Category Archives: Public Markets

Investing in 100 Year Bonds? It Might Hurt


May 16, 2016

Let’s talk interest rates this week. With global growth slowing in so much of the world, low interest rates are becoming the norm more and more. A global search for yield on sovereign debt estimates that over 80 percent of the world’s government bond debt is yielding less than 3 percent. In fact, in certain parts of the world interest rates have gone negative. Let’s look at various countries and what their average government debt is yielding:

Country           Effective Yield

US                           1.29%

UK                          1.41%

France                    0.21%

Germany              -0.10%

Italy                       0.99%

Switzerland          -0.38%

Australia               1.98%

Not much yield on the sovereign side but what about the debt of companies, is there any yield there?

US Corporate Bonds                                       3.03%

US High Yield Bonds                                        7.75%

Emerging Market Corporate Bonds              5.56%

European Corporate Bonds                           0.81%

The demand and need for income is usually high in an investor’s portfolio. It is a fact that today’s buyers of bonds are enthusiastic about investing in bonds at virtually any price for any period of time. The WSJ this week noted that the demand for debt (income) in Europe is so great that companies and nations are issuing very long term debt that doesn’t mature for 50 and 100 years! The Spanish government issued a 50-year bond that rewards the investors a yield of only 3.45%. Last month the French government sold a 50-year at a return of only 1.75%. Six years ago the same 50-year debt carried a rate of 4%. Have investors lost their minds locking in a 1.75% for 50 years?

It’s not just bond investors that are impacted in this new low interest rate environment. We had a discussion this week with a long time real estate professional on the state of his market. He pointed out how the demand for yield and the acceptance of low rates has spread to real estate investors. Report after report shows that the metric used in calculating the value of income-producing real estate called the capitalization rate (cap rates) continues to drop for all property types. Long-term players in the real estate market are beginning to question some of the valuations due to these historically low cap rates. The problem is buyers continue to look for yield.

If you are the manager of a pension fund, you must invest your capital to produce income in order to pay your pensioners. You must find investments that generate the yield you need. In the past you might get that yield from government bonds, but not today. That might cause you as the portfolio manager to turn to riskier options in corporate or high yield bonds. But what if that rate is too low? The next option is to invest in longer and longer term bonds. Both of these options are very risky to the bond investor, but the reality is they are doing it and there is no end in sight to their demand and to their problems. If you need to borrow money globally there has never been a better time – the buyers for your debt await with open arms and low rates.

Carl Gambrell


Q1 2016 Client Letter

April 2016

If you look at markets only once a quarter, the first three months of 2016 appear relatively uneventful, at least on the surface. The S&P 500 was up 1.4%, U.S. small cap stocks were down -1.5%, and the Barclays U.S. Aggregate Bond Index was up 3.0% on the year. Developed international equities were down -3.0% but emerging market equities were up 5.7%.

For those of us who follow markets more closely, it was anything but boring. The final numbers mask the underlying uncertainty and volatility that played out in the quarter. The S&P 500 declined more than 10% in the first six weeks of the year – the worst calendar year start in its history. The downward pressure was fueled by the usual suspects: concern over global economic growth, particularly in China; continued weakness in the price of oil and other industrial commodities; monetary policy uncertainty and fear of rising interest rates in the U.S.; and disappointing prospects for corporate revenues and earnings.

Sentiment improved and markets changed course in the middle of February. There was talk of a potential deal among OPEC countries to cap oil production and address the return of Iran to the global supply chain. The Federal Reserve was more dovish in their comments and reduced the number of expected 2016 rate hikes from four to two. The European Central Bank announced a more aggressive stimulus plan to cut interest rates and increase the size of their quantitative easing program, including a program to purchase corporate bonds. Equity markets responded positively to these developments. After its dreadful start to the year, the S&P 500 enjoyed one of its best ever advances for the month of March. Developed international and emerging market equities also advanced, as did crude oil. By the end of the quarter the S&P 500  returned to positive territory for a quarterly performance that was “turbulently flat”.

Despite the drama and volatility, there was little change in the underlying fundamentals that ultimately drive long-term investment performance, such as sales revenues, profit margins, and corporate earnings. In fact the past year has seen a growing divergence between security prices and their underlying fundamentals. For example, while the market is only 3% below its all-time-high, some analysts are expecting S&P 500 earnings to decline by more than 9% in the first quarter of 2016. This would be the largest decline in earnings since 2009, and the fourth consecutive quarter with a decline in earnings.

Furthermore, the quality of the reported earnings has come into question. There is an increasing separation between GAAP earnings (Generally Accepted Accounting Principles), and Pro-forma earnings (earnings excluding extraordinary or supposedly “one-time” items). Warren Buffett commented on this phenomenon in his most recent letter to Berkshire Hathaway shareholders in typically blunt terms:

“It has become common for managers to tell their owners to ignore certain expense items that are all too real. ‘Stock-based compensation’ is the most egregious example.  The very name says it all: ‘compensation.’  If compensation isn’t an expense, what is it?  And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?”

With organic sales and revenue growth difficult to find, companies are increasingly turning to financial engineering tactics to boost their numbers. Low cost borrowing has fueled merger and acquisition activity and share buybacks. Pro-forma earnings are increasingly emphasized and may obscure actual performance. These activities are a response to stubbornly sluggish fundamentals.


Looking forward, we would expect these divergences to be resolved over time in one of three ways: improving fundamentals rise to meet the market, the market falls to meet sluggish fundamentals, or  some combination thereof.

While most might prefer the first option, we consider the latter to be more likely. Under the third option, we would expect continued volatility as the market moves sideways in a range-bound manner while prices and fundamentals gradually converge. Earnings season has begun and we will be watching closely for signs of improving fundamentals and pockets of opportunity.

In challenging times like these it is important to maintain a long-term strategic perspective.  In an effort to add value over the long haul, we continue to dedicate energy to finding investment opportunities in less-trafficked areas that function independently of the public markets. We remain committed to the thoughtful and diligent process that has served our client families well over the years.

On administrative matters, please find enclosed our privacy policy and a summary of the Material Changes to our ADV Brochure filed on March 25th, 2016.  Please let us know if you would like a copy of the full Brochure. Please also let us know promptly of any significant change in your financial circumstances that would necessitate revisiting your investment objectives or re-evaluating the management of your assets.

As always, we welcome your thoughts and appreciate the confidence you have placed in our firm. We are grateful for the opportunity to work with you and your family.

Nichoals Hoffman & Co.