Junk Bonds, The American Perspective on the Economy & Facebook Currency

We kick this week off with another crazy “this is reality now” article from The Wall Street Journal entitled “U.S. Junk Bonds With Negative Yields? Yes, Kind of.”


US Junk Bonds with Negative Yields? Yes, Kind Of

In today’s topsy-turvy markets, some investors are buying junk-rated corporate bonds that could lose them money even if their prices don’t decline...

This article resonated with me as I spend a lot of time looking for potential fixed income (bond) investments and have noticed an increase in this phenomenon over the last few months.

As of yet, the U.S. has managed to avoid negative interest rates in both government and corporate bonds. However, as the article points out, investors are lending to companies in situations where they can lose money if the bonds are called at a certain point in the bond’s life cycle.

I’ve noticed that some of the highest yielding short term junk bonds available, say a 5% yield to maturity for three years, also carry a negative yield to call. This means investors are knowingly risking a loss of principal for the hope of making 5% per annum on already risky debt. Crazy days in bond-land!

From there we move to an article/infographic from The Economist entitled “Americans are souring on the economy.”

Americans Souring on the Economy.png

In short, the percentage of Americans who think the economy is getting worse, not better, is at an all-time high for the Trump presidency.

Apart from the obvious political ramifications of this data, the perception of the economy’s health by the layperson is likely as important as its actual health (we talked about this “reflexivity” in a previous Beach Reading). As the media has trumpeted ad nauseam in the last few months, the U.S. consumer is the primary driver of economic growth at the moment. Should consumer confidence fade, they may tighten their wallets which would likely lead to a slowdown.

I would bet that the majority of this downturn in confidence is tariff-related. That’s good news because the tariffs could go away tomorrow with a tweet. I'm not sure just how much attention the average American is paying to the trade war, but I do think there's a widespread understanding that tariffs are a (hopefully temporary) drag on the economy. One could argue that the Trump administration’s biggest achievement has been to reignite economic and business confidence, which is apparently a fragile balancing act.

We finish this week with a look at Facebook’s proposed cryptocurrency, Libra. As Fed Chairman Jay Powell recently said, “It could be systemically important right away.”

We’ve watched the rise of cryptocurrencies like Bitcoin with a passing interest. We believe that, as Stan Druckenmiller recently said, Bitcoin is “a solution in search of a problem.” After all, most Americans don’t really suffer from a lack of effective payment options. Certain retailers might be sick of paying credit card fees to the big processing companies, but for the most part the system works well enough that most of us don’t pay any attention to it.

However, we DO see huge potential in the space within emerging market countries. I recently spoke with a Venezuelan friend who sends money home to his father weekly. He said his most recent transfer lost 50% of its value in the few days it took to reach his father’s hands due to the country’s hyperinflation and transfer fees! If that number is anywhere close to correct, any viable alternative would certainly be better. But Bitcoin’s own price instability and the difficulty of actually transacting in it (not just making transfers but payments themselves) renders it an imperfect substitute at best.

Enter Facebook Libra, which has rightfully been scrutinized by lawmakers. If successfully implemented, this “stablecoin,” which is based on the value of existing currencies, could enable people to make virtually free payments and remittances across international boundaries. If you’re like me this won’t change your life. But if you’re one of the tens or hundreds of millions of migrants who send money home to family regularly, this system could save thousands of dollars currently absorbed by companies like Western Union. It would also keep Facebook’s users glued to their ecosystem.

It will be interesting to see if this train leaves the station. If it does, there will be major financial ramifications and cement Facebook, for better or worse, as one of the most important institutions in the world.

LEI, Berkshire Hathaway & John Deere

We start this week with two quick follow-ups to previous Beach Readings.

A client asked us to elaborate on how one would use the Leading Economic Index (LEI), which we discussed last week, in trying to predict a recession. Below is a different version of the LEI chart which I pulled directly from The Conference Board’s website this week. The LEI is in blue, which was the only index featured in last week’s chart, alongside the Coincident Economic Index (CEI) in red and recessions highlighted in the gray shaded areas.

