Shenanigans! Pension Plan Return Assumptions Edition

From Reuters:

New Jersey’s treasurer said on Thursday she will increase the expected rate of return for the state’s struggling public pension system from 7 percent to 7.5 percent, then lower it again over time.

The switch to a higher assumed rate means that the state, and participating local governments in New Jersey, will for now escape the higher costs that arise when investment return assumptions are lowered.

The savings come at a fortuitous time for new New Jersey Governor Phil Murphy, who took office in January and is facing a shortfall ahead of his first budget proposal in mid-March.

The higher rate will save about $238 million for the state and more than $400 million for local governments in the near term, according to the office of Acting State Treasurer Elizabeth Maher Muoio.

Color me gobsmacked. Here is a translation into plain English:

We know that our current return assumption is unrealistic. But, if we lower it outright we are going to have to make large contributions we can’t really afford (we are only 49 percent funded as it is). So we are going to tell a teensy weensy little white lie, and pretend returns will be higher for a while. And eventually we will fix the numbers. It will all work out in the end. Trust us.

Where is one to begin with something like this?

With the fact that New Jersey’s treasurer is OPENLY FUDGING THE NUMBERS?

How about some healthy skepticism regarding whether a bunch of politicians will ever adjust the numbers back down to where they belong if it means a public outcry over unfunded liabilities or higher taxes?

Or maybe the troublesome fact that only 50% of projected liabilities are funded?

Puerto Rico should be instructive where these underfunded state and municipal pension plans are concerned, both in terms of the root causes of the problems and the difficulties inherent in closing massive budget holes. This is not likely to end well for New Jersey.


Remains of a volatility short

Markets are ecosystems. And like any ecology, markets can come to favor organisms with certain traits over arbitrary time periods. In the natural world, dinosaurs flourished when the global climate favored their biology. Then, quite suddenly, that changed. National Geographic tells it like this:

Scientists tend to huddle around one of two hypotheses that may explain the Cretaceous extinction: an extraterrestrial impact, such as an asteroidor comet, or a massive bout of volcanism. Either scenario would have choked the skies with debris that starved the Earth of the sun’s energy, throwing a wrench in photosynthesis and sending destruction up and down the food chain. Once the dust settled, greenhouse gases locked in the atmosphere would have caused the temperature to soar, a swift climate swing to topple much of the life that survived the prolonged darkness.

This is not so much different from those who got wiped out holding large positions in XIV. Short volatility strategies thrived in a market environment that for years has favored long duration assets (long term bonds, high growth stocks, cryptocurrencies) and dip-buying any market decline. When the market environment changed, suddenly and violently, the short volatility trade blew up. Years of gains vaporized in a single day.


Over the past couple of years I have begun to believe there are tremendous benefits to viewing markets through an evolutionary and/or ecological lens. I think this helps you focus on a range of variables impacting the markets, versus wearing blinders that limit you to valuation, momentum, or whatever it is you consider your “thing.” So when a particular asset class catches a strong bid, here are some things I consider:

If this is a cash flow producing asset, what is the relationship between the intrinsic value of the cash flows and the market price? For stocks it is not especially difficult to use the market price and a simple DCF model to derive a market implied IRR. For bonds just check the yield to maturity, yield to call, yield to worst, etc. This gives you an idea of how investors are pricing risk.

Who is driving flows into or out of a sector or asset class? Mutual funds look at the world differently from hedge funds, which look at the world differently from banks and insurance companies. Each of these players has different objectives and constraints, which will impact their behavior as market conditions change.

Are the players driving flows into the asset weak or strong hands? Retail investors are the weakest hands in the markets. I consider many mutual funds weak hands also (depends on the fund family). Mutual fund flows are driven by retail investors and their financial advisors, who are notorious for chasing performance.

How highly levered are the players driving flows into the asset? Leverage can drive extraordinary returns, but it also creates fragility. When deleveraging events occur, prices can collapse suddenly. Many of the short volatility players who got blown up recently didn’t understand the magnitude of the leverage embedded in their positions.

What exogenous factors are driving flows into this asset class? Is an asset in demand due to expectations for low interest rates, low inflation, or other macroeconomic variables? Macro conditions are fickle, and human beings are notoriously poor forecasters.

