Finance blog

THE FRITZ REPORT

Skeet Shooting

December 01, 2020

Near the golf course I play on is a shooting range. It's close enough that when you play the hole near the range, you actually have to ring a bell so the shooters will pause as you walk by! I used to do a little shooting myself and the game that they play is called Skeet Shooting. Some of you may have taken part in the sport. It involves a series of shooting stations and hasn't changed much since it began in the 1920s. There are eight shooting stations where the participants shoot clay birds that are launched from a machine. One of the launchers is high and one is low, so an inexperienced shooter like me is not likely to hit many of these fast-flying targets. There are 25 shots per round—there is no denying it is really fun, but for an amateur, hitting four or five targets is a success. However, there are also really good shooters who might hit all 25 targets. I'm including this graphic so those of you who've never seen the course can get a visual of what I am talking about, and don't think it's just people randomly firing shotguns in all directions around a field.

According to Statista, there are currently over four million people participating in this activity every year.And that's just the people who register that they are involved. If you think about four million people shooting 25 rounds of shots, that makes 100 million rounds! And that is if everyone just does one round.As I mentioned above, there are definitely experts who can hit all 25 targets most of the time. How can they possibly do that, you may ask? Here is a cool video with some serious shooters explaining in detail how it works. Once you get to their level, it's actually more surprising if they miss!

There is one thing I've learned about skeet shooting that would be really helpful for any amateur shooter. It turns out that the targets go through the exact same spot in space, every time. Yes, the exact same spot. In fact, for competitions, they actually set up a hoop which is 15 feet high and 3 feet in diameter right in the middle of the field. The targets must fly through that small aperture every single time. Of course, they take that hoop down while people are shooting, but the simple knowledge that they must go to the same spot is of course very helpful. Unfortunately, I was unaware of that fact for many of the times that I went to the range.

That single nugget of information is a total game changer.

Imagine the challenges a shooter would face if no one explained any of the rules. Success is not to be expected, to say the least. Where to stand, how to load a gun, what happens at the shout of "PULL!" when the target comes flying out?

At times, I feel like I am watching fixed income investors who have been forced to fire on the range without ever being told about the hoop. There has been virtually no formal training in the incredible game that is being played in fixed income with trillions of dollars at stake. Most participants have been encouraged to invest using statistics that are simply not very helpful. There are simple definitional flaws with the most commonly used statistics, that when revealed can totally change the way you play the game.

The two most commonly misapplied and misunderstood of these are yield and duration.

If we were participating in a fixed income market where the only types of securities that were being purchased were classic bullet maturities, for which the cashflows are 100% knowable and there are no imbedded call options, these statistics provide some assistance (though they still have problems), but that is not the market the vast majority of fixed income investors participate in today.

This graphic from SIFMA does a nice job of illustrating the mix of outstanding fixed income in the marketplace as of the end of 2019. I am including a link to this graphic on the SIFMA website, because it is actually a really cool interactive chart. You can use it to get visual breakdowns of all of the various types of debt.

Yes, there are a lot of Treasuries out there, but there are also a ton of securities that have imbedded options. This includes all of the MBS, most of the agency debt, and most of the asset-backed securities…you get the picture. My simple arithmetic throws the portion of securities with some kind of option at around 30%. For round numbers, let's call it 13.5 billion dollars. If I were a betting man, most bank and credit union portfolios have a much higher percentage of these securities in their portfolios.(In fact, I am a betting man, as many of you know, just not when it comes to investing!)

Here is the reality: None of those securities can be adequately analyzed using either yield, or duration, or a combination of the two. They cannot because we don't know what the precise cashflow of such securities will be in advance, which is required to even calculate either of those two statistical measures. Yield and duration are both represented by math formulas based on the fixed timing and size of every cashflow, which doesn't exist for these securities.

Investors are buying these securities without being told about the existence of the "hoop" like I mentioned exists for skeet shooting.

Yield seems so simple. The formula for nominal yield is simple on its face:

Nominal Yield = (Annual Interest Earned/Face Value of the Bond)

The problem for most investors is they don't really know the annual interest they are going to earn on a security that amortizes—like a mortgage-backed security—because homeowners within the underlying pool may prepay at any time. We therefore do not know either part of the simple formula above. We know neither the amount of interest we will earn nor the ultimate face value we will have remaining. This is exacerbated when, as I should, I start to analyze my securities over longer time horizons.

Duration (or modified duration) is no better. Both of these formulas are an attempt to capture the price volatility of a security for a small and immediate change in rates. Both will fail to accurately predict the price change if there is any imbedded optionality. Why? Because to calculate the duration of a security, we also must know the future cashflows precisely. The formula is a little denser, but when we have imbedded optionality, like prepayments. We do not have a fixed set of cash flows, and so we can't even accurately do the calculation. In an unfortunate twist of fate, many of the tools we have been using assume a cashflow to make the calculation. This can cause an undo reliance on a measure that is inherently flawed plus give an undue sense of certainty about those very cash flows.

If we could only figure out where that hoop is when we invest! More on that next week.

Final, final thought: I had the first really good and chewy molasses cookie of the holiday season this weekend…it won't be my last.


Be sure to fill out the form below to subscribe to my weekly blog.