fed boosts rates for first time in 4 years · with his record label sony music. a similar stock...

Fed boosts rates for first time in 4 yearsBy Martin Wolk Executive business editor msnbc.com6/30/2004 4:41:39 PM ET NBCNews.com

The Federal Reserve raised key short-term interest rates Wednesday for the first time in morethan four years, launching a risky campaign to suppress inflation without stamping outeconomic growth.

Concluding a two-day meeting, Fed Chairman Alan Greenspan and fellow central bank policy-makers boosted the benchmark federal funds rate a quarter-point to 1.25 percent, citing recentevidence the economy “is continuing to expand at a solid pace.” The move, which is expectedto be the first of a many over the next year or more, affects a wide range of consumer andbusiness loans.

The federal funds rate is what banks charge each other for overnight loans and last changedin June 2003, when the Fed lowered it to 1 percent, a level not seen since 1958. The last timethe Fed raised rates was in May 2000, shortly after the stock market peaked.

Major turning point in Fed policyThe rate hike, which had been widely expected, marks a major turning point in Fed policy,ending a long cycle of easing that began in January 2001, just as the economy was about toplunge into its first recession in 10 years. Even after the recession ended in November 2001,the Fed continued lowering rates as the economy struggled through a series of challenges,including uncertainty related to the U.S. war on Iraq.

"The simple fact is that the Fed was reacting to a series of crises that hit the economy," saidJoel Naroff of Naroff Economic Advisors. He cited the terrorist attacks of Sept. 11, 2001, thecollapse of the dot-com bubble and a series of corporate accounting scandals in addition tothe Iraq war. "What we have is an artificially low (interest rate) level that was created becauseof crises."

While the economy does not seem in any imminent danger of overheating, nearly 1 million jobshave been added to payrolls over the past three months, ending a long jobless recovery andsignaling that the economy has resumed a robust, sustainable expansion, analysts say.

And consumer inflation suddenly has picked up speed this year, forcing Fed policy-makers torenew their vigilance about rising prices. Even excluding the volatile food and energycategories, consumer prices in May were up 1.7 percent over year-earlier levels, compared with1.1 percent as recently as January.

"We’re seeing the inflation rate starting to creep up," said David Wyss, chief economist atStandard & Poor’s. "It’s not dangerous yet, but the Fed wants to nip it in the bud, and I thinkthey’re right. They have to keep stomping on the lid."

Financial markets took the Fed rate hike in stride, with stock prices edging higher. The DowJones industrial average, which was down about 20 points before the Fed’s afternoonannouncement, ended up 22 points or 0.2 percent.

“You couldn’t have asked for a more tightly scripted Fed decision," said Mark Zandi, chiefeconomist of Economy.com, a forecasting firm. “They didn’t deviate at all.”

In a statement accompanying the rate-hike announcement, the Fed reiterated it planned toraise rates at a “measured” pace, saying the recent surge in inflation appears to be “transitory.”

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But echoing recent comments from Greenspan and other central bankers, the central bankalso said it would “respond to changes in economic prospects as needed to fulfill its obligationto maintain price stability.”

Major Market Indices

Drew Matus, an economist at Lehman Bros., called the Fed’s position a “gamble” that will forcefinancial markets to focus on any signs of inflation, including Thursday’s closely watchedsurvey of purchasing managers and Friday's monthly employment report.

Mortgage rates moving upLong-term mortgage rates already have responded to the anticipated Fed rate-hike cycle andrising inflation. A typical 30-year, fixed-rate mortgage now carries a 6.25 percent rate, up from5.4 percent in March. Rates could rise to 7.5 or even 8 percent over the next 18 months saidNaroff, who estimates the Fed ultimately will push up the federal funds rate to 4 percent,somewhat higher than other forecasters project.

Variable-rate loans, such as home equity lines, short-term business credit and even credit cardrates could respond quickly to the Fed move. Major banks announced Wednesday that theprime rate, a benchmark for many business and consumer loans, would rise a quarter-point to4.25 percent, matching the Fed increase.

Greenspan and other central bankers have spoken frequently of their plan to raise rates in a"measured" fashion, although they also have warned that they will do what is needed toprevent inflation from getting beyond their target level. Analysts say the risk is that the Fedcould raise rates too far and too fast, causing a sharp slowdown in key economic sectors likehousing and auto sales.

Only a few months ago, many Wall Street economists expected the Fed would leave rates onhold until 2005. Now most analysts expect the central bank to raise rates at least two or threemore times this year.

Text of Fed statementThe following is the full statement released by the Fed Wednesday:

"Federal Open Market Committee decided today to raise its target for the federal funds rate by25 basis points to 1-1/4 percent.

The Committee believes that, even after this action, the stance of monetary policy remainsaccommodative and, coupled with robust underlying growth in productivity, is providingongoing support to economic activity. The evidence accumulated over the intermeeting periodindicates that output is continuing to expand at a solid pace and labor market conditions haveimproved. Although incoming inflation data are somewhat elevated, a portion of the increase inrecent months appears to have been due to transitory factors.

The Committee perceives the upside and downside risks to the attainment of both sustainablegrowth and price stability for the next few quarters are roughly equal. With underlying inflationstill expected to be relatively low, the Committee believes that policy accommodation can beremoved at a pace that is likely to be measured. Nonetheless, the Committee will respond tochanges in economic prospects as needed to fulfill its obligation to maintain price stability.

Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F.Geithner, Vice Chairman; Ben S. Bernanke; Susan S. Bies; Roger W. Ferguson, Jr.; Edward M.Gramlich; Thomas M. Hoenig; Donald L. Kohn; Cathy E. Minehan; Mark W. Olson; Sandra

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Michael Jackson Floats Himself on the Stock Exchange

World £1!f~rtaiflmtl1l Ntwj Network

J7·NOV·98

(WENN/P) -- Michael Jackson is hoping to make $\00 million by floating himself on the siock exchange.

The fi nancial move would allow Jackson, in effect, to borrow against fu tu re royalties from his huge catalogue of songs - including those by The Beatles as well as his own.

