Equity In Drag

By Chris Mayer

Investors throughout history have shown a tendency to reach
for yield despite the risks, especially in markets where
good yields are scarce.

The memoirs of Felix Somary cover a career that spanned the
first five decades of the 20th century. Somary was an old-
world banker and a mover and shaker of the time. One of his
anecdotes tells the story of a financier named Baron
Maurice de Hirsch, the inside man on Turkey in the early
part of the 20th century.

Turkey, at the time, was the sick man of Europe and few
investors wanted to make loans there.

Hirsch created a lottery style offering with juicy yields.
"Securities for financial idiots" is what he called these
bonds privately. To which Felix Somary, our sharp memoirist
writes, "but since financial idiots are in a majority, the
issue had great success."

In today’s market, investors are reaching for high-yield
debt (which are issues with credit ratings below Baa3 at
Moody’s and below BBB- at S&P). Sometimes called "junk
bonds," they have also been dubbed "equities in drag" for
the high returns they can deliver. For example, last year
junk bond investors brought home an equity-like total
return of 11%.

The market for junk is hot, with the debtor companies
enjoying "unprecedented access to capital," according to
Robert Auwaerter, manager of a $250 billion bond portfolio
at Vanguard Group in Malvern, Pennsylvania. Some $3.5
billion in new junk bonds are expected to hit the market
next month.

On the hunt for more clues, last week, your Gaitherberg-
based substitute editor ambled over to watch the so-called
Dean of High-Yield Debt, Martin Fridson, give a talk at the
University Club for the Washington Society of Investment
Analysts. His speech was titled: "Can High Yield Bonds
Continue to Excel?"

Anything can happen, we suppose, but your editor came to
the meeting with a preconceived notion that they would not
‘continue to excel.’ High-yield debt is one of many little
bubbles that mar the investment landscape these days where
there is very little that is cheap and much that is

Fridson offered a few points of interest, which may have
salvaged the afternoon (though the table talk was better –
more on that in a moment).

First, he pointed out the yield on junk compared to
Treasuries is narrow, indicating that investors may not be
adequately compensated for the risks they are taking.
Second, according to the periodic senior loan officer
survey conducted by the Federal Reserve, we are in the most
liberal lending period since this series has been tracked
(it goes back to about 1990). Third, default rates are near
historic lows of barely above 2.0%. Junk bond investors
have lived a near idyllic life over the last couple of

Unfortunately, in the perverse world of financial markets,
what is near perfect tends to be over-priced and what is
over-priced tends to lead to lousy future returns. The
default rate, in particular, turns out to be a good
predictor of future returns.

Ironically, when default rates are high, returns over the
subsequent period tend to be good. From 1991 to 1996 (from
a peak in default rates to a trough) the annualized return
on high-yield debt was better than 12%. Equity in drag,

When default rates are low, subsequent returns tend to be
poor. From 1996 to 2001 (from the trough of default rates
to a new peak), the average annualized return was less than

Default rates can scarcely get better than they are today.
So, it would be a reasonable prediction that future returns
in high-yield debt will be light. Interestingly, the data
shows that the first year off a low point in default rates
tends to still be a good year. As Fridson says, if 2004 was
the low in default rates, then 2005 could still be a
reasonable year. Readers are forewarned: sell your junk
before 2005 is out.

Turning from the exciting world of high-yield debt, I must
report on the table talk before Fridson began speaking. I
was sitting at a table of money managers and advisor types,
who echoed the complaints of their institutional clients.
Apparently, they are having a hard time getting returns.
Perhaps these managers and advisors came hoping junk bonds
would be the answer.

I forget how exactly the subject came up, but when it did,
it was all anyone wanted to talk about. The subject was

But the attitude was surprising to me. There was little
enthusiasm for commodities. One fellow went so far as to
say they "never create value" and that they are a "zero sum
game." He then compared investing in commodities to
speculating on currencies. He was so sure of it; he seemed
almost agitated to hear a contrary opinion.

"Have you read Jim Roger’s new book?" your editor helpfully

"There’s another sign," said this fellow, "another sign of
a top." He brushed aside Roger’s success and track record,
saying that Rogers first talked about commodities years
ago, but the moment has passed and now he’s just getting
people to buy his book.

Commodity bull markets tend to last a long time, but this
fellow would hear none of it. It is always interesting to
me how strongly certain investment-types hold on to their
opinions. The market always has special surprises for such

I was just glad this guy wasn’t managing my money.

Did You Notice…?
By Chris Mayer

Rogers believes that understanding commodities will help
make you a better investor in stocks, bonds, real estate
and emerging markets. Once you understand why copper or
lead are rising, or once you can connect the dots in the
grain markets, it’s only a short step to finding great
companies that can take advantage of these trends.

Sometimes the results are quite surprising, and you find
opportunities in hotels or supermarkets in places where, as
Rogers says, "consumers suddenly have more money than
usual." In fact, my best pick in Fleet over the past six
months is a global hotel operator up over 40% since

But for the most part, investors don’t think about
commodities.  As Rogers writes, "for most people, when you
mention the word commodities, another word immediately
comes to mind: risk."

But in 2004, a couple of professors performed research that
confirmed that commodities "add value." They found that
since 1959, commodities have actually outperformed stocks
and bonds with less volatility.

The bottom line: it is worthwhile to study all markets. You
don’t know where your next idea may come from.

And the Markets…



This week

















10-year Treasury





30-year Treasury





Russell 2000


























JPY 104.06

JPY 105.64



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Dollar (USD/GBP)