[davelj]

Well, it appears that those Bear Stearns investors are in for a bad evening – apparently they’ll be getting back exactly $0. Good times. I guess the market will go up tomorrow since now there’s a greater likelihood of a rate decrease from the Fed. It just keeps on going… until it doesn’t.

[davelj]

Yeah, he told me there were some (relatively) small increases last week but that now everyone’s doing an immediate second round of additional increases as the secondary market is demanding it. And the stock market just churns along as if nothing’s wrong… “Move along folks, no problems, nothing to see here.”

[davelj]

Yeah, he told me there were some (relatively) small increases last week but that now everyone’s doing an immediate second round of additional increases as the secondary market is demanding it. And the stock market just churns along as if nothing’s wrong… “Move along folks, no problems, nothing to see here.”

[davelj]

Stan, since I was the only poster to use the word “insane” in describing those who would buy a 1.5% 5-year Japanese note, I assumed your post was aimed principally at me. Thus, your exposition on the yen-dollar carry trade came across as condescending (to me) much like an explanation that 3×2=6. So, pardon the confusion and the condescension – perhaps it was misplaced.

Having said that, I found baffling your comment: “I’m sure you’ll recall from finance 101 that the yield of a longer term bond is a function of the the shorter term yields. If the short term bond is 0.76%, then the implicit assumption is that the 3-5 year yield is probably 2.5% or 3% if the 5 year is yielding 1.5%, which, though still low and possibly not sufficient for the risk undertaken still may make sense.”

I’m not sure where to begin, so I’ll start with the current (as of yesterday) term structure of Japanese interest rates:

3 Month 0.70%
6 Month 0.74%
1 Year 0.81%
2 Year 1.05%
3 Year 1.18%
4 Year 1.37%
5 Year 1.51%

As you’ll notice, the yields on the 2-4 year notes are between 1.05% and 1.37%, not the 2.5%-3.0% (I think) you suggested. Perhaps more important, this 2.5%-3.0% is not “implied,” as (I think) you suggest. Correct me if I’m wrong, but I think you’re getting confused about “bootstrapping,” which is the process of calculating the implied rate on a theoretical zero-coupon bond by using the actual yields on the shorter-term (coupon) securities that would comprise it. For example, because we know the 6-month rate (0.74%) and the 2-year rate (1.05%), we can do a little algebra (via the “bootstrapping” process) and calculate that if a 2.5 year zero coupon bond existed it would yield about 1.13%. So, while you’re correct for the most part that “yield of a longer term bond is a function of the the shorter term yields,” you’ll have to explain to me what mathematical process gets us to implied rates of 2.5%-3.0% for the “3-5 year yield.” Although, perhaps I’m not understanding you correctly.

(As a side note, I’m a big fan of Nassim Taleb, but he’s another guy – like Jim Grant and many others – that’s very, very smart whom you’d never want managing your money. It’s more than a little ironic that the hedge fund that Taleb ran for several years is basically on life-support at this point because he ran across his own financial “black swan” – market volatility has been unprecedentedly low for an unprecedented period of time, while his fund was set up to lose small bits of money during periods of low volatility but to make big money once volatility returned to “normal” levels. The high vol periods were so infrequent that the fund just kept bleeding over several years until people gave up on him. In other words, the outlying event was an absence of outliers! Talk about irony. I think his consulting practice still does pretty well, however.)

[davelj]

Stan, since I was the only poster to use the word “insane” in describing those who would buy a 1.5% 5-year Japanese note, I assumed your post was aimed principally at me. Thus, your exposition on the yen-dollar carry trade came across as condescending (to me) much like an explanation that 3×2=6. So, pardon the confusion and the condescension – perhaps it was misplaced.

Having said that, I found baffling your comment: “I’m sure you’ll recall from finance 101 that the yield of a longer term bond is a function of the the shorter term yields. If the short term bond is 0.76%, then the implicit assumption is that the 3-5 year yield is probably 2.5% or 3% if the 5 year is yielding 1.5%, which, though still low and possibly not sufficient for the risk undertaken still may make sense.”

