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Author: susan400 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 213620  
Subject: bond risk to OIns industry- comments? Date: 2/18/2013 9:26 PM
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Greetings- This is more a insurance sector topic but the BRK board is always lively so I present this theory here. The “long bond” was 14.4 in Sept 1981, CBT futures(8%coupon then), spot month traded 52. I had started a brokerage career just 3 years prior and this youngster had sold some A rated bonds to 70 yr old clients in 79, 15-18 yr maturities that were trading at 45. Today, the long bond is, 3.17, 15 yr high grade corporates, 4ish%. The now CME bond futures, (now 6% coupon derivred) 142.

A fact we all know, credit, fixed income has out performed most asset classes over 10 yrs and have done very well since the high in rates in 1981. Insurance company portfolio have benefited tremendously from appreciation, though reinvestment rates of course are down, down, a corundum and one IMO has to end badly, to some degree anyway.

I like a few Ins names and consider them core but recently saw a list of public ins equities with links to 2012 and Q4 results. Being easy to do a quick take re book growth, combined ratios etc, I looked at 25. I was hit, though I really like my few, there are many doing so well, and foolishly though for a moment, Gee, so many to own! Of course I know better and back to reality it quickly hit me, so much has been gained in fixed income ports in recent yrs, add in a better than avg underwriting year and OF COURSE most did very well.

Which quickly says to me, how much of Ins Co gains of say the last 5 yrs has been “excess” bond port gains, coupons have been earned, OK, but principle gains have some risk. Personally I think bonds are a bubble (I. en-mass public desperate buying-don’t buy darn stks, they go down ala 2008-09, etc II) zero% bank rates gradually pushes the masses out the curve III) it has paid in recent yrs, Hey do more!!, as rates plunged lower, lower. OK, the point, if (when in my book) the long bond goes to 5.5 and short rates 3.5, who would take the losses worst and how much book might be gonzo and might many sell under book as Ins becomes unpopular (OMG, they can lose$$!).

I think one, me anyway, needs to have some capital sitting at .25%, sitting awaiting for grand opportunities in select insurance companies.

Comments, please, other views, ideas re this topic?
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Author: EliasFardo Big red star, 1000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 198824 of 213620
Subject: Re: bond risk to OIns industry- comments? Date: 2/18/2013 11:31 PM
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I think one, me anyway, needs to have some capital sitting at .25%, sitting awaiting for grand opportunities in select insurance companies.

Comments, please, other views, ideas re this topic?


I agree completely, except I don’t know if I am necessarily holding my capital at .25% waiting for opportunities in insurance companies. I don’t know what companies will be the most attractive at that point.

I just can’t get away from the idea that interest rates must go up – at some point. I don’t know when or what will trigger it, but does anyone believe that these low rates are a permanent fixture?

Currently the Fed is financing a huge portion of the federal government’s borrowing. Can that go on forever? I can get real stubborn with this, but I just don’t see how we can continue to print money without consequences.

There was a post earlier on this board about hyperinflation. It does not need to be hyperinflation to be ruinous. Just 10% a year will do quite nicely.

I can also be real stubborn in thinking that we are in bubble territory in many assets. Certainly bonds. Probably farmland. Probably stocks. At some point prices get so high that people are going to decide that they are not receiving enough reward potential for the risk they are assuming.

Munger once described the two types of assets. One type are assets that deprive their value based upon their underlying economic utility. This would include stocks, bonds, real estate – things like that. Another type of assets are basically collectibles such as rare coins, rare stamps, art, and vintage automobiles. Their market value is based upon the expected price someone else will pay for them.

The Fed’s money printing press is distorting the market pricing on the first group of assets. They are being priced less on their underlying economic prospects ( is the economic value of a 30 year Treasury really 3 percent? ) and more and more like the assets in the second group. When economic assets are being priced not on their economics but on what someone else may pay for them it is called Greater Fool Investing.

So, yes, hold on to that .25% return and lose purchasing power every day. Many people like to think of themselves as contrarians. The most contrary position today is cash.

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Author: rationalwalk Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 198837 of 213620
Subject: Re: bond risk to OIns industry- comments? Date: 2/19/2013 10:23 AM
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There was a post earlier on this board about hyperinflation. It does not need to be hyperinflation to be ruinous. Just 10% a year will do quite nicely.

