Keeping Cool On Hot Summer Days

Suppose two investors named Tom and Sarah decide to finance a lemonade stand. The lemons, sugar and wood to construct the stand and get started will cost $100. Tom, being a risk-averse type, decides to loan the stand $50 (a bond investment) but secured by all the property the stand has. That way, if the lemonade stand fails, he’ll be able to scrap the stand and sell the what’s left of the wood to recover his $50. But if the stand is successful, Tom won’t share in the prosperity beyond the repayment of his contribution – the limitation of bond ownership.

 

Sarah decides to contribute $50 in equity (a stock investment). If the stand fails, she could lose her entire investment, but in return she can earn a profit if the stand flourishes.

 

This is a basic illustration of the difference between a stock and a bond.

 

Now let’s make our lemonade stand’s capital structure look a bit more like Freddie and Fannie. Instead of dividing the investment 50/50, Tom loans the stand $99 and Sarah invests just $1. This type of investment could never come about in the real world because Tom wouldn’t have adequate security for his loan. If the stand fails, the scrap wood won’t be worth nearly $99.

 

What could persuade Tom to provide all the capital and assume all the risk of loss without any share in the profits beyond the return of his loan?

 

Only the introduction of a third party can make this investment attractive to both Tom and Sarah: the taxpayers who promise to make it up to Tom if the stand goes under.

 

With a taxpayer guarantee of his loan, Tom is satisfied that his money will be repaid no matter what happens, just like he was in the original 50/50 agreement.

 

Sarah is delighted to speculate on the stand’s future under the new arrangement – she has all the stand’s future profits to gain and only a dollar to lose.

 

And the taxpayers? For some reason, they don’t take much interest in the arrangement. If they ever ask, they are told that it’s very important for the economy that lemon and sugar prices stay high. They hardly ever ask, though.

How To Invest $200 A Month

Many a personal finance column has been written using a simple formula. First, readers are admonished to give up their daily cup of expensive coffee and set aside the proceeds. The savings are next invested in “a low cost index fund” and grown over the years. Finally, the writer unveils the fabulous sum that breaking the latte habit will yield after 30 years at say, 8%, compounded annually.

There is a problem with this approach. The investor of very limited means will have trouble finding suitable investments that accept such low contributions, as we learned recently when Moderndomestic, lacking an employer-sponsored 401(k), asked us to help her create a retirement plan investing $100 per bi-weekly paycheck.

First we determined that a Roth IRA would be a better alternative to a conventional plan. (We’ll save the details of that determination for a future post).

Next we had to decide how to invest the money. A no-commission mutual fund is the only appropriate choice for Moderndomestic, since even a $7 commission would eat up far too much of her contributions.

We wanted to find a low-cost index fund that could match the returns of the broader market, as the latte columnists recommend, but it was not quite possible, at least under Moderndomestic’s constraints.

Both Vanguard and Fidelity offer quality index stock funds, but their minimums start around $2500, beyond the limited means of Moderndomestic’s. (From a previous job, Moderndomestic has several thousand dollars in a conventional retirement plan invested conservatively in a money market fund, so we were unconcerned about the risks of allocating her entire account in stocks.)

Many quality Fidelity funds are eligible for an innovative feature called “Account Builder,” where fund minimums are waived if an investor agrees to attain them by $200 automatic deposits. Unfortunately, the micro-cost funds mentioned above are ineligible for the service at this time.

Eventually, we decided to open a Roth with Fidelity (free!) and invest $200 monthly in Fidelity’s Puritan Fund (FPURX). The fund’s expense ratio, while much less than the average fund at .60, is nevertheless a bit higher than we would like. The fund is actively managed, although to judge from the moderate expense ratio and low asset turnover, the managers make changes infrequently.

For these reasons, we’ve advised Moderndomestic to reexamine her position once she attains the minimum balance to enter some of the more desirable micro-cost funds, such as Fidelity’s Four-In-One (FFNOX). After all, in just a year’s time she will achieve the minimums required.

But in the interim, the Puritan Fund is an attractive way to save. With a 60/40 mixture of stocks and bonds, the fund is diverse enough to hold as a single investment, even for someone lacking Moderndomestic’s money market fund. Over its lifetime, the fund has returned an impressive 11.4%.

The fund is one of Fidelity’s oldest and largest offerings, with a 60-year track record and $22 billion under management. While we think that investors overweight the importance of these factors, all else being equal, they are desirable.