I’m not sure where to begin, so I’ll start with the current (as of yesterday) term structure of Japanese interest rates:

3 Month 0.70%
6 Month 0.74%
1 Year 0.81%
2 Year 1.05%
3 Year 1.18%
4 Year 1.37%
5 Year 1.51%

As you’ll notice, the yields on the 2-4 year notes are between 1.05% and 1.37%, not the 2.5%-3.0% (I think) you suggested. Perhaps more important, this 2.5%-3.0% is not “implied,” as (I think) you suggest. Correct me if I’m wrong, but I think you’re getting confused about “bootstrapping,” which is the process of calculating the implied rate on a theoretical zero-coupon bond by using the actual yields on the shorter-term (coupon) securities that would comprise it. For example, because we know the 6-month rate (0.74%) and the 2-year rate (1.05%), we can do a little algebra (via the “bootstrapping” process) and calculate that if a 2.5 year zero coupon bond existed it would yield about 1.13%. So, while you’re correct for the most part that “yield of a longer term bond is a function of the the shorter term yields,” you’ll have to explain to me what mathematical process gets us to implied rates of 2.5%-3.0% for the “3-5 year yield.” Although, perhaps I’m not understanding you correctly.

(As a side note, I’m a big fan of Nassim Taleb, but he’s another guy – like Jim Grant and many others – that’s very, very smart whom you’d never want managing your money. It’s more than a little ironic that the hedge fund that Taleb ran for several years is basically on life-support at this point because he ran across his own financial “black swan” – market volatility has been unprecedentedly low for an unprecedented period of time, while his fund was set up to lose small bits of money during periods of low volatility but to make big money once volatility returned to “normal” levels. The high vol periods were so infrequent that the fund just kept bleeding over several years until people gave up on him. In other words, the outlying event was an absence of outliers! Talk about irony. I think his consulting practice still does pretty well, however.)

[davelj]

bsrsharma, you’re right, I think there’s some confusion. I don’t think you have a good understanding of how insurance companies operate. I’ll try to explain without getting into too many gory details. (I analyzed insurance companies for a hedge fund several years back – not particularly well, I might add.)

Of course the insurance company WANTS to make a profit in its “insurance business,” as you call it – this is known as an “underwriting profit.” The measure of that profit is the “combined ratio.” A combined ratio of above 100 means that the company isn’t generating an underwriting profit; that is, its insurable losses exceed its premium revenues. A combined ratio of below 100 means there’s an underwriting profit.

Unfortunately (for them), in a normal year, in aggregate, P&C companies don’t generate an underwriting profit. My guess is the average combined ratio for the industry is 105 or so for the last 25 years. They stay in business by generating a profit on their investments that exceeds their underwriting losses. Add in a little leverage and – voila – you can still make a little bit of money. Therefore, your statement, “They have enough risk to manage in insurance business and would probably do a bad job if they try to manage money risk” is incorrect. Most P&C companies pay big money to their in-house and external asset managers to maximize the returns on the investment portfolio (that is, “to manage money risk” in your words) because that’s generally the sole source of profit. Where do you think the lion’s share of Berkshire Hathaway’s equities are held? By Geico, GenRe and Berkshire’s supercat business – Berkshire’s insurance companies.

Now, insurance companies need liquidity, they’re regulated and they also get rated by AM Best (among others), so they can’t go totally crazy with their investment portfolio without some repercussions. So there’s plenty of conservative stuff in their investment portfolios (treasuries, corporate bonds, etc.). But there’s plenty of risky stuff as well – equities, hedge funds, private equity, real estate, etc. It’s typically the returns on the risky investments that makes the difference between overall insurance company returns.

If you want to understand more about this I’d suggest reading all the Berkshire Hathaway annual reports dating back to the 70s. They are a great primer on P&C insurance.

Life insurance companies tend to generate a small underwriting profit and therefore take less risk in the investment portfolio. Life insurance is a more predictable business than P&C insurance due to far better actuarial data (it’s much easier to determine how many people are likely to die in a particular age cohort in a given year than it is to predict how many hurricanes will hit the North Atlantic in a given year). But, even so, all life insurers invest in riskier investments as well – equities, hedge funds, etc. But they do so less than the average P&C insurance company.

The point is that taking and managing investment risk is a CRITICAL part of running an insurance company. They don’t just stick the money in treasuries and pray that the competition will be rational enough for everyone to enjoy an underwriting profit. The insurance markets just don’t work that way.

Hope that clears things up a little bit.

[davelj]

bsrsharma, you’re right, I think there’s some confusion. I don’t think you have a good understanding of how insurance companies operate. I’ll try to explain without getting into too many gory details. (I analyzed insurance companies for a hedge fund several years back – not particularly well, I might add.)

