Category Archives: investments

Have all the World Cup expenses been counted?

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Airports Company SA, “ACSA”  now has some of the highest fees  in the world. Apparently they need to fund the huge “investment expenditure” incurred  in upgrading on our airports recently for the World Cup.

This begs the questions:

  1. What business plans were used in determining investment on our airports?
  2. How did actual experience compare to those budgets?
  3. What can we and ACSA learn from the difference between expectations and actual?
  4. Did the marketing benefit of the World Cup more than offset the de-marketing impact of higher costs of travel to (and inside) South Africa?
  5. Have these “investment expenditures” been capitalised on ACSA’s balance sheet and has the resultant asset been impaired or not?
  6. Have these additional costs been added to the official costs for the World Cup (and why not?)

Who am I kidding -  huge sums of money were spent on the gut feel that it was a good idea and because spending other people’s money is easy and it’s self-glorifying to build grand airports.

SA Bond Market – antiquated or efficient?

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[Update: for some incomprehensible reason the embedded video clips below only work on YouTube. Click the image for a link to the YouTube page]

Andrew Canter (of Future Growth) makes some strong statements about the “phone and dealer” approach to the South African bond market. When one of the arguments against Andrew’s preferred centralised, electronic order book is “we like the information we get from deal flow” I have to say I agree with Andrew.

and part 2 (which also includes some discussion of Covered Bonds with the clear links to Basel and indirect links to Solvency II and SAM) Continue reading →

Fixed Interest is a viable asset class

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I heard someone talking on Classic Business tonight. Pity I didn’t catch his name so I can avoid his advice in future.

He was saying that he doesn’t see the point in investing in debt instruments.  He explained that the return is low and the risk high since if the company gets into trouble, you’ll likely only get a few cents on the dollar back.

Well, he’s wrong.

Risk and asset-liability matching

Fixed Interest investments are often the only investment that makes sense when you need to match or hedge fixed liabilities.  Naively consdering expected return only and not asset-liability risks  gives naive results.

Credit risk premia more than compensate for default experience over time

It’s worth exploring risk a little further. The caller stated that if the company gets into trouble, it’s likely the bondholders will also be hurt, and will likely only get a few cents on the dollar. Well he’s wrong here too.

The historical default frequency for investment great bonds (BBB and above) has been hardly more than a few single digit percent.  The Loss Given Default (how much an investor will typically lose if the bond issuer does default) is anywhere from 35% to 80%, depending on the seniority of the instrument, which estimate you trust, how it is measured and when the estimate was made. It’s because there are so few investment grade defaults that the data is so sparse and the estimates so wide. However, it’s clear that the likely return won’t be “a few cents on the dollar”.

I’m going to hunt round for some references here so you’re not just trusting my word.

Illiquidity premia = higher returns for some

Given the illiquidity of many corporate bonds, the expected returns are even higher if you as an investors are not considered with easy liquidation of your investment. This is a “pure risk premium” that you will earn over time without expected loss.  You could purchase extremely high quality, well-collateralised debt and earn a good return above risk-free as long as you have the patience and resources to hold it for long periods or until maturity.

Implied Pension Return Assumptions and the Equity Risk Premium

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When companies value pension obligations and required contribution rates, they make assumptions about the expected future investment returns. (Accounting standards require market-based rates reflecting fixed interest returns, but that’s a separate point).

So what assumptions are pension funds making? The WSJ has an interesting article showing that the average US pension fund is assuming future returns of approximately 8%. To put that in perspective, yields on 30 year T-bonds in the US are about 3.9%, 10-year yields are below 3% and inflation is currently about nothing. This is a huge real return and suggests that many of these pension funds may be underfunded.

It’s also interesting to work out what Equity Risk Premiums these valuation assumptions imply. FinanceClippings makes  some educated guesses at likely portfolio construction, and estimates assumed ERPs of nearly 8%. For reasons I’ve described before, an 8% ERP is madness.

My own calculations

FinanceClippings assumes a simple portfolio mix of 50% equities and 50% government bonds in this calculation, and assumes the average yield will be consistent with 30-year assumptions. I would differ slightly here. If we are looking at an overall portfolio, I would expect some investment grade corporate bonds and property in the mix too. These assets could be expected to earn 1% to 2% over risk-free over time (after adjusting for expected default loss on the corporate bonds). These return assumptions may seem low to some, but this is another area where it’s easy to overestimate the possible returns based on inappropriate periods of data. Continue reading →

Why you’re mis-estimating the Equity Risk Premium #1

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You base your estimates of the ERP on US history alone

Your ERP estimate is too high because your calculation suffers from survivorship bias and errs by including the largest economy for which the most data is currently available rather than a random sample.

The US has been a spectacularly successful economy over the last hundred years. At the turn of the previous century, Imperial Russia and the US were at about the same level of economic development. Investing in Imperial Russia would have given you a -100% return. If we estimate the ERP from Imperial Russia, we get a very different answer than if we calculate it based on US data.

The US is the largest economy today. It is not a good place to estimate an average, prospective ERP.

Back to Index of reasons

Junk bonds in place of an IPO

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The 30 second intro to Junk Bonds

Junk Bonds, also known as High Yield Bonds, are debt instruments issued by companies with poor credit ratings, or are the debt instruments of companies that were issued as high quality bonds from strong companies that have since fallen on hard times (“Fallen Angels”).

Typically these are any bonds that are not classified as Investment Grade (BBB rated or better).

Junk Bonds behave very differently from Investment Grade bonds. Their value depends only marginally on market interest rates and far more on the underlying economic strength and operational performance of the issuing company.

Junk Bond return characteristics

They don’t often the unlimited upside of ordinary equity, but with the high starting yield (10% to 25% depending on the circumstances) it can provide a very healthy return if the company doesn’t default. There is also a chance for rerating where if the strength of the company improves dramatically, the bond may be repriced to a lower market yield, resulting in a significant capital gain.

Founders keeping control

So company founders can issue junk bonds rather than diluting themselves by issuing equity and still provide attractive returns to investors and an opportunity for savvy investors (and those who just think they are savvy) to “pick” their company with the prospect of fantastic returns if it performs really well. Continue reading →

Repo down by 50bps

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Looks like my money is safe – Reserve Bank cut rates as predicted. Thinking about trying to predict for each MPC meeting then tracking my performance over time so I can be held accountable. Will mull over this first I am not that sure I’ll be sufficiently confident to stick my neck out in future!