle, or suggest it's a good thing. We simply want to point out it is alive and well. The fundamental factors that create it in the first place aren't gone. Names change and leaders switch places, but the same system that brought us all the other booms and bubbles is going to give you another one. We happen to think the global Q/E policies of every modern nation on the planet is going to make this next one a doozie. The good news is you have plenty of time to prepare for the pop and chaos that ensues from the bust.

For a more entertaining perspective, check out the viral video "Fear the Boom and Bust".

Profit Taking Rules the Day

It appears the last two days saw big moves upward in all of the following:

10 and 30 year U.S. Treasurys
GLD
DBB
FXE
SPY
DIA
QQQQ

Stocks, bonds, commodities, everything on a roll at the same time. This can't be a sentiment shift (since Treasurys typically move the inverse of equities.) Our guess is derivative profit taking is pushing up underlying securities.

Who cares about Latvia, anyway?

Apparently the financial markets consider it a minnow in an ocean of liquidity. Stocks and bonds are all doing just fine today, thank you, while Latvia is having serious currency problems that threaten Sweden's banks, while the other Euro nations are strained themselves.

"Latvia's latest crisis unfolded as new data confirmed economic fragility across Europe, where nine countries -- including Germany and Italy -- drew warnings Wednesday from the European Commission for widening budget deficits."
(source: WSJ)

An analyst from Brown Brothers provides more detail of some of the austerity programs -- limiting liability of homeowners. Apparently no big deal to the West, since credit default swaps are down today.

It might very well be a perfect setup, as Jansen at Across the curve points out:

"Maybe all this means that we are setting up for a giant duration grab which will leave the curve far flatter than anyone though possible. Investors will delude themselves into thinking that there is no risk in a 10 year Treasury or a 30 year bond.

When everyone is in the pool someone will saunter by and throw a plugged in toaster into the deep end. It will surely end very ugly."
(Source: Across the curve)

To which someone created a fanciful depiction of the toaster in response. One can only wonder if the founders of Thinkorswim had this type of metaphor in mind when they got started. It certainly seems appropriate.

We believe the thinkers can use today's experience to gain a better understanding why it's prudent to discount the U.S. economy bashers, as it is clear that economic troubles in the U.S. are matched by the Eurozone troubles. There just isn't all that many places to flee to if you want to stay out of financial trouble.

So it's no wonder that even in the face of massive deficits in the U.S. all the way out to the visible horizon US Treasury prices hold their own. Even if it's true that the U.S. is a sinking boat, all the other boats have big holes in the hull, too. The U.S., being the biggest boat in the pool, will most likely be one of the last to soak it's passengers.

Bond Fundamental Shift on the Horizon

Not sure if this horizon is near or far, but it will be an interesting experience when we get there.

Sources say the Fed is in secretive talks with bond
dealers to restart "reverse repurchase agreements" in an effort to siphon
some of the $1T-or-so it's pumped into the economy. Unused since last December, reverse repos take cash out of circulation when the Fed sells securities to its 18 primary dealers for a set duration.
(source: SeekingAlpha).

So if the Fed is delivering inventory into the system, and the Federal Government is issuing new inventory into the system, how exactly are interest rates supposed to stay low for an extended period if this horizon is not equally far away?

Corporate Bonds Priced to Perfection

Just posting this to record the event for future reference. This example of today's bond market pricing is a set up that makes us uncomfortable about bond prices. They've rallied so much that spreads don't allow much in the way of price appreciation on Corporates unless Treasury rates across the curve all come down.

It would be an unusual situation indeed for the U.S. economy to recover and have Treasury yields drop from where they are now. Some examples of price movement lately:

Colgate deal which priced several weeks ago at T+ 67. The deal was a six year maturity. That issue is now traded 14 basis points rich to the 7 year Treasury.
Walmart 5 year paper issued in May at T+ 125 basis points. That paper trades 40 basis points over the 5 year Treasury.
MSFT 5 year paper is freely available at T+ 25

Source: Across the Curve

------
Update 10/15/2009
J.D. Steinhilber, over at Seeking Alpha, provides some current bond information and more detail on the bond investor's dilemma.

The Bond Market Speaks

John Jansen's blog at Across the Curve gives us intraday bond market readings. One of today's posts on intraday spreads seems to us to indicate big money is preparing for economic weakness.

