Keep INVESTING Simple and Safe (KISS)
****Investment Philosophy, Strategy and various Valuation Methods****
The same forces that bring risk into investing in the stock market also make possible the large gains many investors enjoy. It’s true that the fluctuations in the market make for losses as well as gains but if you have a proven strategy and stick with it over the long term you will be a winner!****Warren Buffett: Rule No. 1 - Never lose money. Rule No. 2 - Never forget Rule No. 1.
Malaysian banks rating intact despite US bank failures - RAM Ratings
Publish date: Sat, 18 Mar 2023, 08:06 AM
KUALA LUMPUR - RAM Rating Services Bhd (RAM Ratings) sees no rating impact on Malaysian banks from the failure of the United States Silicon Valley Bank (SVB) and two other smaller banks last week.
The rating agency said that in Malaysia, banks' credit fundamentals remained robust and resilient supported by strong regulatory supervision to weather heightened volatility in global financial markets.
"Compared to SVB, we see fundamental differences in the business and balance sheet profiles of commercial banks in Malaysia.
"Domestic commercial banks typically engage in more lending activities as opposed to relying on bond investments which are exposed to market volatility. The proportion of domestic banking system assets invested in bond securities is less than 25 per cent," it said in a statement today.
SVB, on the other hand, had more than 50 per cent of its asset base in such securities, which led to huge unrealised losses amid rapid and steep interest rate hikes in the US.
Moreover, less than 40 per cent (on average) of bond holdings in Malaysia's eight major banks are classified as held to maturity (HTM), while the rest are marked to market.
"This means that fair value losses on bond securities are already largely reflected in the banks' capital position. In contrast, SVB classified almost 80 per cent of bond securities as HTM (only a little over 20 per cent were marked to market), indicating that unrealised losses had not yet been reflected in its equity.
"HTM bonds are carried at amortised cost in the balance sheet given the intention to hold these securities to maturity, so fair valuation losses are not captured in the capital," it said.
RAM Ratings said fair value losses in Malaysian banks were also significantly smaller, thanks to Bank Negara Malaysia's (BNM) milder pace of rate hikes and banks' prudent strategy of holding shorter-tenure bonds in recent times.
The domestic banking industry's common equity tier-1 capital ratiostayed at a robust 14.9 per cent at end-2022 from 2021's 15.5 per cent.
"Further valuation losses, if any, should be less severe given the central bank's cautious stance on further rate hikes," said the rating agency, adding that banks in Malaysia are predominantly funded by customer deposits, with high granularity.
Their liquidity profiles are also sound with liquid assets to deposits ratio of around 20 per cent and a net loans to deposits ratio of 88 per cent, it added.
According to BNM, domestic banks have no direct exposure to the three failed US banks.
"The central bank's robust prudential oversight and good track record - which have been evident in previous financial crises - should ensure the continued financial stability of the Malaysian banking system," it noted.
Why bonds produced such dreadful returns after 1945
In the 1940s, interest rates had been falling for the better part of 20 years as the Great Depression drove knee-jerk risk aversion, and hit record lows as various policies and incentives moved to cheaply finance wartime deficits.
According to Yale economist Robert Shiller, 10-year Treasuries yielded
5% in 1920,
3% by 1935, and
2% by the early 1940s.
The consensus came to believe low rates were a permanent fixture. "Low Interest Rates for Long Time to Come," read one newspaper headline in 1945.
But as the saying goes, if something can't go on forever, it won't.
By 1957, 10-year Treasuries yielded 4%.
By 1967, 5%.
They breached 8% in 1970, and zoomed to
15% by 1981 as inflation scorched the economy.
Since bond prices move in the opposite direction of interest rates, this was devastating to returns. Deutsche Bank has an archive of Treasury returns in real (after inflation) terms, which tells the story:
Period
Average Annual RealReturns, 10-Year Treasuries
1940-1949
(2.5%)
1950-1959
(1.8%)
1960-1969
0.2%
1970-1979
(1.2%)
Source: Deutsche Bank Long Term Asset Return Study.
Don't underappreciate how awful this was. In real terms, $1,000 invested in 10-year Treasuries in 1940 would have been worth $584 by 1979 -- this for an investment often trumpeted as "risk-free."
Lessons
No one knows if the same performance will be repeated over the coming years.
Japan is a good example of extremely low interest rates sticking around for decades.
But the risks are obvious.
With 10-year Treasuries yielding 1.5%, there is virtually no chance of high returns over the next decade.
The odds of being hammered and suffering negative real returns are, however, quite good.
