Obama’s proposal to restrict the proprietary trading business of investment banks has been fueled by public outrage of investment banks’ ability to make trades that straddle both sides of any market. Goldman Sach’s proprietary trading position in 2007 showed that while the firm was one of the top underwriters of structured loan products throughout the housing and credit boom, at the time of the market collapse they also had a short position in the very same type of paper they were originating. While acting as a principal or as an agent on a trade are separate business activities involving different degrees of risk mitigation and capital commitments, in the public and political eye, it creates many questions as to the legitimacy of allowing those business lines to operate under one roof.

Proprietary trading is when an investment bank’s traders actively buy and sell securities or other financial products for the benefit of the firm’s own account. This activity is sometimes done alongside clients, but can also be done independently. The internal “prop” desks often act similar to a hedge fund, employing strategies to capture market mispricing and arbitrage. Many investment banks also run separate hedge fund or private equity entities where they invest proprietary capital alongside their clients.

It appears both of these are the areas where the bullets from Washington are aimed.

Limiting internal hedge funds or proprietary trading business lines would certainly mitigate the risk that an investment bank is able to undertake, but does this really address the problems that were at heart of the 2008 financial crisis?

Taking risk and managing that risk is what trading is all about. As well, having two sides to every trade is necessary for efficient market liquidity. Whether a trader is consistently profitable or not defines how good they are at placing bets and managing the risk they take. I agree that there were too many risks in the credit and housing markets concentrated in too few places. The remarkable problem was not that these bets went sour or risk wasn’t managed well, but rather that there were minimal consequences to go along with those mismanaged bets. Indeed Bear Stearns and Lehman Brothers felt the consequences of their overleveraged bets, but what about AIG, Fannie Mae or even General Motors? In this writer’s opinion, AIG was one of the most flagrantly mismanaged institutions at the heart of the crisis and is consequently running one of the biggest bailout tabs. AIG was allowed to grow and expand the financial services portion of their business, which was not only outside of their core insurance business practice, but was unhedged, mismanaged, and contributed to the total demise of the company. Unlike all of the major investment banks who have already repaid their TARP loans, AIG’s tab to the government still stands at $180 billion, which is approximately $1100 per American taxpayer. Eliminating proprietary trading activity within the nation’s big banks does nothing to address the excessive risk taken elsewhere in financial services or other areas of the economy. I understand the public ire at policy and corporate failures which is driving the current political backlash, but much of it is misguided and won’t do anything to prevent future calamities.

The focus of any regulatory or reform efforts should not be in limiting specific business units, but rather in addressing the “too big to fail” conundrum. If there are implied guarantees that institutions are “too big to fail,” doesn’t that give organizations a much higher incentive to engage in risk-seeking activity? If the risk-taking pays off, the business will be highly profitable. If the risky business lines fail, the government will provide a low-cost backstop. Herein lies the heart of the problem. It’s not that banks are taking risk – that is the foundation of our capitalist and investment driven society. Offering loans or extending credit to individuals and/or corporations is inherently risky business (that consumers are currently begging for!!) and any capital provider should be appropriately compensated for taking credit risk. The problem is that with a governmental “too big to fail” backstop, there are no consequences for mismanaging or mispricing any economic risk that is taken. Running a diversified business mitigates a company’s overall risk profile and should lead to more stable earnings. Pulling away distinct business lines could have one the following consequences – either banks will contract capital committed to ancillary business units such as corporate or consumer lending because they can’t hedge these business lines, or they will seek out other market areas to take even larger risks in an attempt to make greater profits. As for the latter, as long as “too big to fail” is still in place, why wouldn’t you make even bigger bets if there aren’t any consequences?

2009 was a banner year for corporate bond returns.  As blown-out spreads contracted, investors didn’t have to do much to make money from either yield plays or rising prices.  High-yield bonds earned a staggering 58% total return for the year.  That won’t be true for 2010, however, but the year has begun with corporate bond issuance and investor appetite at record highs.

Treasury yields are staying low and investment-grade spreads continue to contract, so both sectors offer little yield incentive for investors.  As a result, investors are continuing to move further out the risk spectrum to pick up incremental yield.

Source: Moody’s
 
While traditional lending conditions remain constrained, companies are turning to the capital markets to tap into excess investor liquidity and falling risk premiums.  On a fundamental level, corporate free cash flow continues to improve which supports credit technicals.  As well, the threat of higher rates in the future is an incentive for issuers to tap the capital markets.  Most companies are still not spending on new capital investments, nor are they hiring new workers.  This gives them greater cash and balance sheet strength to service new debt commitments.  Of course, increased share buybacks or cash mergers could fundamentally change that picture as cash is reallocated.  Investors have been receptive corporate buyers and risk premiums continue to tighten. 