Today he points out, which has been repeated now for some time, that "TIPS spreads continue to narrow." Early this morning we found out overseas markets had no direction across the curve except in the 30-year bond. This might be anticipation of Federal Reserve interventions, except the long end of the curve has been particularly strong lately, which indicates subdued inflation expectations.

We think all this combined is telling us inflation is not presently feared, and that can only be based on a presumption that the economic environment is going to be soft.

If you you have a lot of long equity at this point, be careful. This same perspective came to us last weekend as we summarized last week's Barrons.

Meanwhile, over at Barrons, Michael Kahn provides technical analysis in "Fear Creeps Back into Bonds" suggesting bond market readings point to risk-aversion in the market place. The stock market is rallying on the new home sales report this morning as we write. Time will tell if equity markets are aware of this risk aversion or not.

Take aways from Barrons, August 22nd, 2009

Stocks: Where's the demand-driven commerce? So far everything has been driven by government spending.

Look before you Leap

Gummy Bears

Banking and Finance: Commercial and Residential mortgages are worsening in some respects, in spite of all the green shoots. Some numbers and quotes from the Federal Reserve, and announcement that TALF will be extened.
Weekly Review

Technology: So where is the so-called PC Refresh cycle going to come from? Intel painted a rosy picture of the future, but three other tech companies have now joined the crowd of those who simply don't see any particular good news in the making.
View From the Top: No Rebound in Sight

Dividend Investing: Another piece on why reinvestment of dividends makes a good long term strategy. Read it if you haven't heard about that angle before. Skim for tickers if you have and like the idea. We think it makes sense to have some long term holdings in this phase of the business cycle in large cap companies with strong dividend histories. We'll leave it to the reader to judge whether Greek history provides any value to the theory.
Marathon Investing

Bonds: The best may be over for the bond market unless we get a sell off in corporates and munies and a rally in Treasuries for another buying opportunity. You can look for bond yields at your favorite quote provider, but there's also a good story on the municiple market. Suffice to say spreads between Treasury and corporates have narrowed in the last few months making it harder to find corporate bonds with a good chance of covering potential drop in purchasing power from quantitative easing. We might as well stick with the safety of Treasurys.
Seeking Yields on Munis That Aren't Puny

Speculative Plays:
Long MELA: "Taking Aim at Skin Cancer"
Short SHLD: "Washed Out"

Strategic Thinking:
Stocks are overpriced unless utopia breaks out real soon now. Commodity prices are priced right as long as China keeps buying what it doesn't presently need and India keeps it's capitalism in tact. Western economies are most likely going to see muted growth while Asia continues it's expansion of the middle-class demand for goods and services. The mindset "follow the money" suggests being invested directly in Asia and Brazil if not indirectly through domestic companies that get a high volume of revenues from them.

The off-the-cuff allocation at this point is long blue-chip dividend paying companies, short US indexes, and long commodity based companies or funds that pay dividends (or short their puts for dividends and purchases on pull-backs).

Caveat: While we are bullish on commodities in the one year time frame, we don't want to hide the fact that this week Barron's has a story that this might be a dangerous outlook. See "Base Metals on Borrowed Time"

Best of the Week
BRIC - forget Russia -- go where the commerce is. The interview with Christopher Wood contains some good insight into the macro-economics of the global economy, and why Brazil, India, and China have some specific characteristics about each of them that makes a focused investment in the right places a good idea. We highly recommend paying particular attention to his analysis of decoupling (in economics as well as the stock market) and what signs to look for that indicate decoupling of Asia equities.

What's our take on his expose?
Look for falling interest rates in Brazil. If FOREX fundamentals are right, Brazil bonds might be choice instruments there for income and long-term capital gains. One might also use the yields to buy something that is a domestic currency hedge in case your FOREX eats away at the gains.

India has the best of the equity markets of the three. See the interview for why that is. Our take then would be to look for small cap companies that supply goods and services to businesses.

In China, the strength is in state-owned companies, as they get the best of command economic privelidges. Thier financial services are especially inviting as corruption and greed that ruined Western finance is dealt with in China via execution. You may not share our opinion on the death penatly, but we think it provides a strong incentive for bank managers in China to be careful of thier actions.