The "Thriller" singer would receive immediate cash, while those who snap up the "Jackson Bonds" wou ld reap the future royalties from the songs he controls . And there's a lot of songs - as well as many Fab Four tracks, Jackson gained royalty rights to hundreds of other songs in a 1994 deal with his record label Sony Music .

A similar stock exchange move by David Bowie last year (97) gai ned the "Ziggy Stardust" hitmaker $55 million.

The man in charge of the Jac kson Bonds is former EMI Capitol Music boss Charles Koppelman , who is poised to announce a deal over the next few months.

He is backed by the Prudential company, which purchased all of the Bowie bonds last year.

April 10, 2013 7:05 pm

By Javier Blas in London and Jack Farchy in Santiago

Trafigura, one of the world’s largest commoditiestrading houses, has launched its first perpetual bond,tapping the public capital market in a further sign ofchange in the way trading titans finance themselves.

The trading house, which last year moved itsincorporation from Geneva to Singapore, raised$500m with its bond, up from an initial target of

$300m. The note, which was five times subscribed, will yield a 7.65 per cent coupon.

Trafigura is the world’s second-largest independent metals trader after Glencore, and the third-largest oil trader behind Vitol and Glencore.

The bond issue is the latest sign that the traditionally employee-owned commodity tradingindustry is opening up to new sources of capital, as European banks scale back their lendingactivities in the sector just as traders need more credit.

Louis Dreyfus Commodities, one of the world’s top food commodities traders, last Septembertapped the public capital markets for the first time in its 160-year history, raising $350m in aperpetual bond. Other commodities houses, including Mercuria, are courting investments fromsovereign wealth funds and private equity investors. Bankers said oil trader Gunvor was alsoconsidering a bond.

The perpetual bond, which international accounting rules count as equity, will strengthen thebalance sheet of Trafigura without diluting existing shareholders. Claude Dauphin, chiefexecutive and one of the founders of the group, owns less than 20 per cent while more than500 senior employees control the rest.

“We want to get the long-term liquidity while maintaining our credit standing,” Pierre Lorinet,Trafigura chief financial officer, said in an interview. “[The perpetual bond] provides us withlong-term money [with an] equity treatment.”

The bond will be listed on the Singapore Exchange, forcing Trafigura to release publiclysemi-annual accounts for the first time. Until now the company has only released financialinformation to a small group of investors and bankers.

The new sources of financing in the Swiss commodities industry are partly driven by a change

©AFP

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in the business model of the trading houses.

Companies have moved away from their traditional role as middleman – selling and buyingcommodities in a business of large volumes but razor-thin margins – increasingly to becomevertically integrated groups, with interest spanning production, logistics, trading andprocessing.

The new areas, such as investing in oil refineries, require long-term capital that the tradinghouses in the past did not need. Some trading houses have not opened their equity to outsiders,but are seeking bond investors.

Trafigura recently spent about $800m through its Puma Energy unit acquiring two petrolstation and oil import terminal companies in Australia. The company is also investing in arefinery in India, and its mining division is ramping up capital expenditure in North and LatinAmerica. “We continue to grow,” said Mr Lorinet, adding that most projects under way were“organic” rather than acquisitions.

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Mexico's President Enrique Peña Nieto

beyondbrics: Times aresweet for Mexico exports

Sweet news for Mexico’s sugarexporters: anti-obesitycampaigns mean exports arebooming . . .

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Last updated: March 12, 2014 4:30 pm

By David Oakley in London and Vivianne Rodrigues in New York

Mexico sold its first ever 100-year bond in sterling on Wednesday, taking advantage of lowborrowing costs and investors’ appetite for higher-yielding debt priced in “hard” currencies.

The century bond raised £1bn and followed the country’s first 100-year bond launched morethan three years ago, in dollars.

The decision to sell the bonds comes as Latin America’s second-largest economy takesadvantage of demand for higher yielding investments against a backdrop of record low interestrates in Europe and the US.

Despite turbulence at the start of the year, debt capital markets have remained open to developing nations. In addition to Mexico,countries including Indonesia, Turkey, Slovenia and Colombia sold a record amount of non-local currency bonds so far this year, insales that were largely oversubscribed, people familiar with the offerings said.

Mexico is considered one of the stronger economies by some investors because of the steady improvement in its economic outlook anda series of far-reaching structural reforms carried out by President Enrique Peña Nieto.

Earlier this year, BlackRock, the world’s largest money manager, said Mexico was one of the economies well positioned to benefit froma broader rebound in emerging markets’ assets given the country’s reform efforts.

UK-based institutional investors were the majority buyers, with demand for the securities reaching the £2.4bn mark, people familiarwith the sale said.

The bonds that will mature in March 2114 were sold at a yield of 5.62 per cent and carry an interest rate coupon of 5.75 per cent, muchhigher than on UK gilts or US Treasuries

That attracts investors who want a yield pick-up in something that is relatively safe, given Mexico’s stable triple B plus ratings from S&Pand Fitch and stable A3 rating from Moody’s, the three main credit rating agencies. Bookrunners on the deal are Barclays and GoldmanSachs.

Mexico’s first 100-year bond, which was launched in October 2010, has been considered a success as thecountry managed to lock in low rates for the $1bn of issuance.

The bond was priced to yield 6.1 per cent at the time in what was then one of the largest century bonds.

Also behind Mexico’s ability to raise the debt on Wednesday is the transformation of its debt profilecompared with the mid-1990s.

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September 9, 2004 9:24 pm

By Aline van Duyn and Päivi Munter

t 4.14pm in London on Wednesday August 18, employees across Citigroup were stunned to see a headline flash up on theirBloomberg terminals: “Citigroup bond trading investigated by UK regulator.”

It was the first anyone at the US bank knew about a formal investigation launched that day by the Financial Services Authority, the UK'sfinancial regulator. Now they could all read the allegations.

