Bondholders: Don't Fear Rising Rates

Many advisors and their bondholder clients are fretting about rate hikes. Here's why they should relax.

Beginning in June 2004 the Federal Reserve raised interest rates a record 17 times in a row, from 1% to 5.25%, over a two-year period ended June 2006. How badly did bond investors do in this period of time? The answer will be disclosed near the end of this article--don't cheat and jump ahead, read the article first, for your own investing good!

Perhaps the question most often presented to us today is, "How will you manage portfolios if interest rates rise?" Of course the fear is that interest rates will not only rise, but rise considerably. Here is what I think:


--An old Wall Street adage says that most of the people are wrong most of the time when it comes to predicting the investment future. Be wary of the investor's epidemic! When just about everyone fears rates will spike tomorrow, our adage tells us that such a dramatic change is highly unlikely to occur.

--Did you know that the 300-year average inflation rate in the United States is less than 1.9% per year? Low inflation is common, not uncommon. We are in a period of low inflation.

--Inflation and interest rates historically move together. With the current lower-than-low interest rates, and without forecasted rises in inflation, we have a long way to go before seeing higher inflation (and therefore higher interest rates).

--Unemployment has a negative correlation with inflation; high unemployment is associated with low inflation. This is because wages contribute such a large amount of overall product and service costs. Unemployment is high and will remain high for a long time to come. Result: continued low inflation and low interest rates.

--The period 1970 through 1990 saw uncommonly high interest rates. Even the 1990s had high rates by long-term comparison. Many of today's investors have grown up in this high interest rate environment. Many homeowners in the 1980s had mortgage rates as high as 16% (yes, 16%, not a typo). Think about that experience and their lifelong perspective on the fear of rising interest rates.

--Safety should keep investors hungry for U.S. Treasuries and help keep interest rates low.

--When interest rates do rise, there is no indication they will rise considerably.

--When interest rates do rise, they usually do not rise in a straight line; they go up a little, down a little less, up a little more, down a little less. To state another Wall Street adage, "there are no straight lines on Wall Street," which applies to the direction and flight of interest rates as much as anything.

--Rising interest rates is not necessarily a bad thing. On the contrary, rising rates would potentially be an indication that sustained economic growth is back. There is also the benefit for fixed income investors to consider--they will be receiving a greater yield!

--Many portfolio managers "ladder" portfolios, which can provide them with a steady stream of maturing bonds to re-invest at the higher interest rates.

Now that I have made the case for a continued low inflation rate, and therefore low interest rate environment, let's ignore that and look at a rising interest rate environment that occurred from June 2004 to June 2006. This is not to say that the past experience will be replicated precisely, but instead for this review is for discussion purposes only.

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Below is a chart of the Federal Reserve Fed Funds Target Rate for the period June 2004 through July 2006. As you can see, the Federal Reserve increased interest rates seventeen times during this period, starting at a Fed Funds rate of 1% and ending at a Fed Funds rate of 5.25%.

Now the answer to the quiz. Below is a listing of various Morningstar U.S. open-ended bond mutual fund categories and their respective annualized rates of return for the period June 30, 2004, to June 30, 2006. Clearly you can see that during this unprecedented rising interest rate time period, bond investors held their own quite nicely.

High Yield Bonds: +6.89%
Intermediate-Term Bond: +2.54%
Short Government: +1.68%
Intermediate Government: +2.05%
Long Government: +3.55%

Are the above outstanding rates of return? No. But investors should never take epidemic, sky-is-falling paranoia as an investment strategy. Interest rates are not going to the moon anytime soon, and if they do rise, investment success is still quite possible--even if your portfolio is brimming with bonds.

By Sean Hanlon, CFP, is the founder, chairman, CEO and chief investment officer of Hanlon Investment Management, a registered investment advisory with $1.8 billion that employs tactical active allocation strategies.

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Google testing Google News tweaks

Google is testing a couple of new features on the Google News page, revamping the way users see stories presented on the page and adding content selected by actual human beings.

