Posted by: Simon Lack | August 12, 2013

Picking The Right MLP

Barron’s published a panel discussion on MLPs this past weekend. The panelists debate whether MLPs are still attractively valued or not and their sensitivity to rising rates. Although MLPs have been very strong this year, with our MLP Strategy +23% year-to-date, we continue to think that distribution yields of 5-6% and conservative growth prospects of 4-6% (implying a total return of 9-11%) make this a good asset class for the long term investor.

It’s important to pick the right names though as in any investment strategy. Because MLP investors are driven in part by the tax deferral treatment of the distributions, this is also not a sector that lends itself to much trading or switching out of names. Indeed, a well-managed MLP portfolio should be the most parsimonious user of brokerage services, because it should have minimal turnover. Selling an MLP typically triggers a taxable gain, and as time goes by the hurdle a new investment must clear in order to justify the tax bill incurred by selling an old one can become almost insurmountable. Earlier this year one friend suggested MLPs were due for a correction and noted a well-regarded MLP investment manager was selling. In our analysis we found that for some long-standing accounts it would have required that the cash thereby raised be reinvested at prices 20% lower simply to break even on the taxes incurred through selling in the first place. Meanwhile, the manager’s track record would not show the after-tax return. His clients could be worse off even while his track record looked as if timing had helped them. As it turned out though, this Spring correction was only around 2% so not worth the trouble.

Some MLPs offer very high but fluctuating yields. Petrologistics, LP (PDH) is an example. They convert propane into propylene, and so their earnings are highly sensitive to the price spread between the two. Their current distribution yields is 9.8%. Their 2011 S-1 registration statement warned of wide fluctuations in their distributions depending on business conditions. Their most recent 10K noted that, “We may not have sufficient available cash each quarter to enable us to pay any distributions to our common unitholders.”

It’s not just that LP investors are typically looking for stable yields and that PDH does not promise that. The additional challenge is that there are probably times to own PDH and times to be out of it. More frequent buying and selling reduces the amount of capital available for an investor to deploy because of taxes.

The Barron’s article mentioned other MLPs with more volatile business models, such as CVR Refining (CVRR). Refining can be a feast or famine business depending on margins which fluctuate widely. CVRR’s current distribution yield is an eye-catching 20%, although there’s clearly some doubt about its sustainability since management recently lowered its guidance.

There was also an interesting piece on Seeking Alpha this morning on StonMor Partners, LP (STON). STON is not in the energy business at all, but is in “deathcare”. They operate cemeteries and funeral homes. For historical reasons they operate as an MLP. The 9.6% distribution yield is attractive, although we’ve never invested because we found the financial structure overly complicated. Managing cemeteries is somewhat similar to running an insurance business, in that you get to invest the float. In STON’s case, people buy cemetery plots with cash and the maintenance costs of the cemetery are spread over many years.

The Seeking Alpha article notes the absence of much insider ownership or even institutional ownership, and asserts that distributions are persistently funded with issuance of debt, rather than out of profits. The writer believes a distribution cut is likely.

If any of these names mentioned above cut their distribution because of insufficient cash, as a friend of mine has said in the past, “Down’s a long way from here.”

Posted by: Simon Lack | August 6, 2013

Recent Reuters Interview on Bonds

Posted by: Simon Lack | August 1, 2013

Bonds Are Not Forever

Later this month John Wiley will release Bonds Are Not Forever; The Crisis Facing Fixed Income Investors. Some might say that one book is enough for anybody to write, but I must confess the experience following release of The Hedge Fund Mirage in late 2011 was sufficiently positive that I decided to indulge my audience’s patience once more. Recent sales and media coverage related to The Hedge Fund Mirage have no doubt been supported by continued mediocre hedge fund returns delivered at great expense. The industry remains a soft target.


Bonds are harder to criticize. For one thing, bond investors really have done well for a very long time. There is no “Bond Mirage” to be written. Bill Gross may have had a hand in more wealth creation for clients than anybody. However, as comfortable as it is to invest in what’s been working well, the math of current yields represents a substantial constraint on anything like past performance repeating itself.

The most important step to getting a book published is a business plan which should include an assessment of other books on the topic. Although ruinously low interest rates are a topic on which millions of savers can quickly commiserate, Amazon’s offerings of bond books are heavily biased towards telling you how to buy bonds and which ones. The view that fixed income deserves a radically small portion of an investor’s assets is not one that has many proponents. As with hedge funds, much of the continuing support for owning bonds comes from those with a self-interest to maintain. In the last few months we have come across some extraordinarily poor advice.