Even 7% is enormously destructive and introduces huge distortions. At that rate the price level nearly doubles every decade. For someone retiring today at age 65 who anticipated living to age 90, his fixed income pension (or long term bond portfolio) will have only roughly one quarter of its purchasing power by age 85 when he is likely to begin to require significant long term care.

Inflation is a tax except it is imposed by an unelected bureaucracy rather than elected representatives. It is also totally capricious in terms of its impact on various groups within society and it tends to hurt the middle class the most, particularly middle class retirees on fixed incomes.

The rich tend to own productive assets which will adjust in real terms along with inflation. The poor tend to rely on government transfers which usually have inflation adjustments. The middle class retiree on a fixed pension or annuity has no protection.

Since politicians do not have the guts to level with the American people regarding middle class taxes needing to go up if we truly want our current level of spending to persist, the Fed will carry the freight of imposing the capricious inflation tax in the decades ahead.

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Author: WendyBG Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 198856 of 213620
Subject: Re: bond risk to OIns industry- comments? Date: 2/19/2013 4:22 PM
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I gave you a rec because I think that you have put your finger on very important issues.

<Currently the Fed is financing a huge portion of the federal government’s borrowing. Can that go on forever?>

I would answer that question "No"...except that Japan has maintained ZIRP and high government borrowing since their real estate bubble popped in 1990. That's over 20 years.

The Federal Reserve is leveraged 55-to-1 with Treasuries and federal Agency debt (e.g. mortgage-backed securities), according to John Hussman. Even a small increase in interest rates will wipe out their equity, which gives the Fed a huge incentive to print money and keep interest rates low.

I agree with you that inflation will have to rise at some point. However, Japan has been struggling with deflation for 2 decades because their economy has been in recession for that entire time.

Similarly, the U.S. will have relatively low inflation as long as the economy is stagnant or in recession because monetary velocity is low - in fact, the lowest since 1957.

http://research.stlouisfed.org/fred2/series/M2V

As soon as velocity increases, the Federal Reserve will be caught between a rock (increasing inflation) and a hard place (trying to sell trillions of dollars of debt into a popping bubble).

When will real GDP grow faster than, say, 2.5%? Tell me that and I will answer all your questions -- but if you knew, you would answer them yourself :-). Recall that Japan has been stagnant for 20+ years.

< The most contrary position today is cash. >

Financial conditions (including the Shadow Banking System) are very loose.
http://research.stlouisfed.org/fred2/series/NFCI

Option-adjusted spreads are low. (See the Fed for spreads on all types of bonds.)

http://research.stlouisfed.org/fred2/series/BAMLC0A1CAAA
http://research.stlouisfed.org/fred2/series/BAMLH0A3HYC

Treasury real yields are very low.
https://www.dropbox.com/s/zuyabqgox359ace/Treasury%20Real%20...

The yield curve is so steep that a positive real Treasury yield is only available on 30 year bonds.

http://data.bls.gov/timeseries/CUUR0000SA0?output_view=pct_1...
http://www.bloomberg.com/markets/rates-bonds/government-bond...

The value of cash is declining at the rate of inflation, currently about 2% a year (if you believe the BLS) and 2.5% a year (if you believe the Treasury - TIPS spread).

Buying alternate investments (e.g. bonds) makes sense if the U.S. economy will stagnate for a long time so the bonds will hold their value. As soon as the economy begins to grow robustly, bonds will lose value. As you know, the longer the bond, the greater the capital loss when interest rates rise.

Whether the bonds are held by individual or institutional investors, portfolios will suffer as soon as the economy improves to the point that the bond bubble bursts. It would have burst long ago if not for the Federal Reserve -- $2.8 Trillion and growing.

http://research.stlouisfed.org/fred2/series/WSHOL

It is not contrarian to hold cash if the investor thinks that the risk-adjusted loss from inflation is less than the risk-adjusted capital loss from increasing interest rates (falling bond prices).

An investor who is not bullish enough to buy stocks due to high valuations...

http://www.hussmanfunds.com/wmc/wmc130218.htm

...is not necessarily being contrarian by holding cash instead of bonds. They may think (with good reason -- negative real yields and low spreads) that bonds are even more overpriced than stocks.