Perhaps the most striking change (see below) is one observed by Search Engine Land, in which Google is experimenting with a blog-like design that lists news stories by category in a single column, rather than the two side-by-side columns currently used on the page. Within that column, users can set preferences as to which stories they'd like to see the most and Google will also display a "Spotlight" on certain stories across a variety of topics.

But Google News--which debuted with the promise that all stories on the page were selected by algorithms--is also trying out a section called "Editor's Picks," where editors from a small group of publications can display five stories they've chosen to highlight. The publication highlighted in that section will change with each visit to the page, with companies such as Reuters, US Magazine, and The Atlantic among the initial partners according to The New York Times.

It's just the latest move in Google's continual dance with the news industry. There's no shortage of news executives who think Google is a pox on their industry, "stealing" their headlines and content in Google News. But Google is sensitive to those concerns, having pointed out several times that it drives an awful lot of traffic to news sites and is working with news publishers to help them get their content online in a way that makes sense for editors and readers.

Not all visitors to the page will see either or both of the tests, as Google follows its usual practice of "bucket testing" new features with small audiences to get a sense of whether the changes make sense.

(Credit: Search Engine Land)

By Tom Krazit writes about the ever-expanding world of Internet search, including Google, Yahoo, and portals, as well as the evolution of mobile computing. He has written about traditional PC companies, chip manufacturers, and mobile computers, spending the last three years covering Apple. E-mail Tom.

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Why Corporate Fraud Is On The Rise

Lax boards, equity-linked pay lead to rise in financial wrongdoing.

Newspaper headlines aside, only a fraction of corporate executives who manipulate or misrepresent their companies' performances get exposed by regulators for such misdeeds. My company, Audit Integrity, is in the business of uncovering such wrongdoing because it represents a substantial risk to stakeholders.

A subset of such manipulation and misrepresentation is securities fraud, which itself is so egregious that the Securities and Exchange Commission does prosecute some offenders civilly. An indication of just how common such behavior is appears in a study analyzing fraudulent financial reporting in the decade through 2007 that was recently released by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission.

It is important to note that, while auditors actively support fraud-detection research, they do not guarantee in their audited statements that they will uncover it. That's because auditors believe they too can be misled by clever fraudsters. I understand the auditors' reluctance; material manipulation and misrepresentation are difficult actions to uncover. Turning to the COSO report, the interesting conclusions include these:
--The number of fraud cases increased between 1998 and 2007 in comparison with the level in the prior 10-years studies.

--The dollar value of fraudulent financial reporting soared in the last decade, despite the implementation of the Sarbanes-Oxley Act of 2002.

The Risk List

--Companies involved in fraud were much larger than those observed in a 1988-1997 study.
--Fraud occurred most frequently in the computer hardware and software industries.

--The SEC cited a company's chief executive officer and/or chief financial officer for some level of involvement in 89% of fraud cases studied.

--The most common fraud techniques involved improper revenue recognition, followed by overstatement of assets and bogus expense recognition.

--Among firms involved in fraud, 26% changed auditors between the filing of their final clean financial statement and their final fraudulent financial statement. Sixty percent of the firms involved in fraud that changed auditors did so during the period the wrongful reporting was taking place; the remaining 40% changed auditors in the fiscal period just before the fraud began.

--Press reports of an alleged fraud resulted in an average 17% abnormal stock price decline in the two days surrounding the announcement. News of an SEC or Department of Justice investigation resulted in an average 7% abnormal stock price decline.

--Long-term negative consequences of fraud included bankruptcy, de-listing from a stock exchange or material asset sales.

--The most commonly cited motives for fraud included the desire to: meet earnings expectations; conceal the company's deteriorating financial condition; bolster performance for pending equity or debt financing; or to increase management compensation.

–The average period during which fraud occurred was 31 months.

The Risk List

--There appears to be no difference between the number or character of frauds since the passage of Sarbanes-Oxley. (Note: the sample periods after 2002 are shorter than those prior to 2002.)

