Weekly Edition #59
Updated: Apr 2
In this edition:
Cam Harvey, professor of finance at Duke, wrote his thesis on yield curve inversions and what they mean for the economy. Typically yield curves (graphical representation of how much bonds of different maturities pay) are positive sloping. Longer dated bonds should pay a higher interest rate than shorter dated bonds. A yield curve inversion happens when the spread (difference) between a shorted dated bond and a longer date bond goes negative. I.e., longer date bonds yield LESS than shorted dated bonds. Since 1962, every yield curve inversion has been followed by a recession.
The last time the yield curve was inverted was in August of 2019, we wrote about it here. As we all know there was a recession in 2020, so the indicator so far has been perfect. However, since the last recession was caused by the Covid pandemic, we have no idea of knowing what would have happened if there had been no Covid. Maybe we would still have gone into recession. Another point is that every time the yield curve inverts, even if it’s temporarily, we get tons of news articles claiming that it’s a perfect indicator and we’re headed for recession soon. The original measure in Harvey’s thesis was very specific, it was the 3 month – 10 year spread and it had to have been inverted for a period of three months. The most recent inversion came in the 2 year – 10 year spread and it was inverted temporarily, not even for a full day. Will we get a recession soon? Maybe, but that shouldn’t mean you change your portfolio entirely. A well-balanced portfolio should have different assets that perform well in different economic scenarios.
There’s a trend that has happened recently in which MBA students raise money in which the investment is the student themselves rather than a specific business. Essentially, they raise money to go out and find a business to buy and become CEO. The idea here is that there are good, profitable businesses that can be acquired at attractive prices. This may be because the business is relatively small so large private equity firms overlook them. Or because the founder is close to retirement, has no clear replacement for them that can take over the business and is in search of liquidity to retire.
We’ve typically seen these search funds in the US, and some in Mexico. The US market is much more liquid than in Latin America and we think there could be interesting opportunities in Latin America. There are many companies that are profitable and have no clear succession plans. A search fund could buy one of these companies, or several and merge them and create a platform. We’re not thinking of doing this but would support someone who has this skillset and was looking to start a fund like this.
Oftentimes we don’t read the fine print. How many times have you signed a credit card contract or accepted a mobile phone app’s terms of service without reading what they say? Or put another way, when have you ever read the terms of service? Well, it’s important to read the fine print. Many times hedge funds have clauses that they can restrict redemptions in extreme circumstances of illiquidity. These clauses are justified, if they didn’t exist then they might be forced to liquidate at terrible prices and hurt investors.
This topic is important because the problem these clauses prevent is present in many different types of funds, not only hedge funds. In fact, it’s even worse in funds which cannot restrict withdrawals. For example, mutual funds generally don’t restrict withdrawals, only in extreme circumstances. Therefore, investors who are quick to sell generally are in a better position. For example, a junk bond mutual fund which faces many redemptions will tend to sell the more liquid positions to fund these redemptions. The more liquid positions tend to be higher quality bonds. Therefore, investors who are not selling are at a disadvantage, because they are still invested in the fund and the fund is now composed of junkier and less liquid bonds. The initial investors which caused the fund to sell, are negatively affecting the investors which stuck around.
As we’ve written several times before, the sanctions placed on Russia and on some Russian citizens have been unprecedented. Many companies have gone further and voluntarily stopped dealing with and selling products in Russia altogether. There are also many companies which are not dealing with Russian companies, even if they could, because sanctions are complicated and they’re afraid of being sanctioned themselves if something went wrong. Hedge funds, and other asset managers are in tricky situations since if they hold investments from sanctioned individuals, they are limited in what they can do. They cannot give them their money back, they can’t accept new money, they can’t transfer their interests to someone else, etc. In essence they’re stuck with the money for the time being. How this will get resolved is hard to guess.
This article is a bit more technical than usual. Banks need to hold certain amount of capital in order to sustain losses in their credit portfolios and other parts of their balance sheet. Regulators have placed different haircuts for different types of investments. For example, short term T-bills can be counted at or close to 100% for regulatory capital. Therefore, $100 investment in short term T-bills is the same as having $100 in cash. Bonds have a haircut vs. T-bills. So, the same $100 invested in corporate bonds would count as $90 (something less than $100, not $90 exactly) from a regulatory perspective. Basically, the riskier the asset is, the larger the haircut. Since stocks are riskier than bonds, the haircut applied to equities is larger than that of bonds. For regulatory purposes, ETFs are classified as stocks, even if their underlying holdings are all bonds. A new rule is proposing a look through of ETFs and to classify them based on their underlying holdings instead of all of them being classified as equities. This means that banks now have an incentive to hold more assets in bond ETFs than before.
This is interesting because many times markets are driven by flows and not fundamentals. If a bank invests more heavily in bond ETFs and they suffer losses and have to sell their holdings in order to meet capital constraints; ETFs might be negatively affected. However, we think this is a good rule. Bond ETFs are more liquid than their underlying holdings, since some ETFs hold bonds that trade very rarely. Therefore, banks should have more liquidity by having ETFs and selling them than by having corporate bonds and selling those.
Thanks for reading!
To receive this information weekly subscribe your e-mail clicking here:
Past performance is not a guarantee of future performance. Future returns are not guaranteed, and loss of capital may occur. This material is not to be reproduced or distributed to any other persons and is intended solely for the use of the persons to whom it has been delivered by or on behalf of K Squared Capital. This material is not for distribution to the public. The sole purpose of this material is to inform, and it is in no way intended to be an offer or solicitation to purchase or sell any security, other investment or service, or to attract any funds or deposits. The information provided herein does not constitute tax, accounting or legal advice. Investing in financial markets involves risk, including the risk of principal loss. Information in this document is in no way intended as personalized investment advice and should not be interpreted as such. Past performance is no guarantee of future results. K Squared Capital disclaims responsibility for updating information. In addition, K Squared Capital disclaims responsibility for third-party content, including information accessed through hyperlinks. Certain assumptions have been made regarding historical performance information included herein, and such performance information is presented by way of example only. No representation or warranty is made that the performance presented will be achieved as a result of implementing an investment strategy substantially identical or similar to that described herein or that every assumption made in achieving, calculating, or presenting the historical performance information has been considered or stated. Any changes to assumptions could have a material impact on the investment returns that are presented by way of example. Returns for any period may be attributable to certain market conditions, fund size, and timing of transactions, which may not be repeated. Diversification does not assure a profit or protect against loss in a declining market. Past performance is no guarantee of future results. Actual results may vary.