“The FSA has been making inquiries into the unusual trading activity initiated by Citigroup in European government bond and bondderivative markets,” the regulator said. “Large players in financial markets are expected to have regard to the likely consequences oftheir trading strategies, such as implications for liquidity, spreads and general stability.”

The trading at the centre of this broadside from the FSA had taken place some two weeks earlier, on August 2, and was simple. Itinvolved selling a lot of bonds unexpectedly, watching prices fall, and then buying them back more cheaply. But what was exceptionalwas its speed. In less than two minutes, Citigroup's London-based government bond traders sold more than €11bn of bonds, takingadvantage of special rules on an electronic trading platform called MTS.

The MTS system, developed with European governments to improve the tradeability of their debt, requires its 55 market-makers toprovide price quotes for bonds at restricted bid-and-offer spreads for at least five hours a day. In practice, a bank would expect buy orsell orders for five or 10 different bonds at any one time.

But this time Citigroup had placed simultaneous sell orders for more than 200 different bonds, using a special computer systemdesigned by the bank's government bond trading desk. The “go” button was pressed on that quiet Monday morning in August - whenholiday torpor had set in.

At first traders assumed a mistake had been made as the Citigroup name flashed across their MTS screens. Frantic calls to MTS soonrevealed the orders were genuine. The mass sale triggered automatic selling of European government bond futures as positions werehedged: futures prices also fell sharply.

Citigroup later bought back €4bn of bonds on the MTS trading system. It may have wanted to buy more but many dealers stoppedtrading. “We just were not prepared to take more losses on the chin just because of the MTS trading rules,” said the head of trading atone of the biggest dealers. “We pulled the plug on it, the first time we have ever done such a thing.”

It is likely that Citigroup netted a profit of about €15m - perhaps more depending on the bank's starting position and how much of thetrading was done for its proprietary trading book.

The trades' wider repercussions, though, are now becoming clear. The world's biggest bank has raised the hackles of Europeangovernments and exposed weaknesses at the heart of the eurozone capital markets. The barrage of criticism from its competitors andcustomers, and the possibility of action from the FSA, are particularly galling for Citigroup: it has promised to keep its hands clean andset exemplary standards of behaviour following huge fines for malpractice in the US.

Citigroup's gain, of course, was someone else's loss. Big trading banks - ABN Amro, Deutsche Bank, Barclays Capital, JP Morgan Chase,UBS - nursed losses estimated at €1m-€2m. “We were hit, but that happens every once in a while,” said the head of trading at one bank.


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“Pretty much all's fair in the inter-dealer market and Citigroup spotted a way to make a quick buck. I guess we just have to say welldone to them.”

Not everyone saw it that way. Many smaller, local European banks are also signed up as MTS dealers: for these banks a loss of€1m-€2m is more difficult to shrug off. Banks were soon on the telephone to government treasury officials. They, in turn, calledCitigroup. “We told Citigroup we didn't appreciate it and felt it was against the spirit of the primary dealer contract,” said an official at aEuropean government treasury. “We feared for the liquidity of our bonds.” Some European governments were clearly furious that theMTS system had been used in such a way. “By some European government treasuries, this trade was perceived as open warfare,” said ahead of debt capital markets at a large European bank.

Citigroup had hit upon the weaknesses in a trading system that is at the heart of the borrowing strategies of many Europeangovernments. The bank - which counts those same governments among its biggest clients - also touched a nerve within the 5½-year oldeuro project.

Governments had to cede control over monetary policy to join the single currency. But they foughthard to keep fiscal policy out of the clutches of Brussels. As a consequence, all 12 eurozonecountries still borrow in the bond markets for themselves.

The biggest buyers of their debt are local financial institutions such as banks, insurance companiesand pension funds. Most are subject to stringent rules that require them to invest heavily indomestic assets - a handy source of money for governments spending more than they earn.

The euro, though, threatened to end governments' access to this easy money. Since financialinstruments in at least 10 other countries were now priced in the same “local currency”, aninstitution in one country could buy bonds issued by other eurozone members with no qualms.Many government treasuries were worried that, if investors piled into German bonds - thebenchmark for the whole region - it could cut the liquidity of their bonds and raise borrowing costs.

Take Austria and Germany. Although both countries have top-notch AAA credit ratings, the lower liquidity of Austria's bonds means itmust pay more for its debt than Germany: only five-one-hundredths of a percentage point more, but multiplied by many billions ofeuros borrowed every year, it adds up to extra expense for taxpayers.

To fight back, governments needed to enhance the liquidity of their bonds - and their main weapon was to promote greater electronictrading of their bonds through the MTS system.

MTS, a privatised platform operator created by the Italian treasury to trade domestic government bonds, and which retains close ties tothe Italian government, sensed opportunity. Government issuers and banks signed a “liquidity pact” through the MTS system. Forbanks, this meant agreeing always to trade for certain minimum amounts. Such a quote-driven system is unusual: most electronictrading, and telephone trading, is order-driven. But banks were prepared to subsidise their MTS business by trading unprofitablybecause European governments, when choosing banks for lucrative business such as derivatives transactions or syndicated bond sales,often picked those that came top of the list in terms of MTS trading volumes.

The quote-driven system has been accused of creating false liquidity. It is not really false - Citigroup demonstrated the market was realenough - but it is forced. And the exposure that such forced liquidity creates has not been correctly priced. “There is no reward to thedealers for the additional risk capital mandatory market-making requires, other than to position themselves with the issuers to beselected for other profitable underwriting opportunities,” said Garry Jones, chief executive of ICAP Electronic Broking, which operatesa rival electronic trading system.

Many traders on the day Citigroup did its deal thought the bank was breaking a “gentleman's agreement”. It is now clear that banks didnot correctly price the risks they were taking by always agreeing to be available to trade. “The system was basically a free lunch forEuropean governments - they got improved liquidity at no extra cost,” says a trader.

By lunchtime on that first Monday in August, Citigroup's European government bond traders had completed their sweep of the market.


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But the celebrations were limited. Phones were soon ringing incessantly.

