Friday, May 12, 2006
After finishing my call with Mrs. H., I received a telephone call from a friend and fellow employee of the Indianapolis based investment firm I was with at the time. He was a broker, and I was in the money management department. He explained that he needed a bid on some Indiana University bonds for a customer who was panicked by the crash and wanted to sell. I asked him why he called me and not the bond desk. As he put it, the bond desk was “shut down.” Actually, what was happening was that the stock market crash overloaded the quotation systems, and no one knew for sure if the prices we were seeing on our Quotrons were current or hours old. Under normal circumstances, municipal bonds trade with a spread to US Treasury bonds. The collapse in stocks had caused a flight to the perceived safety of Treasury bonds, thus the prices of municipal bonds like IU’s should have been rallying along with Treasuries. But correctly valuing municipal bonds in the middle of the stock market crash was next to impossible because, again, no one was sure if the prices on our Quotrons were accurate, and no one knew if the normal spreads between Treasuries and municipals were holding. As a result, many bond desks at firms across the country had almost suspended operations. When I heard the news that our bond desk was not bidding on bonds, my heart sank. This was a proud and prosperous firm. To effectively shut down the bond desk was shocking to me, and opened my eyes to how big the crash was. It was starting to shut down the whole system. Shutting down the bond desk was like the power company shutting down one of its generating plants. The only reason they would do it was to salvage the system. Stocks were collapsing and bond desks nationwide were shutting down. Momentarily, I was seized with the notion that maybe this was, indeed, another 1929-type crash and everyone would lose everything. I had to practically shout at my ruminations that this kind of thinking was not true. The economy was strong. Furthermore, only about 25% of the American people owned stocks. They would wake up tomorrow, brush their teeth, eat an Egg McMuffin, drink a cup of coffee or a Coke, get in their car, and drive to work. Life would go on. My friend said that the seller of the bonds was a long-time client who was convinced that a 1929-type depression was imminent and wanted to hold cash. My friend said, he really needed the favor. He needed a bid on the bond because the client was intent on selling and the bond desk could not help him. I told him I could not do favors with other people’s money. He said he didn’t mean a favorable bid; he just wanted a bid, any bid he could show his client. I asked him, “If the bond desk doesn't know where the market was trading, how was I supposed to know?” He said he understood the problem, but that he had nowhere else to go. He thought that since I bought bonds for the firm’s money management clients that maybe one of them would be interested in his client’s bonds. He was in luck by mentioning this last point. I had several clients tell me during the day to keep an eye out for bargains on bonds. I told my friend that I would think about it, and that he should call back in 45 minutes. I also told him that if he could sell the bonds somewhere else he should do so since I was unsure I would make a bid. By law, the State of Indiana cannot have direct debt. The law was the result of the Wabash and Erie Canal debacle of the 1840s, which forced the state into bankruptcy and produced an 1851 statute prohibiting any future issuance of debt by the state. The law was still in effect, and the prohibition against debt meant that Indiana had one of the strongest financial conditions of any state in the nation. As I thought about the bonds, I realized that Indiana University was as close to state debt as you could get. The good citizens of the Hoosier state would sell off their family jewels before they would let Indiana University go under. In addition, Bobby Knight and his Indiana Hoosier basketball team had won the NCAA championship the preceding March, and the state would have probably sold off the capitol rotunda rather than give up the basketball arena. The bonds were safe. The only question was…what were they worth? The toughest hurdle to get over in valuing the bonds was that they were 20 years from maturity. As I thought about it, however, I realized life and taxes would go on no matter what happened in the crash, and that the tax exempt interest the bonds paid would always be prized by investors in high income tax brackets. I knew that US Treasury bonds had started the day yielding about 10.25%, and I knew that bond prices were rallying, so the yields were probably near 10%. I remember thinking that if I could buy the IU bonds to yield 10% that I had a real bargain, and one that I was comfortable making. The broker called me back and I told him I would buy the bonds to yield 10%. I told him to call the bond desk and get their approval before he told his client about my bid. The head of the bond desk called me immediately and tried to explain what was going on with the bond market and his inability to bid. I stopped him and told him that I was aware of what was going on, but the broker had asked me to make a bid, and if he approved it, I was willing to buy the bonds. He said he thought that 9% might be a better level for the bonds. I told him he was welcome to buy them there, but my bid was 10%, and if he did not think it was fair, I was fine with dropping the whole matter. He said he had learned through my broker friend that the client wanted the bonds sold by the end of the day, and that he could find no one else to bid. I told him my bid was good until the close of business. He said he would call me back right away. The broker called back in minutes and said the bond desk would not approve the 10% level. I said that that was fine with me. He stopped me and said, “but they will allow it at 9.40*%.” I told him if his client would take it, I would buy the bonds at that level. I then called the bond desk and told them I would offer a bid on any other bonds that people wanted to sell. I had budged on my level, but I realized that buying Indiana University bonds when no one would make a bid was sure to be a good buy, ultimately. The destruction of hundreds of billions of dollars by the crash was a deflationary event, and I was convinced that this would cause interest rates to fall. As I returned to my blinking phone, I paused for a moment. Something had happened here -- something that was new to me; something that I had never done before. I had just valued a bond in the absence of a trading market. I had just committed my clients to up to 20 years of ownership of this bond, and I had done it in the middle of a panic unlike anything I had ever seen. But what surprised me the most was, as I said earlier, that it moved almost in slow motion and almost intuitively I was able to clear away all of the clutter surrounding the decision and zero in on just the few details I needed to make the decision. *This is my best recollection of the final level. I know it started at 10% and the bond desk asked that it be lowered. I have checked the records as far back as I can, but the company has changed hands twice and no one seems to know where the old records are.
Labels: The Rising Dividend Story