February 22, 2014 The Difference

Risk/Reward Vol. 209

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

"It ain't that I'm too big to listen to the rumors
It's just that I'm too big to pay attention to 'em
That's the difference."---lyrics from "What's The Difference" sung by Dr. Dre

"I'll make a wish/Take a chance
Make a change/And breakaway."---lyrics from "Breakaway" sung by Kelly Clarkson

"I've been working on the railroad/All the live long day
I've been working on the railroad/Just to pass the time away."---lyrics from "I've Been Working On The Railroad" sung by Everybody

Comprehending yield spreads (discussed at Vol. 207 www.riskrewardblog.blogspot.com ) necessitates learning "the difference" between interest rate risk, which is a relative number, and credit risk which is an absolute (although not a constant) one. Last year when the the interest rate on the benchmark 10 Year Treasury Bond spiked from 1.6% to nearly 3%, the interest rates on securities priced or "spread" in relation thereto (such as preferred stock and real estate investment trusts) spiked similarly causing their prices to fall accordingly. (Remember, when interest rates increase, prices of the underlying securities decrease.) The risk of this occurring is called interest rate risk, and one must always "pay attention to it". On the other hand, credit risk is the risk that an obligor will default on an obligation---like back in 2009 when, if one had "listened to rumors," one reasonably could have concluded that the major banks would suspend dividend payments on their preferred stock. (Sixty percent of preferred stock is issued by banks.) After all, most major banks had suspended payment of common stock dividends. Fear of this occurring (and it did not occur) caused the price of preferred stocks to plummet, and their yields to spike. Those who bought preferreds in this trough have reaped bountiful rewards as major banks have rebounded (e.g. 400% price appreciation plus 25% annual dividends).

I believe preferred stocks are again ready for a "breakaway" to the upside. This belief is not "a wish." It is based upon my study of credit risk and is something upon which I have "taken a substantial chance." Allow me to explain. Prior to the 2008-2009 banking crisis, the difference between the yield on the benchmark 10 Year Treasury Bond and the yield on investment grade preferred stock hovered around 2.4%. This difference reflected the premium one received for shouldering what the market perceived as the risk of default on these preferreds. Thus, if the prevailing 10Year rate had been 2.7% back in 2007 (as it is today), the prevailing yield on an investment grade preferred stock would have been 5.1% (2.7% + 2.4%=5.1%). At the height of the banking crisis, the spread between the yield on the 10Year and the yield on an investment grade preferred stock spiked as high as 13% reflecting the above described fear that payment of dividends would be suspended. Since 2010 this spread has come to rest at around 4%. The recent issuance of JPMorgan's Series T preferred shares which pay a 6.7% dividend based an issue price of $25 exemplifies this spread (2.7% 10YearTreasury yield + 4% spread=6.7%). To me, continuing a 4% credit risk spread given the financial strength of investment grade banks is no longer warranted. In other words, the credit risk premium is overblown, and the market may be ready to "make a change" by migrating back toward the historic spread of 2.4%. This, of course, would mean a commensurate rise in prices. A quick glance at all of the green on the far right hand column of the preferred stock closing table indicates that my belief may be correct (http://online.wsj.com/mdc/public/page/2_3024-Preferreds.html ). I am using several preferred stock closed end funds (e.g. FFC, HPF and PDT) and some individual issues as vehicles for this play.

The resurgence of domestic oil production impacts our economy in a positive way "all the live long day". Look at what it has done for those who "have been working on the railroad." In 2008, only 9500 carloads of oil were transported by rail: last year over 400,000 carloads were transported. This equates to over 800,000 barrels of oil per day. Railroads and those that supply them no longer need to merely "pass the time away." Take Trinity Industries (TRN), a multi line manufacturer. One of its business units is the largest supplier of oil tank rail cars in the U.S. On Thursday TRN reported record sales of over $4billion dollars. More importantly, it reported a $5billion order back log in its rail car division alone. The stock spiked that day and is up 16.6% since I bought it on January 22, 2014.

