Cov-Lite – Yield hunting shifts power from lenders to borrowers

on Jun 26, 2013 in Fixed Income, Home | 2,062 comments

In their pursuit of yield, investors appear to have materially increased their appetite for risk by accepting increasingly looser covenant packages. During the last credit bubble, we saw a large increase in cov-lite loans and this phenomenon is now reemerging again. The question is, what if cov-lite features are given to less worthy borrowers? I personally have some reserves for cov-lite loans being extended to companies in dubious financial health, which could be adversely affected by higher interest rates. As far as literacy is concerned, a single borrower, rather than borrowing from a single bank, would borrow from a consortium of banks, also known as syndicated loan. Since no borrowers can maintain relationship with dozens of different banks at the same time, covenants – promises the borrower would make to its lenders – replaced the trust relationship previously established between a borrower and its prevailing bank. Essentially, loans were becoming more like bonds: they were becoming debt instruments to be traded between various investors, rather than loans which a single bank would hold to maturity and beyond. Coming back to our topic, cov-lite loans are more appealing to issuers because they entail less-restrictive covenants that enable lenders to take action if a company’s financial ratios breach specific limits. If any of those ratios were violated, that would count as an event of default on the loan, and the borrower would be forced to renegotiate with the consortium. A recent Moody’s report says, “a cov-lite capital structure allows for increased financial flexibility at a time when a company needs it most, potentially allowing it to forestall default while getting through a choppy patch in its business”. But does that flexibility only serve to increase the severity of default further down the road? If banks can’t interfere early, does that mean they are going to end up taking bigger losses later? As Moody’s puts it, there’s an assumption “that cov-lite issuers are less likely to default, but once they do, value may have deteriorated to a greater degree than it would have if lenders had been able to step in earlier to address a breached covenant”. Is the recent surge in cov-lite a source of concern for...

Regaining trust in a broken industry

on Jun 26, 2013 in Home | 2,118 comments

Today’s markets are experiencing unprecedented swings, and the investment management industry has also become far tougher than ever before: revenues have plummeted, costs have remained sticky, and the playing field has been leveraged. The global economic crisis ripped through the financial sector, one of the first casualties was client trust. Investors began to question whether the sector was acting in their clients’ best interest or their own. At the same time, the majority of investment managers have underperformed market index, meaning many individual and institutional investors are paying fees for disappointing performance. Capital requirements are now increasing, the profits are becoming more volatile and both investment risk and reputation risk are rising. Attempts to cut operating costs failed to achieve the necessary savings and the result has been a significant deterioration in the industry fundamentals. As a result, these companies are questioning the strategic fit of their non-core business activities within their portfolio; and some are logically divesting them. Indeed, there is a clear consensus that alignment of interests between the company and client will be at the center of the winning business model. But the industry desperately needs to rebuild trust and confidence, which means giving customers what they really want: unbiased advice, transparency, accountability and service...

High dividend strategy

on Mar 10, 2013 in Equity, Home | 2,143 comments

A High Dividend Strategy is structured to provide for the higher cash flow needs of the income oriented investor. The strategy seeks to provide both a stable and growing income stream while also giving clients less volatile participation in market movements, while providing principal protection during periods of rising interest rates. However, with all investment stories, there are caveats and these are the most significant ones for High Dividend Strategies: Dividends are not legally binding: Unlike coupons on bonds, where failure to pay leads to default, companies can cut dividends without legal consequence. Liquidating dividends: When companies are in decline, they may pay large liquidating dividends, where assets are sold to fund the dividends. Dividend yield for a share shoots up mainly due to price drops, not because the dividend is increased. Sometimes price drops occur because there is trouble looming on the horizon. Higher tax liability: At least in Switzerland, dividends have been taxed at a higher tax rate than capital gains. Sector concentration: If you pick the highest dividend yield shares, you may find yourself holding shares in one or two sectors. In early 2008, for instance, you may have ended up with five banks in your portfolio. Considering the shock to that sector end 2008, your portfolio literally collapsed! By screening  tax-advantaged, dividend paying shares, for suitable candidates with a market-cap greater than CHF 5 billion, above average dividend growth, investment grade debt rating, and candidates that have not have been forced to cut their dividend over the past 5 years, should provide confidence that the dividend payout is sustainable. Once a candidate has been identified, a thorough fundamental analysis of the company focusing on valuation and key balance sheet and income statement information should be conducted. With such an approach, you can construct a reasonably diversified portfolio by owning 30-40 securities spread across sectors, although higher dividend sectors such as for instance utilities will have larger...