What does the bond market turmoil mean for investors?
US Treasuries have suffered the worst start since 1788 after falling by 9.8 per cent this year, triggering experts to question the 60/40 portfolio strategy
The bond market has suffered a record $10 trillion sell-off this year. AP
Investors fretting over this year’s $13 trillion global stock market crash may have overlooked similar carnage in a market that is actually more important for the global economy.
The bond market has also suffered a record $10tn sell-off and this could hit investors just as hard because a strange thing is happening.
Both shares and bonds are crashing at the same time. That is something financial experts say isn’t supposed to happen.
But in 2022, it is. Which means there is no hiding place for investors in this troubled year. There may also be an opportunity, if you are sharp.
Retail investors may pay little attention to the bond market but institutions and governments have been known to obsess over it.
For them, the bond market is the big one. It is about triple the size of the global stock market and plays an essential role in keeping economic activity ticking. At the end of last year, the bond market was worth about $120tn, against $41.8tn for global shares.
If the bond market gets bumpy, everybody is in for a rough ride.
Governments issue bonds to raise money for their spending while companies use them to generate the funds they need to grow. Both promise to pay investors a fixed rate of interest over a preset term, with a guarantee to return their original capital afterwards.
At maturity, the issuing government or company must repay the debt. If it cannot, there is trouble.
Bonds are traded by investors, which means their value can constantly change, depending on factors such as inflation, interest rates and demand. As is the case with shares, bond prices can rise and fall. Just not as much. Usually.
Ordinary investors rarely buy individual bonds but invest through a fund holding a spread of government or corporate bonds.
Bonds offer them a fixed rate of interest plus capital growth if prices rise, with fewer of the ups and downs you find with shares.
The two are supposed to be non-correlating assets. So, when shares fall, bonds are supposed to mitigate losses by standing firm.
The one thing they are not supposed to do iscrash simultaneously. Yet, that is what is happening right now.
For decades, financial planners said the safest way to generate steady, strong long-term returns is to invest 60 per cent of your money in shares and 40 per cent in bonds.
The classic 60/40 portfolio strategy has generated an impressive average return of 11.1 per cent a year over the past decade.
You can even buy exchange-traded funds (ETFs) that automatically deliver this, such as the BlackRock 60/40 Target Allocation Fund or the Vanguard 60% Stock/40% Bond Portfolio.
The writing was on the wall for the 60/40 strategy last year, as US large-cap stocks hit record-high valuations, while US Treasury government bond yields neared record lows.
“For all intents and purposes, we think investors have many reasons to be concerned that the 60/40 might be dead,” Nick Cunningham, vice president of strategic advisory solutions at Goldman Sachs Asset Management, said last October.
This will hit investors who had even never heard of the 60/40 rule because “we see shades of the classic 60/40 present in many portfolios due to an over-concentration in the most familiar asset classes", Mr Cunningham added.
As this warning proves prescient, it may be worth looking at your portfolio to see how exposed you are to this double jeopardy.
This has been a challenging year across the board, says Jason Hollands, managing director of investment platform Bestinvest.
“2022 has seen one of the worst starts to a calendar year for core US assets on record,” he says.
US Treasuries have suffered the worst start to a year since 1788, according to Deutsche Bank, falling 9.8 per cent. Bloomberg
US Treasuries have suffered the worst start since 1788, according to Deutsche Bank, falling by 9.8 per cent. That isn’t supposed to happen to the bond market.
“At the same time, the S&P 500 Index of US shares has fallen 20.38 per cent, the worst first half for US equities since the Great Depression in 1932,” Mr Hollands says.
This is happening because central banks, led by the US Federal Reserve, are throwing monetary policy into a sharp reverse.
After decades of slashing interest rates and pumping out stimulus, they are tightening as fast as they dare to curb inflation.
“Central bankers have now yanked away the key supports for equity and bond markets that turbocharged them in 2020 and 2021,” Mr Hollands says.
Rising interest rates are bad news for shares because higher borrowing costs squeeze both businesses and consumers, hitting profits.
Bonds suffer because they pay a fixed rate of interest, which looks a lot less attractive when rates are rising and investors can earn higher yields elsewhere.
The stock and bond sell-off isn’t over yet despite signs of a recovery in recent days, says Fawad Razaqzada, market analyst at City Index and Forex.com.
Optimists convinced themselves that the Fed would curb rate increases for fear of tipping the US into recession, but this is a misreading.
“The Fed is in a hawkish mood. I think the start of another equity and bond market sell-off is nigh,” Mr Razaqzada says.