One large firm acknowledged the poor return prospects in fixed income but still valued their diversification qualities (i.e. they’ll lose money when your other investments are profitable, which is supposed to be helpful). Another published a chart showing the uncannily strong relationship between the yield on ten year treasuries and the subsequent ten year holding period return (yes, really!). The author of that particular insight probably also marvels at just how reliably bond yields rise when prices fall (and vice-versa). Whether fixed income returns after taxes and inflation are modestly negative (the most likely outcome) or worse, the originators of the insights listed above will work hard to present the results to clients positively. They’ll need to avoid numbers though, because that’s unlikely to help. Adjectives such as “decent”, “acceptable under the circumstances” or “OK” will be favored over more measurable assessments.

One friend showed us a taxable trust for which she’s the beneficiary that retains a substantial fixed income holding yielding 1.5% — coincidentally the same as the management fee charged by the trust company (pun intended). The U.S. Treasury and managers of the trust are both doing well out of this arrangement, although unfortunately my friend is not.

While there’s plenty wrong with low interest rates, the approximately thirty year bull market in bonds has coincided with two other evolutionary shifts. One is that debt outstanding has, by any measure, soared to levels that until recent years would have been believed unsustainable. When other significant public obligations such as Medicare and unfunded public pensions are included along with consumer debt we collectively owe more than twice the size of the U.S. economy. The second is the steady growth in financial services, including securities trading, money management and banking of all kinds. Since the peak in inflation in the early 1980s we have a substantially bigger banking sector and far more debt, but approximately unchanged median per capita GDP. In short, there’s not a lot to show for all this borrowed money and frantic trading.

How this all resolves itself is unclear, but the Federal Reserve sees ultra-low interest rates as part of the solution. Indeed there is so much debt and so many borrowers that providing a return above inflation would seem to be against the public interest, a needless waste of money. To the extent that the Fed, and by extension the U.S. government, can control it they’re likely to side with borrowers over lenders and maintain low rates. The evidence so far is that they can pursue such a strategy indefinitely. Inflation is a time-honored solution to excessive debt. Combined with financial repression, a regime of rates maintained artificially low, this can allow debt to be repaid at a negative real cost. Whether rates and inflation move up together or remain low together, yields below inflation plus taxes appear inevitable.

The growth in financial services supported the growth in debt, through financial engineering that sliced up obligations to meet every conceivable investor’s taste. Markets developed for derivatives of all kinds from interest rate to credit risk and complexity combined with leverage in a profitable waltz until the music stopped in 2008. Although the benefits of this bigger financial sector are hard to identify in the rest of the economy, banks were hardly to blame for the financial crisis. Government policies that subsidized debt and promoted overinvestment in housing were a significant factor. However, the aftermath which included the TARP program created a popular perception that Wall Street nearly blew up Main Street.

The public policy response against banking is well under way, justified by the imperative of avoiding a repeat. Under such circumstances it’s hard to imagine a return to the pre-2008 interest rate regimes that generally provided reasonable returns to lenders. A “better bargain for the middle class” for which President Obama recently called, probably excludes interest rates high enough to compensate lenders for inflation and taxes. Bonds Are Not Forever does not take political sides. Saving for the future transcends politics, and both blue and red investors need to coolly assess the populist shift in Washington’s policy response to banking.

The question facing bond investors is, how to respond to this steady transfer of real wealth from savers to borrowers. Three central banks (U.S. China and Japan) own almost $6 trillion of U.S. government debt and they remain significant buyers. In addition, by maintaining short term rates at virtually 0% the Fed keeps additional downward pressure on longer term rates. Their motivation is not commercial, but low benchmark rates tug most other rates down, limiting the opportunities for a commercially driven bond investor.Equity Risk Premium August 2013

Hence, the radical advice to abandon the bond market as irretrievably distorted by government activity. If the Fed wants to own bonds so badly, let them own the lot! Take your ball and go elsewhere, to a place where the rules of private sector supply and demand still operate. The Equity Risk Premium, often reproduced on this blog, is a simple visual explanation of our bond-free investment philosophy at SL Advisors as well as the inspiration for the book. Bond yields are highly unattractive compared with the earnings yield on equities. The odds of bonds beating stocks over the long run are extremely poor. Meanwhile, the need for stable investment income is as strong as ever. Bonds Are Not Forever explains why investors should have low expectations for fixed income returns, and SL Advisors runs strategies designed to meet the need for stable investment income without using fixed income. Quite simply, the book explains the philosophy behind our investment business but also seeks to entertain the reader along the way. Clients of SL Advisors can expect to receive their autographed copy within a few weeks.