Of course the insurance company WANTS to make a profit in its “insurance business,” as you call it – this is known as an “underwriting profit.” The measure of that profit is the “combined ratio.” A combined ratio of above 100 means that the company isn’t generating an underwriting profit; that is, its insurable losses exceed its premium revenues. A combined ratio of below 100 means there’s an underwriting profit.

Unfortunately (for them), in a normal year, in aggregate, P&C companies don’t generate an underwriting profit. My guess is the average combined ratio for the industry is 105 or so for the last 25 years. They stay in business by generating a profit on their investments that exceeds their underwriting losses. Add in a little leverage and – voila – you can still make a little bit of money. Therefore, your statement, “They have enough risk to manage in insurance business and would probably do a bad job if they try to manage money risk” is incorrect. Most P&C companies pay big money to their in-house and external asset managers to maximize the returns on the investment portfolio (that is, “to manage money risk” in your words) because that’s generally the sole source of profit. Where do you think the lion’s share of Berkshire Hathaway’s equities are held? By Geico, GenRe and Berkshire’s supercat business – Berkshire’s insurance companies.

Now, insurance companies need liquidity, they’re regulated and they also get rated by AM Best (among others), so they can’t go totally crazy with their investment portfolio without some repercussions. So there’s plenty of conservative stuff in their investment portfolios (treasuries, corporate bonds, etc.). But there’s plenty of risky stuff as well – equities, hedge funds, private equity, real estate, etc. It’s typically the returns on the risky investments that makes the difference between overall insurance company returns.

If you want to understand more about this I’d suggest reading all the Berkshire Hathaway annual reports dating back to the 70s. They are a great primer on P&C insurance.

Life insurance companies tend to generate a small underwriting profit and therefore take less risk in the investment portfolio. Life insurance is a more predictable business than P&C insurance due to far better actuarial data (it’s much easier to determine how many people are likely to die in a particular age cohort in a given year than it is to predict how many hurricanes will hit the North Atlantic in a given year). But, even so, all life insurers invest in riskier investments as well – equities, hedge funds, etc. But they do so less than the average P&C insurance company.

The point is that taking and managing investment risk is a CRITICAL part of running an insurance company. They don’t just stick the money in treasuries and pray that the competition will be rational enough for everyone to enjoy an underwriting profit. The insurance markets just don’t work that way.

Hope that clears things up a little bit.

[davelj]

bsrsharma, that’s actually a good answer, albeit with one attendant observation. While there probably are Japanese insurance companies that would buy that note for the very reason you stated, that 1.5% return would likely not be “gravy.” More specifically, like all insurance companies there’s a set of cash outflows that’s being matched up (in theory) with that inflow of 1.5%. My bet is that the insurance company isn’t making any net profit once the two are netted out. But the Nips are famous for tolerating break-even/unprofitable enterprises – look at their banks – so it wouldn’t surprise me one bit. But, you’re right in that Japanese insurance companies are probably one of the buyers, although certainly not the sole buyers. Personally if I were running an insurance company I’d rather capture a higher yield in a different currency and simultaneously hedge away the currency risk which should net a higher return (even after hedging costs) – but it is more risky, however minute.

[davelj]

bsrsharma, that’s actually a good answer, albeit with one attendant observation. While there probably are Japanese insurance companies that would buy that note for the very reason you stated, that 1.5% return would likely not be “gravy.” More specifically, like all insurance companies there’s a set of cash outflows that’s being matched up (in theory) with that inflow of 1.5%. My bet is that the insurance company isn’t making any net profit once the two are netted out. But the Nips are famous for tolerating break-even/unprofitable enterprises – look at their banks – so it wouldn’t surprise me one bit. But, you’re right in that Japanese insurance companies are probably one of the buyers, although certainly not the sole buyers. Personally if I were running an insurance company I’d rather capture a higher yield in a different currency and simultaneously hedge away the currency risk which should net a higher return (even after hedging costs) – but it is more risky, however minute.

[davelj]

Stan, your post offers a blinding glimpse of the obvious while completely missing my point altogether despite my attempts to articulate my point in the simplest terms possible.

Your post can be summed up as follows: If you’re engaging in the yen carry trade you might want to be long some yen in case it increases in value vis-a-vis the dollar. There’s nothing “overly technical” about that I can assure you; I think we can all follow you on that one.

My point – again – was that this is not a yen issue, per se, but a relative yield issue between the short and long ends of the curve and the relative risks incurred. As I stated in my last post, if you have some reason to be long the yen then just buy the currency or some short-maturity bill. But, for god’s sake, don’t buy that piece of 5-year paper yielding 1.5% because you’re just not getting compensated for the risk.