The most fragile market ecology is one where weak hands are using leverage to play some exogenous variable with known unstable or mean-reverting properties. From this perspective, systematically shorting volatility was stupendously risky–a form of Russian roulette. A large number of retail investors were trading instruments (volatility linked ETPs) with significant embedded leverage, placing a massive directional bet on low rates, low inflation and market momentum.

A market ecology I believe is extremely fragile, but hasn’t blown up yet, is high yield debt. This is an asset class that is highly leveraged by definition, and has attracted massive flows from yield-starved investors. Strong flows have pushed prices up to the point where future expected returns are dismally low, and protective covenants are the weakest on record. Perhaps worst of all, there is a liquidity mismatch between the ETPs (HYG, JNK, etc.) providing investors with easy access to high yield debt and the underlying high yield bonds. For a preview of what happens when a liquidity mismatch meets a stampede for the exits, refer to Third Avenue Focused Credit.

Next stop: Adaptive Markets by Andrew Lo.

Blood In The Water

I was reading a cryptocurrency report from Goldman Sachs this morning and stumbled upon the following chart:

Source: Goldman Sachs

Now, put those dates in the context of the Bitcoin price action (which I think is a fair approximation of investor appetite for cryptos more generally):

Source: Bloomberg / coindesk

This speaks to a corollary of The Golden Rule:* The market supplieth what investors doth demand. If people are willing to throw billions of dollars at crypto lottery tickets, you can bet they will find an ample supply of coins and tokens to invest in.

Another, perhaps more intuitive way of thinking about this is that “easy” money attracts “investors” like blood attracts sharks. The sharks come swimming, and if there is enough blood in the water a feeding frenzy will ensue.

This description from Wikipedia is rather evocative:

In ecology, a feeding frenzy occurs when predators are overwhelmed by the amount of prey available. For example, a large school of fish can cause nearby sharks, such as the lemon shark, to enter into a feeding frenzy. This can cause the sharks to go wild, biting anything that moves, including each other or anything else within biting range. Another functional explanation for feeding frenzy is competition amongst predators.

In boring old non-tokenized finance, this dynamic drives the credit cycle. Suppliers of capital get good deals when capital is scarce. They get crap deals when capital is plentiful. When capital is plentiful, and investors are overly trusting, capital ends up in the hands of miscreants and value destroyers (though admittedly, many value destroyers are well-intentioned). In fact, driven wild by greed and vying for deal flow, investors compete aggressively to offer capital on favorable terms to miscreants and value destroyers.

What kind of deal do you suppose you are getting when you exchange cold hard cash for a token with no protective covenants, that gives you no claim on equity or future cash flows, and which may not even exist yet?

Source: Wikipedia

* The Golden Rule: He who hath the gold, maketh the rules.

One For The Books

Source: Seeking Alpha

It gets worse. The indicative values for SVXY and XIV had fallen over 90% when they finally printed for 2/5. Word on the street is that the collapse of XIV may have blown a $500 million hole in Credit Suisse’s balance sheet (at pixel time Credit Suisse was the largest holder of XIV, owning about 4.8 million shares).

No one who lost money in this trade has anyone to blame but themselves. The risks were well known. And any time you see stories like this, you know you’re looking at a disaster in the making.

UPDATE: News reports indicate Credit Suisse is fully hedged for their XIV exposure.

UPDATE #2: Credit Suisse is calling (a.k.a “accelerating”) the XIV ETN.

UPDATE #3: Marketwatch relates one retail XIV trader’s tale of woe:

“I started with 50k from my time in the army and a small inheritance, grew it to 4 mill in 3 years of which 1.5 mill was capital I raised from investors who believed in me,” Lilkanna explained, adding that those “investors” were friends and family.

“The amount of money I was making was ludicrous, could take out my folks and even extended family to nice dinners and stuff,” he wrote. “Was planning to get a nice apartment and car or take my parents on a holiday, but now that’s all gone.”

UPDATE #5: The FT has some details on Credit Suisse’s positioning:

Credit Suisse said the closure of the VelocityShares product, whose valued peaked at $2.2bn on January 11, had “no material impact” on the group and a Credit Suisse insider said its exposure was “fully hedged”. The Swiss lender was listed as the biggest holder of the note, but the insider stressed that the bank did not hold any of the product’s notes on its own behalf, rather they were held in custody for clients. He also stressed that the notes were not sold through Credit Suisse’s private bank.

