Notes – AlephBlog Digest #1 – David Merkel On Corporate Bonds (@alephblog, #bonds

David Merkel, author of the AlephBlog, has an extensive background on Wall Street and is something of a value investor when it comes to his money management principles. There is a lot of good content on his site in various disciplines within the investment analysis and money management domains so this will likely be the beginning of a multi-part digest series. This one deals with his lessons about the corporate bond market. To read the entire original discussion, please click the title heading of each section.

The Education of a Corporate Bond Manager, Part I

How I learned the basics, and survived 9/11.

• “Bond swap”– trading away an older bond of a company for a new issue
• New deals almost always came cheap
• Think about bonds as a put option on the equity
• When selling a bond, look at what investment banks ran the books of the deal
• Never make it look like there are two sellers (by working with two banks) or bids will vanish; bad etiquette to employ two banks without telling them they’re in competition with one another

The Education of a Corporate Bond Manager, Part II

How I learned to trade bonds, and engage in intelligent price discovery.

• If you want to buy a bond not presently offered, find out who brought the deal and made a market in the bond issue
• Price discovery toolkit:
  • Comparable bonds in the same industry
  • Credit spreads across rating categories
  • Credit spreads across the maturity spectrum within rating categories
  • Spreads on CDS on the same name
  • Value of scarcity vs cost of liquidity
  • Proper spread tradeoffs on premium vs discount bonds
  • Calculate spread on last few trades
• There is a price to gain liquidity that the issuer pays
• “One-minute drill” creditworthiness check on Bloomberg:
  • GPO, how has the stock price moved over the last year?
  • HIVG, how have option implied volatilities moved of late?
  • CH6, how is operating cash flow?
  • DES, what industry is it in?
  • DES3, major financial ratios of the company
  • CH2 or ERN, earnings declining?
  • CRPR, credit ratings?
• If these tests are passed, odds of company doing badly while waiting for a credit analyst’s opinion are slim

The Education of a Corporate Bond Manager, Part III

What is the new issue bond allocation process like, and what games get played around it?

• Speed of decision process when buying new bond issuance based upon:
  • complexity of deal
  • creditworthiness of issuer
  • speculative nature of market
• When market runs hot, odds rise that the syndicate will overprice a deal and deliver losses to those asking for overly large allocations
• Dealing in the gray market has taint, you don’t want to be seen doing it lest your allocations be reduced
• Syndicates want to place bonds entirely with long term holders if they can, implies they priced it right, leaving little money for speculators

The Education of a Corporate Bond Manager, Part IV

On the games that can be played in dealing with brokers.

• Poker aspects of the bond market:
  • be honest, keep your word on trades, don’t weasel out once you say “done”
  • have a fair reputation, that you don’t try to pull fast ones on the broker community
  • reputation for fairness should be reinforced by other actions
    • if ibank quotes price/spread out of market context, let them know what you know; only trade against them if they insist they’re right
    • if risk control desk comes to you with a trade to cover a short and you own the bonds, help them; make them pay a little more than the ask but don’t gouge, then they might offer you the long cross-hedge bond at a nice price
  • have an “openness policy”; reveal 80% and conceal 20%, the most critical 20%
  • your broker at the ibank is proud of his best clients; he doesn’t want to lose you if you’re bright, trade a lot, run a big account
  • never tell your whole story to any broker; break up your business among many brokers, with no overlap
  • it’s good to have a reputation for being bright, or at least not a pushover
• It’s freeing to not think about whether a particular trade will generate a gain or a loss but rather how the portfolio can be improved

The Education of a Corporate Bond Manager, Part V

On selling hot sectors, and dealing with the dirty details of unusual bonds.

• It takes time and effort to farm, but financial products can be whipped up in any season
• If I am underweight, someone else must be overweight versus the index; someone has to absorb all the paper of a hot sector, don’t let that be you
• Credit analysts understand the creditworthiness of bonds; what do PMs understand?
  • portfolio composition vs needs of the client
  • trading dynamics of the marketplace, whether good bonds might temporarily be mispriced
  • dirty details of the bond; covenants, terms, etc.
• A lot of value is added by document review; in a time of panic, those insights are golden because other managers toss out illiquid bonds they don’t fully understand

The Education of a Corporate Bond Manager, Part VI

On dealing with ignorant clients, and taking out-of-consensus risks.

• Optimal strategy for life insurers: interest spread enhancement with loss mitigation
• Defaults are a fact of life; if you run with such a thin capital base that you can’t survive a few modest defaults, you’re running your insurance company wrong

The Education of a Corporate Bond Manager, Part VII

On the value of credit analysts.

