Long-term government bonds

Yields are now higher on 30-year government bonds than they have been since 2011.

There was a time where you could put money away into government debt and earn a satisfactory return on investment, especially if you are into the annuity-type investments. For example, if you bottom-ticked the 30-Year US treasury bond in September 1981, your yield to maturity would have been north of 15%. Ignoring the coupon differential (as those bonds surely at the time would have been trading at a discount), pouring a million dollars into fixed income would yield off $150k/year for the next 30, virtually guaranteeing a high cash stream.

At the same time, your dreams of going into margin to buy such a financial product would have been unattractive because short term rates would have spiked up to 21% at the time. Speculating on buying 30-year government debt was exceptionally difficult at the time – high inflation, a massive recession, and just doom and gloom everywhere. Of course, such times tend to be perfect for buying assets which are being liquidated wholesale.

Timing the market is always subject to psychological urges and always looks easier in retrospect. One year earlier, in September 1980, the same bond yielded around 11%. At that time, CPI inflation from 1979 to 1980 averaged 13.5% and such a long-term investment would seemingly have been locking in a real negative rate of return. Had you invested in the 11% yielding long bond at the time, over the course of the following year you would still be sitting on significant capital losses (about 25%) a year later and looked quite stupid.

I don’t think we’re going to get to that magnitude of interest rates, but there is going to be a parallel between how CPI persists, and the continuing downward slope of the yield curve. It doesn’t appear to be the right time to pounce. It’s just not painful enough.

Don’t get me started on whoever got trapped into buying these things a year ago when yields were less than 2% – they’ve lost over a third of their capital at present. A large cohort would be pension funds that have gotten annihilated on fixed income, coupled with insurance companies that keep the bulk of their capital into the same financial instruments. Look to see massive losses on the comprehensive statements of income from these entities when they announce their upcoming quarters.

The Biden Oil Put

Link to: FACT SHEET: President Biden to Announce New Actions to Strengthen U.S. Energy Security, Encourage Production, and Bring Down Costs

Quote:

DOE has finalized a first-of-its-kind rule that enables it to enter into fixed-price contracts with suppliers, through a competitive bid process, to repurchase oil for future delivery windows. This new authority will shore up demand for oil when supply is less uncertain and prices are anticipated to be lower. For example, if the market were to price barrels for delivery in mid-2024 at $70, the new rule allows DOE to enter into a contract now for mid-2024 delivery of oil at, around or lower than that price. DOE plans to use this authority to enter into contracts to repurchase oil for the SPR, targeting a price of about $67 to $72 per barrel or lower, with initial repurchases being delivered in 2024 or 2025. In addition, DOE is prepared to undertake additional SPR repurchases at times when the price of oil for current delivery drops to about $67 to $72 per barrel or lower, supplementing its future fixed-price contracts as appropriate.

SPR Reserves – September 30: 416,319 million barrels remaining – October and November will feature another 25 million barrels or so out of the reserve.

Notably with the above quotation, it puts an effective floor on oil pricing for a certain amount of capacity. This has the makings of a one-way trade, providing that demand does not collapse to the point where prices go even lower than that due to perhaps an impending recession in 2023.

Always interesting times ahead, navigate carefully!

Patience

Most of financial media is designed to get you to trade around your positions. There is always attention deficit disorder-inducing information about some minute development that tries to nudge you to getting in or out of positions.

Such actions are most typically very destructive for performance and also the disposition of securities destroy long-term benefits of tax deferrals on non-registered accounts.

There are times to pounce and there are times to just twiddle your thumbs and spend 10 bucks on a Netflix subscription and catch up on the soap operas. (I’m trying to make a modern-day version of a phrase Warren Buffett used to describe himself about “going to the movies” instead of taking an action in the market that he later regretted).

Right now is one of those times.

The Bank of Canada is going to raise interest rates on October 26, quite likely 0.5% to 3.75%. Then the Federal Reserve is going to raise interest rates on November 2, quite likely to the 3.75-4.00% range.

In both cases, QT continues concurrent to rate increases. The Bank of Canada has $370 billion in federal government bonds, and $17.6 billion goes off the books at month end. The US Federal Reserve peaked at $5.771 trillion in treasury securities at the beginning of June and is now at $5.629 trillion – and is mandated to drop $0.06 trillion a month.

While liquidity levels are ample, it is decreasing. The cost of capital is rising – while you can still get capital, it is a lot more expensive than it used to be.

Laying in the financial bushes and stalking targets is the mode of the day. In the meantime, cash is offering a dividend level not seen in well over a decade.

Lacy Hunt on the Federal Reserve

The Hoisington Investment Management Company has been completely slammed in the past year because of their bullish projections on long-dated treasury bonds, but one of their principals, Lacy Hunt, makes for always educational reading. The fund’s Q3 commentary is well worth reading. Key takeaway:

The Fed’s mettle will be tested because highly over leveraged institutions will fail as they historically have done in such situations. Bad actors or their enablers should be directed to bring their collateral to the discount window or, if necessary, to the bankruptcy process rather than be given bailouts that have severely widened the income and wealth divides in the U.S. while causing the Fed to sacrifice price stability that’s so essential for broad-based economic gains.

This is the goal of using monetary policy in the current circumstances – there is no gain without pain. And the pain is coming.

We look at the trajectory of the 30-year US bond yield:

An investor that was long this since the beginning of the year (a rough proxy for a 25-year duration product is TLT) would be down about 32% on price. This is more than the S&P 500, which has seen “only” 25% depreciation to date.

Does the pain get worse? Probably. I’m wondering what institutions out there are unduly exposed to the 30-year yield rising to some “unthinkable” level, say, 500bps before they blow up. Just remember – in September 1981, the 30-year yield got to 15.2%!

Revisiting Teledyne

It’s always good to review some companies that have crossed your radar in the past – the library of knowledge that gets built up becomes an investing competitive advantage when the market decides to vomit.

Teledyne (NYSE: TDY) got on my radar when they acquired FLIR Systems (I was a shareholder of FLIR at the time). They are competently managed, in a market space that is relatively insulated (they have a lock on certain technologies and are strategically well positioned). However, they took on a ton of debt when they took over FLIR and here is the salient table:

We see a structure that is $550 million variable, and $3.4 billion fixed rate. Clearly the highlight debt offering was the $1.1 billion of 2.75% notes due April 2031!

TDY currently makes an annualized operating income of $900 million. Current annualized interest charges are approximately $100 million. The residual after income taxes will be poured into debt repayment over the next few years. However, the problem from an investor perspective is that this capital has an effective return limitation – for instance, the 0.65% notes due on April 2023 (half a year from now) will effectively be re-financed at higher rates via the credit facility. Ironically, the Federal Reserve increasing interest rates improves the return on capital of TDY’s debt repayment and because most of it is fixed for the next 9 years, an increasing interest rate structure should not harm the company too much.

However, the debt burden poses significant limitations on shareholder returns (traditionally this has been in the form of share buybacks), in addition to making the valuation from an EV/FCF perspective even more expensive. The share buyback history of TDY in itself is a fascinating story – the last time they did so was in 2015.

Despite the business being great, it suffers from the same problem I identified when the FLIR takeover was happening – it is just too expensive. They did crash down to $200 during Covid, where they may be worth considering. Unfortunately if it got to this point, there’s likely to be a lot of other stuff on sale at the same time. But I continue keeping it on the radar.