Posted by: Simon Lack | July 29, 2013

U.S. Equity Returns Lead The Way

Outside of managing SL Advisors and writing books I chair two investment committees for local non-profit organizations. In reviewing returns for the first half of 2013 for one of them I was surprised at how U.S.- centric investment returns have been this year. Our benchmark is 50% Developed Market Equities, 20% Emerging Market Equities, 20% Fixed income and 10% Cash or “Other” (if we have an inspired idea that doesn’t fit the other three). Sitting here focused on U.S. stocks which is what we do every day, it feels like a banner year. So the 4.1% return on our benchmark was weaker than I expected. The 14.3% return in U.S. stocks (Russell 3000) was substantially offset by the MSCI Emerging Equities Index (down 12%) and the Barclays Aggregate Bond Index (down 2.5%). Our allocation is appropriate for a long-lived investment portfolio, but it illustrates some of the pitfalls in conventional wisdom. In our own business we don’t invest in fixed income because the entire bond market has been distorted by the Fed’s Quantitative Easing. My upcoming book Bonds Are Not Forever; The Crisis Facing Fixed Income Investors explains why. Shunning bonds entirely is quite radical and was outside the remit for this endowment, although we’re at the lowest level permissible under its mandate. No bonds at all would have been better.

The conventional wisdom of owning emerging market equities has always struck us as poorly conceived. No doubt emerging markets are where the GDP growth is, but it doesn’t follow that high equity returns will follow. In addition, there are significant challenges in selecting securities in countries where U.S. corporate governance, shareholder rights and accounting standards rarely prevail. Once in New Delhi, I asked a senior regulator how many insider trading cases are typically prosecuted each year. “Oh, none. There is no insider trading in India” was his breezy if not very reassuring reply. Or put another way, if you’re going to invest in India you might want to align yourself with someone who embraces local customs.

U.S. multinationals also understand that growth in markets is in developing countries. Why not let Coca Cola (KO), Procter and Gamble (PG) or Mondelez (MDLZ) decide how much capital to allocate to each opportunity? Receive the returns on these companies’ emerging markets activities through the relative security of U.S. reporting standards. That’s always seemed to us a preferable way to invest globally – through companies that are themselves global. So far in 2013, it’s looking like the right approach.

Posted by: Simon Lack | July 29, 2013

The Unsteady States of America

The Economist has informative coverage of the developing public pension crisis using Detroit’s bankruptcy filing as an illustration. It’s well worth reading. The issue is not going away.

Posted by: Simon Lack | July 23, 2013

Working With God’s Aluminum

A couple of years ago Goldman Sachs’ CEO Lloyd Blankfein was on TV almost every day promoting the good his company does for the economy. One of his less fortunate phrases in his otherwise highly articulate defense of his firm was that Goldman was “…doing God’s work.” I imagine he meant Goldman was engaged in doing things of which they could be proud rather than running a charitable enterprise, but it was an expression that stuck, such is life in today’s soundbite world.

Banks are fundamentally about aiding capital formation. This includes directing savers to sound investments that will preserve the purchasing power of their capital, and helping companies fund themselves with appropriate amounts of debt and equity capital. All of the trading, wheeling and dealing, M&A activity and fee generation ultimately comes down to the business of moving capital efficiently from those who possess it to those who can use it more profitably.

Given this calling, it is no doubt with some discomfort that on Saturday Mr. Blankfein and his colleagues confronted a New York Times article that described how their ownership of aluminum warehouses in Michigan was adding to the cost of anything that uses aluminum (which includes everything from soda to airplanes). When highly sophisticated managers of capital take on the business of holding inventory of raw materials, their natural inclination towards exploiting any arbitrage results in huge aluminum ingots being shuffled around the warehouse with no apparent purpose beyond increasing their cost to the buyer. For reasons not entirely clear, holding aluminum in a series of warehouses can be more profitable than delivering it, since longer storage time adds to the price paid by the buyer and therefore, ultimately, the consumer.

There’s still too many bankers, and maybe banks, who just don’t get it. The long, steady growth in financial services that began in the early 1980s and culminated with the Crash of 2008 brought with it a great deal of unnecessary trading and arbitrage that didn’t support the basic business of capital formation (see paragraph #2, above). The reasons for the financial crisis are varied and substantial blame lies with regulatory failures (poor oversight of mortgage lending) and poor public policy (over-investment in housing). But banks weren’t totally blameless, and the type of story highlighted above is just why Main Street thinks so little of Wall Street.

Where’s the judgment at that company, for someone to wonder whether managing an aluminum ingot warehouse so as to extract additional profit from just about everybody else was what banks are for?

In my upcoming book, Bonds Are Not Forever: The Crisis Facing Fixed Income Investors, I link the growth in financial services with the growth in debt and pose the question, is more banking really good for the rest of the economy? Goldman Sachs is certainly not all bad, but in this one vignette they have tossed a little more ammunition to those who believe that when it comes to Wall Street less is certainly more.