--Fraudulent firms disclosed significantly more related-party transactions than non-fraudulent firms.
--All 347 firms prosecuted by the SEC for financial fraud during the decade studied received unqualified opinions from their auditors for their final set of misstated financial filings.

--Financial statement fraud sometimes implicated the external auditor.

--The consequences associated with financial statement fraud were severe for the individuals allegedly involved. However, the severity of the penalties may not be a sufficient deterrent, the COSO believes.

--There were few differences in the boards overseeing companies involved in fraud and those that weren't.
Audit Integrity's independent findings largely mirror the COSO's conclusions. From our perspective, four important issues stand out:

1. Fraud continues to increase, despite Sarbanes-Oxley.
2. The motivations continue unabated.

The Risk List

3. The methods of committing financial fraud have not materially changed.
4. Traditional measures of corporate governance have no impact on predicting fraud.

While the COSO study does not categorically state that fraud has increased (or, at least, has not diminished) since the implementation of the Sarbanes-Oxley Act, it does confirm that there is no evidence Sarbanes-Oxley has had any impact on the commission of fraud.

We are highly doubtful that additional analysis would show any decline in the fraud rate. As mentioned in the COSO report, 89% of the fraud cases implicate the CEO and/or CFO. Sarbanes-Oxley's primary focus is on establishing more rigorous internal controls (Reg. 404); those controls are targeted at multiple levels of management but only indirectly at the C-suite. The board of directors is responsible for protecting stakeholders; it is our opinion that until corporate directors are held to a higher standard, fraud will continue regardless of the rigor of internal controls.

As the economy has faced mounting stress, many companies have been feeling pressure merely to survive. This pressure may lead to fraudulent behavior to mask decaying operations, the COSO points out.

The COSO and our analysis concur that the methods of committing fraud remain unchanged: The majority of the fraud metrics included in Audit Integrity's Accounting and Governance Risk (AGR) model have remained relatively stable over the past decade.




Revenue recognition, asset/liability valuation and expense recognition are the keystones of the AGR model.
It is interesting to note that insider trading was involved in 24% of the cases; insider trading is a key high-risk metric in assessing potential fraud.

In contrast, board composition resulted in no significant difference in the prevalence of fraud, the COSO found. Audit Integrity's research likewise indicates that board composition plays a very small part in predicting fraud.

We do, however, believe certain governance metrics that are independent of accounting metrics do have an impact. These include frequent amendments to financial filings; boards chaired by the CEO; prevalence of incentive pay vs. annual pay for the CEO and CFO; a high ratio of CEO to CFO total pay; large volumes of stock sales by top executives, relative to market capitalization; frequent legal and regulatory issues; and frequent officer changes.

The Risk List

• The Risk List

• Comprehensive Rankings

• Why Corporate Fraud Is On The Rise

• In Pictures

• Retailers Flashing Financial Danger Signs

Among the important conclusions that could be used to curb future fraudulent activity are the following:

--Fraud will persist until boards of directors are held more accountable for their actions.

--If the economy remains under pressure, fraud will continue to increase.

--The 347 cases of fraud prosecuted by the SEC between 1998 and 2007 represent a small number and a nadir during which a blind eye was often turned to fraudulent activity. Under Chairman Mary Shapiro, the SEC appears to have "found its legs." We believe the number of enforcement actions will increase substantially in the coming years.

--The 347 companies prosecuted in the decade through 2007 represent a small fraction of the number of financial fraud cases that occurred. Very few frauds result in SEC enforcement action; many more are adjudicated by class actions. Most are recorded only in stakeholder disappointment, large price drops, bond defaults and insolvency.

James Kaplan is cofounder and chairman of Audit Integrity, a financial research firm based in Los Angeles.

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‘Shameful’ suicides

THE differences between Western and Eastern, particularly Confucian and Buddhist-based, cultures and attitudes towards crisis, hardship and austerity are great, like day and night.