It is not all bad news, though.
Bonds do this odd thing that sometimes confuses private investors. When bond prices fall, yields rise.
While the bond price crash is bad news for existing holders, new bond investors are earning a higher rate of income. Yields on 10-year Treasuries have almost doubled from 1.63 per cent to 3.06 per cent this year.
Stock and bond market crashes have one thing in common. Both can throw up opportunities for forward-looking investors.
The Fed will continue to raise rates this year but it also wants room to cut when the US economy slips into recession as a result, probably in 2023, says Lisa Emsbo-Mattingly, managing director of asset allocation research at Fidelity Investments.
“If inflation comes down, real rates, which are yields minus the rate of inflation, could rise further into positive territory after being below zero for the past two years,” she says.
This would allow government bonds to carry out their old job of providing a steady level of income for lower-risk savers and pensioners. Bonds could then start making a meaningful contribution to that balanced 60/40 portfolio split again.
Bonds are cheaper than they were after this year’s dip and are starting to look better value for money.
It could soon be time to start buying bonds again, ideally before the Fed starts cutting rates next year to reverse the recession, at which point bond yields will fall again, Ms Emsbo-Mattingly says.
“But the window of opportunity for yield-seekers may be brief,” she says.
There are hundreds of bond ETFs to choose from, including iShares Core 1-5 Year USD Bond ETF, iShares Global Government Bond UCITS ETF (IGLO) or db x-trackers II Global Government Bond UCITS ETF.
Accurately timing bond fund purchases is no easier than timing the stock market, yet recent volatility is throwing up an opportunity.
Let's take a look at the bond table, and see how to break it down.
Column 1: Issuer. This is the company, state, province or country that is issuing the bond.
Column 2: Coupon. The coupon refers to the fixed interest rate that the issuer pays to the lender. The coupon rate varies by bond.
Column 3: Maturity Date. This is the date when the borrower will pay the principal back to the lenders (investors). Typically, only the last two digits of the year are quoted, so 25 means 2025, 04 is 2004, etc.
Column 4: Bid Price. This is the price that someone is willing to pay for the bond. It is quoted in relation to 100, regardless of the par value. Think of the bond price as a percentage, a bond with a bid of $93 means it is trading at 93% of its par value.
Column 5: Yield. The yield indicates the annual return until the bond matures. Yield is calculated by the amount of interest paid on a bond divided by the price -- it is a measure of the income generated by a bond. If the bond is callable it will have a "c" followed by the year in which the bond can be called. For example, c10 means the bond can be called as early as 2010.
The five year gilt yield has fallen to a new low (Photo: AP)
The benchmark five year gilt yield fell to a new low of 1.43 per cent on Thursday, which astonishingly takes it to a 25 basis point discount to that of its German bund counterpart. The UK Government likes to think of the record lows to which gilt yields have sunk to be a vote of confidence by international investors in its plans for fiscal consolidation, and no doubt there is a small element of truth in this contention. But the main factors driving government bond yields ever lower, not just here in the UK, but in the US too, are much more worrying and have little to do with the bravery of George Osborne’s deficit reduction programme.
In essence, both the UK and US government bond markets have become giant bubbles which are now largely divorced from underlying realities and almost bound to end badly. Yes, for sure if the UK Government hadn’t done something about the deficit, then we might be looking at far less benign conditions in the gilts market, but just to repeat the point, it’s not really enhanced credit worthiness which is causing these abnormally low yields.
The US is experiencing much the same phenomenon, even though its public finances are in just as big a mess as the UK’s and it has virtually no plan that I can discern for deficit reduction, besides the wing and a prayer hope that growth will eventually come to the rescue.
So what’s really driving this dash for government debt?One possibility is that bond markets are already pricing in a depression, or at least a Japanese style lost decade of deflation. Despite ever more mountainous quantities of public debt, bond yields in Japan have been at abnormally low levels for years. Indeed, in Japan the abnormal is now normal. If you think the price of goods and services will soon be deflating, then even bonds on 1 per cent yields offer a healthy rate of return.
But no, the real reason lies in the market distortions that result from ultra easy monetary policy and the demands being put by regulators on banks to hold “riskless” assets. This is leading to a profound mis-pricing of government bonds, which now take virtually no account of significant medium term inflation risks.
If you think markets are always right, then bond prices are indeed signalling the inevitability of a depression, but if there is one thing we have been forced by the events of the last three years to relearn about markets it is that they are prone to episodes of extreme mispricing. The bond phenomenon is very likely one of them.
