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.
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.
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