Friday, August 27, 2010

Just how low will credit ratings agencies go?

Credit ratings agencies are a protection racket. Issuers have to get a rating and at the same time, they have to pay the rating agency for it. If they don't pay then their rating will suffer, and this will cost the issuer.

Now the ratings agencies are worried about potential liability if they are wrong about their ratings. So they have added clauses to their ratings contracts requiring that the debt issuer indemnify them if they are sued. The self evident blog presents a couple of examples of this.

It would be one thing if the issuers had a choice about whether or not they could get a rating, but they don't. They have to participate in the protection racket. But now the local thugs are wanting the victims to pay their court costs as well.

There is a better way. One in which ratings are paid for by the bond buyer and where ratings firms don't have monopolies and are liable for their mistakes. Essentially a free market for ratings.

Perpetual Bonds

A nice piece today from one of my favorite Finance bloggers, Felix Salmon. Felix talks about perpetual TIPs and whether the government should issue them. Perpetual TIPs would be inflation linked bonds that never mature. Sort of like inflation linked preferred stock. The example given is for a bond paying an annual coupon of $120 in a world of 2% inflation and 2% real return.

The nominal return (from the Fisher equation) would be (1.02)(1.02)-1 = 4.04%

We could value the perp TIP in two ways.
First treat it like a growing perpetuity (that grows at the rate of inflation):

Price = cpn(1+i)/(R-i)
where i=inflation, and R=nominal rate. In this case the price would be:
6000 = 120(1.02)/(0.0404-0.02)

Alternatively we could value it in real terms and ignore inflation because inflation affects both the growth rate of the cash flow and appears in the nominal discount rate:

Price = cpn/r
where r = real rate of interest.
6000 = 120/0.02 = 6000.

The problem with a perp TIP though is that the duration (sensitivity to interest rate movements would be quite high. A 100 b.p. increase in the real rate would cause you to loose 1/3 of the value of the TIPs.

From a retirement point of view, I think Duration matched TIPS portfolios make more sense. This is an idea promoted by Zvi Bodie and apparently implemented at Boston U. With those I could buy a portfolio of TIPs that would be immune to interest changes provided I held them for the correct holding period.

Monday, August 23, 2010

Is there really a mutual fund outflow?

Felix Salmon gets to the bottom of the Mutual Fund outflow statistics which caused quite an uproar today. There was even a story on Public Radio's marketplace tonight about the $33 bn that apparently has been pulled from equity funds.

The truth, as Felix nicely points out is that while there has been an outflow from domestic equities, the overall flow into world wide equities as a whole is still positive.

Overall, mutual fund flows are pretty much flat this year.

Small Investors Flee Stock Market

Small investors are pulling money out of stock mutual funds and parking it in bonds.

Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year, according to the Investment Company Institute,

As Warren Buffet once said, "be greedy when others are fearful" (or something like that).

HT: Craig Newmark.

Friday, August 13, 2010

More on the negative TIPs yield

The self evident blog argues that the negative TIPs yield is a rational response to the volatility in the "traditional" inflation hedge markets such as gold and real estate. In other words, investors are accepting no real return in return for stability, something which can't be found anywhere else.

The great one liner...

In short, the negative TIPS yield is a rational reaction to the lunatic casino that has infested essentially every market in the world.

Wednesday, August 11, 2010

Uh Oh. Negative real TIPs yields...

Felix Salmon talks today about negative real TIPs yields.

What does this mean? Well basically investors are happy to park money in TIPs just to keep pace with inflation. They are not actually earning a real return.
Why would investors do this? Perhaps there aren't any better places to put cash right now.

So overall this probably isn't the greatest news...

Wednesday, August 4, 2010

Money Illusion and a new blog added

With the fall semester rapidly approaching, it's time to get back into blogging.

The Finance Professor blog posted a link on Money Illusion from the Psy-Fi blog. The Psy-Fi blog is new to me, but looks pretty interesting - with a focus on behavioral finance.

Money Illusion, as I've discussed before, is the act of failing to incorporate inflation into financial decisions. Research (including some of my own) has shown that money illusion affects stock prices and house prices. Despite the phenomenon being well documented, new cases of money illusion are always cropping up.