• Credit analysts are a corp bond mgrs best friend
• Provide a necessary check on a PM trying to play “cowboy” and be a yield hog
• Native tendency is to reach for yield:
  • a portfolio with more yield earns more
  • a higher yielding credit will rally, due to mean-reversion
• The second is true about 50% of time, but rewards are assymetric; gains are small, losses are large– it doesn’t pay to be a yield hog
• All analysts have biases; to overcome, give them a list of spreads for companies they cover and ask them to rank the credits in that sector
• For Mr. Yes, ask him about risk factors; for Ms. No, ask what are the best names she’d invest in
• Every investment shop tends to create a monoculture modeled off the PM at the top; to avoid bias:
  • have multiple analysts look at a conviction idea
  • have PM take it home and analyze it
  • look at Street research to find bears, and circulate the opinion to the team

The Education of a Corporate Bond Manager, Part VIII

On price discovery in dealer markets, and auctions gone wrong.  I never knew that I could haggle so well.

• There may be 7000 actively traded stocks in the US but there are nearly 1,000,000 bonds, the last trade of which may have been a week or a month ago
• After adjusting for default risk, the number one predictor of portfolio return is yield
• Default risks are lower after the bust phase of the credit cycle, rise as the credit cycle gets long in the tooth
• David does a trade: “But how to come to the right price/yield/spread?  I had a few trades, but they were dated.  I knew the spreads then, and used the spreads of more liquid similar credits to adjust it to a likely yield spread today.  I put in a fudge factor because illiquid bonds are higher beta, and then studied which of my brokers might have a bead on the bonds in question.  I would ask them their opinion, and if they were in my ballpark, I would back up my bid some, and bid for $1 or $2 million of the bonds.  The response would come back, and I would have a trade, or nothing, but maybe some color on where they would be willing to sell.  If a trade, I would back up my bid a little more, and offer to buy more.  If no trade, I would offer 50-70% of the distance between our bid/offer, and see what they would do.”
• How to have a successful auction of bonds you own:
  • limit auction to dealers who have most interest
  • say you’re just raising cash, eliminates information risk, makes them willing to bid
  • cover level is the second place bid
  • can’t come back begging for love
  • ties are fine; no love, both brokers get half
  • not enough bids, cancel it
• Limits to haggling: when you’re already getting an unreasonable deal, smile, say thanks and move on; it’s more important to be invited back
• Bid/offer fewer bonds than wanted by the seller/buyer at the level, and ask for better terms at their size; makes them more willing to deal
• Always pay your brokers, it makes them more loyal to you
• Trading is an amplified version of character; try to be fair everywhere you can while still making money for the client
• Playing for the last nickel costs 95 cents in the long run

The Education of a Corporate Bond Manager, Part IX

On the vagaries of bulge-bracket brokers, and how a good reputation helps on Wall Street.

• You aren’t supposed to act like a market-maker; if it’s known you aspire to risk-free profits, they might use their power to hurt you:
  • lower allocations on new deals
  • tougher in haggling
• Reputation matters
• Gravitate secondary trading business to those who “walk the walk”

The Education of a Corporate Bond Manager, Part X

On how we almost did a CDO, and how it fell apart.  Also, how to make money in the bond market when you reach the risk limits.

• You can only do deal #2 if you’ve done deal #1
• Macro theme: stability usually triumphs over discontinuity

The Education of a Corporate Bond Manager, Part XI

On my biggest mistakes in managing bonds.  Also, on aggressive life insurance managements.

• Bonds are assymetric
• Paid to be cautious regarding failure
• When in doubt, sell
• Don’t always take your broker at face value

The Education of a Corporate Bond Manager, Part XII (The End)

On bond technical analysis, and how to deal with a rapidly growing client.   Also, the end of my time as a bond manager, and the parties that came as a result.   Oh, and putting your subordinates first.

• On timing purchases and sales:
  • the large brokers generally know who is doing what
  • be nice to sales coverage, you’d be amazed what they’ll tell you
  • keeping the VIX on screen helped accelerate or slow down purchases and sales in a given day; yield spreads lag behind option volatility
• On time horizons:
  • Three horizons
    • daily
    • weekly-monthly
    • credit cycle
• On scaling:
  • moving in and out of positions slowly, as market conditions warranted, is useful
  • “Never demand liquidity unless it is an emergency and you meet the strenuous test that you know something everyone else does not. But, make others pay up for liquidity where possible. You are doing them a service.”