How to determine the return on your portfolio?

on Jan 27, 2013 in Home, Portfolio ad hoc | 2,200 comments

  In an ideal world, you would be updated semi-annually or annually with your portfolio’s performance, enabling you to compare it to the appropriate benchmarks. In reality, some asset managers may not provide you with the accurate figure! As a matter of fact, deciding on which return measurements should be used is a key element to evaluate the true performance of your portfolio. Below are two of the most commonly calculated return methodologies, which will be discussed in detail. If you want to measure your asset manager success as a decision-maker, meaning how well did his selection of assets perform relative to a benchmark portfolio, use the time-weighted return methodology. On the other hand, if you want to determine how well your invested assets performed, meaning how much your money earned for you during the year, I would suggest you to use the money-weighted return methodology. An investment fund for instance uses the money-weighted return methodology. Mainly because the timing of cash flows into and out of the fund will have an impact on fund performance. Asset managers, on the other hand, are required to use time-weighted return when reporting their performance. Simply because a prospective client or yourself need a measure of the decision-making ability of the manager that excludes the effect of cash inflows and outflows that are beyond the manager’s control. The money-weighted return can differ substantially from the time-weighted return largely on a combination of the following three variables: The timing of the cash flows, the size of the cash flows and the volatility of the portfolio’s market value. The main difference between the two is that time-weighted return ignores the effect of cash inflows and outflows, whereas money-weighted return incorporates the size and timing of cash flows. The money-weighted return internalizes both the timing and size of external cash flows (such as deposits and withdrawals), whereas time-weighted return allows different sub-periods to have different returns. In most cases at portfolio level the time-weighted return methodology is the most appropriate to measure portfolio performance. Primarily to allow comparison between asset managers with different cash flow history. Ask yourself the question, would the investment decisions, asset allocation and investment selections been different, had a different amount of money been available. Almost certainly...

A strategic and tactical asset allocation mix

on Jan 4, 2013 in Home, Portfolio ad hoc | 1,004 comments

Today’s investors clearly face significant challenges in meeting investment objectives, particularly in an environment of relatively modest returns. Identifying and efficiently executing an appropriate asset allocation strategy to meet those investment objectives is important. Neither strategic nor tactical portfolios will shoot the lights out, as they are structured to obtain a specific return for a particular risk over a market cycle which is generally defined as eight to ten years. The primary goal of a strategic asset allocation is to create an asset mix that will provide the optimal balance between expected risk and return for a long-term investment horizon. In other words, there is no attempt on the part of the investors to purposely deviate from the original determined weights. The emphasis is on preserving the fixed weights because they ultimately relate to a larger performance objective. Tactical would be more suitable for investors who want to see the sails of their ships adjusted as the winds change direction. The objective of tactical asset allocation is to move among various asset classes within a risk-controlled framework to seek to create an additional source of return. An attempt is made to take advantage of short and intermediate term market inefficiencies as a means of managing investors’ exposure to market risk by evaluating the relative attractiveness of equity and fixed income markets through financial valuation, growth and sentiment measures. The investment philosophy is usually based on the belief that investor psychology and market forces can lead to periods of misevaluation. A tactical allocation process attempts to capture these misevaluations. In summary, it is fundamental to decide upon an investing strategy, and stick to it. It can be compared to setting a course when starting on a long journey and following it faithfully. On a tactical level, you simply adjust your route only when conditions change. The type of asset allocation strategy that works the best for you then will depend largely on your time horizon and your ability to tolerate risk. I suggest that investors must realize that asset allocation is critical when seeking an investment strategy. They should spend a great deal of time and effort on making sure their asset allocation strategy best reflects their temperament, time frame and objectives. So in the words of the famous saying, conservative investors aim to keep the “bird in the hand,” while aggressive investors seek to gain the “two in the...