Traders faced a barrage of hostile questions from competitors and European governments. Some government treasuries complainedthat Citigroup's bond trading desk contact details had been removed from the Bloomberg system, used by most bond marketparticipants for information and to communicate.

On August 4 MTS introduced emergency measures - limiting trading volumes - to ensure such a trade would not happen again. Dealerson the system were refusing to honour their market-making requirements for fear of again being hit by a mass order. The measureshave now been dropped, and MTS is today discussing at its board meeting in Rome how to deal with the crisis.

It had become clear by the end of the first week of August that this was not an issue that would go away. Rival banks met to discuss thematter. European treasury officials are to meet on September 21. And regulators are prowling: the FSA is the only one to have launchedan official investigation but others are looking into the matter.

Citigroup was the only bank not to send a representative to an MTS dealer meeting on Wednesdaythis week, though they did participate by telephone. Even within Citigroup, staff on other tradingdesks say they are in the dark as to exactly who or what lay behind the trading of August 2.

Why did the trade get the go-ahead? The estimated profit of €15m is quite a lot for governmentbond trading desks, where strong competition in Europe has pushed margins to near invisiblelevels. But government bond trading is now part of broader interest rate trading departments,including trading of more profitable interest rate derivatives such as swaps. Annual profits for therate trading desks run into hundreds of millions of euros.

A trade like this would probably require authorisation from the head of fixed income trading, butnot necessarily beyond that. Although some heads of trading at big banks said they would havevetoed the trade on the grounds that it might ruffle too many European government feathers,others admitted they would have given it the green light. “I would have considered the broader implications, but would never haveguessed the ripples would have been as strong as this,” said one trading head. “A big wild card in all this has been the response from theregulators. Without that, this would have died down right after the trade.”

The FSA may decide there was no wrongdoing; give the bank a verbal reprimand; or impose a fine. If the latter happens, Citigroupfaces being barred from certain government work: the Italian treasury's rules, for example, state that “exclusion may occur when aspecialist dealer acts in a way that jeopardises the efficiency of the secondary market and orderly trading”. Even if it is not formallyfound to have contravened any regulations, its actions may leave a bitter taste for some government clients. “The reputational losscould be bigger than any instant profits from these trades,” said an official at a eurozone treasury department.

The regulator's ruling on Citigroup's trade may also be important for the trading environment in the City of London - potentiallysignalling a tougher attitude towards enforcing trading standards. Regulation in the UK is based around principles, rather than strictrules, and this allows for a degree of subjectivity. Compliance departments at banks may be more reluctant to allow large trades if thereis a specific precedent for regulatory action.

“Block trades are increasingly being used by investors, in equities as much as foreign exchange or bonds,” said Clifford Dammers,secretary general of the International Primary Market Association, which represents a large group of banks.

“If the FSA takes punitive action against Citigroup in this case, there could be consequences for the liquidity of many markets if itprevents traders from carrying out large trades.”

The credibility of the MTS platform has also taken a knock. Banks had long been unenthusiastic about rules that require them to buy orsell come what may - but a change to the basic operating rules of forced liquidity is in the hands of the European governments whosebonds are traded on MTS. Although governments with big, liquid bond markets, such as Germany's, are not worried about removing theforced liquidity requirements, many smaller countries are.

If the MTS rules were changed, traders say the buying and selling of the less liquid bonds would be likely to take place mainly on thephone-brokered market, and not electronically. Some governments fear this would raise borrowing costs. However, if governmentsused data from all electronic trading systems and phone brokers to assess which banks ranked top in terms of trading - and thusqualified for other lucrative business - there would still be an incentive for banks to trade even less liquid bonds at attractive levels.

France, for example, is including trading statistics for other trading platforms, not just MTS. Italy has adopted more qualitative, ratherthan just quantitative, measures.

FSA action against Citigroup would deter similar trades. This would deflect the calls for a fundamental reform of the trading platform.But some wonder if this might be in the best interests of maximising efficiency in European capital markets.

The head of debt capital markets at the large European bank says: “For many years MTS has worked well to bring liquidity to


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previously very illiquid markets. A lot of emotion, reputation and money was at stake. But just because it has worked well in the past, itdoes not mean it isn't time to take another look at the MTS system. This, however, is not what treasuries want to hear.”

............................................................................................................................................

Issues that divide

One of the dreams that accompanied the development of the single European currency was that Europe would finally have capitalmarkets comparable to those in the US.

On the surface, the two are more comparable now than ever before. Including all bond issues, the US is still the world’s biggest marketwith over $21,351bn outstanding at the end of 2003, according to Merrill Lynch. Europe’s debt markets were the world’s second-largest, with $10,306bn. But the figures do not tell the whole story. Although there is $4,639bn of eurozone government debtoutstanding (versus $10,404bn from the US Treasury), the European market is still split because issuance is divided between12different countries. With fiscal policy still in the domain of each individual country, rather than centrally controlled, each governmentdecides how much to borrow and how to place the debt.

This continued segregation is the main reason why eurozone government bond markets are much less liquid than their UScounterparts.

In the US market, which is dominated by only a handful of big banks, most interest rate trading is done in the cash Treasury market.But in Europe, the biggest benchmark trades take place in the futures market and in the interest rate derivative markets. These are notsplit along country lines: the benchmark future in Europe is the German government bond future. Volumes dwarf the trading of USTreasury futures because the divided cash market cannot provide sufficient liquidity.

The creation of the MTS electronic trading system reflects the quirks of the European market: although the platform operator runs apan-European trading system called EuroMTS, a significant part of the trading between banks takes place on the parallel, local MTSplatforms.

Many smaller eurozone governments have been keen to foster the local markets, as their existence gives them more sway over themarket. Given a trend toward more syndicated bond issues, the eurozone’s sovereign borrowers have become important clients forinvestment banks.