Posted by: Simon Lack | July 17, 2013

Discussing Bonds Are Not Forever on Bloomberg TV

Posted by: Simon Lack | July 11, 2013

Bloomberg Businessweek Offers a View on Hedge Funds

Bloomberg Businessweek, July 2013

Simon Lack, December 2011

Obviously, I was too kind. What does the hedge fund industry’s chief lobbying group AIMA (Alternative Investment Managers Association) have to say?

Posted by: Simon Lack | July 10, 2013

Where Next for Interest Rates?

Fixed income managers have recently had to practice a rarely used skill; explaining poor investment performance to their clients. Bonds have been a great investment for a long time, but Fed Chairman Bernanke’s press conference last month has at least introduced two-way risk into the market. Quite possibly, he heralded the end of the secular bull market in bonds, a run that has lasted with few interruptions for over thirty years. Certainly the past few weeks have not been much fun for bond investors. If a generational low in U.S. interest rates really has taken place and bond yields are about to move irregularly higher, it will be a drawn out process. Bond managers will need to find variations on the theme that holding an asset that loses you money is a good idea because it’s uncorrelated with your other assets. After a few quarters it may become a rather tedious discussion.

By fortunate coincidence, my new book Bonds are Not Forever; The Crisis Facing Fixed Income Investors looks as if it will be coming out at a time when falling bond prices are on the minds of many investors. Few books currently advise on the dangers in bond investing. No doubt there will be more. The finished manuscript went in to publisher John Wiley this week. Reaching the goal line partially explains my relatively few recent blog postings.

The Eurodollar futures curve offers quite precise market forecasts of interest rates. You can compare them with the FOMC’s own forecasts on their website. The consensus among FOMC members is that they’ll begin raising short term rates in 2015. Eurodollar futures currently price in 53 bps between September 2015 and March 2016, or about two 25 bps tightenings over two quarters. Such a measured pace is probably a neutral forecast right now, which is to say that the futures market and the FOMC are in reasonable agreement on the near term path for short term rates. That’s about as close as you can get to saying bonds are fairly valued. They’re certainly not a good investment at current yields, but the market has largely removed the expectation of a more benign monetary regime than that forecast by the FOMC itself.

Posted by: Simon Lack | June 21, 2013

Bonds Still Aren’t Cheap

It’s a long time since we had a bear market in bonds. Some may remember 1994, when Greenspan shocked the market from its complacency with a series of hikes in the Fed Funds rate. Events culminated that year with the bankruptcy of Orange County due to ill-advised bets on continued low rates by its treasurer Robert Citron. Or 1987, when a weak US$ and rising trade deficit led to rising bond yields and ultimately a stock market crash. The economy barely reacted to the turmoil on Wall Street and continued its expansion.

The problem today for bond investors is that, although the value in bonds is somewhat better with higher yields, they’re still not remotely cheap. The FOMC tells you on their website that the equilibrium Fed Funds rate is 4%. They don’t tell you when we’ll get to that level, but a clear consensus of FOMC members expects to begin raising the Fed Funds rate by 2015, two years from now. Even a measured pace of 0.25% per quarter would get short term rates to 4% by 2018. On that basis, a ten year treasury note yielding 2.4%, albeit 0.80% or so better for investors than a few months ago, doesn’t exactly represent compelling value. Personally, I think ten year notes would need to yield 4%, or 2% over inflation, before they’d even be worth considering. The same applies to corporate bonds adjusted up by an appropriate credit spread. The realization that the Fed will, in the foreseeable future, curtail their support of bond prices reveals how little true value they offer once the biggest buyer modifies its interest.

Based on what the FOMC discloses publicly about their rate forecasts – and their forecasts are more important than yours or mine since they can make them happen – I imagine Ben Bernanke must not think bonds represent a particularly good investment for anyone who’s a commercially driven investor. In other words, unless you’re a central bank looking to influence rates or park large reserves somewhere safe, don’t do what I’m doing.

In spite of the equity market’s poor reaction, it’s worth considering that the FOMC’s latest move (or signaled move, since they haven’t actually curtailed their $85 billion a month in purchases) may be well judged. So far since 2008 you’d have to give them credit for pursuing unconventional means boldly. Inflation remains low and economic growth remains positive although unemployment is still high. The Bernanke haters who own gold and gold-related investments on the dubious grounds that some greater fool exists to pay a higher price for a fairly useless, heavy, non-income generating mineral have done even worse than bond investors. As the Irish builder in Fawlty Towers sagely noted to Basil following a botched job, “There’s always someone worse off than yourself, Mr. Fawlty.” To which Fawlty replied, “Well I’d like to meet him then. I could do with a laugh.” So Mr. Bond Buyer, cast your gaze on the Gold Bugs and cheer up.

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