There are a number of ways in which bond markets are being distorted. One is regulatory demands on banks to hold bigger “liquidity buffers”. The asset of choice in boosting these buffers is government bonds. These have already been proved by Europe’s sovereign debt crisis to be very far from the “riskless” assets of regulatory supposition. Even so, banks are still being forced to max out on government debt.
A second distortion is caused by the “carry trade” opportunitiesof exceptionally low short term interest rates. Put crudely, you can borrow from the central bank for next to zero, lend the money out at a higher rate further up the yield curve, and pocket the difference. In a sense, that’s the purpose of ultra-easy monetary policy – to create a generally low interest rate environment – but the dangers of it are obvious. Central banks are creating a bubble in government debt.
And so to the biggest reason of the lot. Look at the chart above (created from Bloomberg data), which shows the yield gap between the five and thirty year gilt, and you can see that it has widened substantially over the past year. The reason is that investors are anticipating another bout of quantitative easing from the Bank of England. In the last round of QE, the Bank concentrated purchases initially on UK gilts in the five to 25 year range, but then widened this to include three year gilts and some 25 year plus bonds after running up against supply constraints. Investors are buying up the five year gilt because they know this is where the Bank, if it does more QE, will find most scarcity. Exactly the same thing is happening in the US, where more QE is already pretty much a done deal.
Anyone with half a brain can see that Germany is a rather more credit worthy and naturally inflation proofed country than either the UK or the US, yet the cost of five year money in Germany is now higher. How can this be? The explanation lies in the absence of overt QE in the eurozone. There have been no purchases of German bunds by the European Central Bank.
In fighting the aftermath of the last bubble by flooding the market with ultra-cheap liquidity, the Fed and the Bank of England seem only to be inflating new ones. There are others besides government bonds, commodities and emerging market assets being the most obvious. I’m not saying these policies are as a consequence flawed and wrong. That wider debate involves an altogether more complex and diverse range of issues. But the risks are self evident.
One persuasive argument for why stocks are a better buy than bonds today is that, for the first time in over half a century, the Dow Jones's dividend yield exceeds the yield on 10-year Treasury bonds.
There's really only one way to justify this: panic-driven fear over deflation that could make the Great Depression look like a sissy. The market is saying, and saying loudly, that dividend payouts are going to be butchered over the next 10 years. By a lot. Unless you think this is likely -- and if you do, bask in your bond bubble -- there's practically no way to justify the current divergence between dividend and bond yields.
Or is there? One popular argument making the rounds comes from a group who says the past 50-some-odd years of bonds yielding more than stocks was the anomaly, not the current reversal. Their evidence seems bulletproof: Before the 1950s, stocks almost always yielded more than bonds. And shouldn't they? Stocks have a nasty tendency of blowing up, and stockholders stand second in line to bondholders, so investors are right to demand extra yield. Only from the 1950s to circa-2009 was this view thrown out the window.
If you think of markets from this historical perspective, the implications are grim. Perhaps the past 50 to 60 years was one giant equity bubble that's now fraying at the seams. Perhaps we've been fooling ourselves for generations, glued to a cult mentality that says stocks are forever and always superior to bonds, amen. With that cult dying bit by bit, perhaps we're headed back to the pre-1950s days when stocks consistently out-yielded bonds. Woe is our future, basically. That's the argument I've been hearing a lot lately.
But there's a major flaw in it. And it's a simple one: To accurately compare dividend yields over time, you have to assume that dividend payouts as a percentage of net income stay the same. But that's not even close to how history has played out.
In the 1973 version of his classic book The Intelligent Investor, Ben Graham -- Warren Buffett's early mentor -- notes an important shift:
Years ago it was typically the weak company that was more of less forced to hold on to its profits, instead of paying out the usual 60% to 75% of them in dividends. The effect was almost always adverse to the market price of the shares. Nowadays it is quite likely to be a strong and growing enterprise that deliberately keeps down its dividend payments ...
His point, of course, was that dividend payouts as a percentage of net income were falling. And that's exactly what happened. From 1920-1950, the average S&P 500 company paid out 72% of net income in the form of dividends. From 1950-2010, that number dropped to 51%. From 1990-2007, the average was 45%. Over the past year, it's down to 33%. Today, some of the most profitable and fastest-growing companies -- including Apple(Nasdaq: AAPL), Google(Nasdaq: GOOG), and Cisco(Nasdaq: CSCO) -- pay no dividends at all. The slow-growers -- like Altria(NYSE: MO), Verizon(NYSE: VZ) and Consolidated Edison(NYSE: ED) -- are where you find yield. That was unheard of 60 years ago.