Although liquidity in the eurozone market still trails the US market, the prospect of underwriting new debt has persuaded banks tokeep a strong presence on the “semi-official” MTS trading platform. The platform is supported by eurozone governments - even ifmargins on the system are razor thin. On the other hand, the creation of the euro has opened a new and potentially lucrative primarymarket for US banks such as Citigroup.

Sources for charts: Reuters; Dealogic; Thomson Datastream, UBS


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With more than $3 trillion in assets, Larry Fink and histeam at BlackRock are the world's largest moneymanagers. And Fink thinks he's just getting going.

By Shawn Tully, editor at large

August 17, 2009: 10:01 AM ET

(Fortune Magazine) -- On Oct. 1, 2008, BlackRock's CEO, Larry Fink,

was sitting in his glass-framed Manhattan office when CNBC reported

that Warren Buffett was buying a big stake in General Electric.

BlackRock's nearby trading floor erupted with excitement. The experts

and the pundits on the tube viewed the Buffett news as a sign that the

markets were stabilizing. Fink didn't see it this way and shared his gut

reaction with an associate.

"This isn't about a sweet, clever grandfather from Omaha making a nice deal! It means GE can't roll

over its commercial paper, and corporate America can't fund itself!" As the TV buzzed with happy

talk, Fink predicted a new round of fear, panic, and collapsing asset prices, loudly concluding, "This

is a disaster!"

It is precisely this type of contrarian, worst-case-scenario thinking that has propelled BlackRock

(BLK, Fortune 500) over the past 21 years from an eight-partner bond shop to the best-performing

financial services company of its generation. Since BlackRock made its debut on the NYSE in late

1999, its shares have jumped 14-fold, from $14 to $198, creating more than $25 billion in market

value. By contrast, Goldman Sachs's just about tripled during the same period.

BlackRock is now by far the biggest, fastest-growing asset manager in the world. When BlackRock

completes its $13.5 billion acquisition of Barclays Global Investors (known on the Street as BGI)

later this year, it will more than double its assets under management, to $3.1 trillion -- yup, trillion.

That's twice as big as its nearest rivals, State Street (STT, Fortune 500) and Fidelity.

BlackRock is also a totally new creation in the world of asset management, a one-stop shop offering

a smorgasbord of products to both institutional and retail investors. Unlike banks or brokerages, it

does nothing but manage money, and it is the largest provider of fixed-income funds. No wonder

Cisco (CSCO, Fortune 500), FedEx (FDX, Fortune 500), and the public school teachers of

California trust the firm to help invest their retirement savings.

But as the Book of Luke says, "To whom men commit much, of him they will demand the more."

And therein lie the challenges for BlackRock: Can a former bond boutique manage trillions of

dollars? What are the thought processes that drive its investment decisions? Can BlackRock deliver

consistent returns in an industry where turnover is frequent and talented money managers don't

always play nicely with one another?

Inside the trillionaires' club of BlackRock - Aug. 17, 2009 http://cnnmoney.printthis.clickability.com/pt/cpt?expire=-1&title=Insi...

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Answers to these and other mysteries are just some of the secrets that Fortune sought to unlock by

spending a month talking with BlackRock executives about how it has flourished during some of the

most nightmarish moments in high finance, including 1998's Long-Term Capital Management

debacle, 2000's tech crash, and 2008's credit crisis. What follows are four strategies for managing a

company and gauging the markets that have driven BlackRock to No. 50 on the Fastest-Growing

Companies list.

LESSON 1: Make a big business feel like a small company

To understand BlackRock's corporate culture, you need to understand the interplay of Fink and the

firm's president, Rob Kapito, who have worked as a team for more than 20 years, and have two

very different styles of leadership.

The son of a shoe store owner, Fink is a workaholic who arrives at the office at 5:45 a.m. He

spends most of his time on the big picture, talking to important clients, plotting acquisitions, and

counseling the Washington regulators who have become a crucial source of business. In his spare

time he likes to live well. His brother Steve, a Silicon Valley entrepreneur, describes Larry's property

in rustic North Salem north of Manhattan as "Disneyland on a farm." It boasts an indoor riding ring

and an 18th-century manor house containing one of the greatest collections of American folk art.

Kapito, 52, is as quiet and precise as Fink, 56, is gregarious and opinionated. Kapito runs the

day-to-day operations -- everything from personnel to accounting. He is also the guardian of

BlackRock's corporate culture, doing a lot of little things to keep BlackRock feeling familial. One

manager found Kapito sitting in her hospital room when she awakened after cancer surgery. In July

2008, Kapito wanted to do something special for the London gold and natural-resources team when

their funds reached a milestone of $50 billion. So he flew to London, rented a house, and personally

cooked a lamb-chop-and-salmon dinner for the troops, whom he enlisted as sous-chefs with toques

inscribed with their names.

Another hallmark of the BlackRock ethos is the daily morning meeting, held at 8 a.m. around a

gigantic oval table in a fourth-floor Manhattan conference room. "It's mandatory, like church when

you're a kid," says co-chief operating officer Charlie Hallac, who each morning takes the 6:03 a.m.

train from his home in Scarsdale, N.Y., with a bunch of BlackRock managers.

More than a dozen offices from around the world -- London, Tokyo, Hong Kong, to name a few --

attend via audio- or videoconferencing. Some satellite offices appear in boxes on a giant screen. It's

sort of Hollywood Squares meets high finance. Around the table, managers with nameplates

reading "U.S. rates" or "Securitized assets" give pointed, usually one-minute presentations ending

with "That's it!"

One morning in July the round of presentations jumped from a description of potash pricing in

Britain, to the chances of the government's nationalizing Fannie Mae, to an update on CIT's efforts

to raise capital. When participants talk too long, Kapito chides them to keep their presentations brief

and pithy.

Aside from Kapito and Hallac, key leaders include COO Sue Wagner and Ben Golub, a Ph.D. from

MIT, who is the overlord of BlackRock's risk-management system. These managers devote a lot of

attention to employees, who are encouraged to spend their entire careers at the firm -- in fact, the

turnover rate is a mere 11%, a figure unheard-of on Wall Street.

