Investors Are Main Lenders To U.S. Businesses, But May Not Understand Risks

By Path Financial President and Chief Investment Officer Raul Elizalde

today imageFaced with regulatory constraints and stricter guidelines, bank lending to businesses declined since the financial crisis. The business sector filled the void by issuing bonds, which were quickly swallowed by yield-seeking investors. This amounted to a transfer of lending risk out the banking sector and into the investor class. This is good news for the banks, which are now in better shape, especially in the U.S.. The bad news is that, unlike banks, the investor class has no safeguards if something should go wrong. Also unlike banks, the average bondholder is ill-prepared to ascertain credit risk. And there are signs that the risks bond investors face are increasing.

There is no doubt that the role of investors as lenders to businesses has become more prominent. In the U.S., for example, companies in the non-financial sectors now have well over twice as many bonds than loans outstanding. In Europe, although bonds are not a widespread source of private sector financing, the proportion of bonds still nearly doubled with respect to loans since the financial crisis.

first graph

Another reason to worry is that U.S. corporate bonds rated at BBB by Standard and Poors represent the largest group by far, at 37% of all non-financial corporate bonds outstanding, or $2.7 trillion. This is a credit rating category at the very bottom of the “investment grade” ladder. Bonds downgraded from this BBB category fall to the “non-investment grade” land where many investors are forbidden from entering. Thus, a downgrade that pushes a bond across that divide triggers selling that can drive the bond price even lower.

There is a large wave of bonds maturing in the next five years, which could be as large as $10 trillion globally according to the McKinsey Global Institute report. These bonds will be replaced with new ones that would be more costly if they are issued at higher rates than the ones maturing. This is likely to be the case, since interest rates are going up. Bonds at the threshold of investment grade quality could easily fall into the “junk” world.

There is also the issue of bond liquidity. The McKinsey report reminds us that “buying and selling corporate bonds often requires a phone call to a trading desk at an investment bank, and there is little transparency on the price the buyer is quoted”, a feature that can seriously curtail bond liquidity if a credit event were to take place.

Mutual funds – the largest holders of corporate bonds – can easily withstand the first wave of redemptions with their cash holdings, but because many funds hold similar positions, a selling wave could pose a problem when everyone is on the same side of the trade. Both practitioners and academics like Caitlin Dannhauser of Villanova University and Saeid Hoseinzade of Suffolk University have studied this point in depth.

A liquidity crisis is more likely today, when trading desks at investments banks that used to hold large bond positions are now restricted from doing so. Bond holdings of primary dealers, for example, have steadily declined and are now about a fifth of what they were before the financial crisis, even as the outstanding amount of bonds more than doubled.

Investors are now much more exposed to business lending risk because of their large holdings of corporate bonds, a risk that will increase if economic conditions suffer. While the economy is currently firing on all cylinders, it is vulnerable to the tightening efforts of the Federal Reserve, a slowing global economy and the risk that today’s trade disputes could turn into a full-scale global trade war.

Any of these issues could push some corporate bonds over the non-investment-grade category, severely affecting bond prices. While it is unlikely that bond weakness could turn into a broad crisis, bondholders will be hurt. They need to pay close attention to the risks they face, especially because nobody will be there to help them if their investments sour.

This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.

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Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Park Your Money in Four ETFs To Cut Market Exposure

By Path Financial President and Chief Investment Officer Raul Elizalde

raul imageFrom time to time investors look at reducing their market exposure and “parking” their money safely. Some choose plain cash, but cash has a negative real rate – it does not grow, and inflation eats away at its value.

Some ETFs can provide stability and a moderate return with very low exposure to market risk. While no investment is completely safe (even cash under a mattress can catch fire) these ETFs have solid sponsors, large portfolios and plenty of liquidity. Each one has different characteristics, so using them in combination may be better than settling on any single one.

SHY, for example, has $14 billion of U.S. Treasury notes and bonds with maturities between 1 and 3 years. Its liquidity is excellent and its sponsor, BlackRock’s iShares, is one of the strongest financial institutions around. Because all its holdings are in fixed-rate instruments, its value declines when interest rates go up. Quality is unmatched: the assets are backed by the full faith and credit of the United States Government.

FLOT, also from iShares, has $10 billion of floating-rate securities issued mostly by corporations with an average maturity of about 2 years. These underlying instruments pay interest that moves with market rates, so they tend to benefit when rates climb. Like SHY, it is a very liquid ETF.