Still, there could be some repercussions for the bank, which is midway through a restructuring plan designed to make it less dependent on risky investment bank activities. “The reputational issue is more tricky and it can’t be comfortable having put clients into a product that has imploded like this,” said Piers Brown, an analyst at Macquarie. “They’ve indicated it was mainly sold to hedge funds so I guess you’d say they are sophisticated investors who knew the risks. However, they’ve also talked of the opportunity they see in selling more structured products to their private banking clients. This might raise a few question marks over that idea.”

UPDATE #6: The vol shorting ex-Target manager turned day trader apparently survived the blowup. If this is true, I have to give the guy credit for managing risk in his book.

The Insidious, Creeping Horror Of Artificially Low Interest Rates

Source: Night of the Living Dead

“Volatility is about fear… but extreme tail risk is about horror […] It is not the first act of the horror movie when people start turning into zombies… it is the end of the second act when the hero realizes he is the only person left not a zombie.”

Chris Cole, Artemis Capital, “Volatility and the Allegory of the Prisoner’s Dilemma”

Here is how a mutual fund manager responsible for billions of dollars in client assets is setting his return hurdles:

Source: Google Talks Transcript via MicroCap Club

You should read the whole talk. It is fascinating and informative. Bill Nygren is a well-regarded mutual fund manager. This post isn’t meant to impinge on his intelligence or skill (your humble blogger is acutely aware he is a nobody). What this post is meant to show is how some of the most capable investors in the world have been impacted by very low interest rates.

We know from prior analysis that the riskfree rate of interest has varied dramatically over the last 50 years, and that current rates plot on the low end of the historical range. Here is a visual from my discount rate post:

Data Sources: Aswath Damodaran & Michael Mauboussin

So is a 100 bps upward adjustment to the market yield really giving you a conservative hurdle rate?

Nygren is hardly an idiot. But he is running a multi-billion dollar mutual fund. If his team jacks their hurdle rate up to 10% it will get very, very difficult to find things to buy in the current market environment. And as we have discussed in the past, mutual fund managers cannot sit on large cash stockpiles.

This is the critical difference between an investor concerned with relative performance versus a benchmark index and an investor concerned with absolute performance that will compound capital at attractive rates over time. Ambitious absolute return goals should be accompanied by high return hurdles. When a hurdle is set at “bond yield + x bps” in a low rate environment it may underprice risk.

Shenanigans! PIK Bond Edition

As follow on to my recent post on “return free risk” in the high yield market, here is a real gem via the FT:

One of Ireland’s richest entrepreneurs has embraced an aggressive new version of an already esoteric form of junk bond, highlighting the level of risk that debt investors are willing to tolerate as they seek higher yields in hot credit markets.

The $350m “super PIK,” or payment-in-kind bond, raised at the end of last week will pay a dividend to a group of shareholders in Ardagh Group, a one-time small Irish glass bottle maker that has grown in the past two decades into one of the world’s largest metal and glass packaging companies.

PIK refers to bonds or loans that can pay their interest with further debt rather than cash. This means the size of the debt can balloon quickly and leave lenders with steep losses if the underlying company is not able to handle the growing burden.

No, your eyes do not deceive you. The company raised a $350mn bond issue that gives it the option of paying coupons with IOUs instead of cash. So it can pay insiders a dividend.

While Ardagh listed on the New York Stock Exchange last year, 92 per cent of its shares are held privately, with its billionaire founder and chairman Paul Coulson the largest shareholder. It is these private shareholders that are receiving the dividend. “In plain terms, the use of proceeds is essentially providing a ‘margin loan’ to legacy shareholders,” noted analysts at credit research firm CreditSights.

Here is the cap structure, if you are interested in a quick round of Spot The Suckaz:

Source: FT

And where exactly did this boondoggle price?

Despite its risky structure, the PIK bond sale drew roughly $2.5bn of orders, said a person close to the deal. This allowed it to ultimately price with a yield of 8.75 per cent, below the 10 per cent initially marketed. An older PIK dollar-denominated deal sold by the company in 2017 currently trades with a yield of 6 per cent.

Yeah, I know, it’s all anecdotal evidence. You can’t time the market or the credit cycle. Blah, blah, blah. Nonetheless, I vaguely recall an old Warren Buffett saw… something about when to be fearful and when to be greedy…