THINKING UPSIDE DOWN

We believe 2011 will be a year that forces many investors to reform and rethink their belief structures regarding the world of investments. And if we're correct, many safe-and-sound bond investors will be confronted with harsh new realities.

Losses will begin to appear on their statements from investments they thought were bullet-proof. This will prompt the question, "Why are these investments suddenly losing money?"...followed by, "I thought these bonds were perfectly safe!"

For bond holders, it will be the perception of safety (or lack thereof) which will increasingly come into question. Moreover, the traditional hierarchy or pyramid of safety may soon swing upside down and safety itself may become the most glaring of investment illusions.

Too much debt and threats of default will continue to be the underlying nemesis. We will continue to hear more and more about institutions that are having great difficulty servicing and paying up on their obligations. Loss of principal may raise its ugly head, with the loss of liquidity following close behind.

Remember, certain bond issues fell by over 50% in value during the shocking days immediately after Orange County plunged into bankruptcy in 1994. Although they ultimately recovered, there were some mighty bleak, dark periods for these “otherwise risk-averse” investors.

There are some very interesting developments unfolding in the world of bonds as we know it. Some might suggest there is a reversal of fortunes taking place, and if this is true it might make sense to view such investments from the bottom up or, stated another way, to start thinking upside down.

THE WAY IT USED TO BE

In the historical hierarchy of bond obligations, sovereign debt has always been thought to be the safest. These are the obligations issued by Nations themselves (U.S. Treasury Bonds, Euro Bonds, etc). Those who issue this type of debt pay the least interest and, in return, those who buy their investments anticipate the least risk.

Next in line has always been municipal debt. These include bonds issued by states, counties, cities, water districts and the like. Although the payouts made on municipals are among the very least, the attractiveness of their offering has been enhanced in that they are income tax free.

Third place has been occupied by mortgage bonds (that which secures a given piece of real property).

Trailing the pack were corporate bonds, which historically paid the highest rate of all to entice investors, as they were thought to carry the highest risk of default.

HAS THE SHEEP BECOME THE WOLF?

Today, the perception of low (or zero) risk provided by government debt has shown foundational cracks. We are all quite aware of stunning revelations in the European Zone involving credit developments in Ireland, Greece, Portugal, Spain and Belgium. Japan, the third largest economy in the world, has issued more bonds than almost the rest of the developed world put together, and has been described by one futurist as an “accident waiting to happen” or even more euphemistically, “a fly looking for a windshield”.

We are well aware of how many of the so-called developed countries (the U.S. included) have leveraged and borrowed against their futures. Will each and every one of them always be able to pay up? Or will this debt mysteriously go away? Will taxpayers graciously accede to paying higher taxes? Or is the pure sanctity of sovereign debt just a myth? Just how this comes to be perceived on a global scale is unknown, but rest assured, a serious threat of default anywhere in the world could set off a cataclysmic reordering of values and risk.

We have been quite public with our concern for municipal bonds for nearly a year. Municipal defaults, in our estimation, are another “accident waiting to happen”. During our Advisor Q&A event at the Pacific Club last September, we warned that most municipalities were technically bankrupt and that many of them would find it increasingly difficult to service their obligations. We reduced or eliminated nearly 95% of these holdings from our clients’ portfolios some time ago when it was not very popular to do so. In light of meaningful decline in the prices of these investments, how comfortable we now feel with this decision. Notwithstanding, we think it is quite possible that the worst has yet to come.

Mortgage debt will continue to be viewed as a higher risk undertaking. Housing prices will continue to be weak with foreclosure levels high. The number of homeowners that are underwater (with mortgages in excess of their home’s value) may grow in numbers. Many of them, finally willing to throw in the towel, will exercise their prerogatives stemming from the growing popularity of strategic foreclosure.

In the meantime, lenders still smarting from losses incurred in the 2008-2009 property meltdown will be baffled by regulatory indecision; finding themselves confronting new legal hurdles regarding their foreclosure (loan protection) rights. Now even the judicial system seems to be against them, requiring “proof of ownership” for loans that have long been gone from their portfolios. These loans have been fractionalized, packaged, and sold to others. In turn, many of them have then been repackaged, resold, and redistributed to the point there is little paper trail.

So who owns what? In many cases it is virtually impossible to know or prove. But the fallout from all of this is most important, begging the question, how many lenders will commit new money to our housing market under such travail?

Meanwhile, with little fanfare or notoriety, it is corporations that are emerging from this recession with huge positive earnings, strong cash flows and burgeoning balance statements. It now appears as if their financial statements are displaying plentiful amounts of cash and generous levels of liquidity. In general, their relative debt levels are quite low and their obligations are serviceable and well protected.

So, in the parlance of investments, will the riskiest really turn out to be the safest? Will corporate bond investors suddenly begin to receive more for less? Has the sheep become the wolf?

SUMMARY

The aforementioned does not reflect any new thought for us. We have sensed this shift for quite some time and have already adjusted our clients’ portfolios in a way designed to minimize the harm we feel could be waiting around the corner.

We may find that is sometimes smarter to think upside down. Or, as the famous hockey player Wayne Gretzky once offered when asked about his success, “I skate to where the puck is going to be, not where it has been.”

Ironically, in this complicated world of investment management, one may need to stand on his head from time to time to see more clearly.

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