Friday, October 16, 2015

The Muni King of New Mexico

I just finished writing a short blog piece trying to untangle the inverse relationship between bond values and interest rates. While marshaling my thoughts, I remembered a day many years ago when I got my first lessons on municipal finance, yields, and how the game is played.

My financial career started at the Merrill Lynch branch in Santa Fe, New Mexico. On my second day at work (February 19th 1985 -- I looked it up) my boss called me into his office and said he needed me to run over to the state capital building and put in Merrill's syndicate bid for a municipal bond underwriting.

He handed me an envelope containing; instructions, a delivery receipt in case we won the deal and a check for $5 million payable to the State of New Mexico. I'm sure I either stared or blinked for a couple seconds and then he told me process. I touched the envelope in my suit pocket a dozen times during the one mile trip to the state house.

At the time, my wife was a municipal bond analyst so at least I knew what munis were -- but two days into my illustrious career, that was about all I knew about the securities business. Six or seven well dressed men (including me) were shown into the governor's office and given a single sheet of paper listing ten general obligation series bonds with differing amounts, coupons and maturity dates.

We all scattered to various pay phones we'd scouted earlier that morning (no cell phones back then) and called our underwriting desks. I gave my contact the bonds he had to price then waited a few minutes while they did the calculations. He got back on phone and gave me the yield-to-maturity and bid price for each issue and, most important, a weighted total for the whole enchilada. I think it came to $56 million and change -- which was a big deal for a small, solvent state.

What the underwriter had done, I would learn a month later in training, was calculate what we and our partners thought we could sell those bonds for after various markups in the sales food-chain.

This was a competitive bid. The state already had their ducks in a row -- credit rating, maturities, amounts, coupons and a half-inch red-herring prospectus. All they wanted was the highest dollar amount. You never see the other bids but this could have been decided by a hundredth of a percent.

All of the bidders were back inside our half hour deadline and we presented our envelopes to an aide. In addition to my meteoric rise in high-finance, I got to meet Governor Toney Anaya. Until then, the highest political figure I knew was the mayor of my former town -- who was also the catcher on my softball team.

The governor and several financial staffers opened the bids exactly on the hour and sorted through the bids. Then one of them asked me to come over to the desk and thanked the other bidders. We'd won! Governor Anaya shook my hand and said thank you and I handed him the good-faith check. Years of manners training kicked in and I managed to thank him for his trust. He gave the check to an aid who signed the receipt and I was on my way back to the office five minutes later. The underwriting desk would handle the rest.

I walked straight into my bosses office and told him the news. He was all smiles and congratulated me on a job well done. I found out later that Merrill hadn't won a New Mexico bid in years so this was rare. I think it was the only deal we won in the 15 years I worked there.

The office didn't get a piece of the underwriting fees but the brokers knew there would be quality local inventory soon -- and that we'd be the only ones in town who had it. Plus we knew the size of the deal and the maturities so people could line-up their call list for when those bonds hit the street. Not that we knew how many we would get. As the lead, Merrill would get more than anybody else but the other syndicate partners, all big names on Wall Street, would get their share. And everybody's institutional desk would get their fill before the branch offices got a sniff.

I must have been a little full of myself because one of the old hands chuckled and asked how much I made on the deal. Well, I got the same couple hours training pay I would have gotten if I'd studied for my securities exam -- so Skip wasn't buying drinks at the Palace that night.

It didn't matter. For that day, I was the Muni King of New Mexico!

Skip and his wife Nancy in 1985

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

Municipal bonds are subject to availability and change in price. They are subect to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply.

Tuesday, October 13, 2015

Good, Bad, or Unfathomable

Most of my short-term market indicators have gone green (positive) on US stocks. The medium-term indicators are still underwater since they have to overcome the sharp sell-off in August to regain their momentum. Long-term indicators have been bullish since 2011.

As long as the long-term indicators stay green, such market-timing as I ever attempt is limited to trying to find the strongest industries and right-sized companies within strong markets.

I’ve been calling clients this week to commit cash reserves. Conversations after a correction always bring out their political concerns. That’s when I explain that markets and politics almost never correlate. A country’s economic system (capitalist, socialist, communist, kleptocracy) matters – but guessing what politicians will do is a hard way to make money.

Barry Ritholtz (money manager, Bloomberg columnist and interesting man) has a funny story that says it well. He said when George W. Bush brought his tax-cuts forward in 2001 and 2003, his liberal friends said it would blow-up the deficit and sold their stocks. Stocks went up almost 100%.

When Barack Obama was elected, his conservative friends were sure this Kenyan socialist would destroy the economy and sold their stocks. Stocks went up almost 200%.

Long-story short – a stock only goes up for one reason: more people want to buy it than sell it. Good, bad or unfathomable, those people are entitled to their opinions. We’re more concerned about what they do than why they do it. sh

The opinions expressed here are those of Skip Helms and do not necessarily reflect those of LPL Financial or anyone else. Investing involves risks, including the loss of principal. Past performance does not guarantee future results. Please consider potential transactions carefully and read all appropriate materials before investing or sending money. Securities offered through LPL Financial, Member FINRA/SIPC

International investing involves special risks such as currency fluctuations and political instability and may not be suitable for all investors.

All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.

Friday, October 9, 2015

A Question on Bonds and Rates

Hello Mr. Helms,

On your podcast you said that bonds lose money when interest rates rise. I thought bonds always paid the same interest. How does that change?

You're right about the interest. The vast majority of bonds pay a fixed cash-flow during their life and return a fixed amount at maturity. Since those two things don't change, the only way markets can react to supply and demand for those payments is the price of the bond itself.

I've never done a good job explaining this. Rates and prices work inversely. It's like trying to cut your hair in the mirror.

But I've got a good example that seems to work:

Let's say you loan me $1,000. I agree to pay the owner $50 a year for the next 10 years and return the principal with the last payment -- basically a 10-year 5% bond.

A year later, you need to sell your bond. Unfortunately, the going rate for 9-year bonds has gone from $50 a year (5%) to $100 a year (10%). Nobody is going to pay you $1,000 for your bond when they can get twice the income for the same investment.

If you want to sell, you'll have to discount the price until the combination of the profit the new buyer makes in 9 years -- plus my $50 a year -- equals a 10% return. In the business that's called yield-to-maturity. Some of it is interest. Some is the gain (or loss) at payoff.

With a bond-price calculator I entered $50 a year for 9 years with $1,000 at the end at a yield-to-maturity of 10% and got a price of $712 for your bond. If rates had gone down, you could expect a profit instead.

And it isn't just your bond. Bonds are priced constantly in world markets whether they are for sale or not. That's why the values can change on your statement even with no activity.

As a rule, the longer an owner has to wait for his principal, the wider the price fluctuations because of market uncertainty. Lower-quality bonds usually fluctuate more than high-quality bonds for the same reason.

So the best answer to your question is that yields rise because bond prices fall. The new owner's increased yield comes from the old owner's wallet.

I used an extreme example to show the process. Rates doubling in a single year would be a disaster for the bond market and probably every other financial market in the bargain. Right now rates are historically low but don't appear to be in any hurry to go up either.

And advisors can't legally borrow money from clients. -SH

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.