As debtmocratic Greece has shown in the current debt crisis, the ordinary Greeks have resorted to violent demonstrations, strikes and public anger over the various austerity measures being tied to the proposed eurozone and International Monetary Fund rescue package.

While the public outburst over the corrupted Greek government is somewhat justified, their reaction is grossly different from the Confucius and Buddhist-influenced Asians.

The ordinary Greeks should take a very hard look at themselves, and ask honestly whether they should bear a big part of the blame for the serious debt crisis that Greece is in now instead of only violently pointing their fingers at the government for all the blame.

The way the Confucius and Buddhist-influenced Asians would have reacted in such situations would have been totally different. They would have taken the blame mostly on themselves.

We all know that the Japanese economy has not been performing well for the last 20-odd years but do we know the social costs of this slump?

The number of Japanese who committed suicide in Japan in 2009 stayed above 30,000 for the 12th straight year, with suicides due to hardships of life and job losses rising sharply, states a Japanese police survey.
More significantly, suicides traced to job losses surged 65.3% to 1,071 while those due to hardships in life jumped 34.3% to 1,731.

More worrying, depression continued to top the list of reasons for the suicides.
Perhaps even more worryingly, the number of suicides per 100,000 people came to 24.1 among those in their twenties, an all-time high for that age category, and 26.2 among those in their thirties, a record for the third year in a row.

Not surprisingly, the number of suicides jumped in October 2008 – a month after Lehman Brothers collapsed.
This taking-all-the-blame on oneself instead of looking for easy scapegoats can also be seen at another level.
In 2009, monthly suicides increased year-on-year from January to August.

They were especially rampant from March to May as fiscal year-end fund demands picked up during the period.

From 1990 onwards, even as the ordinary Japanese increasingly suffered under the grossly inept Liberal Democratic Party, one has not seen the violent demonstrations, strikes and public anger that is being seen in Greece, at present.

Instead they take their own lives, probably in shame.
As the ordinary Japanese suffers in silence, the economy stumbles from one recession to another. The cycle repeats.

Now, with the global economic recovery in full swing, the ordinary Japanese gets another cyclical and temporary respite from the rising economic hardship.

How to Prevent Deepwater Spills

Safety upgrades are critical but could mean higher prices for oil and gas

A culture of tighter safety and more experienced regulators might have prevented the BP Deepwater Horizon leak. But equipment modifications and new technology will be needed to minimize the risk of such deepwater oil leaks. According to some petroleum engineers, recommended technology upgrades could price some deepwater resources out of the global energy market.

A mess: Workers clean up oil from a beach on Grand Isle, LA, earlier this week.  Credit: U.S. Coast Guard/PA2 Gary Rives

This could help extend the six-month moratorium on deepwater drilling instituted by President Obama last month. "I tend to be kind of a glass half empty guy, but I think there's a 50/50 chance that the current six-month moratorium will stretch out," says Paul Bommer, a senior lecturer in petroleum engineering at the University of Texas at Austin.

Documents and statements released by various federal investigators point to several decisions and at least one faulty piece of equipment that allowed uncontrolled gas and crude to blow out and destroy the Deepwater Horizon rig in April, initiating the worst oil spill in U.S. history.

Engineers contacted by Technology Review insist that conclusive answers will come with completion of the investigations, but criticize, for example, BP's decision to install a continuous set of threaded casing pipes from the wellhead down to the bottom of its well. "The only thing I can figure is they must have thought it was a cost-cutting deal," says Bommer of BP's well design.

This can be problematic in deep, high-pressure wells for two reasons. First, it seals off the space between the casing and the bore hole, leaving one blind to leaks that sneak up around the casing pipe (as the BP Deepwater blowout is suspected to have done). Second, the long string gives gas more time to percolate into the well. A preferred alternative in high-pressure deepwater is a "liner" design in which drillers install and then cement in place a short string of casing in the lower reaches of the well before casing the rest of the well. This design enables the driller to watch for leaks while the cement is setting. "It takes a more time and costs a little more but it's a much safer way to do it," says Geoff Kimbrough, vice president for deepwater operations at Houston-based drilling consultancy New Tech Engineering.

