Series I bonds are 30-year US treasury bonds that earns fixed interest with an adjustment to the rate to account for inflation (changes in CPI-U, semi-annually). However, they differ from TIPS in many ways. They are not marketable, they have a limit of $10,000 per person per calendar year, and taxes are due at maturity vs. on an ongoing basis. Oh, and Series I bonds interest rates cannot go below zero, unlike for TIPS. You have to buy them on an ancient looking website, though I will say the security guards looked up-to-date.
However, one issue for Series I bonds is the rate can go down if inflation cools. Right now, the “fixed” portion of interest is literally zero. So the interest is 100% made up of the inflation measures in CPI. So if CPI goes to 0%, there is potential the rate is 0%.
And if you redeem within the first 5 years, you lose the last 3 months of interest. So if you are like me, and think inflation statistics will move lower over time, then the rate you earn in a couple years may not be satisfactory.
At the time of writing, the WSJ wrote:
However, now the Series I bonds rate is much higher:
So if you held for 1 year, now the rate you’d earn would be more like 5.34%. Yes, that is “the catch”. But that is for a US government security! Literally no default risk. By comparison, look at the median corporate bond yields from 1 year+
In addition, while you can only invest $10,000 per person per year, we’re close to the end of the year, so I can stuff an extra $10,000 in there early next year. And my wife can do it. Kids can do it.
Normally I don’t think I’d write much about an “opportunity” like this but it definitely is interesting. If you’re one that thinks inflation will spin out of control, you probably are in some other “hedge” investment, but I like this as a modest hedge (though I will likely cash out early).
Personally, while I want to say I can constantly find equities that will beat this hurdle, it doesn’t seem terrible to me to have some portion of the portfolio in these I bonds. This certainly beats my cost of debt threshold on my mortgage!
Timeshare stocks look attractive… as does their debt. I know what you are thinking – time shares are the last place I want to be investing right now. Just look at hotels – demand has evaporated. Just look at the google search history:
But there may be some things you don’t know about the timeshare business model that may show they are more resilient than you think.
Out of the timeshare stocks, I’ll use Wyndham Destinations (WYND) as the example. WYND generates revenue through two ways:
I’ll briefly explain “ownership” as I think most people are familiar with it. The company sells VOIs and in exchange the purchaser can use a specific unit in a property for a week or so. Or they can use allotted points to go to another property.
Typically, WYND and the other players either sell the VOI and get paid upfront or have financing options for the customer. (Note: yours truly recently attended a timeshare pitch – it was around $15k to buy the unit showed to me and they offered financing around ~14-15%).
After the purchase though, the purchaser must continue to pay an annual maintenance fee, which is the share of costs and expenses of operating and maintaining the property. So here we have a major difference between hotels. Hotels have to cover opex and maintenance of the property through its sales revenue (i.e. selling nights). Timeshares already have a book of business that they collect maintenance fees to cover costs. Timeshare costs cover:
“housekeeping, landscaping, taxes, insurance, resort labor, a management fee payable to the management company, and an assessment to fund a reserve account used to renovate, refurbish and replace furnishings, appliances, common areas and other assets, such as structural elements and equipment, as needed over time”
A lot of these costs a hotel must cover even if revenues are zero. Sure they can cut costs, but some of these (taxes and insurance) don’t go to zero just because sales are. Plus, the timeshare is clearly receiving a management fee here as well.
How are timeshare stocks different than 2008/2009? Timeshare companies are different now in a few ways:
They are mostly all independent – VAC used to be a part of Marriott and Starwood, Hilton Grand Vacations is now independent from Hilton.
No longer sell high-end products – prior to the financial crisis, the timeshare companies got into “high end” time shares in residential units, which collapsed. They no longer focus on this.
No longer sell to sub-prime – as shown later, WYND’s credit book has an average FICO of ~720 compared to sub-prime, low-FICO borrowers in the prior downturn
Before I dive more thoroughly into the company, I want to explain really quickly why I am focused on WYND and keep this in mind for the remainder of the post:
Why WYND? There are other Timeshare stocks with good names like Hilton and Marriott…
Roughly 1/3 of WYND’s exchange business comes from membership fees, balance is from members swapping timeshares. Cash is actually received when they book, not at the time of stay. So any timeshare opportunists out there may be swapping for 2021 as we speak… and WYND will be collecting cash.
Another 17% from WYND come from HOA and property maintenance fees. This is very stable.
