September 22, 2003

The Mother of All Bond Funds

You know that I’m excited about ETFs and other “Precision Guided Investments.” They’re better than mutual funds because their expenses are lower and you get to invest in a basket of stocks that acts as a proxy for a sector, country, or an asset class. But even I was surprised at this mother-of-all banner ads I saw on Yahoo. Then again, an investment vehicle of this magnitude deserves a banner ad like none other. Barclay’s has come up with a new iShare that packages up a basket of bonds and trades like a stock. Only unlike IEF and TLT, this bond fund includes corporate bonds, agency bonds (Freddie and Fannie), and securitized bonds (asset backed securities, commercial mortgage backed securities, and fixed rate mortgage backed securities.) Let me summarize: Wall Street now makes it possible for your to cheaply take a short position on the largest train wreck in modern financial history. You can be short the entire financial economy (financial economy vs. real economy) in just one single investment. Talk about a risk to return ratio!! You get to finally be a counter party to all those horrible derivative risks…but you can do it over the counter for less than $500. Seriously, no word yet on if or when you’ll be able to trade options on the new PGI. For the record, the name of the index is the Lehman Aggregate Index (AGG). Nearly 70% of the funds holdings are rated triple A or better. The real interesting breakdown is by sector. ·U.S. Government: 34.04% U.S. Treasury- 21.87% U.S. Agency- 12.16% ·U.S. Credit Corporate- 23.23% Non-corporate- 4.23% ·Securitized: 38.50% CMBS- 2.51% ABS- 1.81% MBS Fixed Rate- 34.17% Although I’m not a bond expert, I’m assuming the advantage of owning a fixed rate Mortgage Backed Security is that at a fixed rate, the mortgage borrower (whose payment passes through a bank to you) is less likely to refinance and pay off all at once. In other words, the fixed-rate mortgage back is less “callable” than other mortgage bonds, and thus, less likely to be repaid in full if interest rates change. That said, that’s a whopping amount of risk in the housing market. I’ll try and get a closer peak and the bonds holding sin the next few days. But at first blush, this fund has a big fat bulls eye on it in a rising rate environment. Speaking of which…the Fed is going to have its hands full keeping rates from rising with the new “not-as-strong-dollar” policy. You can see that Lehman’s 30-year bond PGI (TLT), hasn’t fared too well as investors dump bonds and push rates up. This from the boys at, “The direct, near-term implication for the Treasury market is that the Bank of Japan and other - primarily Asian - central banks will not be motivated to purchase and hold Treasury securities as a means of preventing their respective home currencies from appreciating in value too far, too fast vis-à-vis the dollar. To add insult to injury, Fed Governor Bernanke said this morning that he sees a "definite pick-up in growth" and that this looks to be a "very strong quarter". Although this morning's initial downtick had come amid relatively light volume, we're hearing that selling activity accelerated a bit following Bernanke's comments.” Intraday Bond-Whipping for the 10-Year And this from my macro trader oracle, Greg Weldon: “Officialdom is losing control. Integrity is being questioned. Assets held in USD are being liquidated. A re-balancing may ultimately take place, regardless of the direction and stance taken by central banks, and it will not be pretty, from the global economic perspective, during the interim period of time. Indeed, be careful what you ask for … YOU JUST MIGHT ‘GET IT’.” Of Other Risk Of course it’s not just the U.S. Treasury on the line. It’s bonds that enjoy the implied guarantee of the Federal government as well, including Fannie Mae and Freddie Mac, whose outstanding debt exceeds that of the U.S. government. Could Fannie Mae and Freddie Mac contribute to the take-down of the dollar? Or would they be among its victims? I’ll be exploring that later. But for now, enjoy these passages I gleaned from the White House’s own report on the 2004 budget called Analytical Perspectives. It includes this bit on the GSEs. "The Federal Government also enhances credit availability for targeted sectors indirectly through Government-Sponsored Enterprises (GSEs)—privately owned companies and cooperatives that operate under Federal charters. GSEs provide direct loans and increase liquidity by guaranteeing and securitizing loans. Some GSEs have become major players in the financial market. In 2002, the face value of GSE lending totaled $3.6 trillion. In return for serving social purposes, GSEs enjoy many privileges, which differ across GSEs. EMPHASIS ADDED HERE IS MINE: "In general, GSEs can borrow from Treasury in amounts ranging up to $4 billion at Treasury’s discretion, GSEs’ corporate earnings are exempt from state and local income taxation, GSE securities are exempt from SEC registration, and banks and thrifts are allowed to hold GSE securities in unlimited amounts and use them to collateralize public deposits. These privileges leave many people with the impression that their securities are risk-free. GSEs, however, are not part of the Federal Government, and their securities are not federally guaranteed. By law, the GSEs’ securities carry a disclaimer of any U.S. obligation." So, it appears that the U.S. government has no obligation to bail out Fannie and Freddie, even though its implied guarantee and granting of privileges have allowed the two GSEs to create trillions in new debt based on the mortgages of millions of new American homeowners. This debt is held by thousands of investors, hedge funds, and firms as a way to balance other interest rate risks. Would Uncle Sam really let Freddie and Fannie sink and sell out all those bond holders? And would then own the notes on all the Freddie and Fannie-issued mortgages? Uncle Sam as landlord? Just asking…


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