Kimbrough cautions that transforming corporate cultures will take time because choosing the more conservative operation can easily cost $10 million to $20 million. Not all companies have leaders who readily support these decisions, says Kimbrough: "The courage to do that doesn't come overnight. It comes from years and years of support from senior management."

Regulatory ideas for how to push a culture of safety appear in a 30-day safety review delivered to Secretary of the Interior Ken Salazar late last month, and include establishing new drilling guidelines, operator certification requirements, and tougher inspection regimes. Kimbrough says the Interior Department must simultaneously boost its internal training so that it can effectively review drilling plans.

Attention has also focused on the failed blowout preventer, or BOP, that could have saved the Deepwater Horizon. The Interior safety review calls for upgrades to BOPs to address various failure mechanisms that may have doomed the Deepwater Horizon, such as placement of redundant shear rams strong enough to cut through the toughened threading between casing pipes.

One inherently safer option that many petroleum engineers are considering is bringing BOPs to the surface. In this scheme the BOP on the wellhead thousands of feet below the ocean surface is backed up by a second BOP on the drill rig that would be accessible for more regular inspection and testing. Doing so would mean hardening the risers that link the wellhead and the drill rig to handle extreme pressures.

It's a suggestion that Kimbrough thinks is impractical. "The cost would be somewhere near prohibitive," he says. "Just the cost to develop the system would be astronomical." Mandating something like that would delay new drilling by at least several years. "You're talking about years to develop and test and prove up something like that."

But Bommer says the potential costs are likely to be small compared to the economic impact and incalculable ecological damage that the Gulf region has sustained from BP's leak. In Bommer's view, if such "brute force" safety engineering pushes oil and gas companies to question whether it's economically viable to tap deepwater reserves, so be it. "Cost is the last thing people should be thinking about now," he says.

Another area pegged for technology development is deepwater leak response. BP's ad-hoc response to the Deepwater Horizon leak has revealed the lack of equipment and procedures for high-pressure remote operations. BP's CEO Tony Hayward acknowledged as much last week, saying that despite assurances in its drilling permit applications, BP "did not have the tools you would want" to respond to a deepwater leak.

In fact, the tool shortage for deepwater intervention is an issue long recognized by petroleum engineering researchers. The months-long process of drilling a relief well was, until now, the only proven fallback available in cases where the BOP fails to stop a blowout. A 2003 presentation by Texas A&M University researchers modeling deepwater blowouts cited reliance on relief wells as evidence of a "fatalistic mind-set in the industry."

The lack of progress since then supports that assessment. Since 2005 Congress has left deepwater research primarily in the hands of the Research Partnership to Secure Energy for America, a U.S. Department of Energy-supported petroleum industry consortium in Sugar Land, Texas. But RPSEA has focused its $17 million annual budget for deepwater R&D on production-related issues.

Drilling engineers say the BP accident could finally provide the impetus for deepwater response tools. Funding to perfect some of the schemes that BP has thrown at the spill, they say, should spawn an entire deepwater response industry, analogous to the well-control contractors who secure hundreds of dangerous onshore wells per year worldwide.

James Pappas, RPSEA's vice president of technical operations, claims that his consortium is already beginning to refocus its research agenda toward safety-related R&D. For example, he sees an opportunity to improve sensing capabilities inside deepwater wells after the drill bit is pulled: "That's a weak spot right there, a blind side, that we haven't really addressed as an industry."

But Pappas and other engineers acknowledge that better training, BOPs, and response tools may not convince an outraged country that a sequel to the Deepwater Horizon disaster is impossible. They say it may take more radical upgrades to drilling technology to lift the current six-month moratorium. "We have to go back to square one and prove that we're reliable and responsible enough to take care of our business," says Pappas.

By Peter Fairley

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