Wendy

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Author: ptheland Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 198928 of 213620
Subject: Re: bond risk to OIns industry- comments? Date: 2/20/2013 6:53 PM
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fixed income has out performed most asset classes over 10 yrs and have done very well since the high in rates in 1981.

Bingo. We are at the end of a 30+ year bull market in bonds. That's more than long enough for everyone to "know" that bonds are always a good, stable investment, throwing off a decent interest return with the occasional kicker of some growth if you bought at a discount to the face value.

I believe that bull market in bonds has come to an end. It HAS to have come to an end, as it has been driven by slowly but steadily falling interest rates. With real rates at zero (or even negative), there's nowhere left for rates to fall. If they can't fall further (and that might be a bit of an overstatement, as there is still a nominal percent or two left they could theoretically fall), they must then either remain steady or increase.

When - not if, but when - rates increase, bonds are going to get hammered. What happens to the value of a 30 year bond with a 3% coupon if (when) the yield required by investors rises to just 6%? It's down to less than 60% of it's face value. And at the 10% inflation mentioned up-thread, we're looking at a loss of over $6.5k for every $10k invested. That is simply huge and something that will likely never be recovered.

In comparison, that .25% from sitting in a bank savings account is looking positively stellar.

The other investing take-away is to only buy a bond you're willing to hold to maturity. At least you'll get your principal back. If the holder hasn't defaulted in the mean time.

--Peter

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Author: rationalwalk Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 198929 of 213620
Subject: Re: bond risk to OIns industry- comments? Date: 2/20/2013 7:07 PM
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What is even more scary is that plenty of individual investors do not even realize that bond prices decline when interest rates rise.

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Author: eurotrash01 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 198930 of 213620
Subject: Re: bond risk to OIns industry- comments? Date: 2/20/2013 8:43 PM
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What is even more scary is that plenty of individual investors do not even realize that bond prices decline when interest rates rise.

But what many bond bashers forget is that bonds eventually mature and shorten in duration over time and they ride down the positively-sloped yield curve. So a "bubble" in bonds may only lead to opportunity cost for a holder of individual bonds, not a capital loss.

Now of course an owner of long-dated STRIPS or a holder of a l/t bond fund with a fixed duration target is toast...and long-dated junky spread product is poison.

et

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Author: susan400 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 199028 of 213620
Subject: Re: bond risk to OIns industry- comments? Date: 2/23/2013 3:23 PM
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Peter- I don’t mean to pile on, but cash at .25 has strategic value, of course I have been saying that for 10 yrs after seeing Jim Grant’s quote. Have not been heavy in cash, but know too well, it isn’t as simple as today’s rate. Getting old here, in 1981, just 3 yrs into the brokerage field, XON’s div was 8%, t-bills 19% and 30 yr 14.4%.
It WAS HARD to buy a 30 yr, after it had been down 48% in just 3 yrs, but. Exxon, accept 8% over 19 in bills? A client smarted that I bought 1000 shs, 25K, I think div reinvested is about 900k today.

But are we asymmetrical vs Sept 19911

Elias – Not wishing to jinx you, I concur bur admit I have been thinking we are asymmetrical to Sept 1919 for 8 + yrs.

BTW Perma-GoldBugs always predict hyper inflation, maybe some day but have been wrong for 100 yrs.

One observation you both allude to, few remember a bond market, in the 70s only widows, or those over 75 knew what a bond was.

Today I know 60 yr olds who never owned an equity (too risky!) and feel very secure having not lived their neighbors ’08-‘9 nightmare, unable to fathom that ABC even “safe” short term bond fund, can lose 25% like ‘nuttin.

Thanks for the replies.
Susan400

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Author: susan400 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 199030 of 213620
Subject: Re: bond risk to OIns industry- comments? Date: 2/23/2013 3:32 PM
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Nothing anyone here wouldn't know but for someone i-rate conscious who doesn't qant 100% in equities, a laddr is a good route.
20% in 2 yr, 20% in 2yr and so on til 6.

As those bonds come due, see where things sit, if rates are up, equities may be cheaper, if 10 yr fixed income still isn't attractive, do a fresh 7 yr from taht point.
It means trying to NOT be a hero, reinvests over a timeline, because nobody KNOWS.

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