CSJ is another iShares ETF. It resembles SHY in that it contains $11 billion in fixed-rate instruments with maturities between 1 and 3 years, but it is mostly comprised of corporate securities, which pay higher rates than the US Treasuries in SHY. Like SHY, its value tends to drop when rates go up. Roughly 16% of its portfolio is made up of supranational and government-guaranteed bonds.

Finally, SPSB is an ETF sponsored by State Street’s SPDRs, another very strong sponsor. Like CSJ, it contains corporate bond holdings between 1 and 3 years. However, there are no supranational or government-guaranteed bonds among its $4 billion in assets, which results in a higher return than CSJ but also higher volatility. Both CSJ and SPSB offer plenty of liquidity with very narrow bid-ask spreads, but their daily volumes are smaller than SHY or FLOT.

We ran a few combinations of these ETFs using approximately seven years of data, looking for an optimal blend of low volatility, high return and minimal drawdowns (i.e. declines from peaks) for that period. A mix that seems to satisfy these elements is a 65% FLOT, 10% SHY, 15% CSJ and 10% SPSB allocation rebalanced monthly, as shown in the graph below. Drawdowns and volatility were minuscule. Returns were moderate, as one would expect for a cash alternative, but accelerated in the last two years as rates rose.

graph one

We tried including other short-term and floating-rate ETFs such as BSV (Vanguard’s short-term bond ETF) and FLRN (State Street’s SPDR Floating Rate) but we found no measurable contribution to the portfolio metrics achievable with the four ETFs we focused on.

While this mix worked well in the past, the optimal blend going forward may contain a larger proportion of FLOT if rates rise, or a smaller proportion of CSJ and SPSB if credit spreads widen along with lower equity prices.

A word of caution: ETFs, like any instrument, can be subject to liquidity constraints. Unlike a mutual fund, owning an ETF does not give the holder direct ownership to the underlying instruments. A serious market dislocation can affect corporate bonds spreads and cause FLOT, CSJ, or SPSB to experience significant price drops or a wide gap between market value and net asset value.

However, barring the unknowable effects of abnormal market conditions, which in any case tend to be temporary, these ETFs offer investors an attractive alternative to cash.

This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.

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Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Earnings Forecasts Optimism Could Spell Trouble for Market

By Path Financial President and Chief Investment Officer Raul Elizalde

photoStock prices depend on future earnings expectations. The current consensus is for earnings per share (EPS) to grow through the end of 2019 by about 30% to record highs. These are risky forecasts: if numbers come out short, stock prices will take a hit. Can investors rely on these forecasts?

first graph

Operating earnings estimates from hundreds of analysts pooled by Standard and Poors’ Capital IQ show that optimism about earnings is strong. This is noteworthy because observers are also contemplating the possibility of a slowdown, or even a recession, in 2019.

The enthusiasm may be due in part to the strong acceleration of operating EPS growth that started in mid-2016. Remarkably, a related set of numbers – corporate profits before tax from the U.S. Bureau of Economic Analysis (BEA) – lack the same vitality. The BEA numbers, in fact, have more or less stalled since 2010, and there is little indication that they are ready to take off.

To be sure, the two sets are quite different. The S&P numbers only pertain to public companies belonging to the S&P 500, while the BEA numbers are intended to cover all corporations, public or not. Additionally, while both figures are calculated before tax, various other accounting items are treated differently.

Nevertheless, the rate of growth for both tends to move in the same direction, with peaks and troughs reached at the same time, as in 1994, 2003-04 and 2010-11. One key observation would be whether the gap between the BEA numbers and operating earnings narrows or widens at the end of the second quarter. If both measures continue to diverge, the chance that operating EPS will achieve the 2019 targets will diminish.

second graph

It is important to point out that the strong earnings growth rates of 2003-04 and 2010-11 were possible because of the low starting points caused by prior recessions. In comparison, the strong rate projected for 2019 would have to be reached after almost 10 years of expansion. It may be harder for earnings to accelerate from the current high base.

Plenty of research throws doubt on the ability of analysts to predict earnings far in advance, and this is borne by the evidence. According to Standard & Poors, only 9% of analysts were able to forecast current quarter EPS correctly in the last five years. Most forecasts exceeded the actual numbers, or came out short.

