November 2000
Risk Without Debt?
| "A national debt, if it is not excessive, will be to us a national blessing." |
| -- Alexander Hamilton |
NE OF THE MAJOR DEBATES IN THIS year's presidential campaign revolved around the purported budgetary surplus. The candidates disagreed on how it should be spent, but they did concur that at least part of it should be used to pay down the national debt.
Earlier this year the government began the process by purchasing longer-term higher-yielding debt in the open market. While the amount of repurchased bonds was relatively insignificant, the immediate effect was to cause -- or at least exaggerate -- the inversion of the U.S. Treasury yield curve.
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 Source: Baseline As the government uses the current surplus to repurchase longer-term higher-yielding debt, demand increases while the remaining supply dwindles. The result is a downward sloping curve with lower yields and higher prices for longer maturities. This yield curve from mid-September shows the effects. |
The Treasury yield curve plots the yield of U.S. Treasury Bills, Notes, and Bonds against their terms to maturity. Normally the curve is upward sloping since investors commonly demand a yield premium for assuming the risk of longer maturities.
But this year, the inversion may be partially explained by supply and demand: When the government entered the open market and began repurchasing longer-term Treasuries, demand rose at the same time that the repurchased issues decreased supply. As a result, yields fell and prices rose at the long end of the yield curve.
Unintended Consequences
So what happens if the government really does make an effort to reduce the amount of outstanding Treasury securities? As this year's inversion illustrates, even a relatively small repurchase can have a major impact. For example, this year's initial transactions led most strategists to abandon the 30-year Treasury and begin using the 10-year note as the government benchmark.A recent report from one of the major U.S. brokerage firms suggests the reduction of outstanding Treasuries may have some negative unintended consequences. Essentially the argument goes like this: As the repurchase program continues, neither the 10-year note nor any other maturity will have enough liquidity to serve as a viable benchmark. As a result, mortgage backed or asset backed securities will need to fill this role. Not being backed by the government like Treasury securities, the new benchmark will introduce greater risk to asset allocation models and investors' portfolios. The overall investment process will become riskier.
This concern makes a lot of sense. 
If a relatively safe asset class is removed from the asset allocation process, all resulting portfolios must be riskier. Is this a real possibility?
To test it out, we looked to the Ibbotson data for the S&P equity indexes and Merrill Lynch fixed income series. First we created a balanced portfolio utilizing large, mid, and small cap stocks as the equity component, the Merrill Lynch Treasury Index and Merrill Lynch Corporate Index as fixed income series, and the U.S. 30-Day Treasury Bill Index as the cash proxy. To estimate the effect of a major government repurchase program, we then repeated the process by substituting the Merrill Lynch Asset Backed Index for the Merrill Lynch Treasury Index.
If our concerns are justified, the second portfolio should have greater risk for the same return. But that's not what we found.
Actual Consequences
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 Source: Ibbotson Associates The only difference in these three portfolios is that the first utilizes the Merrill Lynch Treasury Index while the other two substitute the Merrill Lynch Asset Backed Index. Surprisingly, the latter have less risk for the same return or greater return for the same risk. |
The first portfolio, constructed as it would be with today's adequate supply of government bonds, has 38.5% treasury securities. The average annual return is 13.89% and the standard deviation, a measure of risk, is 8.55%. The Sharpe Ratio, a measure of risk-adjusted return, is 7.34.
Now for the surprises. The other portfolios substitute asset backed securites for Treasuries. The second keeps the return the same as the first (13.89%) but the standard deviation falls to 7.67% while the Sharpe Ratio rises to 10.00. Judging by the Sharpe Ratio (13.11), the third portfolio is even more efficient with the same risk as the first (8.55%) but average annual return of 15.14%.
In other words, risk-adjusted return increases when asset backed securities are substituted for Treasuries. This is particularly ironic given that Treasuries' low risk is their major calling card.
The explanation lies in the correlations and Sharpe Ratios. The nearby chart shows these statistics for the three Merrill Lynch fixed income series.
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We included the Corporate Index to show why it wasn't used in any of our portfolios. All three series are highly correlated but the Corporate Index has the lowest Sharpe Ratio. Given that it will perform similarly to the other two series, there's really no benefit to using it over them.
The correlation between the Asset Backed and Treasury Index is also high (0.90) yet the former has a significantly higher Sharpe Ratio (225.06 vs. 135.84). That explains why portfolios constructed with Asset Backeds are actually superior to those utilizing Treasuries.
This is one of those situations where a reasonable-sounding theory is undermined by the facts. Maybe we won't miss Treasuries so much after all.
Essentially Regulation FD ("Fair Disclosure") prohibits companies from disseminating material information to analysts before releasing it to the general public. It's an effort to make sure everyone gets the same information at the same time. As recently as ten or maybe even five years ago it may not have
Yet when the SEC submitted the regulation for comment, it spurred a major backlash primarily from sell-side Wall Street brokerages. Their main contention was that denying their analysts advance information would add volatility to the equity market. According to them, their analysts are able to guide investors' expectations so that when companies finally do make the information public, much of its impact is already factored into stock prices, thus reducing volatility.
There's no denying analysts' have a impact on the market. It's only become more exaggerated this year as stocks became more and more overvalued and volatile. While it's not entirely clear that analysts, through their preferential treatment, can reduce market volatility, even more questionable is the need for this preferential treatment in the first place.
In our earlier example, a real analyst would contact General Widget's suppliers and customers. He or she would find accounts receivables increasing while payables were decreasing. He or she would see if inventories were building or competition was holding down selling prices. In other words, a real analyst would discover this information the same way management did, maybe even sooner.
That's precisely what Regulation FD will require analysts to do. Instead of being given privileged information, they'll actually have to do their job. That's also why brokerage firms oppose it -- they don't have much confidence in their highly compensated employees. If forced to do what they've been claiming to do all along, it won't take long for investors -- their customers -- to find the truth about the emperor's new clothes.
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"I don't wanna work, I just wanna bang on the drum all day." -- Todd Rundgren
OMETIMES THE THINGS THAT SEEM THE MOST obvious cause the greatest consternation. Take the SEC's Regulation FD for example. It's pretty straight forward and makes a lot of sense, but at the same time it's caused a turmoil on Wall Street.
been doable, but in this age of the Internet and wireless communication, there's no excuse not to require equal access to material information
From where we sit, that's a self-serving argument and nothing more.
The Way It Is
From where we sit, that's a self-serving argument and nothing more. To see why, all you have to do is look at the current process. Here's how it works:
The Way It Ought to Be
In fact, it's our contention that if analysts were doing their jobs -- the jobs they're being so dearly paid to do -- preferential treatment wouldn't be necessary. Why? Because they'd already know the scoop before management gives it to them.
Instead of being given privileged information, they'll actually have to do their job.
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