In a four day week, the Dow Jones Industrial Average traded in a narrow range, ended down 51 points and remains 2.68% to the negative for the year. The yield on the 10Year likewise moved only slightly ending the week at 2.73%. This rate stability played into my fixed income strategy. Preferred stock, business development companies and real estate investment trusts all gained ground as investors are becoming progressively more comfortable with the prospect that the 10Year rate will stay below 3% (interest rate risk) and with the financial strength of the underlying institutions (credit risk). Like Kelly Clarkson, I've been waiting "For A Moment Like This." May it continue for a long time.

February 15, 2014 Don't Let Her Be Misunderstood

Risk/Reward Vol. 208

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

"I'm just a soul whose intentions are good
Oh,Lord, please don't let me be misunderstood."---lyrics from "Don't Let Me Be Misunderstood" sung by The Animals

"Now you're here/And I know just where I'm going
No more doubts or fears/I've found my way."---lyrics from "Just In Time" sung by Frank Sinatra

"You can have any of 'em/You can take your pick
But you need to check with me/Girl, I promise I'm legit."---lyrics from "Pick Me" sung by Justin Bieber

Many Civil War scholars attribute much of Ulysses S. Grant's success as a commander to the clarity of his dispatches and orders. Anyone who has read his Personal Memoirs must agree that his prose leaves little room for ambiguity or confusion. Testifying before Congress on Tuesday in her public debut as Federal Reserve Chair, Janet Yellen proved herself Grant's equal in this regard. I recommend her comments to your attention. ( http://www.federalreserve.gov/newsevents/testimony/yellen20140211a.htm ) One can debate whether "her intentions are good", but one need not pray "Oh, Lord, please don't let her be misunderstood." In a prepared statement that was one half the length of those routinely submitted by her predecessor, Chair Yellen advised the world, in no uncertain terms, of the following: 1) QE3 tapering will continue absent a significant change of circumstances; 2) the Fed will keep short term interest rates at or near zero well beyond the time that unemployment falls below 6.5%; 3) disruptions in the economies of other countries are not a concern to her unless they impact the United States; 4) Fed policy will stay accommodative until the rate of inflation reaches 2%. She remained firm on these points through six hours of questioning. The stock market liked what she said, rising 193 points that day.

Janet Yellen understands the difference between clarity and transparency--a distinction that was lost on Ben Bernanke. Recall the confusion last summer and fall resulting from Bernanke's very public vacillation as to if and when the tapering of QE3 would begin (read Vols. 170 through 187 www.riskrewardblog.blogspot.com ). Market stability suffers when central bankers display Hamlet-esque indecision ("To taper or not to taper?") which is how transparent decision making invariably is interpreted. If her debut testimony is prologue, the Fed will be more disciplined in its communications under Ms. Yellen's command. Hopefully, "now that she's here/ we will know just where the Fed is going. No more doubts or fears/Yellen's leading the way." Oh and could it be that being straightforward is contagious in Washington? Almost unnoticed in this week's news was the passage of a clean resolution raising the debt ceiling. Apparently, Congress has learned that engaging in brinksmanship on matters impacting the nation's economy is not only bad policy, it's bad politics.

