Warm Days and Thunderstorms: Bond Prices Are Rumbling

Michael FarrPresident and majority owner, Farr, Miller & Washington, LLC

Posted: 03/21/2012 1:30 pm

Article from The Huffington Post

Spring arrived early for 2012. In spite of the predictive powers of Punxsutawney Phil, the cherry trees along the Tidal Basin next to the National Mall are in full bloom -- weeks ahead of their "normal" cycle.

Spring brings us out of the dullness of a barren winter and helps remind us that change is inevitably constant. Faced with this reality, smart investors continually seek to manage unforeseen risks and uncertainties. We at Farr, Miller & Washington have a balanced approach to portfolio management. We seek investments that are likely to benefit from the long-term growth in the global economy. At the same time, we place high value on an investment's ability to withstand turbulent economic times. This approach has suited us well since we opened our doors in 1996. 

The bond market has become a source of consternation for many investors in recent years. Following a 30-year trend of falling interest rates, many investors justifiably wonder if bonds are a smart investment. We have our opinion, but we don't have a definitive answer. In any event, bonds do have a place in many investor portfolios, depending on a variety of different factors. In general, many of our clients hold bonds to provide stability and income to their portfolios. Typically, when the equity markets deflate, bonds get a breath of fresh air and smooth the overall portfolio values. 

Last week we saw the other side of the coin as the DOW surged through the 13,000 barrier, hitting highs that have remained untested since pre-crisis 2007. Yields on the 10-year Treasury, in turn, leapt from below 2% to the current (as of this writing) return of 2.38%. Remember that as bond yields rise, bond prices fall. 

During historical economic recoveries, bond prices fared a good deal worse than they have in the current recovery. This is because the Federal Reserve and Treasury Department have taken enormous actions to keep yields low, thereby increasing the odds that the recovery becomes self-fulfilling. The recent year's experience of near-zero interest rates has been unexpected. But it may be that we are seeing the rate tide turn. 

Past Farr Views have warned of risks to bondholders in rising rate environments. The current jump in the 10-year yield from 1.85% in January to 2.38% on March 19th meant that the price fell from $101.35 to $96.66, or 4.6%. Obviously, investors who purchased 10-year notes with a 1.85% yield to maturity will suffer if they have to sell today. Moreover, returns will only become more negative as yields rise further. Should rates rise to 4%, the price on the US Treasury 2% of 2/15/22 will fall to $83.78.

Naturally, there is no way to know whether this jump in rates is just a blip or the beginning of a trend. But being aware of potential threats is every investor's job. Our strategy for bonds has been defensive for some time. Average maturities and durations have been shorter, and purchases have been well-researched and opportunistic. 

If you own bond mutual funds, check the price action over the past couple of months. If your exposure to rising interest rates is unacceptable to you, it may be time to consider re-allocation. Interest rate movements affect almost every type of investment in some way, but bond investments will react with direct negative correlation. The rule for bond investing is that the lower the coupon and the longer the maturity, the more volatile prices will be. Therefore, higher coupons and shorter maturities mitigate volatility, and therefore, risk.

The tide in the Tidal Basin may be changing. As soothing as 80 degree March afternoons can be, we diligently prepare to avoid the bite of a late market frost. Understanding that risk exists is the first step in combating it or taking advantage of it. Be careful out there. 

Article from The Huffington Post

Budget 2012: Infra bonds may no longer be tax-deductible

Published on Sat, Mar 17, 2012 at 12:21 

Updated at Sat, Mar 17, 2012 at 16:32  

Article from Moneycontrol.com

Arnav Pandya

 

If you were celebrating about some small tax saving gains due to the announcements in the Union Budget then you actually need to stop and see whether you will actually end up with some benefits at the end of the day. While there was a lot of talk about the increase in the basic exemption limit what nobody would have told you is that one of the investment benefits consisting of the deduction from investing in long term infrastructure bonds is no longer present in the coming financial year.

Nature of benefit

Two years ago there was an additional deduction introduced to encourage investors to put money into infrastructure bonds. This consisted of bonds with a 5 year lock in and the maximum benefit for the year was restricted to Rs 20,000 of investments. The benefit was a deduction which meant that this amount of eligible investment was reduced from the taxable income of the individual. The tax benefit depended upon the slab that the individual fell into so this could vary. The most important part of the entire action was this was an additional benefit as compared to the Rs 1 lakh investment limit under Section 80C so it was something extra.

