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Buffett hints at bond bubble


omagh
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Am I missing something here or there is something truly wrong with this market?

 

You have gold exploding. The U.S. dollar is plummetting. Long term treasuries are still going up. Japan is desperate, cuts its rate to 0% and its market along with every other world market surge. Commodities are now surging which at some point should act as an economic brake as it did in 2008. Note also that every time the market goes up that the Euro goes up. Carry trade and massive leverage being employed?

 

Gold and treasuries are not where they were when the equity correction began in April. They are still much higher while the market has regained most of its losses. There is a dislocation somewhere in there.

 

How is that going to end? Hyperinflation? Crash?

 

Sure, you can make money being long almost anything in this market, but what we are witnessing here isn't the signs of something truly nasty down the road?

It feels like you need to be in this market to make a return, but eventually something will arise that will make you lose most and maybe more of the gains in short order.

 

Kyle Bass made a pretty compelling case about Japan's coming problems. He looks very foolish right now, but so did he during the U.S. housing bubble until proven right.

 

I don't know. Maybe I make too much of this, but I feel very uneasy.

 

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Regulators are also adding to the confusion.  There is a proposal for Sovency II (snippet & link below) which would pile even more funds into bonds as a regulatory requirement to meet payout needs.  It just feels like throwing gasoline onto a raging fire.  I share your general unease with the market.  Growth is slow in wealth-creating companies, country balance sheets are over-leveraged and the lemmings are running after the latest fads (gold, commodities, currencies, etc).  Klarman writes about deflationary markets as being the most difficult to guage since what might seem like a reasonable discount turns out to not much discount at all.  Cash (in the right currency) will be quite valuable when the next big dislocation occurs.

 

-O

 

http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2010/10/04/insolvency-too.aspx?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+John_Mauldin_Outside_The_Box+%28John+Mauldin%27s+Outside+the+Box%29

Last week, Niels Jensen (head of Absolute Return Partners) and I were talking with a variety of pension funds. They started telling us about this thing called Solvency II. Outside the arcane world of European pension funds and insurance companies, it is not on the radar screen of most people. But it may be one of the more explosive problems in our future. Cutting to the chase, the new rules require insurance companies and pension funds to buy more bonds to match their liabilities. But as yields go down they are required to buy yet MORE bonds and then yields go down some more. And so on. The possibility of serious defaults by these same pension funds in the wake of these new rules (setting aside whether it makes sense to actually require pension funds to set aside enough assets to pay their obligations) is all too real. And more pervasive than we now think.

Am I missing something here or there is something truly wrong with this market?

...

 

I don't know. Maybe I make too much of this, but I feel very uneasy.

 

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Here's a link to the interview with Carol Loomis where Buffett mentioned that it's a mistake to be buying bonds now. This particular comment is towards the end, during the Q&A session (at the 36:45 mark or so).

 

http://money.cnn.com/video/news/2010/10/05/n_buffett_MPW.fortune/

 

I thought Buffett stuck to his usual themes and did not say anything really unexpected. Here are some of the other things he said (paraphrased):

 

Business is coming back slowly. He doesn't think there is much of a slowdown compared to earlier in the year.

 

In two to three years, unemployment will be much less and the economy will be humming.

 

It's clear that stocks are cheaper than bonds. Those buying bonds now are making a mistake.

 

When he and Charlie are talking about buying a business, they don't spend 10 seconds on macro factors. They talk about whether they like the business, whether they like the management and what the business will look like in ten years.

 

Europe is the big unknown. The European Union may be challenged by the financial problems of some of its member countries. He doesn't know how this is going to end.

 

Hard to have words to describe the change in China. When government, management and labor all work together with a great sense of urgency, miracles happen. Spoke about BYD's growth.

 

Very bullish on America and on the American system.

 

He probably pays a lower tax rate that his cleaning lady does. Just not the way the system is supposed to work. Taxes have to provide 18%-20% of GDP. Need to tax the super-rich more.