The one benefit in favor of Hilton (HGV) and Marriott (VAC) is that they charge annual membership fees at the beginning of the year and have already collected the cash. WYND automatically deducts on a monthly basis. I’d prefer to have the cash in the door day one, but beggers cant be choosers.
Sources of Revenue:
Timeshare sales (pretty intuitive)
Finance the purchases noted above. Average customer FICO was 727, 727, 726 for 2019,2018, and 2017 respectively
During 2019, the company generated $1.5BN of receivables on $2.3BN of gross VOI sales – timeshare companies typically securitize this, which WYND does, so that they create capacity on the balance sheet to sell more VOIs.
Company has 3-5 year property management agreements, which typically renew automatically
This essentially means that you can use your time share as currency for an “exchange” on another platform. RCI is a popular company for this. The tour that I did was in Florida for example, but I could exchange my points to go to a Disney vacation club or Aspen.
The vast majority of revenue here is driven by annual membership dues and fees for facilitating exchanges.
OK – if there aren’t many exchanges this year due to a slowdown in travel, that will get hit, but annual membership fees should be very stable
Now that we’ve gone through the revenues side, we should look at the major expenses. I.e. Let’s stress test WYND.
I’m doing this to see how much is variable vs. fixed and what they can cut to preserve cash. Note, I pulled these breakdowns from Hilton Grand Vacations because they do a great job breaking it out line by line whereas WYND brackets a lot of it together:
Cost of VOI sales – represents the costs attributable to the sales of owned VOIs recognized, as well as charges incurred related to granting credit to customers for their existing ownership when upgrading into fee-for-service projects. If you’re not selling new VOIs or acquiring new inventory and customers aren’t exchanging, this probably can flex considerably lower.
Sales & marketing – relatively obvious. But if you know you’ll have no sales in the next few months, you could cut this back tremendously. Perhaps 90%.
Rental and ancillary services expense – These expenses include personnel costs, rent, property taxes, insurance and utilities. These costs are partially covered through maintenance fees of unsold timeshare slots and by subsidizing the costs of HOAs not covered by maintenance fees collected. These are relatively fixed, however.
Resort & club management fees – payroll and other admin costs associated with running the clubs. I think this could be cut back drastically, but maybe will say 50%.
Financing – financing charges for securizations, but is offset by financing income
General & Administrative – back office costs in general. I assume this could be cut somewhat, but might be 75% fixed.
All in, I would say not super variable cost structure, but also not terrible.
Here is my breakdown of what I expect could happen to WYND for the balance of 2020. Yes, it looks brutal, but at the same time, with a complete halt of travel its not really as bad as you think. They actually remain EBITDA positive throughout this year. If you look at the price of Timeshare stocks too, I can’t help but think this is priced in.
How does this translate into FCF? Believe it or not, I think the co could be FCF positive this year:
Therefore, if I think the business isn’t permanently impaired, we could be scooping it up for a great discount. This actually will build the company’s liquidity position as well.
Looking out to 2022, WYND is trading at <3.5x EPS and ~4.5x EBITDA. That seems way too cheap to me.
Finally, why is the debt interesting?
If the company maintains over a $1bn of liquidity this year, they will have no problem addressing their next maturity, a $250MM tranche in 2021. Right now, that bond trades at around 90 for a YTW of 17.6%. I’ll take that all day. Frankly, the company may want to scoop some bonds up on the open market. Buying the bonds at even 95 cents would save the company ~$12.5MM in principal plus additional savings from interest expense.
As I write this, the yield curve is about to be inverted.
I was taken aback today when I saw that 3-month LIBOR is now sitting at 2.6%. As a reminder, LIBOR is the rate that other banks will lend funds to each other on a short-term basis. It is often used a benchmark interest rate for other loans, for example corporate loans will typically be set at LIBOR + some spread.
For a long time coming out of the crisis, LIBOR didn’t matter that much for these loans since there was a floor set at 1%. As such, and L+200 loan would be 1% (the floor) plus 2.0%, to equal 3% yield. Now however, that loan would yield 4.6% due to move up in LIBOR. It has moved up as the Fed has raised short-term rates which in turn impacts other rates of similar maturities.
If we look at the 10 yr rate today however, obviously a much longer-term bond/rate than 3-month LIBOR, we can see the yield is still just ~3.2%. What this tells us right off the back is that the spread between long-term bonds and short-term bonds is very narrow. Said another way, the term structure of interest rates, or the “yield curve” must be very flat.
In a healthy market, the yield curve will typically slope upwards and to the right as investors demand higher rates of interest for longer-term investments. You want to be paid for the unknown for a longer period of time.