With Fed policy clearly articulated and a possible debt ceiling crisis averted, the stock market traded on fundamentals for the remainder of the week. Like the performance of their underlying companies, some stocks did well; others not so well as 2014 is developing into a stock picker's market---a market that rewards those who can pick winners over those who passively invest in broad indices. "You can have any of 'em/You can take your pick." But, remember to do your own homework as to which are "legit." " You need not check with me" as to which ones you select, but I would appreciate learning what you buy and why. One sure winner for me has been biopharma Regeneron (REGN) which this week reported a block buster quarter driven by sales of its drug Eyelea (for macular degeneration). I own REGN through HQH, a closed end fund which holds large positions in REGN, Celgene, Amgen, Gilead and Biogen. HQH pays a 6.7%% dividend and is up 9.8% since I bought it on a dip on January 28, 2014. Another big winner for me so far has been GGN, a closed end fund comprised of gold miners and other mineral companies which pays a 11% dvidend and is up 8% year to date. Gold mining stocks were brutalized throughout 2013, but have recovered nicely so far this year as has the price of gold. HCLP, the fracking sand miner, has also done well. It is up 21% since I repurchased it in October, 2013. I bought more this week after reading the transcipt of its quarterly earnings call in which the CFO stated that 2014 will see a minimum 10% increase in its dividend.

Holy Eric Burdon, despite two down days, the Dow Jones Industrial Average closed the week up 360 points leaving it down only 2.5% year to date. Is Mr. Market back in "The House of the Rising Sun?" Or should we be pleading to him-- "Don't Bring Me Down?" Either way, maintaining a principled approach with a watchful eye on the ever important 10 Year Treasury Bond (the yield on which held at 2.75% even as QE3 tapering was made more certain) should curb any sense of over confidence or any panic-driven belief that "We Gotta Get Out of This Place."

February 8, 2014 For What It's Worth

Risk/Reward Vol. 207

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

"Carefree highway, let me slip away on you
Carefree highway, you see a better day."---lyrics from "Carefree Highway" sung by Gordon Lightfoot

"Spread your love/Let's spread our love together
Spread your love/I can feel it getting better."---lyrics from "Spread Your Love" sung by Earth, Wind and Fire

"Was I too far gone
Too far gone/Too far gone
For you?"---lyrics from "Too Far Gone" sung by Neil Young

Recently, I was asked why I obsess on the interest rate paid on the 10Year Treasury Bond. I attempted an explanation in Vol. 172 ( www.riskrewardblog.blogspot.com ), but in re-reading that edition I found it dense---barely intelligible in fact. Therefore, Dear Readers, allow me once again to attempt to explain this obsession. Modern portfolio theory rests in part upon the following principle as articulated by Warren Buffett: "The rates of return that investors need from an investment are directly tied to the risk free rate of return." Although the concept of "risk free" is as illusory as a "Carefree Highway", the asset universally recognized as the least risky in the world is the debt of the United States government. The denomination thereof most often used as the risk-free benchmark is the 10Year Treasury Bond. Thus before this concept "slips away on you", let's paraphrase Mr. Buffett: "all investments are directly tied to the interest rate of the10Year Treasury Bond." This principle is not difficult to grasp since no rational investor would make an investment involving risk without the prospect of a return greater than that afforded by the risk-free benchmark. Rational investors expect to be rewarded for the risk they take, and the more risk they assume the more reward they intend to reap.

This risk/reward scale is often expressed as the "spread" between the forecasted yield on the "risk-free"10Year Treasury Bond and the yield (dividend-interest plus capital appreciation) expected from the acquired asset. For example, since the 2008 financial crisis the spread between the expected return on the 10Year Treasury Bond and investment grade preferred stock has been 3.5%. So if in the foreseeable future, the 10Year is expected to yield 3.5%, then one would expect investment grade preferreds to be priced so as to yield 7% (3.5%+3.5%=7%). If the forecasted yield on the 10Year is 3% then one would expect a preferred stock to "spread its love together" and to be priced to yield 6.5%. As we all know, with bonds and bond-like assets (such as preferred stock) PRICES GO UP AS YIELDS GO DOWN. And when prices go up, "I can feel it getting better."