What does the growing spread between WTI Crude and Brent Crude reflect?

on Nov 19, 2012 in Commodity, Home | 1,427 comments

  A price widening has been observed between West Texas Intermediate (WTI), and its global counterpart, Brent Crude, which has gradually become the international marker. Approximately two thirds of traded oils are currently priced relative to it. Historically the price differential between the two was generally around USD 1 or USD 2 a barrel in favor of WTI. However, sometime in 2007, the premium shifted gradually in favor of Brent over WTI and in early 2009, WTI traded at USD 10 a barrel discount to Brent and Saudi Arabia shifted to Brent in pricing its crude to the US. The differential between WTI and Brent worsened since then and reached almost USD 28 a barrel. Moreover, much of the crude oil produced in the US eventually finds its way to Cushing, Oklahoma storage facility. Cushing is the delivery location, and the NYMEX pricing point, for West Texas Intermediate (WTI) crude oil. Over the last year, increasing supplies from Canada and the Bakken have continued to find their way through Cushing and due to limited capacity to get oil out of its storage complex, WTI prices have remained under pressure. Thirdly, WTI typically reflects supply and demand conditions in the US and Canadian oil markets. Brent crude oil, on the other hand, tends to reflect global supply and demand dynamics. Whereas developed-world oil demand declined from 2000 to 2010, oil consumption in countries outside the Organization for Economic Cooperation and Development (OECD) has soared by 12.5 million barrels per day. Chinese oil demand has roughly doubled in 10 years. Today, China consumes more than 10% of global oil demand. Meanwhile, India uses more oil each day than Germany and the Netherlands combined. Within the next 7 to 10 years, India will overtake Japan to become the world’s third-largest oil consumer. These demand trends are reflected in the widening gap between WTI and Brent crude oil. Since key emerging economies also show no signs of slowing or temporarily soft landing, I believe the gap between Brent crude, traded on the ICE Futures Europe exchange in London, and WTI crude, traded in New York Mercantile Exchange reached will remain elevated for a while and not contract as Goldman Sachs analyst...

Exchange Traded Note explained

on Nov 8, 2012 in Fixed Income, Home | 1,767 comments

Exchange-traded notes (ETNs) are structured products that are issued as debt securities by banks and are linked to the performance of various assets, indexes or strategies. Though linked to the performance of an asset, ETNs are not equities or index funds, but they do share several characteristics of the latter. Similar to equities, they are traded on an exchange and can be shorted and similarly to index funds, they are linked to the return of a benchmark index. When you buy an ETN, the underwriting bank promises to pay the amount reflected in the index or strategy upon maturity, like a bond investor would. Instead of being backed by the assets that are in the investment fund like ETFs are, ETNs are simply backed by the full faith and credit of the issuer. For instance, if you buy an ETN covering oil and the value of oil appreciates during the time you are holding the ETN, your investment will consequently benefit from the uptrend and you will receive a higher payment at maturing. ETNs have less than a decade history! The lack of tracking record could be a concern for investors who are considering adding ETNs to their portfolios. In addition, the investment and its return will depend on the bank ability to deliver what it has promised to investors. Better pray the bank will still be around 20 years from...

Allocate commodities in your portfolio

on Nov 1, 2012 in Commodity, Home | 1,833 comments

The traditional mainstays of any portfolio are equity and fixed income investments. While finding the appropriate balance between the two can have a paramount impact on your portfolio, there is one asset class that investors overlook: commodities. Now, with the rapidly expanding ETF industry, investors can establish a long term exposure to commodities without having to participate in futures markets by trading on margin and the roll process which takes place on a regular basis to maintain constant futures exposure. While commodities are a cornerstone of investment portfolios, they do not deserve a major allocation. Even though commodities provide inflation hedge, they are subject to high volatility and price correction. Instead, they should be used as satellite investment and account of no more than 5% of your portfolio depending on your investment strategy. When you pick asset classes, you intend to bring the correlation down. Generally speaking, bonds are only minimally correlated with equities which are one of the reasons investors like holding them in their portfolio. But commodities have actually been negatively correlated to both equities and bonds historically. Commodities are the only asset class negatively correlated to bonds, making them a powerful diversification tool. The returns should do well over a holding period of a couple decades if you buy a broad index of commodities. Investing in a commodity ETF is one of the easiest ways to participate in the commodity markets and also diversify your investment portfolio. For decades, commodities remained for good reason the exclusive domain of professional traders, financial institutions and hedge funds. Futures trading require an in-depth understanding of economic trends and the ability to anticipate the impact those trends will have on the cost of goods, as well as the willingness to monitor trading activity on a daily...