When Premiums Make Sense

In the car industry there are rare events where certain cars sell at a premiums to MSRP when the product is rare and not likely to ever be available again.

While it's useful to know fact from fiction, especially in something that's easy to mathematically quantify, it's also good to know free market prices that are out of line with traditional pricing models don't necessarily indicate irrational behavior. Context is always the most important thing. While "bubble" is one of the most popular words in the investment community today, not everything you see that you don't value highly is a bubble. Context is everything.

When context lines up with analysis, you have strong forces at play. Such was the case in the dot.com bubble and the more recent real-estate bubble. On the other side of such crisis, when context no longer lines up with analysis, you have to put aside computer models and add human insight. In the case of PHK, the context is a rare bond market dynamic unavailable to retail investors. So it's not irrational for buyers to pay a premium to get a piece of something that won't be available shortly, specifically because it has very, very strong fundamental market forces behind the assets, and many of those assets are still priced to account for the end of the American economy within thier lifetime.

If $1.3 trillion of newly created money weren't chasing the bond market; if the Federal Reserve wasn't the primary market maker in commercial paper; if MBS and CDO bonds were trading in a free market; then PHK would probably be the worst product on earth. But this is not a free market. The dynamics of a deep pocket buyer chasing what no one else wants is unlikely to ever occur in my lifetime. Owning anything that has that kind of demand behind it can't be evaluated by traditional methods.

When the Delorean sold over MSRP, it wasn't foolish for those who paid the premium to get it while they could, because those who knew the auto market knew the prices would never be that cheap again, and the opportunity was limited. Now in hindsight we can see Delorean motors collapsed. So if you think the bond market and Federal Reserve buying program is going to collapse, you should not be participating in these bonds. But if you think the market is normalizing like it did in the other crisis, then a little investigation of fundamental forces is in order.

For months I would read John Mualdin describe the valuation of collateralized debt and the out of proportion pricing relative to real risk during the worst of the credit crisis. Every time I would salivate over the chance to buy those out-of-favor bonds as the irrational fear that the world as we know it was going to end tomorrow drove prices of even well-structured bonds into the ground. Not having a Bloomberg terminal or a bond trader's account, there was a fundamental opportunity of a lifetime that I had no way on earth to participate in. Then I discovered PIMCO was chasing that market for the same reason and in the same way I wanted, and had a vehicle available for me to jump on.

I paid a premium to get a piece of it because a) there was no other way for a common citizen to sell junk to the Federal Government at top dollar, and b) there were no option contracts I could buy to lock in the inevitable rise in price for this class of bonds, and c) Ben Bernanke's actions made it undeniably clear there was nothing on earth in the financial market that he wasn't willing to buy - nothing, not even the worst junk imaginable.

Like an option, there's no guarantee the market moves in your favor. One has to know the deeper fundamentals behind the cash flows and demands for the assets of the entity in question. You can't just look at the balance sheet values of the Real Estate assets of Sears Holdings Corporation (SHLD) and know what it's really worth. You have to know the actual location of that real estate and whether the real estate market itself will sustain, threaten, or increase that value. If the market for those R/E assets is drying up, SHLD may be overpriced. If they have a large government revitalization program behind them, SHLD may be under-priced. The issue boils down to whether the retail market has realized those values yet, or not. Price to book value may grow far more quickly than book value, primarily because book value is constrained while human intellect is not, even if abstractions and market forces not quantifiable by GAAP make it clear where future book values are most likely to move.

If we revisit this CEF when the credit crisis of 2008 is a distant memory, after bond spreads have normalized, and it still trades at a high premium, then I will join the short-seller's camp. Until then, Uncle Ben and Tim are ensuring the bonds I own through PHK have a strong, liquid, demand-driven market. I don't know any other product on earth that has an avid open buyer standing in the wings with an unlimited supply of blank checks to buy product.

When that buyer departs, things will change. But at this point their interest is strong and reliable.

Corporate Bond Rally May Stall Now

Today high-rated corporate bonds are trading just barely above government guaranteed bonds.

Yesterday we got a glimpse through Seeking Alpha just how far we've come in the last year.

At least at the top end of the rating scale, there's hardly room for any more contraction in spreads. The long term prospects for high-rated corporate bonds doesn't look good unless in fact Bernanke can actually overcome the forces of monetarism and keep real inflation at historical lows.

