Shanghai is a city of nearly 25 million people, and they have been in an iron-clad lockdown now for almost six weeks now. This is not a stay-at-home order like we experienced in the United States, where guidelines have been loosening—wearing a mask on an airplane has even become optional for us. Alternatively, in Shanghai, the government has implemented measures such as installing electronic door alarms on the homes of those who have tested positive for COVID-19, forcibly removing people from their homes while leaving their pets behind and leaving the doors to their homes open to permit industrial-style sanitation. They have bussed people who have tested negative more than 100 miles from their homes, just because they had close contact with a positive case. Freshly built chain link fences are suddenly popping up around people's houses and apartments, locking residents in. They are disinfecting the street surfaces with lime! How many people are contracting COVID-19 by walking on the streets? The lime they are using to "cleanse" all the outdoor areas is extremely alkaline and will likely mess up local waterways for years to come. The local authorities have been told to stop the spread at all costs, and that is what they are trying to do.
Some in the locked-down areas of the city are struggling to get food and medical supplies. There are heart-wrenching videos of citizens yelling out at night, begging for anyone who might have fever medication for their family members. Commonplace surgeries and lifesaving medical services are not available. Out of the 25 million people in Shanghai, only about 87 people have died due directly to COVID-19. Somewhere around 4,000 have had symptoms (most of them from the elderly population, according to Bloomberg. Think about that number for a minute: out of 25 million people, 0.00034% have died. Most cases are asymptomatic. This is all due to the Omicron BA-2 strain which is easily transmissible. Scientists generally believe it to be more transmissible than the measles, the common cold, and even the flu. Thankfully, it is not nearly as virulent as earlier COVID-19 strains.
All of this is happening because the Chinese government has issued a zero COVID-19 policy. Unfortunately, just this week, some cases have now been popping up in Beijing, and the markets and others fear that the dystopian policies in force in Shanghai might soon be enacted in Beijing. The local population is already waiting in long lines to buy as many groceries and supplies as they can get their hands on, while they still can.
The reality is that the Omicron BA.2 variant, according to the research I have been able to do, is not stoppable. You can put as many people in the streets with hazmat suits as you like, lime-dust as many streets and "disinfect" as many buildings as you want, but you will not be able to stop it.
Nonetheless, Beijing is preparing to institute similar measures. They have had a total of 70 cases since last Friday and are now planning to test every single person in Beijing three times each over the next ten days. That is something like 80 million tests, a staggering number.
So, what in the world can this all have to do with bonds and investing?
It is connected in that in both the Chinese zero COVID-19 policy, and many investment approaches, spurious and misleading statistics are leaned upon in an attempt to perfectly measure risk. Those in investing might fail almost as miserably as the Chinese government has. I want to look at three of the most obvious and often misleading statistics but will reserve the right to highlight more in a future post. Let's start with the big three:
Yield, Duration, and Average Life
Let's start with the granddaddy of all single-statistic parameters: yield.
I think it is helpful to go back to the origins of the term yield, which comes from farming. According to the Merriam-Webster dictionary, when yield is used as a verb it means to produce or provide. In the financial context, it has become a shortcut for how much income I should/might receive from an investment. When you start digging into the way that Bloomberg and other financial calculators try to measure this value, the waters start to get really muddy really fast. From Bloomberg, the following caveat is in their definition:
"While there are a lot of variations for calculating the different kinds of yields, a lot of liberty is enjoyed by the companies, issuers and fund managers to calculate, report and advertise the yield value as per their own conventions"
Furthermore, Bloomberg suggests the entire calculation of yield as null and void once you start looking at floating coupons derived from an index, since we cannot know the future levels of the index. They should offer a similar caveat for any security with unknown future cashflows.
Is it really that complicated? The street would love for us to believe that it is simple. It helps to sell securities and is used as a talking point in almost every single sale of a fixed income security. In the most common presentation of a mortgage backed (or asset backed) security, yield is actually calculated out to the fourth decimal place. The interesting thing that anyone familiar with the math would confirm is that this calculation is almost certainly wrong from the outset. Wrong. Dead wrong. Known to be wrong in the sense that it is almost certainly never going to play out to that fourth decimal—or even to the first—in reality.
Here's the catch. We cannot even make the yield calculation work if we do not know the exact cashflow and re-investment rate of every single payment. In the case of a simple 15-year mortgage pool, that means we would need correctly predict exactly what the payment stream is for every single future month - 180 months in a row. It's just not possible.