However, when the yield curve flattens people often wonder whether the yield curve will become inverted — when short-term rates actually will exceed long-term rates.
This is often viewed as a harbinger of a recession. The reason it’s a recession predictor is that every recession since 1970 has been preceded by an inverted curve.
In addition, a rise in short-term rates pulls back on the capital available on the “fringes” of the economy (e.g. entrepreneurs). At the same time, expected deflationary pressures in the long-term may push long-term rates down. The combination of these factors results in an inverted yield curve and is easy to see why this would indicate a looming recession. (Note, though, this is a small sample size of predictors and there is no perfect predictor out there!)
Ray Dalio wrote in “Principles for Navigating Big Debt Crises” that,
“Typically, in the early stages of the top, the rise in short rates narrows or eliminates the spread with long rates, lessening the incentive to lend relative to the incentive to hold cash. As a result of the yield curve being flat or inverted… people are incentivized to move to cash just before the bubble pops, slowing credit growth…”
A look at prior 10-2 year spreads:
I decided to look at other instances when the spread between the 10 and 2 year were this tight and what the right investment decision at the time would be.
Below are four different instances when the spread between the 10 year and 2 year yield were as tight as it is now and what unfolded few years or months. Note, I start each the 10 and the 2 year yield at 100 and mark the change in yield over time (since price data isn’t available) which is charted on the left-hand side. The right-hand side and in gray is the spread between these two rates (the “10-2 spread”), essentially showing the data another way.
What may or may not be surprising is that in most cases, the yield on the 2 year tightens more than the 10 year by a dramatic amount in percentage terms. Why that may not be surprising is that the Fed uses short-term interest rates to dictate monetary policy and historically, that has had a less pronounced impact on long-term rates.
Since yields move in an inverse relationship to prices, this points to price appreciation for bonds in each of the cases.
This may not be a great predictor since you can imagine the spread widening as long-term rates gap wide and short-term rates move less, such as a long-term change in the inflation assumptions. However, given demographics and a technology changes resulting in long-term deflationary pressures, this currently seems unlikely to be the case to me.
Should we be adding long-term bonds or short-term bonds to our exposures:
Does it make sense to buy short term bonds today, which are yielding ~2.98% or the 10 year, which is yield 3.24%?
At first, I would clearly say buying a 2 year bond makes a lot of sense. You’re getting paid the same as the 10 year essentially and we know rates will go lower, driving bond prices up. However, we must remember that interest rate risk cuts both ways.
Let’s run through some scenarios by comparing the purchase of a 2 year bond and re-investing the proceeds after 2 years into another 2 year bond. We will compare this to holding a 10 year bond for a total of 4 years.
First, I’ll go through what I personally think is most likely to happen.
We undoubtedly are later in the business cycle and when we inevitably enter a recession, I think the fed will once again lower short-term rates to help the economy with a softer landing and to spur investment. I have written a bunch of posts on why I think lower for longer is here to stay, even though that is not a popular opinion (mentioned here and here and here).
As such, I show the 2 year rate moving to ~1.80% and the 10 year moving to 2.92%. I base these numbers off of the typical tightening we saw in prior cycle in the charts above. E.g. the 2 year yield comes in by about 40% and the 10 year much less (I assume about 10%, which is not as much as it has, but am being conservative). The result may surprise you.
The 2 year actually under-performs the initial coupon rate on an IRR basis given you must re-invest in a lower yielding security at maturity. On the flip side, the 10 year appreciates in value as rates move lower and you can sell it for a nice profit, for an IRR above the initial coupon rate.
I know what some of you are already thinking… OK that is great, but I think rates are going up, not down! Well for that scenario, we could look back to 1994 when the Fed abruptly raised rates.
I didn’t show this one before given the spread between the 10-2 was high and tightened over time (opposite than today). Recall in 1994, there was a great “Bond Massacre”, as Alan Greenspan who was the Fed Chair at the time, decided to let air out of the system to prevent an overheating of the economy (that really only had been out of a recession for a couple years).
Let’s look at the numbers if that were to occur. I assume the 2-yr rate moves higher to 4.47%, nearly 150bps higher than today and also 1.5x the current level and assume that the 10 year has a 80bps spread to the 2 year, which implies a 5.27% yield.
In this case, it is obviously advantageous to invest in the two year bond and roll over into a higher yielding bond for the next two years. However, it is also interesting to see that you don’t witness a negative IRR on the 10 year bond (and obviously if held to maturity, you still capture the 3.2% that you locked in a purchase).