Buying, selling and holding an account with Fidelity is entirely free, so the only cost of the retirement plan is the modest expense ratio of the fund. We think the first-year savings program we describe here is optimal, or close to it.

Ignorance Is Bliss

“The soundness of the best (bond) investments must rest not upon the legal rights or remedies, but upon ample financial capacity of the enterprise.” –Benjamin Graham.

 

Today, Freddie and Fannie debt investors continued to ignore Graham’s excellent advice, and instead bid the “risk premium” even lower in anticipation of legislative relief – which still doesn’t, by the way, provide an explicit guarantee of debt.

 

 

Freddie and Fannie Bonds

Will the U.S. government will take steps to keep the bonds of Freddie Mac and Fannie Mae safe should they falter? Probably. But legendary investor Benjamin Graham would argue that even a shadow of bailout doubt should send bondholders running for the exits.

 

Graham often argued that investors should assign much less weight to the legal protections of bond in default and instead focus on selecting companies where debt is so entrenched that a default is highly unlikely in the first place. In this spirit, we’ll examine the bonds of Freddie and Fannie without regard to their special properties as GSEs and see how they conform to some of Graham’s rules. We’ll find that by Graham’s admittedly conservative tests of bond investment, the bonds of the two companies seem woefully unprotected.

 

Interest Coverage - Graham believed that the most important test of a bond’s safety was an adequate ratio of earnings to interest charges. As insurance against a downturn in a real estate company’s fortunes (which the housing crisis surely is for both Freddie and Fannie) Graham said bond investors should insist on an earnings coverage of twice interest payments.

 

Over the last five years, Freddie earned an average of $1.74 billion, while in 2007 paying $8.77 billion in interest. As Graham would express it, Freddie’s earnings coverage was only 1/5^th of its outstanding debt. According to Graham’s test, Freddie’s average earnings would have to be ten times higher to safely accommodate its interest payments. Fannie Mae flunks the test by a similar proportion.

 

Graham’s method of bond selection ensures that a company can withstand a severe reversal but still be able to comfortably meet its interest requirements.  Freddie and Fannie’s capital structure is set up so that the opposite is true: a slender margin of earnings coverage is the only protection over a huge debt issue. Even a small reduction in earnings could threaten their bonds.

 

Market Cap - As a supplemental test, Graham said the market capitalization of a company’s stock should be no less than 50% of its total bonded debt. By virtue of their top-heavy capital structure, Freddie and Fannie again fail the test. Freddie, with $739 billion in outstanding debt, has a market cap of only $5.9 billion at the time of this writing. Even before the sharp decline in the share price of both GSEs, their market caps were off by an order of magnitude below what Graham considered safe.

 

Graham acknowledged that this test was imperfect in light of the “extreme and senseless variations” of the stock market. But, he said, before purchasing a bond, the investor must be convinced that the business is worth a great deal more than it owes, and this test offers the market’s consensus. But since Freddie and Fannie’s primary method of financing is through debt issues, it is unlikely that either could ever be worth all that much more than they owe, and their market caps reflect that.  

 

The Guarantee – Analyzed without regard to the government’s implicit guarantee, the bonds of both agencies make what Graham would politely term “an unsatisfactory exhibit.” That suggests that the safety of the bonds depends a great deal on the guarantee, which is, after all, only an implicit one. The recent severe deterioration of the common stock’s market value supports this hypothesis, since a bailout is unlikely to assist stockholders. Apparently because of this guarantee, bonds from Freddie and Fanie continue to be regarded as safe investments.

 

For example, Freddie 6.75% bonds due 2031 trade for 121.7, a yield-to-maturity of 5.12%, while Treasury 6.25% bonds due 2030 trade at 122 to yield a nearly as attractive 4.63%, but with an explicit guarantee. As Graham points out over and over when discussing bonds on the margin of his criteria, safety of the principal is of overwhelming concern. Since a straight bond is an investment with limited return, it makes sense to reject any security that doesn’t offer promise of repayment beyond any reasonable doubt. If an investor chooses a risky issue that ultimately prospers, no great advantage is derived from her foresight, but if she is wrong, she has placed her capital in great peril.

 

Graham would probably be shocked to learn that Freddie and Fannie debt securities carry a yield only about half a percent higher than comparable U.S. Treasury bonds. Thanks to their top-heavy capital structures, they are highly vulnerable to periods of economic decline, or even uncertainty. Continued difficulties in the real estate market will undoubtedly cause both to edge closer to their minimum capital requirements. In this environment, it is worth asking why an investor would choose an implicit promise when an explicit one is available at almost no cost?