Wednesday, December 10, 2008

Inflation or Deflation: Bond Alternatives/

There were some individuals who prospered in the Gilded Age of the 19th Century who justified their rise to power and the treatment of the people who worked for them by the theories of Social Darwinists who came into vogue in the late 19th Century. The Social Darwinists made an effort to apply Darwin's theories about evolution to society and business. Social Darwinism

Those who prospered in the financial system were the most fit to survive. I had trouble with this theory back in my days as an undergraduate at Tulane University, many moons ago when Nixon had just been elected President. I started to think about the Social Darwinists last night as I read yet another story about how a few ridiculously compensated people at AIG lost 10 billion betting that mortgage securities would rise in value. Is their compensation linked in some way to their performance or "fitness" to invest anyone's money. The same could be said about the few individuals at Merrill Lynch who destroyed that firm's viability while making tens of millions. NYT  No, it is not survival of the fittest for the financial titans but survival of the unfit who prosper while others more deserving suffer the consequences.

While I have been an investor my entire adult life, starting when I was a teenager investing my accumulated wealth garnered from saving my summer paychecks at $85 a week, I have never formally studied economics. I did major in history, philosophy and political science at Tulane with no courses in economics.  History helped me with perspective on human events whereas philosophy help me to think. Those are the tools that I bring to investing along with about 40 years of experience. My subsequent degree and career gave me some tools to evaluate human behavior and to analyse complex business transactions.

I do not deal in absolutes as an investor but a series of probable and possible outcomes. When it comes to big picture issues like deflation and inflation, I can not say with any degree of certainty that inflation will follow the current bout of deflation (or more appropriately a fall in inflation and inflation expectations) due to a rise in the money supply.

For one, part of the Feds actions over the past several months is- partially at least- a replacement of money that has gone up in smoke, rather than net new money being added to the system. Tons of money has just evaporated in an ill-advised credit expansion. The investment bankers and assorted whiz kids loaded up thousands and thousands of dump trucks full of $100 bills and burned them in the trash incinerators.

So a period of lower inflation is in the cards for several months but I recognize the possibility that inflation may easily become the problem in a few years due to the current extreme amounts of fiscal and monetary stimulus. This is why I have been adding some inflation protected bonds to my portfolio now, when the pricing is advantageous in the event inflation fears return down the road, and I may hedge my long bond portfolio which is significant within a year, possibly two, with an inverse bond ETF.

The TIP was bought recently when its price did not carry a premium for its inflation protection. I had sold out of TIP about a year ago (11/18/07 at around 106), and have been building my position back as the spread between the TIP price and the comparable treasury without inflation protection has become insignificant- with my last buy at around 93 just recently.

I do not know when inflation will return as a problem. To me, this is unknowable with any degree of certainty for an individual investor like myself or anyone else. It is conceivable that a long term deflationary cycle will come to past, similar to what happened to Japan after the bursting of its real estate and stock bubbles in the late 1980s or to the world during the Great Depression. I only know that the return of inflation is a possibility, even probable two years or more down the road, and now is the time for me to start buying some assets like TIP as part of a bond portfolio when the pricing is favorable compared to non-inflation protected securities.  

Moreover, the perpetual floating rate preferred stocks may work under both scenarios at their current prices since they provide the greater of a guaranteed rate or a spread over 3 month LIBOR.  If inflation accelerates, I would reasonably expect the short LIBOR component of the interest rate calculation to kick in whereas the guarantee provides protection in the event of deflation. This is discussed in more detail in prior posts.  I have bought some of those securities recently because they can swing both ways, that is, work in both deflation and inflationary environments.

BUT, like many investments, there is a downside to those floaters with the major ones being the absence of a maturity date, issuer deferral rights for cumulative distributions or elimination for non-cumulative distributions, and poor preference rights in the event of bankruptcy.

One of them, for example, the Aegon floater pays the greater of 4% or .875% over 3 month LIBOR. It has a $25 par value. The current guarantee is worth $1 per share annually in dividends, paid quarterly.  It just went ex-dividend. At the current price of  6.8 the guarantee provides a yield of 14.7% which is the deflation protection. That is the lowest yield payable at that cost. If inflation returns and 3 month Libor rises to 6%, for example, then the annual interest on 1 share would be .06875 x $25=$1.72 or over 25% under that assumption, which is the inflation protection component.

With the 3 month LIBOR rate near 2%, after rising close to 5% during a peak period of fear, the guarantee is the rate being used in all of these preferred stock floaters like METPRA and AEB, and many others that I have discussed. The guarantee is only interesting to me due to the huge discounts to par value, which juices the value of the guarantee to a current buyer as opposed to the the unfortunate ones who bought at par value.

Some of the cumulative preferred REIT stocks that I have bought recently go ex-dividend tomorrow, including the two issued by First Industrial and one by CB & L Properties. I am wary of these issues, so I only do nibbles. I am unable to avoid them due to the staggering yields being offered by them at their current prices now, plus their cumulative feature which provides some protection not available to a common shareholder. I may add a new one today.

  I am not a financial advisor but an individual investor trying to navigate my way through a difficult market. In these posts, I am acting as an unpaid financial journalist and an occasional political commentator.   I am also aggregating financial news stories that I view as important and providing any reader of these posts, assuming there are more than a couple, with links to those articles, sort of a filtered, somewhat intelligent, free search engine.  Any discussion made by me of particular securities  is not a recommendation to buy or to sell.  Trade at your own risk.  Consult with your financial advisor prior to making any purchase or sale. I will try to identify my sales too but it may take a few minutes after I implement them to create a post explaining my reasons.  The sale may before or after the post.  Before buying or selling any stock, even one recommended by a trusted financial advisor,  please research it and make up your own mind which is what I always try to do.  Research would include reading reports, reviewing financial records, earnings estimates, sec filings and prior earnings releases and news.  In this post, and all others by me, I am merely describing my reasons for purchasing  or selling securities, and the potential pitfalls that I identified prior to purchase or the reasons for a sale.  The securities mentioned in this and all posts written by me may not be suitable for others based on their unique financial position and risk profile.  Always read the prospectus before buying a Trust Certificate, bond, preferred stock or other bond or bond like investments.    

No comments:

Post a Comment