Last May after the Federal Reserve announced that it would taper its monthly purchases of Treasury Bonds (QE3) sometime in the then near-future, conventional wisdom was that the value of the 10Year Treasury Bond would decrease (since the Fed would no longer be bidding prices up) and that concomitantly the 10Year yield would go from a mid-May, 2013 rate of 2% to 3.5% or above as tapering progressed. Almost overnight, the price of the 10Year dropped precipitously to reflect the taper's anticipated impact. In turn, this move in the 10Year quickly was reflected in a steep drop in preferred stock and all other assets priced to produce a return tied or "spread" to the yield on the 10Year ( e.g. real estate investment trusts (REIT's), corporate bonds, junk bonds, senior notes, exchange traded debt---in other words everything income investors such as me like). I sold most of my spread-priced assets at that time. I watched the bond market closely over the next few months. By September I predicted that the yield on the 10Year would not exceed 3% even after tapering began, ( My rationale for so predicting can be found at Vol. 186 www.riskrewardblog.blogspot.com ). I also concluded that the market had "Gone too far/Gone too far for me" in pricing "spread" assets as if the10Year yield would rise to 3.5%. Accordingly, I re-invested heavily into preferred stock funds and REITS which I viewed as mis-priced. So far so good. The Dow Jones Industrial Average (DJIA) has dropped 4.72% year to date, but my portfolio has risen in value as the yield on the 10Year continues to hold around 2.7% even as the tapering of QE3 (which began last month) progresses. In sum, owning "spread" assets that were priced as if the 10Year interest rate were going to rise to 3.5% has been a good place to be recently as the market has become more comfortable with the prospect that the 10Year rate likely will stay at or below 3%, tapering notwithstanding. Recognizing this possibility is why I obsessed on the 10Year and continue to do so.

Another roller coaster ride was had on Wall Street as the DJIA started with a 326 point loss on Monday but ended up 96 points for the week. Here is my take on the situation, "For What It's Worth." (apologies to Neil Young and Buffalo Springfield) The markets are becoming range bound. If I am correct, anytime the indices try to break out either to the top or to the bottom, they will be "getting so much resistance from behind." It's as if "battle lines are being drawn." But, "stop children what's that sound?" It's a sigh of relief from those like me who are heavily invested in spread priced income securities. As explained above that's because "everybody look what's going down"---the current and forecasted yield on the benchmark 10Year Treasury Bond.

February 1, 2014 Buy, Buy Baby

Risk/Reward Vol. 206

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

"Fools rush in/Where wise men never go
But wise men never fall in love/So how are they to know?"---lyrics from "Fools Rush In" sung by Ricky Nelson

"If the sky above you should turn dark and full of clouds/And that old north wind should begin to blow
Keep your head together and call my name out loud/And soon I'll be knocking at your door."---lyrics from "You've Got a Friend" sung by James Taylor

"Bye, bye baby/Baby, bye, bye
Bye, bye baby/Don't make me cry."---lyrics from "Bye, Bye Baby" sung by The Four Seasons

Recall that in May, before there was any mention of quantitative easing (QE) tapering, I wrote as follows:

"Clearly QE and the search for yield have led many to make risky investments : ones they "will wish weren't chosen." A case in point is this week's sale of $400million worth of 10 year Rwanda bonds. "Yeah, Rwanda, Rwanda"---you remember, the genocidal nation featured in the movie "Hotel Rwanda". That bond issue was oversubscribed and the bidding drove the bonds down to a 6.625% interest rate---roughly the same yield one would get from the tax advantaged preferred shares of an A rated insurance company or of the Royal Bank of Scotland." (See Vol. 168 http://www.riskrewardblog.blogspot.com/ )

Back then (and for some time before and after) yield hungry "Fools rushed in" to emerging markets like Rwanda and even more so into South Africa, Turkey, India, Brazil, Russia, etc. Flattered by their new found attractiveness, many emerging market nations incurred debt at levels "where wise men never go." Awash in money, necessary economic reforms were not enacted and international account deficits grew. "How were they to know" that at some time this apparent love affair would end. But, when social unrest hit some (e.g Turkey) and economic slow down hit others (e.g Brazil and Russia), many heretofore fools suddenly became wise. They started selling emerging market securities and abandoning emerging market currencies. "Wise (money) men never fall in love" with a company or a country, and if holding any investment becomes too risky, they exit. What started as an orderly emerging market sell-off late last year became a stampede this week. Central banks in South Africa, India and Turkey took desperate measures to support the outflow of capital, but failed to stem the panic. In Russia, the leading tabloid advised its readers to convert half of their savings from rubles to dollars or euros. Every stock and bond market in the world has become volatile.