Fink prizes loyalty in his people and his partners. He steams when he doesn't get it. A case in point

would be his reaction in the summer of 2008 when he learned that Merrill Lynch, which then owned

a 49% stake in BlackRock and needed to raise capital, was considering selling that stake.

According to close friends of Fink, he called Merrill CEO John Thain and exploded: "Why the

[expletive] did I read about this in the paper? Why didn't you tell me to my face?"


2 of 5 4/4/2014 8:17 AM

LESSON 2: When investments get complex, do your homework

The simplest explanation of how BlackRock's strategy differs from that of other bond experts like

Pimco: BlackRock does not invest by forecasting which way interest rates are headed. Instead

BlackRock wonkishly focuses on the other factors that drive bond values: prepayments and default

risk. As a result, BlackRock was better equipped to analyze the complex mortgage securities that

came to dominate the fixed-income markets and that caused so much havoc last year.

BlackRock's approach works like this: Say mortgage bonds are selling at a big discount because

rates recently rose. BlackRock's models are expert at judging if those bonds are "rich" or "cheap"

based on its technology for predicting prepayment trends and defaults. If the model predicts, for

example, that prepayments will be higher than most investors expect, BlackRock can garner extra

returns because homeowners will pay off their loans at full value, and the fund can reinvest the

proceeds at higher rates.

The firm's analytical modeling gets so granular that BlackRock found that people living near IBM

offices prepay frequently because IBM executives are often dispatched to new cities. "The

BlackRock team is one of the few that can break down those products and assess their true risks,"

says Michael Rosen of Angeles Investment Advisors, a firm that counsels pension funds and other

institutions on choosing money managers.

BlackRock executives are constantly refining their models to stay one step ahead of the latest funky

financial product from Wall Street's wizards. "The firms that design securitized products are always

conspiring against us with new, increasingly complex instruments," says Rob Goldstein, who

oversees BlackRock Solutions, which leases an ultrasophisticated technology platform to clients

and has a team that helps companies analyze and run their portfolios. "It's our mission to make

sure they don't win." On behalf of the Federal Reserve, BlackRock Solutions is managing troubled

assets from AIG (AIG, Fortune 500) and Bear Stearns.

Even with all this quantitative firepower, the company does not always get it right: BlackRock

spotted the bubble in subprime, but it misjudged the commercial mortgage-backed securities

market.

In late 2006 the company developed a model that put a lower, more realistic number on the

incomes subprime borrowers were claiming on their "no doc" loans. The projections were shocking:

BlackRock figured that when the loans reset to their new, higher rates in a couple of years, most

borrowers would be spending more than half their real incomes on mortgage payments. Foreseeing

an avalanche of defaults, BlackRock dumped subprime bonds in early 2007 when the prices were

still lofty.

Nevertheless, even the best models can fail when markets go haywire, and that explains how

BlackRock simply misread the commercial real estate market. As subprime bond prices plunged in

late 2007 and early 2008, the value of real estate securities that BlackRock deemed far more solid

dropped as well. By the spring of last year, the interest-rate spreads between Treasuries and

commercial mortgage-backed securities (CMBS) -- loans secured by office buildings and shopping

centers -- ballooned from 2.5 to 10 percentage points.

BlackRock thought the bonds were a great buy, since the buildings were often fully leased, their

AAA tranches had first claim on payments, and the mortgages frequently dated from 2004 or 2005,

before lending got wildly excessive. BlackRock placed the bonds in dozens of its funds, often

substituting them for Treasuries or corporates, reckoning that they were safe and would produce

superior returns.

But by late 2008 the prices of CMBS cratered again, this time sending spreads to an incredible 16

points. It wasn't that the bonds were unsound, at least over the long term. The problem was that


3 of 5 4/4/2014 8:17 AM

highly leveraged hedge funds, REITs, investment banks, and other investors that depended on

short-term financing couldn't roll over their commercial paper and other loans, so they were

dumping whatever they could sell, including CMBS.

Because of the drag from CMBS, BlackRock's returns were so weak that two-thirds of its bond

funds languished in the bottom half of their categories for 2008. The apocalypse Fink predicted as

he watched the Buffett announcement on CNBC had trampled even BlackRock's vaunted risk

models. "It was a year where the unpredictable turned into the unimaginable," says Fink.

This year the bonds have rebounded strongly, providing a major boost to the company's

performance in fixed income. For 2009, BlackRock's 124 bond funds have delivered average

returns of almost 20%. Nearly two-thirds rate in the top half of their categories. BlackRock still

hasn't caught the benchmarks for the past 18 months, but the gap is narrowing dramatically.

For BlackRock the lesson of 2008 is that "market risk can hurt you, but liquidity risk can kill you,"

says Goldstein. In other words, BlackRock was prepared to cope with the normal ebb and flow of

the market, but not a panic where no one wants to own anything but Treasuries. As a result,

BlackRock has now recalibrated its models to predict scenarios where buyers disappear.

To do so, it's tracking the leverage of financial players as never before -- the more leveraged the

system, the bigger the chance for another chaotic selloff. It's also advising college endowments and

other clients to reduce their exposure to illiquid private-equity investments and hold far more in

easy-to-sell bonds or even hedge fund stakes.

LESSON 3: Acquire to grow, not to cut

BlackRock does not make acquisitions where the main goal is to pare costs by eliminating people

and combining similar products. "We've seen in many mergers, both in asset management and

banking, that bloodletting doesn't work," says Fink. Instead, Fink prefers to go after firms that add to

BlackRock's roster of products and extend its footprint into new international markets.

Nor does Fink want to sell BlackRock to a major bank, in part because he believes that if he did so,

other banks would be reluctant to sell BlackRock's products. An illustration of Fink's credo in action

was BlackRock's 2006 acquisition of Merrill's asset-management arm, known back then as Merrill

Lynch Investment Managers.