This is not surprising. Not only there are many exogenous, unpredictable factors affecting earnings, but also the accounting input needed to make forecasts is hopelessly complex. As Mike Thompson, S&P Investment Advisory chairman said on a recent TV interview, “you almost need forensics to understand some of the accounting that goes on to get to EPS.”

So is the current projection for the next seven quarters of earnings achievable? Yes, it is, but that is not saying much. Any projection is possible. One as optimistic as the current one may also need a generous serving of luck to come true.

This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.

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Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Do you need stocks in your portfolio?

rollercoasterMost financial professionals would tell investors not to focus on matching or beating market indices, but rather on making sure that they stay on track to meet their financial goals.

Some investors push back against this advice, perhaps thinking that it is an excuse advisors have for not being able to beat the market. Yet, the advice is sound. While some investors need full exposure to equities, others do not need to take that much risk and some would be much better off having no exposure to stocks at all.

How much risk one takes depends on personal circumstances. Unfortunately, investors are bombarded with 24/7 stock recommendations, and they become more receptive to them when the market has been strong and steady as it has been in the last few years. While bull markets make people feel more confident taking on risk, relying on your level of confidence to decide how much risk to take is the wrong way to pursue your financial objectives. The risk inherent in the stock market is high, and it should be handled with care.

Consider a 75-yr old widow (i.e. without a significant other, for simplicity) who wants to make sure that her $2.2mm in savings will be enough to pay for $100,000 of yearly expenses for the rest of her life. As that rate, she will spend $2mm by the time she reaches 95, leaving $200,000 to spare. Probably her best bet is to invest those savings in short-term, high-quality fixed income products to protect them against inflation. This ultra-low-risk strategy would be aligned with her goal, which is to minimize the chance of running out of money. It would have the important benefit of being highly predictable and likely devoid of unpleasant surprises.

What about a 75-year old single man who has the same expenditures but $1.5mm in the bank? Spending $100,000 per year will deplete his savings in 15 years, or sooner if he spends more due to inflation. Because there is 100% certainty that he will run out of money way before he reaches 95, he needs the extra return of stocks to make his portfolio last.

How much stock exposure does the less-wealthy investor need?

One way of answering that question is by simulating sequences of stock market returns and examining how his portfolio would fare under each sequence. This can give a sense of how his situation can be improved.

Without stocks, his portfolio will inexorably shrink by $100,000 per year. Because stocks are volatile, adding them to the portfolio will make it less predictable. The higher the proportion of stocks, the more it will depart from that steady declining path. To illustrate this, we ran a few possible ways his portfolio can depart from the no-stock scenario (see first graph).

portfolio paths 50% stocks

Adding stocks clearly makes it possible for this retiree to stretch his portfolio past year 20. But it can also make his portfolio run out of money sooner than 15 years, or subject it to a terrible start such as a 25% decline in the very first year.

How would he react to a bad start? If his tolerance for risk is low, he may close out his positions right away, book a loss, and end up worse off than before. Every investor should consider his or her risk tolerance carefully with the help of a professional.

Things can go very wrong when the volatility of stocks is not properly understood. Imagine that the widow in the first example, even though she has plenty of savings and little need to invest, becomes convinced that she is “leaving money on the table” by not keeping up with a rising stock market. She decides (or is encouraged) to deploy all her portfolio in an S&P 500 index fund.

portfolio paths 100% stocks

While her final portfolio could potentially be much bigger than without any exposure to stocks, she now has a small but very real chance that she could run out of money – a scenario that, before switching to stocks, she was virtually assured not to face (see second graph). In exchange for the chance of having more money at the end of her life (when it is least useful) she introduced the risk of being wiped out sooner, or experiencing distressing early losses that could prompt her to close out positions in a panic and lock her out of her goal.

It is tempting to invest in stocks when they seem to carry little risk. Investors should not rely on forecasts; instead, they should examine their own situations, understand their tolerance for risk, and develop an appreciation for what could go wrong with their investment strategies.

What now?

We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, and we always put their interests first. That means we do not profit from transactions or by selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours. We can also help you evaluate your current goals and establish an investment plan aiming at achieving steady, long-term returns while managing downside risk. You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more.

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Raul newsletterWhat are you reading to stay on point for your financial future?

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Raul Elizalde’s commentary is frequently published on major financial and investment news sites such as Investopedia, and his insights have appeared on The Motley Fool, the opinion pages of the Sarasota Herald Tribune, Morningstar, and Yahoo! Finance.

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