Devil in the detail

The manner in which this section was structured was that this was applicable initial for just one financial year and this was later extended for one more financial year which meant that the benefit was available for the financial year 2010-11 and 2011-12. Now there is no mention in either the explanatory statement to the budget or in the part of the budget that makes the changes to the income tax act about any change in this particular section. What this actually means is that the term of the section has not been extended and that it will end at the end of March 2012.

Implications

The implication of this is that the individual investor will lose the opportunity of this additional investment in the next financial year. This is a huge blow to them because this will actually push up their tax burden which will eat into the savings that they would have made due to the rise in the basic exemption limit. Take the case of a male person who has an income of Rs 6 lakh and they are using this benefit. The savings that they would have earlier got was Rs 2,000 on account of the rise in the basic exemption limit to Rs 2 lakh but a higher tax of Rs 4,000 due to the end of this benefit means that they are actually in a negative impact to the tune of Rs 2,000.

For those who are in the higher tax bracket the net impact will still be positive which is just due to the fact that the change in the tax slab has meant that there is an additional benefit that is available which is quite extensive. So for a male individual with a taxable income of Rs 12 lakh the net savings will be Rs 16,000.

Different

Investors should not confuse the increase in the permission given to institutions to raise additional amounts of tax free bonds with this particular benefit. Those are tax free bonds where the interest earned is not taxed while these are bonds that allow for deduction based upon the amount of investment in the bonds and the interest income earned here is taxable.

The author can be reached at arnavpandya@hotmail.com

Article from Moneycontrol.com

Bonds: Risk is back!

By Maureen Farrell @CNNMoneyMarkets March 14, 2012: 12:51 PM ET

Article from CNN Money

BlackRock: Get out of cash

NEW YORK (CNNMoney) -- The risky bond deals that were a hallmark of the pre-financial crisis boom are staging a comeback as investors continue to hunt for ways to find higher rates of return.

And companies are willing to meet the demand. Roughly $58 billion of high yield, or junk, bonds have been issued by 95 corporations since January. That's the fastest start in 15 years, according to Dealogic.

Investment grade bonds, which offer a lower, albeit more stable yield, have also continued to attract investor interest. Since January, about $150 billion of corporate bonds have been issued by 315 companies, according to Dealogic. While that's slightly faster than the past two years, it's well behind the pace set in 2007, 2008 and 2009.

But what's really captivating market watchers is the reemergence of a particular bond that has a so-called 'toggle pay-in-kind', or PIK, structure that allows a company sell new bonds rather than make semiannual payments to creditors.

Analysts and traders see these bonds as the first clear sign of a return to the pre-crisis era of financing.

Last week, Goldman Sachs' (GS, Fortune 500) private equity firm GS Capital Partners and Advent International issued $600 million in toggle PIK bonds with a 9.625% coupon to help finance their $3 billion buyout of TransUnion, the third-largest credit reporting company behind Experian and Equifax (EFX).

Meredith Whitney was right

The "toggle PIK" structure gives TransUnion the option to issue more debt instead of doling out $29 million in semiannual cash payments to debt holders.

"This deal got everyone's attention because it showed that there really is an appetite for these risky securities," said Richard Farley, a corporate partner at Paul Hastings.

TransUnion, Goldman Sachs, and Advent International declined to comment on why they chose this financing structure.

Because of the success of the TransUnion deal, several sources said deals with this type of financing are in the pipeline and could be announced in the next several weeks.

In theory, this structure should give a company like TransUnion more options should it run into trouble. If it sees a decrease in cash flow for a few quarters, it can issue more bonds and conserve cash.

In practice, however, companies with toggle PIK bonds have been more likely to wind up in bankruptcy. Between 2006 and 2010, companies with toggle PIK bonds defaulted at nearly twice the rate of companies with similar amounts of debt, according to Moody's.

My panicked trade

One trader called the reemergence of the toggle PIK bonds the first sign of "financial promiscuity" coming back to the bond market.

Farley says the PIK bonds and several other trends he's seeing in the high-yield market are functions of a hot market where investors are aggressively seeking yield again.

Among other signs of an aggressive lending market is talk of more high-yield deals that contain few covenants, or ways for bondholders to force companies to take certain actions.

Meanwhile, private equity firms are also issuing more debt to give themselves dividend payments.

One of the more high profile recent deals is Chicago private equity firm GTCR's marketing of a new $545 million loan for Protection One, a home alarm system company that GTCR bought for $828 million in late 2010.

The loan is expected to give GTCR a healthy cash dividend. Protection One and GTCR did not immediately respond to requests for comment.

Should this trend continue, industry watchers say private equity firms will continue to add debt to their companies to reap the dividend rewards.  

Article from CNN Money