Fixed Income, Inflation And Deflation – Fire And Ice

Fixed Income, Inflation And Deflation – Fire And Ice by David Merkel, CFA of Aleph Blog

This is a hard time to be managing fixed income.  Yes, if you are at a big shop with access to deal flow, not so bad — but when you are small like me and have limited tools for a small client base (less than 10% of my assets are fixed income… smart people, because I am better at equity investing) it is really difficult.

Everyone knows interest rates have to rise.  That is why I own long Treasuries.  If the certainty level were truly that high, we would have sold off a lot more by now.  As it is, oldsters, their intermediaries, and pension plans are investing in longer fixed income to provide long-term income.  The need for income, at least for now, holds rates down.  If price inflation kicks up, my view will change, and so might the view of millions of others.

I call that position “ice.”  What will do well if the global economy goes cold?  That’s 20% of the portfolio.

Then there is “fire,”  credit risk in mild and stronger forms.  40% of assets in short investment grade bonds.  20% in bank loans.  20% in short-dated junk.  What will do well if the economy expands?  “Fire” will do well.

What I did wrong last year

My big mistake last year was owning emerging market bonds, both dollar-denominated, and local currency.  That market fell apart after Bernanke uttered the word “taper.”  I held, thinking there might be some recovery, only to sell in November, ahead of the first real taper.

I forgot what I knew, that immature/emerging financial markets are disproportionately sensitive to changes in monetary policy from developed markets.  Michael Pettis’ book, The Volatility Machine, makes that point ably.

On the bright side, maybe I missed the second half of the losses.  As for now, Fire and Ice is working, and providing returns to the small number of clients that use me for fixed income.



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.