The boon of new issuance is not without problems, however.  High-yield issuers are still very highly leveraged and they are not using cash raised to improve balance sheet strength.  Most are restructuring existing debts and extending maturities, which in essence pushes out their obligations and increases debt service commitments without fundamentally improving their operating business.  At tighter spreads, investors are not getting as highly compensated for the downside risk.

Corporate spreads should continue to tighten in the near-term with lifting uncertainty and continued economic recovery.  While negative economic developments could derail the strength of corporate issuance, we are more likely to see this trend continue to pick-up for some time, especially as more traditional funding sources remain strained.

You may have already received many petitions from worthy organizations arranging rescue and relief efforts.  No doubt these platforms have their work cut out for them and can use all the help from donations they can get. 

There are other non-charitable ways to contribute as well and fixed income investors might be interested in these alternatives.  You may have already heard or read about “microfinance” or “socially responsible investing.”  Microfinance is a means of providing small dollar loans to the working poor in developing countries.  Organizations such as Kiva and MicroPlace enable microfinance enterprises in developing nations to receive funding through contributions from individual investors.  Typically, credit is unavailable in impoverished nations and the overhead cost of making small loans to those without any formal credit history is very high.  Microfinance organizations work on the ground to make business loans to the working poor, many of which are done within a community setting that encourages repayment through groups within a given society.  As a result, the default rate for most microfinance lending institutions is low and the impact is high.  Successful microfinance endeavors enable the working poor to raise their standard of living and begin to provide food and shelter for their families.

Where this discussion gets interesting to investors is in platforms that operate as for-profit entities.  MicroPlace is a social business owned by eBay that is working to alleviate global poverty.  It’s not a charitable organization, rather it allows individuals to make investments that help microfinance organizations fund loans to the working poor.  You can deploy your excess investment dollars and earn a financial return in the process, anywhere from 1-6% annually.  Investments are illiquid for the one to four year term and carry various degrees of credit risk, but in an environment of relatively low interest rates where charitable donations have been falling, this is an interesting alternative that allows you to make a social investment for a financial gain.

 
Work in Haiti

MicroPlace has a funding relationship with a Microfinance Enterprise in Haiti named Fonkoze and sells investment notes through a partnering fund to benefit this organization.  Fonkoze’s goal is to provide financial and educational resources to help eliminate extreme poverty in Haiti.  It seems like there is no better time than to bolster these efforts.  While assistance provided through this channel is not immediate, it is more sustainable than one time charitable grants.  Helping people help themselves is the most powerful way of creating better living conditions.  Doing so at a financial gain diminishes the opportunity cost for investors and ultimately helps others create a better life for themselves.  This particular note carries a 4.25 year term and pays investors 2.0% per year, which is in-line with comparable U.S. Treasury yields.  To learn more, visit: http://bit.ly/8o19U4.

Disclosure: At the time of writing, Adrienne Penake has no position in the security mentioned, but has other outstanding investments through MicroPlace.  Be advised that positions may change without further notice

Apparently, many Chinese banks make most of their lending decisions in the first half of the year. This year, many have moved to do so in the first few months of 2010, anticipating tighter lending restrictions later this year. The Chinese government wanted to contain that flurry of lending before it was issued.

This move raises the question of whether or not China’s economy is currently overvalued. The government is putting on the breaks with the following implications:

• The Chinese economy has gotten ahead of itself. Many months of robust capital has propped up a new asset bubble that the government is trying to reign in.

• Inflation is rapidly accelerating. That will lead to higher rates and difficulty maintaining their currency peg.

• China is experiencing a loose credit binge. Cheap money rates and high growth prospects have created an unsustainable environment.

The real question to answer is whether this is a preventative measure or if there is already an asset bubble caused by excessive financial leverage. While the next several months should help answer that question, there is no doubt that an unexpected tightening of the credit environment is a signal to the international community to beware of higher rates and a containment of growth expectations going forward.

The treasury market is rallying in reaction to the weaker report and the yield curve is steepening yet again with 2s/10s spread at 285 basis points, bringing us to the widest level in decades.

Also noteworthy is that the end of the dollar carry trade has not yet arrived. It’s looming, but any weaker than expected economic data will keep short rates down, long rates volatile, and contain the dollar’s recovery enough to keep traders engaged.

Amidst a steeper curve, there is still some room for corporate spreads to narrow in the short-term. The credit curve has tightened all year and overall, investors were richly rewarded for taking credit risk throughout 2009. Single-A industrial bonds averaged a spread of 133 bps to comparable treasuries in the 4th quarter, down from 373 bps a year earlier and Baa industrials narrowed to 215 bps in the 4th quarter from 545 bps a year prior. While I don’t foresee moves anywhere as dramatic in 2010, with a sustained environment of recovery (however muted) we should see corporate spreads continue to narrow in the next few months.