Accounting for only 7% of Merrill's profits, MLIM was something of an orphan. The group had built

an excellent family of mutual funds, but they were shunned by other brokerages and banks

precisely because they bore the Merrill moniker. "Even the Merrill financial advisers were reluctant

to sell our funds, because clients would think they favored the hometown product," says Frank

Porcelli, who joined BlackRock from Merrill and now heads the U.S. retail business. MLIM

executives became so frustrated that they planned on dumping the name and rebranding as

Princeton Portfolio Research.

In the Merrill deal, BlackRock followed its classic template: It acquired a business with

complementary financial products, stamped its brand on them, and then inducted the conquered

people into its culture. One way that Fink does this is by avoiding the toxic power-sharing

arrangements that are common in Wall Street mergers, where the head of the division from the

acquired company is given a seat alongside the person who runs the same division at the acquiring

company. No co-heads, no infighting.

Fink wanted to keep MLIM's talented money managers, so he elevated Bob Doll, a Merrill veteran,

to head equities over the BlackRock candidate. All told, BlackRock kept around 2,400 of MLIM's

2,500 employees (BlackRock will have 9,000 employees after the BGI merger), and the deal is a

proven winner: Under the BlackRock banner, the former MLIM funds now sell briskly at Morgan


4 of 5 4/4/2014 8:17 AM

Stanley Smith Barney, UBS, Wachovia, and of course Merrill.

BlackRock's independence and lack of its own brokerage business helped it beat out Goldman

Sachs (GS, Fortune 500) and Vanguard for the soon-to-close BGI deal. iShares, which is the

world's largest family of ETFs, are sold through brokers, and Barclays president Bob Diamond

feared that as the bank grew bigger in the securities business, rivals would shun his trophy product.

The opportunity to own a 19.9% stake in BlackRock also proved extremely alluring.

The deal's announcement this summer had its comic side. Diamond flew in from London for an

interview on Bloomberg TV. When he was dropped off at Bloomberg headquarters in the pouring

rain, he discovered that the interview was to be held at the BlackRock building, and that with

nothing but British pounds in his pocket, he couldn't pay for a taxi. So Diamond grabbed a young

Bloomberg reporter, dragged him into a cab, and got the young man to pay for his ride to

BlackRock, where he bummed the bucks to pay him back. "I practically scared the journalist to

death," jokes Diamond.

LESSON 4: Know where your business is heading

With his trader's gut, Fink is betting that last year marked a paradigm shift in the ways institutions

invest their money. He calls it the "new conservatism."

In recent years, pension funds and endowments rushed to diversify into alternative assets like

private equity and timberland, which turned out to be highly illiquid when the credit crunch hit. To

meet their obligations, those investors were forced to sell their best, most liquid assets at distressed

prices.

Now, he predicts they will move to a "barbell" strategy: They will place the bulk of their portfolios in

plain-vanilla bonds and indexed equity funds. That tranche will form the low-risk, conservatively-

managed end of the barbell. To boost returns, they will stick the rest with a select group of equity

managers with sharply-focused strategies and a history of high returns, as well as hedge funds with

easy-to-trade financial assets. Private equity investments with their long lockups and illiquid

holdings will fall out of favor. "We're in a period where liquidity will be far more important," says Fink.

So the next time disaster strikes and Buffett is snatching bargains from the flames, Fink --

��and investors with trillions looking to BlackRock to model the unimaginable -- ��will

be prepared.

Reporter associate: Sarah Kabourek

Find this article at:http://money.cnn.com/2009/08/12/news/companies/blackrock_trillionaires_club.fortune/index.htm

Check the box to include the list of links referenced in the article.

© 2007 Cable News Network LP, LLP.


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ROI

Bonds may not keep up with inflation, lose ground

Updated Aug. 31, 2009 2:31 p.m. ET

If you or a member of your family has a lot of money invested in bond funds, you should hear whatThomas Atteberry has to say.

He's a partner at fund group First Pacific Advisors and co-manager of the successful New Income bondfund.

His warning? Investors in long-term Treasury bonds and high-grade corporates run a serious risk oflosing money in real, inflation-adjusted terms, over the next few years. They may lose money evenbefore you count inflation.

Why?

The yields on these bonds are ominously low. If they reverted to long-term averages, the prices wouldtumble. You may end up losing more on the falling price than you could earn from the coupons.

This is a Main Street danger. Many ordinary Americans who have fled the stock market have moved theirmoney into the supposed "safe haven" of bonds instead.

According to the Investment Company Institute, investors this year have so far poured a remarkable$142 billion net into taxable bond mutual funds. By contrast, the amount of new money invested in stockfunds has barely matched the amount withdrawn.

Investors seem indifferent to the risks. Right now, 10-year Treasurys yield an anemic 3.47%. Theirmedian over the past 50 years was far higher: 6.21%.

The yield on investment-grade corporate bonds is better. According to the Federal Reserve, the averageyield across two benchmarks of these bonds is now about 6%. But even that's well below the averagesince the late 1950s, which was about 7.75%.

Bonds are like a seesaw: If the yield rises, the price falls. Rising worries about inflation, rising interestrates, or both could cause that to happen.

Atteberry has run the numbers on a few scenarios, and they aren't pretty. If the 10-year Treasury revertsto more typical levels over the next five years, investors will end up making just 1.1% a year over thattime. That's before inflation.

A faster move would be even worse. If the bonds reverted to average yields within a year, he says,investors will lose nearly 16%.

Ouch.

By BRETT ARENDS

Brett Arends: Bonds May Not Keep Up with Inflation, Lose Ground - W... http://online.wsj.com/news/articles/SB1000142405297020473180457...

1 of 2 4/2/2014 10:32 AM

The story for investment-grade corporate bonds is only a bit better. If these reverted to their 50-yearaverages over five years, investors would still make about 3.3% a year. Over one year they'd lose 9%.Again, this is before inflation, and any taxes.

Among the added dangers for private investors is that bond coupons are taxable as ordinary income.Meanwhile, any capital losses have to be used first to offset the lighter taxes on capital gains.

