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View the First Principles Quarterly SPRING 2015 FIRST PRINCIPLES QUARTERLY FPCM is a privately held investment management firm with expertise across the global fixed income securities and derivatives markets. Founded in 2003, FPCM is a Registered Investment Advisor. FPCM is a fixed income investment manager with over $10bn in assets under management. We provide customized investment portfolios for our institutional clients, which include endowments and foundations, commercial banks, insurance companies and corporations. To our private clients - which include single- and multi- family offices, trusts and high net worth individuals - we offer various investment management and wealth maximization strategies. SPRING 2015 FIRST PRINCIPLES QUARTERLY Contact: In This Issue First Principles Capital Management, LLC CIO PERSPECTIVE ............................................... 2 140 Broadway, 21st Floor RATES, INFLATION AND MUNIS ......................... 5 New York, NY 10005 Tel: 212-380-2280 MORTGAGE-BACKED SECURITIES .................... 9 Fax: 212-380-2290 www.fpcmllc.com CORPORATE CREDIT ....................................... 13 EMERGING MARKETS DEBT ............................. 17 The information contained herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of ASSET-BACKED SECURITIES .............................. 20 any offer to buy or sell any security. First Principles Capital Management, LLC (“FPCM”), or any of its affiliates, do not make any representation or warranty, express or implied, as to the accuracy or completeness of the information contained herein, and the information contained herein should not be relied upon as a promise or representation whether as to the past or future performance. The information contained herein includes estimates and projections that involve significant elements of subjective judgment and analysis. These statements are not purely historical in nature, but are “forward-looking statements”. They may include, among other things, projections, forecasts, targets, sample or pro forma investment structures, portfolio composition and investment strategies. These forward-looking statements are based upon certain assumptions. Actual events may differ from those assumed. FPCM or any of its affiliates do not make any representations as to the accuracy of these forward looking statements or that all appropriate assumptions relating thereto have been considered or stated and none of them assumes any duty to update any forward-looking statement. Accordingly, there can be no assurance that estimated returns or projections can be realized, that forward-looking statements will materialize or that actual results will not be materially lower than those presented. FPCM and its affiliates disclaim any and all liability as to the information contained herein or omissions here from, including, without limitation any express or implied representation or warranty with respect to the information contained herein. The information contained herein is confidential and proprietary to FPCM and its affiliates. This material and information should be treated as strictly confidential and cannot be disclosed to any other party other than the recipient and its advisers. Notwithstanding anything to the contrary contained herein, the recipient (and each employee, representative, or other agent of the recipient) may disclose to any and all persons, without limitation of any kind, the tax treatment and tax structure of the transactions described herein and all materials of any kind that are provided to the prospective investor relating to such tax treatment and tax structure (as such terms are defined in Treasury Regulation section 1.6011-4). This authorization of tax disclosure is retroactively effective to the commencement of discussions with prospective investors regarding the transactions contemplated herein. By accepting this information, the recipient agrees to be bound by all of the limitations described herein. First Principles Capital Management, LLC FPCM Copyright 2015© | 1 SPRING 2015 FIRST PRINCIPLES QUARTERLY CIO PERSPECTIVE Doug Dachille Get Real! CEO & CIO In recent weeks, a number of investment managers have offered their views on European interest rates, with a [email protected] particular focus on the yields on German Bunds. One fixed income manager described the ten-year German bund as 212.380.2281 “the short of a lifetime.” A prominent hedge fund manager added it’s crazy to hold nominal bonds with a negative yield, while another fixed income manager suggested a 100 times leveraged short of the German two-year note could produce returns of 20 percent. My response to these comments is to Get Real! Negative Nominal Yields – The Practical Reality of the Theoretically Infeasible There is little controversy regarding the rationality and economic fortunes of investors purchasing nominal bonds with negative yields, assuming these investors have an investment alternative that enables them to earn a nominal rate of zero for a comparable credit risk in their base currency. Since bank depositors are afforded the option of redeeming deposits in exchange for paper currency, it would seem irrational for investors to ever accept a negative nominal yield on deposits or government bonds. Or is it? Essentially, paper currency is the economic equivalent of a government bond with a zero nominal yield and a stable asset value in local currency terms. This currency conversion option has long served as the source for the assumed zero rate boundary for nominal interest rates. This option also strikes fear into the hearts of central bankers since it enables depositors to adversely impact banking system reserves and potentially confound expansionary monetary policy. The traditional monetary policy response to economic weakness typically involves the purchase of government bonds, which causes a commensurate increase in banking system reserves. The expansion of bank reserves serves to increase lending capacity and to lower interest rates. However, bank depositors can elect to redeem deposits in First Principles Capital Management, LLC FPCM Copyright 2015© | 2 SPRING 2015 FIRST PRINCIPLES QUARTERL Y CIO PERSPECTIVE exchange for paper currency and drain the banking the prepayment option is actually a perfectly rational system of expansionary reserve balances targeted by the decision by an individual borrower when her unique central bank. Thus, the action of depositors could serve to constraints are considered. neutralize monetary policy. A similar phenomenon exists with respect to the exercise of Additionally, the seemingly logical presumption that the currency conversion option. Redeeming a bank deposit investors would efficiently and rationally exercise this for paper currency transforms an electronically stored asset conversion option, placing a floor on nominal interest rates into a physically stored one. There are a number of friction at zero, has been another longstanding concern of central costs associated with holding paper currency, including bankers who fear they would lack any policy tools to explicit storage and insurance costs, as well as implicit costs stimulate an economy experiencing deflation. associated with the inconvenience and the reduced timeliness in making payments and transfers. The Since nominal interest rates were presumed to be floored at magnitude of the friction costs will vary by holder zero, the key objective of stimulatory monetary policy was depending upon scale and transaction frequency. to drive the real yield (nominal yield minus inflation) to as Although paper currency theoretically enjoys a zero negative a rate as possible, as quickly as possible. For once nominal yield, in reality the friction costs of managing paper inflation turns negative, it was presumed to be impossible currency holdings can result in an equilibrium negative for central bankers to maintain stimulatory negative real nominal yield – a rational economic reality to what is yields if nominal yields were floored at zero. seemingly ludicrous theoretically. Central bankers around the globe likely breathed a While zero may not be the lower boundary for nominal collective sigh of relief when nominal yields breached the interest rates, central bankers should not assume there is no theoretical barrier. The ability of central bankers to drive lower boundary. As central bankers attempt to drive the and maintain nominal interest rates at negative levels is nominal yield more negative, the threshold of breakeven now presumed to be a new monetary policy tool to fight cost and inconvenience of holding physical currency deflation by many market participants. However, bankers should begin to be breached for more and more should not set off on their victory lap just yet. individuals, making it economically rational to exercise the conversion option. This would serve to limit the degree of As discussed earlier, efficient exercise of the currency negativity. conversion option is central to flooring nominal interest rates at zero. However, there are numerous examples in financial Central bankers should also not underestimate the impact markets where individuals do not, or cannot, exercise of ingenuity. In the U.S., there are a number of easy ways to options that are seemingly economic to exercise. The best circumvent negative yields on deposits and government example of this is found in the U.S. mortgage market. bonds with reduced storage and inconvenience costs. One Borrowers are afforded the option to refinance
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