Screen Shot 2019-09-03 at 3.21.08 PM.png

As you can see, the CEI tends to flatline and then turn down concurrently with the onset of a recession which, in isolation, is not a particularly useful indicator. But when the LEI (which gives plenty of fair warning) is declining precipitously through a “topping” or flatlining CEI, history would suggest the odds of a recession in the near future are high. In other words, tracking the relationship between leading and coincident indicators is likely the most reliable predictor of economic downturns. Together, these indicators are still reflecting positive economic growth but we will stay tuned and follow up as future data is released.

From there we move to one last follow up chart from Beach Reading three weeks ago. We mentioned then that Berkshire Hathaway is “close to the valuation level (~1.2x book value) at which Buffett has said that he would buy back almost limitless amounts of Berkshire stock which should support the share price going forward.” Someone asked what book value was and why it is important in the context of this investment.

In short, book value is the net worth of a company. And while Berkshire is moving away from book value as the main methodology for valuing the company (explaining why would require far more digital ink so we’ll leave that for another day!) it's still a decent metric for tracking what you’re getting vs. what you’re paying for it. We think Berkshire’s intrinsic value is likely between 1.5x and 2x book value. Below is a snapshot of Berkshire’s 5 year historical Price to Book ratio taken on Tuesday of this week.

Screen Shot 2019-09-03 at 9.36.09 AM.png

You can see from the chart above that the stock tends to trade at a decent premium to book value. In the last five years the valuation has ranged between just under 1.2x book value to over 1.55x book value. Keep in mind this isn’t a price chart, but rather a valuation chart. So even though the stock is up substantially over the last five years, at ~1.28x book value it’s actually one of the most opportune times to own the stock in the last half-decade from a valuation perspective. Good news for shareholders!

We finish this week by diving into the wild world of corporate credit with a WSJ article entitled “Deere Sells 30-Year Corporate Bonds at Record Low Yields.


Deere Sells 30-Year Corporate Bonds at RecordLow Yields

Deere DE +0.15% & Co. sold 30-year bonds at a record low yield for U.S. corporate debt of that maturity on Tuesday, seizing on tumbling U.S. Treasury yields to lock in favorable interest rates...

John Deere just borrowed money for 30 years at 2.877% interest per year, a record low yield. It’s yet another example of how low bond yields are and how desperate some investors are for what they perceive as safe income. Disney, Apple and others are following suit by borrowing money they have no real need for simply because they can at such low rates. From their perspective, this makes perfect sense; borrow cheaply and invest in the future (or buy back stock). It’s also unequivocally positive for American businesses that such cheap long term funding is available to them in public markets.

But from the creditor’s perspective, we can’t see the logic in loaning money out (even to great companies who will almost certainly repay the debts) at levels barely above today’s already low inflation rates. Keep in mind that the 30 year Treasury, which is backed by the U.S. Government (which can print infinite amounts of money) yielded MORE than 2.9% as recently as May of this year! And while the 30 year Treasury yield dropped below 2% recently, who’s to say yields will always (or at least for the next few decades) be this low?

This may be a bold prediction, but at some point in the next 30 years, the folks lending to a company (that cannot print their own money) at 2.877% may wish they’d passed on that offer. If the 30 year Treasury yield merely returns to its May 2019 levels, these John Deere bondholders will be sitting on substantial face value losses. The best-case scenario is making less than 3% and the worst case is losing substantially more than that. The risk/reward seems highly skewed towards the risk side of the equation from our perspective. For this reason, we continue to eschew new investment-grade bond purchases in most cases.

Economic Confidence

There’s a lot happening in markets so let’s jump right in! (Friendly reminder that some articles may be behind paywalls.)

We start this week with an article from The Economist entitled “The onset of a downturn is as much a matter of mood as of money.” The article is the best I’ve read this year on the relationship between the economy, confidence and markets.

Below is an anecdotal example of the fragile nature of economic confidence.

A friend from college (Go Gators!) visited over the weekend on his way to Atlanta, where he’s moving for a few years to finish a PhD. He’s a very intelligent person but has never expressed any interest in economics or financial markets. I asked if he was going to buy a house in Atlanta and was taken aback when he said “Aren’t we going into a recession soon? Wouldn’t that be a bad idea right now?”