Perhaps you’d like to proffer a good reason for buying a 5-year piece of paper yielding 1.5% in any currency when the 6-month equivalent in that same currency is yielding 0.76%. Perhaps you believe that the long end will decline to 1% over a couple of years? If so, we can definitely do business.

(P.S. I’ve already read “Fooled by Randomness,” and while it’s a fine book – one of my favorites, in fact – I don’t see how it is any more relevant to this discussion than to any discussion on investing and humans’ various built-in behavioral biases, including the tendency to underestimate the probability of outliers.)

[davelj]

Stan, your post offers a blinding glimpse of the obvious while completely missing my point altogether despite my attempts to articulate my point in the simplest terms possible.

Your post can be summed up as follows: If you’re engaging in the yen carry trade you might want to be long some yen in case it increases in value vis-a-vis the dollar. There’s nothing “overly technical” about that I can assure you; I think we can all follow you on that one.

My point – again – was that this is not a yen issue, per se, but a relative yield issue between the short and long ends of the curve and the relative risks incurred. As I stated in my last post, if you have some reason to be long the yen then just buy the currency or some short-maturity bill. But, for god’s sake, don’t buy that piece of 5-year paper yielding 1.5% because you’re just not getting compensated for the risk.

Perhaps you’d like to proffer a good reason for buying a 5-year piece of paper yielding 1.5% in any currency when the 6-month equivalent in that same currency is yielding 0.76%. Perhaps you believe that the long end will decline to 1% over a couple of years? If so, we can definitely do business.

(P.S. I’ve already read “Fooled by Randomness,” and while it’s a fine book – one of my favorites, in fact – I don’t see how it is any more relevant to this discussion than to any discussion on investing and humans’ various built-in behavioral biases, including the tendency to underestimate the probability of outliers.)

[davelj]

Yeah, but, from the other side of the equation, the landlord knows that even the cheapest move is going to cost you $100-$200 bucks (and likely much more if you have any “stuff” at all – plus a lost weekend) even if you find another place to live that costs the same as the one you’re in. So, it’s a matter of who’s going to budge first – you know the landlord doesn’t want a vacancy and the landlord knows you don’t want to pay for moving. My previous experience renting was the landlords knew how much they wanted to raise the rent and if I wasn’t willing to pay it, so be it – I ended up moving.

[davelj]

Yeah, but, from the other side of the equation, the landlord knows that even the cheapest move is going to cost you $100-$200 bucks (and likely much more if you have any “stuff” at all – plus a lost weekend) even if you find another place to live that costs the same as the one you’re in. So, it’s a matter of who’s going to budge first – you know the landlord doesn’t want a vacancy and the landlord knows you don’t want to pay for moving. My previous experience renting was the landlords knew how much they wanted to raise the rent and if I wasn’t willing to pay it, so be it – I ended up moving.

[davelj]

bsrsharma, tomorrow morning you can buy many billions of dollars worth of 3-month treasury bills yielding 5.04%, all backed by the US Treasury. How’s that for preservation of principal and practicality? For that matter, if you just love the yen you can purchase many billions of dollars of 6-month Japanese bills yielding 0.76% backed by the Japanese Treasury. That’s just 74-ish basis points less than the 5 year is yielding. Who in their right mind would trade 74 basis points for 4.5 years in maturity (and its attendant duration) risk?

Again, I reiterate… buying an asset – even one backed by the taxing authority of an industrial nation (such as Japan) – that yields 1.5% with a maturity of 5 years is just plain nutso… and even more so when you can get 0.76% investing for just 6 months. Blips for Nips…

[davelj]

bsrsharma, tomorrow morning you can buy many billions of dollars worth of 3-month treasury bills yielding 5.04%, all backed by the US Treasury. How’s that for preservation of principal and practicality? For that matter, if you just love the yen you can purchase many billions of dollars of 6-month Japanese bills yielding 0.76% backed by the Japanese Treasury. That’s just 74-ish basis points less than the 5 year is yielding. Who in their right mind would trade 74 basis points for 4.5 years in maturity (and its attendant duration) risk?

Again, I reiterate… buying an asset – even one backed by the taxing authority of an industrial nation (such as Japan) – that yields 1.5% with a maturity of 5 years is just plain nutso… and even more so when you can get 0.76% investing for just 6 months. Blips for Nips…

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