To back this up, I used portfolio visualizer to show the results of either buying $10k of 10 year treasuries (Portfolio 1) or $10k of short-term securities in 1993 (Portfolio 2) and holding through 1995. The 10 year dips below on performance for a bit, and then returns to outperforming.
Rates moving like this is an unlikely scenario for me to bank on for a few reasons.
One, it is hard for me to see an abrupt change in the long-term inflation assumption, which will cap long term rates. For example, if the “real yield” i.e. the yield in excess of long-term inflation is 1.7% today (3.2% less 1.5% inflation assumption) then the inflation figure would have to move up to ~3.6% for the 10 year to be priced at 5.3%, keeping the real yield figure flat.
Second, it would then be tough to see how a sharp rise in short-term rates doesn’t cause a significant tightening on the economy.
Bottom line: I hope this is helpful analysis for those making long-term asset allocation decision for an inverted yield curve.
For me, interest rates could likely move up further, but it doesn’t mean that we should be significantly underweight long-term, high quality securities at this point in the cycle. Especially when it appears to be contrarian to do so…
It makes some sense. If investments are competing for my next dollar, it is true that treasuries at 3% look a lot better than <1%.
I have already argued that I am bearish on the notion that interest rates will rise much further from here.
I have based that on (i) real long-term interest rates are lower than people probably think, but are skewed by the high rates of 80s & 90s, (ii) demographic headwinds (baby boomers aging will roll into lower risk securities), (iii) technological improvements are a large deflationary headwind, which will keep rates in check, and (iv) global interest rates remain very low compared to the US and the US is the best house in a bad neighborhood, which will drive increased demand for US$. A strengthening dollar also puts downward pressure on inflation.
Given rates moved up quickly from their lows to ~3.2%, I wanted to show interest rates affect on stocks using a hypothetical company.
I have made these numbers up, but used average S&P EBITDA and EBIT margins for my starting assumptions, assumed a 25% incremental margin, and a 27% tax rate. I also assumed capex = depreciation as this example is a mature business and growing only at about GDP (3%).
Here’s a summary below of where it is currently trading and model:
As shown, the company is currently trading around 12x LTM EBITDA (average S&P company trades for 12.5x LTM). Let’s see if this particularly equity looks cheap based on a DCF. I use both the terminal multiple method and the perpetual growth method below.
As you can see, the implied prices I get are right around the stock’s price today meaning the stock is trading for fair value. What’s the downside if interest rates go up 1%?
Well first, we need to access the impact on our weighted average cost of capital, or WACC. I assume the risk free rate is 3%, as it is today, the beta of this stock is 1.1, and the equity risk premium is ~5%, in-line with long-term history. I also assume the cost of debt is ~5.5%. It is important to remember that many company’s have fixed and floating rate debt.
As such, a 1% increase in the 10 year won’t actually impact a company with fixed rate debt until they need to reprice it. But for conservatism, I assume it is a direct increase in their cost of debt. Bottom line: I increase the WACC by 1%.
So how does this translate into our company? Well, as seen below in the bottom right box, a 1% increase in the discount rate would have a ~5% impact on our stock value, all things being equal.
Bottom line: Interest rates really have not moved to 4% and so I am skeptical of the 10% correction in stocks today and the increase in rates thus far actually impairing their prospects. Rising rates simply do not affect stocks this much.
But coming back to the topic at hand – no one can predict interest rates, especially long-term rates. The former Fed Chief, Ben Bernanke recently said in late 2015 that he admittedly didn’t expect rates to remain this low for this long and followed that perhaps lower rates are here to stay:
“Certainly there has been a long-term downward trend in longer-term interest rates and every indication is that the equilibrium interest rate —the rate that ultimately will be consistent with stable growth — is lower than it has been in the past. So that’s clear. I expect the Fed will be very cautious and gradual, that’s what they’ve told us many times, and they’ll be looking for evidence that the economy has been able to accommodate the higher rate increases and still continue to grow.”
It is important to remember that demographics change.
People in the US are living longer and population growth is slowing. This puts a downward pressure on interest rates. The former causes pressure since people live longer = people need to save more and this may have a ripple effect (e.g. pensions need to adjust for longer life times than the past).
In addition, as people still retire in the 60-65 age range, but need their capital to be stable for retirement, they buy more bonds. Demand is greater than supply.
Low population growth also means slower GDP growth which pushes interest rates down.
Are we anchoring to high interest rates?