As volatility has increased (check out the price action on Friday!) a flight to safety has ensued. Savy investors know that "if the world's economies should turn dark and full of clouds/And that old north wind begin to blow", "Keep your head together" and invest in US Treasury securities. This notion was reinforced by PIMCO's Bill Gross who Tweeted on Wednesday "Turkey & South Africa flunk currency test-don't wait around to see who's next. De-risk, move to Treasuries." And move many did, as investors came "knocking on the door" of those holding Treasuries. So much so, that when, on Wednesday, the Federal Reserve announced that it was reducing (tapering) QE3 by another $10billion dollars in February (an event which in the past would have caused the 10Year Treasury to plummet in price and thus spike in yield), the influx of funds into Treasuries counteracted the taper and caused the price of the 10Year to rise and the rate to plummet to 2.67%---the lowest since early November. This drop was very good for interest rate sensitive/fixed income securities which have traded for months as if interest rates would rise as tapering progressed. Year to date the value of these has increased even as the general market has faltered. The Dow Jones Industrial Average fell 181 points for the week and experienced its worst month since May 2012.

One of the reasons I write this column is to record and hopefully to learn from past judgments. This is what I wrote in Vol. 99 (http://www.riskrewardblog.blogspot.com/ ) as I reviewed my performance at year end 2011:

"....I need to appreciate that although world events (i.e. the European debt crisis) do impact our stock markets, those events are not the only factors to be considered. United States companies currently have extremely healthy balance sheets, very high productivity, excellent managers and world class franchises. As a consequence, McDonalds, CocaCola, Johnson & Johnson, Yum Brands, Apple, Caterpillar etc, are positioned to grow here and abroad for years to come, and should not be abandoned for any substantial period of time simply because Greece can't repay its debt"

Is the emerging market crisis of 2014 so terribly different from the European debt crisis of 2011? Should I simply ignore the fact that on Thursday the Department of Commerce reported that the US economy grew at a robust annualized rate of 3.2% in Q4 2013? Am I experiencing deja vu? Well, this time instead of selling into the panic, I decided not only to hold firm, but to "Buy,buy, baby/Baby, buy buy." On a dip, I bought HQH, a closed end fund that holds substantial amounts of Celgene, Biogen, Gilead and a host of other biotech and biopharma companies. I had tried to buy some months ago, but it was like trying to catch a rocket as HQH rose over 60% in 2013. I also added more AAPL after the market expressed disappointment with its earnings. I simply can not resist buying the shares of a company that continues to grow earnings year over year, has no debt and has accumulated over $160billion of cash while at the same time undertaking the largest share buy back program in history. Carl Icahn says that buying AAPL is a "no brainer." At least on that score, I qualify as a stockholder. I also bought more ARRpB, a mortgage real estate investment trust (mREIT) and added to my municipal bond fund holdings. The prospects for mREITS (my favorite, MTGE, is up over 9% year to date) and leveraged municipal bond funds have brightened with the 10Year yield moderating. On the speculative side, I added to my holdings of GGN in the belief that currency devaluation throughout emerging markets will spur the purchase of gold as a hedge.

This week, more than ever, experience, as recorded in my writings, guided my decisons. As you, my loyal readers, know, during my four years of active investment management, "I've seen fire and I've seen rain/ I've seen sunny days that I thought would never end/I've seen lonely times when I could not find a friend." But through it all, "I always thought I 'd see good, fixed income returns again." Let's hope they stay.