If you think I am overstating this, do a little research of your own. What you will find is that any serious discussion of yield on a security (or loan!) in which the future cashflows are not certain is a very vague and almost meaningless discussion. And yet we all engage in it.
If possible, the use of duration as an investing tool/measuring stick can be even more pernicious and potentially misleading than the use of yield.
Why is it such a troublesome statistic, you may ask? I think mostly because it is so misunderstood. In our common vernacular, the term duration almost always means measurement of time. For example: "What is the duration of the musical recital?" or, "The duration of the flight is around six hours." If you go to the dictionary, you will find that duration is defined as a time during which something occurs. In my experience teaching about fixed income across the country for the past 25 years, that is what most investors think duration is supposed to mean in the world of investing…and this is incorrect. Duration and its derivatives (Effective, Modified and Macauley) in the financial markets were designed to attempt to measure the sensitivity of the price of a bond to an immediate change in an interest rate.
As you can see, it is a complex formula, and beyond the scope of this little post, but there has been a tremendous amount of serious thought on the topic. It makes sense, because we would all love to know the price sensitivity of our portfolios to given changes in rates. Unfortunately, most serious students of this topic acknowledge that we cannot know the future cashflows of most securities, and even less of portfolios of securities, nor can we know the yield curve's shape in the future, or the path rates will take to get there. Can we approximate? Sure. Will it be correct? Probably not, and if so, it will most likely be by coincidence.
However, this brings me back to my opening thought on how deadly this statistic can be. Many investors will compare two or more securities with approximately the same duration but with dramatically different types of cashflow volatility as though it is apples to apples. But the differences not apparent in the duration value render the calculations irrelevant and inaccurate.
Of the three statistics we are examining today, average life is probably the simplest. Maybe that is why it is so often used incorrectly. The simple physical analogy for average life is a teeter-totter (in some parts of the country, you may call it a seesaw). When we think of teeter-totter, we know that there is a balancing point somewhere in the middle.
Your physics professor in college referred to this as a fulcrum. We can calculate where this point will be using simple math. There is no need to use the present value equation and there are no derivatives. All we need is to figure out the weights and positions of the objects on the beam and we can find a balancing point. But we do need accurate weights and positions.
If we can consider a pool of 15-year mortgages and think of the principal payments as the weights, and the timing of these payments as the positions, we can come up with a picture and process for finding this equilibrium point and call it average life. Depending on the level of interest rates, this number will vary, but for simplicity's sake let's call the typical result somewhere around five years. Each month, homeowners will make a payment on their house which is partially principal and partially interest. The breakdown of these payments changes every month. Some people will prepay, refinance, or change their payments based on personal situations. These changes are unknowable to us in advance, as investors.
This is where the problem starts. As I mentioned above, the expected average life might be five years, and so the broker-dealer community will seize on that statistic and compare it to other five-year assets, such as a 5-year Treasury. When they throw in the granddaddy of stats (yield) and compare them they will almost always find that the mortgage pool's calculated yield is higher than that of a Treasury. It will also have a lower duration.
You honestly could not find two more dissimilar securities. The comparison makes no sense whatsoever, but it is used every single day in the capital markets. The pool of mortgages has 180 principal payments, which change every month, and the Treasury has only one principal payment, five years hence.
The three statistics discussed above drive billions of dollars' worth of fixed income decisions and they are wildly misunderstood and misused. As a portfolio manager, developing an understanding of these widely unnoticed flaws gives you a great advantage.
Just as the Chinese government cannot stop Omicron BA.2 by throwing lime powder on the sidewalks and putting all their citizens under house arrest, we cannot collectively stop the use of these statistics, but we can understand how they are misused and deploy this knowledge to our advantage. One thing I know for sure: single statistic parameters that do not incorporate dynamic cashflow and interest rate scenario analysis are virtually useless.
Remember - I don't know what the future will bring, and neither do you. Evaluate a broad, meaningful set of scenarios, and do not rely on what the "street" gives you as being useful.
Final, final thought: I'm on a bit of an Indian food kick…but I need some new recipes. Please send them my way!
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The information, analysis, guidance, and opinions expressed herein are for general and educational purposes only and are not intended to constitute legal, tax, securities, or investment advice or a recommended course of action in any given situation. Information obtained from third-party resources are believed to be reliable but not guaranteed. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. Past performance does not guarantee future results