 

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the lesson, as I understand it, is that we often fail to recognize the absolute significance of marginal compromises

 

Bingo... this is what human history tells us.  Upheaval after upheaval.  Small things culminate and come to head eventually almost exactly because the cause and effect feedback loop is too long for the human mind to appreciate.

 

Timing is really hard though.

 

Ben

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we own a rate cap on the 10-year constant maturity swap rate.  a 5 year policy with a 9% strike presently costs $300,000 for every $100MM notional insured.  if rates go to 9% in the next 5 years, we make $0MM from price alone. if rates go to 20%, we make $11MM from price alone.

 

I am not familiar with CMS, could you please clarify: if rates go to 20% tomorrow and stay at 20% for the next 5 years, would you make $11MM PER YEAR for the next 5 years (i.e. $55MM total, undiscounted)?  Thanks,

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we're looking for a similarly cheap hedge against continued deleveraging/deflation as well but have yet to find one...

 

At the risk of pointing out the obvious, isn't this exactly what Fairfax already did earlier this year?:

 

http://webcache.googleusercontent.com/search?q=cache:OnEWcgPgEksJ:online.wsj.com/article/SB10001424052748704540904575451910642552160.html+firm+makes+bold+bet+on+falling+prices&cd=1&hl=en&ct=clnk&gl=us&client=firefox-a

 

Given the nominal figures you're throwing around, I'm guessing you're able to play in the same market, and the cost is at least the same order of magnitude as what you're paying for inflation protection, especially given the difference in the hurdles. (A +2% hurdle for deflation protection seems much closer to the money than a +9% hurdle for inflation protection.)

 

Did you look into this and determine the protection is simply too expensive?

 

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Another option for those with smaller portfolios are puts on TLT. The problem is, the expirations don't go out that far. The January-12 puts (15 months out) that are far OTM are probably cheap for a good reason -- rates would likely take longer to move up significantly. But you never know.

 

Here are some of the returns for the TLT puts with an $80 strike (annualized cost of protection is 1.9% for strike of 5.3% yield):

Bond yield    Gain on $1,000
-----------   ----------
      4.0%    Total loss
      5.0%    Total loss
      5.5%    $     0 (break even)
      6.0%    $ 2,809
      7.0%    $ 7,547
     10.0%    $17,080
     15.0%    $24,858
     20.0%    $28,524

Also, TLT is for 20+ year treasuries but its current average maturity is 28.1 years so yield is closer to the 30-yr bond. The cost is cheaper the further OTM you go (54 basis points annually for strike of 8.7% yield) but I have a hard time believing we will see those yields within 15 months time. If you can get them, those 5-yr CMS look like some pretty cheap insurance for a cost of only 6 basis points a year.

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the payout is the 10 year CMS rate less the strike (in this case 9%) at the end of the period multiplied by the notional coverage (in this case $100MM).  the payout numbers I gave are at the end of the 5 year period; if rates go up before then, the rate cap would be worth more due to the increased volatility and residual time value etc... that said, we intend to hold to maturity (and then re-up our coverage) as a cheap insurance policy against a low probability but high severity scenario.

 

Thanks for your explanation.  8)

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  • 2 weeks later...

I'm confused.  Buying cheap insurance to hedge out one's UNDERLYING exposure to a given tail risk hardly seems like "gambling"...

 

For example, the bulk of my capital is in dollars and is interest rate sensitive.  Because of the medicine currently being prescribed to reflate the US economy (which may or may not work), I worry that there could be a crisis of confidence in the US dollar/creditworthiness.  That doesn't mean that it will happen, but I'd like to preserve the real purchasing power of my capital if it does.  How is risking a minimal amount of capital (12bps annually for 2X notional protection in my example) "gambling" if I believe that I can structurally protect the real purchasing power of my capital in that scenario (if rates spiral to 30%, the protection will be worth 4200bps from price alone)? 

 

Are Seth Klarman and the team at Fairfax "gamblers" as well because they hedge out their underlying exposures in a similar manner? 

 

 

As used intelligently by people like Prem, WEB, and Seth, derrivatives are generally prudent.  As used by most novices, generally not.  Caveat emptor.

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