The best bet in bonds is the lower grade issues at this point. If high-grade rates remain low on a recovering economy from central bank purchase demands, those lower rated investment grade bonds will see continued contraction in spreads as default risk subsides. If high-grade rates rise while the economy recovers, lower rated investment grade bonds may not see declining yields, but contraction in spreads can still produce stable prices and above-inflation yields.

There are two primary risks, one of which is almost ignorable. The first is demise of the global economy, which is most unlikely but theoretically possible. For that scenario you better have backup food supplies, loads of currency (legal and barter) tucked under your mattress, and a plan for wilderness survival. The second is inflation rates rising to the point where low grade bonds fall in value with or without contracting yield spreads. This is much more likely than the former, and highly probably if Governments around the world don't back off their stimulus programs in rapid fashion.

The good news on the inflation story is monetarism reveals this kind of inflation takes 12 to 24 months to find it's way into consumer prices. At that point one will have to switch to inflation investing.

Until then, high yields, contracting spreads, and green shoots are the fundamentals one should be keeping their eyes on, and high yield investment grade bonds provide a tempting opportunity not often available with fundamental support like we have today.

TALF Fails Its Objectives

That title might be misleading. It fails the stated objectives, but some might wonder if the real objective is to ensure a steady stream of large transactional revenue for primary dealers.

According to the federal reserve:

The Federal Reserve created the Term Asset-Backed Securities Loan Facility (TALF), to help market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities...
Source: NY Fed

Notice on the July 16th facility, a full $0.6 billion in loans were requested. However, they weren't new loans. These were legacy securities. That means someone is putting up some old commercial real estate loans as collateral for cash, so they can do something better with them. It also reveals while they want to "support the issuance" of new securities, those working face to face with them aren't interested. There's too much junk in bonds they need to get rid of first.

One might argue, the proceeds from this loan might be used to fund new loans. While that's possible, its also possible they might be using the proceeds to fund payroll, pay bills, or who knows what.

But you see why the larger banks are in the money these days?

...Eligible borrowers must use a primary dealer...

The fee for the Fed alone is 20 basis points, or $1.3 million for this one operation on one day. No telling what kind of haircut the borrowers of the securities have to take with the primary dealers.

That also means one or more of the 17 dealers get piece of this action, even if they don't lend consumers a penny. One way to keep the banks solvent is to simply lend money back and forth between them; and you wonder if GDP is going to take off?

Maybe, maybe not. But one thing is for sure: those Goldman employees are going to be buying some pretty nice cars, clothes, jewelry, and other luxuries with their $386,395 annual salaries. Goldman is one of the primary dealers, and is no doubt making a boatload of money churning these legacy assets through all the facilities, not to mention the new bonds being issued by corporations, and the Federal Reserves direct purchase of securities.

As a matter of fact, Goldman is doing so well they confidently plan to issue around a billion dollars in unsecured bonds so they can leverage this new world of global liquidity. We don't yet what asset class is going to get that billion dollar stimulus injection, but something bubble somewhere is being pumped up.

Round 2: Smart Securitization

Here we go again, boys and girls. Let the music begin. Last one without a chair is out!

Thanks to the wonders of modern finance, we can now spread out the risks of debt defaults by repackaing instruments into ladders of risk. Sound familiar? Well, you're wrong. No sir, this is the new era of smart securitization. Unlike the last time this system collapsed, this time the wizards of finance are going to do it right. So says Geoff Smailes, managing director of global credit solutions at BarCap.

These new mechanisms are in some respects similar to discredited structured products such as collateralised loan obligations, which were widely blamed for fuelling the financial crisis. But the schemes' backers argue there are two significant differences. First, they involve the securitisation of banks' existing assets, rather than of new lending. Second, bankers argue that the new products do not disguise the transfer of risk.

"This is the world of smart securitisation… not securitisation for leverage and arbitrage"
(Source: Financial Times)

Darn, we sure wish we had contacts with their buyers. We've got a great idea to lease the Brooklyn Bridge. No, we're not talking about selling the Brooklyn Bridge. That's obviously an old con job. No sir, we just plan to lease it. That makes all the difference in the world.