More than anything, this explains why stocks consistently out-yielded bonds before 1950. Back then, stocks were essentially just high-yield bonds with variable-rate coupons. Today, companies tend to hoard net income to finance growth, acquisitions, and buybacks. It's inane to compare the two periods without adjusting for that paradigm shift.
What happens when you do? Well, if you model the past to assume that S&P companies have always paid out 33% of net income as dividends, like they do today, then prolonged periods of stocks out-yielding bonds become incredibly rare. There would have been only two such periods in modern history: from 1940-1944, and 1947-1955.
And what's neat about these two periods? They were both phenomenal times to buy stocks. In the 10 years after 1944, stocks surged 161%. In the 10 years following 1955, investors were rewarded with a 145% return -- and both figures don't include dividends.
History is pretty clear on this stuff: When stocks out-yield bonds, it's a great time to buy them. Some patience may be required, but the rewards for those patient few are invariably awesome. Today, with the average large-cap stock out-yielding Treasuries, there's little reason to think patient investors won't be rewarded like champions 10 years from now.
Ben Graham gets the last word: "The market price is frequently out of line with the true value. There is, however, an inherent tendency for these disparities to correct themselves."
Strategy: Government bond markets for the major economies are not prone to crashes
The characteristics of bonds:
1. The level of interest rates set by the government are somewhat predictable 2. They are not as risky as stocks.
Many people point out that stocks outperform bonds in the long run. Perhaps. However, one comfort you do have with high-grade bonds is that you are unlikely to wake up in the morning and find you have lost 25% of your investment, which of course does happen occasionally with stocks.
Most unexpected shocks to the economy are bad news:
a crash in consumer or business confidence,
a terrorist attack,
a war,
a SARS crisis, etc.
Now if one of these pushes the economy into a dive, stocks plummet while bond prices can actually go higher (that is, pushing the yields lower).
In the 1987 October share crash, panic was everywhere. Those who were holding bonds did very well. The bad news for the economy was good news for interest rates.
There is also the interesting effect of government deficits on bond yields, especially in the United States.
One could argue that the government bond markets should work like all markets, so that if the government wants to borrow more and more, it has to pay a higher interest rate, and sell bonds at a lower price.
This was a criticism of fiscal policy by one brand of economists - the monetarists. They argued that 'crowding out' would mean that higher deficits don't help a weak economy, because they simply push up borrowing costs for everyone.
However, current interest rates in the US are normal even though the deficit is at an all time high, therefore such an argument is not convincing.
As an investor in the stock market, bonds are alternatives. There have been dream runs in the share market. This article alerts you to the attractions of the bond market when your strategies steer you in that direction.
Strategy: Short term interest rates will tend toward the inflation rate plus the economic growth rate
There is always a great deal of discussion about interest rates, particularly US rates. Short term rates are set by governments and this can be a fascinating process to watch. The rates affect the economy and many of the markets.
The benchmark strategy helps to make sense of discussions about their direction and their level. It is a rough guide which is often missed by many commentators. With this rough valuation target, interest rates are easier to understand than most markets, where it can be hard to have a clue what the prices should be. Equities, the market that most investors concentrate on, do not have this kind of benchmark.
An interest rate is made up of the inflation rate plus a 'real' rate. That is, the real interest rate is what is left after allowing for inflation.
Interest rate = Inflation + 'Real interest rate'
The economic growth rate is the percentage expansion or contraction in the economy with inflation stripped out. It can be loosely considered as the dividend paid by the economy in general.
Economic Growth rate = Rate of expansion or contraction in the economy - Inflation
Rate of expansion or contraction in the economy = Inflation + Economic Growth rate
Over time, the real interest rate moves towards the economic growth rate. In that way, the return from interest rates and the return from the economy in general, are equal.
In 2005, the short term rates in the US are 1%. When they start to rise, how far could they go? In the US in 2005, you may wish to target 4% because inflation was around 2% and growth was also around 2%. Add them and you get the target.
Rates had started moving lower worldwide and the question was, how far they could fall? Using the rate of contraction in the economy and the inflation rate gives you an estimate of the economic growth rate. As over time, the real interest rate moves towards this economic growth rate, using this simple strategy, you can have an idea how much further interest rate could move and in which direction.
As the level of interest rates are somewhat predictable, this benchmark strategy helps you to invest intelligently in the bond market.