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First, it has been a year of recovery. Markets entered the year battered and bruised and there was a great degree of uncertainty surrounding the direction the economy was headed. We continued to sell off through the first quarter as bearish sentiment prevailed. We entered ’09 with the 10-year at 2.46, the 30-year at 2.83% and 2s/10s (a measure of steepness of the yield curve) at 158 basis points. The dollar index stood at $81.84 and we faced a 7.6% unemployment rate.

Next, the main liquidity provider over the course of the year has been the US government. Treasury bond issuance was high and grew and the Fed has been the main buyer of all mortgage debt in this country. Interestingly, over the course of the year, private capital has not taken over in these sectors. Instead, it has been allocated to the corporate markets – both bond and equities. Corporate bond spreads began ’09 around 500 bps for investment-grade issues and 1500 for high-yields, both of which have tightened considerably over the course of the year to around 200 and 650bps, respectively. Investors began to get rewarded for taking risk, which has played out in rising equity indices, tightening corporate spreads, and strong demand for new bond issuance.

Additionally, low treasury yields and mounting debt have written weakness for the US dollar and prompted a rally in commodities. Where oil was the hot topic in 2007, gold became the word of the day in 2009 as investors chose commodity assets as a source of hedging value.

Moving into 2010, I see the key theme as “tepid recovery.” The economy is still in rough shape. The government continues to be the backstop of mortgage markets and our housing crisis is far from over. Higher rates will exacerbate credit delinquencies and we are already seeing evidence of serial defaults, even with modified loan programs. To compare market metrics, the 10-year is now at 3.85%, the 30-year at 4.69% and 2s/10s have steepened to 276 bps, which is right around the high of the year. Our dollar index stands at $77.63 (which is only a 5% difference from where the year began) and unemployment has risen to over 10%. 2010 will be a bearish year for bonds. Rising yields will send prices lower, although investors should be able to outperform with smartly chosen corporate sectors which will tighten and should continue to look at higher quality municipal issues. As well, bond funds that are actively traded may add to a diversified portfolio.
The play in commodities is nearing the end of its bull run, unless we see inflation expectations change significantly. Dollar weakness has run its course as we are already seeing a turnaround in relative value. Capital markets have been adjusting by pushing yields higher on the long-end of the yield curve – an effect which will compensate foreign buyers for future dollar weakness.

Overall, we will remain along the course of recovery, but still face significant economic headwinds which will not be easily solved. Investors should remain cautious by locking in gains and putting new cash to work only on market dips.

Banks love a steep yield curve as their primary lending business becomes more profitable. With the Fed’s pledge to keep short-term rates low for the foreseeable future, we are setting up for a curve that is steep and moving steeper. This is inherently bearish for bonds on a total return perspective. As I have reiterated, bond investors should stay short to reduce their exposure to duration moves and pick sector-specific strategies.

The question on where we go from here depends on many unknown factors including how and when the private sector will takeover from the government to stabilize markets. We have seen private capital fill the gap in corporate bond issuance – banks are limiting commercial loans, but both investment-grade and high-yield companies have been able to sell new issues to the market at attractive long-term rates. This has not happened in the government or mortgage markets, a trend which will continue as long as the Fed remains a backstop.

As predicted here three months ago (http://bit.ly/8RISst), investors are rotating sectors and pulling capital from the long-end of the curve and reallocating it to short-dated notes. As a result, the yield-curve is steepening. As long as the Fed keeps short-rates low and the current pace of economic growth is sustained, I expect the curve to remain in this range and even steepen further.

In general, bullet strategies outperform on a total return basis in a steepening yield-curve environment. A bullet strategy is when all bonds held in a portfolio have a similar maturity date. This is opposed to a barbell strategy, where bonds are held of the edges of the term structure (5-yr and 30-yr, for example) or a laddered strategy where bonds are held at incremental maturity ranges to spread out maturity and reinvestment risk. Bullet portfolios 5-years or less should outperform other strategies on a total return basis even though short rates remain low. As the curve steepens, the short-dated notes will “rally,” or move up in price, down in yield, while the longer-dated notes will “sell off” in price and rise in yield.

I will run through my annual investment outlook then suggest three portfolio weightings for conservative, moderate and aggressive investors. These portfolio classifications are tiered by risk tolerance which should be influenced by your investment horizon, liquidity needs, future earning potential, and level of investment sophistication. I believe it is important for individual investors to reassess these needs about once a year and make honest shifts in their portfolio strategy as your life evolves and changes.

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