Junk Bond Defaults Rise in 2016?

Moody's Investor Services expects default rates on junk bonds to increase to 4 percent this year, up from the 3.5 percent default rate in 2015. The default rate for all bonds is expected to be 2.1 percent for 2015. Low commodity prices, widening yield spreads, and potential interest rate increases by the Federal Reserve are reasons given by Moody's. During 2015, there were 109 corporate defaults, totaling $97.9 billion.

Valuation Models Go Up In Smoke

Students often ask us how stocks are valued in the "real world." While analysts go into more depth than we do in this textbook, commonly used models are PE ratios, EV/EBITDA ratios, and free cash flow models, which we have discussed. However, in some cases, these valuation models go up in smoke. Take a look at Cannabis Sativa (CBDS), which is trading at just under $2 per share and has a market cap of about $31 million. The company has had negative earnings for the past three years, but more importantly, had revenues of $8,000 through the first 9 months of 2015 and $7,000 in 2014! Since the company has had no earnings, the PE ratio is not reported, but the PS ratio is almost 2,000. All-in-all, CBDS is priced at an extremely high growth rate.

Warren Buffett Vs. GAAP

A basic purpose behind accounting procedures, including GAAP, is to standardize financial statements. However, many companies are currently pushing non-GAAP earnings, which can exclude a number of non-recurring items. The write-down of an asset or restructuring are common non-recurring items. Another major item than can cause a big difference between GAAP and non-GAAP earnings is stock-based compensation, often in the form of employee stock options or restricted stock. As Warren Buffett argues: "If compensation isn't an expense, what is?"  We would advise you to learn about accounting, not only because a lot about a company from reading its financial statements, as Buffett warns "Accounting tells you a lot and it can be used in many ways to deceive."

Correlations They Are A Changin'

From what you have learned about what is often referred to as Modern Portfolio Theory (MPT), a diversified portfolio can significantly lower the risk of your investment. To create a diversified portfolio, you should choose assets with low correlations (covariances). However, this can be more difficult than it seems. A recent article on Bloomberg discusses how correlations between various asset classes have changed over time. For example, if you look at the 1988 to 1997 period, the correlation between the S&P 500 and the S&P GCSI Total Return Index, which measures the return on a broad class of commodities, you would find the correlation between these two asset classes was –.20, a very low correlation that would provide substantial diversification benefits. However, in the past 10 years, the correlation between these two asset classes has increased to .50, which would only provide moderate, if any, diversification benefits. We agree with the author's conclusion that even with a high correlation, owning a greater variety of assets is safer than owning only a few assets.  However, we would like to extend this conclusion and state that you should rebalance your portfolio based on the changing correlations.

Ratios And Lease Accounting

Beginning December 15, 2018, new FASB accounting standards will require public companies to include both capital and operating leases on balance sheets. Currently, only operating leases are reported. The effect of this new standard will be an increase in the reported value of assets and liabilities, which will result in an apparent overnight jump in the book value of many companies. According to one estimate, over $1 trillion will be added to balance sheets. Because of this increase in assets, several commonly ratios such as return on assets and the equity multiplier will be dramatically changed for companies that use lease financing. Of course, trained analysts have already been adjusting balance sheets for estimated lease liabilities. Although not mentioned in the article, there could be unintended consequences. For example, if a company has bonds containing a covenant that prohibit the company from exceeding a specific debt-equity ratio, the increase in liabilities could potentially cause a breach of that covenant.

It's Market Efficiency By A Length - Or Several Lengths Now

Back in 2013, we posted about Warren Buffett's bet with the founders of the Protégé Partners hedge fund that the S&P 500 would outperform a hedge fund index chosen by Protégé Partners over a 10-year period. At that time, the S&P had cumulatively outperformed the hedge fund index by about 8.5 percent. Even though the hedge funds outperformed the S&P 500 in 2015, the Vanguard Admiral index fund is up a  cumulative 65.7 percent in the last eight years, while the hedge fund index is up only 21.9 percent. One scenario for a possible comeback for the hedge funds, which is outlined by Ted Seides, the man who engineered the bet for Protégé, is a severe market downturn. Of course, he added about such a circumstance: "No one wins when that occurs."

Negative Corporate Bond Yields

Last year, we posted about how the size and number of negative interest rates were increasing in Europe, and how one member of the Federal Reserve was pushing for negative U.S. interest rates. Since then, negative interest rates have increased again in size and number. For example, Sweden increased its central bank rate from negative .35 to negative .50 percent and Japan moved its central bank interest rate into negative territory. What is also surprising is that the market has joined into the negative interest rate fray as 2-year Swedish government bonds yield negative 1.12 percent. And, recent comments by Janet Yellen indicate that even the U.S. Federal Reserve may consider negative interest rates, although the legality of such a move in the U.S. is not clear. While negative interest rates by central banks are uncommon, they are not without precedent. What is without precedent is negative corporate bond yields, which happened last week as the yield to maturity on Nestle corporate bonds went negative!