Look back at the interest rate in the 1960s. This followed WWII’s boost to America, creating a powerhouse economy, and encompasses most of the baby boomers being born (this ranges from early-to-mid 1940s and ends in early 1960s). From 1960-1965, the US GDP growth rate was anywhere from 5.5% to 10.7%, much higher than the 2% growth we target today. and yet, where was the rate on the 10 year treasury??
It was between 4.0%-4.5%.
Sure, that’d be nice to have if you want to put cash away in a safe place and earn 100-150bps more than what you get today, but the times were different then.
Ok, now that I can get off my soapbox and hopefully help you think somewhat differently about interest rates, I want to turn to the argument of why someone who chooses to invest in bonds is really adding a ballast to the portfolio.
While it’s tough to swallow a security that is guaranteed to only return ~3% p.a. if you hold it to maturity, I think it’s helpful to realize that you want something in your portfolio that will zig while everything else zags.
That is to say, when you invest in bonds, don’t look at just the coupon on bonds and think that is the only return you can get. If we hit a recession or there is fear in the market, these safer bonds will likely move up, while the equity market goes down. Indeed, since the Fed’s main tool here is to tighten rates in order to stimulate an economy going through a recession that is what we saw in 2008.
However, the counter argument that “interest rates may not help you in the next down turn because they are already low” is equally weak. At the end of 2013, the 10 yr treasury sat at 3.0%. It then went to 1.38% in the beginning of 2016. If one had chosen to invest in bonds at that time, it would have paid off.
For context on that, lets run through a case where you invest in bonds at the end of 2013: you buy the 10 year and sold it 2.5 years later when rates actually tightened. After 2.5 years, you have a 7.5 yr bond now with 3% coupon. The rate for 7 yr bonds at that time after some tightening was then 1.2% in 2016, which means your bond would’ve traded up to ~113 to match current on-the run rates.
Even though you bought a 3% 10 yr bond, it went up as people flocked to securities that are safe havens and that investment would’ve provided a ~8% IRR if you then sold it. Not too bad!
Comparison of Different Portfolios I’d like to show you a few scenarios. First, the results of a portfolio invested 100% in US stocks late in a cycle where a bubble bursts (tech bubble) compared to one that is 80 / 20 stocks to bonds as well as one with some allocation to gold to show the impact of non-correlated assets. I will also show this for 2008. This comes to an interesting tool I’ve been utilizing at www.portfoliovisualizer.com. I know I’ll get this comment, but obviously past results are not a predictor of the future, but do think it helps at what may happen in the future.
The first results show what the value would be if you invested $10,000 in 1998 and rebalanced semi-annually.
Portfolio 1 = 80% US stocks, 20% 10-year treasury
Portfolio 2 = 60% US stocks, 20% 10-year treasury, and 20% Gold
Portfolio 3 = 100% US stocks
As you can see, portfolio 1 & 2 performed better over this time frame. Interestingly, portfolio 2 performed the best with its allocation to gold. It worst year was only a 5.7% drop as well, compared to 21% drop for Portfolio 3. Portfolio 1 & 2 underperform in bull markets, which might be obvious, but helped outperform during the bear.
Let’s again look at the 3 portfolios with a starting point of 2004 and ending in 2012. Again, portfolio 2 outperforms the all US stock portfolio as does portfolio 1. Portfolio 2 this time outperforms by a much wider margin since gold is seen as a hedge against extreme scenarios, like the one we saw in 2008. Remember from 2004-2006, the Fed was also raising rates.
I am a total Buffett follower and understand the difficulty buying gold since it is an asset that produces no cash flows. But from a portfolio perspective, I understand the rationale for buying. If your gold assets go up in a time like 2008, that gives you flexibility to sell it and buy stocks at very attractive valuations, which is flexibility I find valuable (though admittedly, I currently have no allocation to gold in my personal accounts). Also, you should watch this video I find humorous on Bernanke’s view on gold vs. Ron Paul.
At the same time, I also realize that a 30 year bond today that will fall 17% if rates go up by 1% may not be attractive despite the upside if rates tighten. The point of this analysis is to say that having a moratorium on bonds may not be the best idea either.
Bottom line: Do I think one should invest in bonds and even gold?Yes. Do I think they will return less than stocks over the next 10-20 years? Also yes. But the flexibility these asset classes may provide this late in the cycle may be attractive (much like insurance). You also have the option to buy corporate bonds which offer slightly higher yield than treasuries, but are still safe havens in times of distress.