No one knows what is going to happen next, of course. Bonds may not revert to historic averages. If wesee persistent deflation, the yields may even fall further and the prices may rise. But it's a question ofodds. Those investing in bonds may think they are playing it safe. Instead, they may be taking a bit of agamble on inflation.

Mr Atteberry's advice right now seems sensible. If you want less volatility and less risk, stick toshorter-term bonds.

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Benz: Are there bond-fund categories where duration is a less useful measure,where I should probably take it with a grain of salt?

Jacobson: Absolutely. Any area outside of the traditional government area, so inother words short-, intermediate-, or long-term government bonds--those areplaces where it tends to be most reliable unless there is lots and lots of mortgages

How to Assess Bond Risks in Your PortfolioBy Christine Benz and Eric Jacobson | 02-04-2013 01:00 PM

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With bond yields aslow as they are right now, many investors are concerned that rising bond yieldscould hurt bond prices. Joining me to discuss how to assess the risks in your bondportfolio is Eric Jacobson. He is a senior analyst with Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Hi, Christine. Good to talk to you.

Benz: Eric, we usually think of there being too key risk metrics that you want tofocus on when evaluating a bond fund: the interest-rate sensitivity and the creditquality. Let's start with interest-rate sensitivity, and one of the statistics we provideon Morningstar.com is duration. A lot of people are looking hard at duration thesedays. Let's talk about what that measure is and how it may indicate whether aportfolio is risky or maybe a little less risky?

Jacobson: We'll as lot of folks know, duration is an estimate of how muchinterest-rate sensitivity your portfolio is going to have should market yields moveup or down. Generally speaking what you want to do is look at the durationnumber, let's just say for example that it's 2.5 years, and multiply that by 100basis points, or 1%.

What we at that point say us if interest rates move up, for example, 1 fullpercentage point, you would expect the fund to lose about 2.5% based on thatduration and vice versa. Now, the most important thing I think for a lot people torealize is, it's not a foolproof number. It's a mathematical construct. It is a modelednumber. It isn't perfect, and it doesn't necessarily account for changes in interestrates in every scenario. Sometimes, it's because shorter rates move up.Sometimes, it's because longer rates move down, things like that, but it is a prettygood estimate of what you can expect in a short shock of interest rates in onedirection or the other.

Benz: So, the thing is though if interest rates move up, I get some of that back inthe form of a higher yield. So, even if my principal values on my bonds might bedepressed in my portfolio, my manager or I, if I'm buying individual bonds, am ableto obtain new bonds with higher yields attached to them, right?

Jacobson: That's right, and you know, there are studies out there--Vanguard hashad one from a couple of years ago, for example--that show different interest ratepaths and how portfolios tend to recover reasonably quickly from interest-rateshocks. We should be careful not to try and scare people too much over the longerterm. You're generally going to make out OK with your bond portfolio, but I thinkthe one thing people need to realize is if under certain scenarios, if we do have aquick and large rate shock, you are going to have a period of perhaps very poorperformance in a bond portfolio.

Print http://www.morningstar.com/Cover/printArticle.htm

1 of 4 2/19/2013 1:25 PM

in the portfolio, and it can slip around a little bit. But when you stretch over to, forexample, multisector bonds and even more importantly, high-yield bonds, you startto get to points where even though the math is right technically, the fact thatthose markets don't move as tightly to the Treasury market means that you don'tneed to pay as close attention to it. So, for example, a high-yield fund might floataround in the 3-6 year range, but probably isn't going to be quite as rate-sensitiveas a 3-6 year core or high-quality bond fund. You want to pay much more attentionto what's going on in the credit markets when you're evaluating a fund like that.

Benz: That segues to my next question, credit quality, the other metric thatinvestors pay a lot of attention to when thinking about the riskiness of their bondholdings. Morningstar.com provides a few different statistics related to creditquality of a bond portfolio. One is that average credit quality and then you can alsosee how your funds holdings shake out in terms of the various credit quality rungs.How should investors use that data when they are thinking about their portfolios?

Jacobson: Well, the average credit-quality rating is really just a quick hit. It's aweighted average based on default probability for, in particular, corporate bonds.So, I'd be careful putting too much emphasis on that because you are going to seea lot of portfolios where because the default probability for junk bonds is so muchhigher statistically over the last decades, that average credit-quality number isgoing to be pretty skewed. And pretty much any portfolio that's got a little bit ofjunk bonds in it is going to come up with a pretty low average credit quality.

Just as important arguably is what the breakdown of credit is from the differentstrata. So, hopefully a lot of investors are familiar with the fact that AAA is thehighest quality then you go down to AA, A. Then it goes to BBB. That's thebreaking line between what we think of as investment-grade and high-yield.

So BB, B, CCC, those are the high-yield strata on the way down. You want tocompare your funds if you're looking to try and understand which one has more orless risk than the other in terms of what the percentages are in those differentstrata.

Benz: You also say sector weightings can work hand-in-hand with some of thosecredit qualities. How should investors look at that data? A, should they find themost current data, and B, what should they make of it when they see how a fundsis apportioned among government bonds, corporate bonds, and so forth?

Jacobson: Sure, well I would say often the best place to look for an updatedsector weighting is at the fund company website. Almost every fund company nowdoes a pretty good job of putting those on their websites. The thing you want tokeep an eye on is what kinds of sectors--in particular the basic ones likegovernments and corporates are pretty self-explanatory. But if you see things likecommercial mortgage-backed securities, emerging-markets debt--in particularemerging markets is a good example, because there are cases there where theytend to be a lot higher rated than they used to say 10 years ago, because so manyof those emerging markets have done better on their fiscal health.

On the other hand, they tend to still be pretty volatile in the marketplace. So eventhough you may not see anything too suspicious on the credit side, if you see areasonably large weighting of emerging-markets bonds in that portfolio, you knowit has a possibility of being a little bit more volatile and potentially dangerous in abig sell-off.

Benz: The last point that you think investors should focus on when they are


2 of 4 2/19/2013 1:25 PM

evaluating the risk of their bond funds, it's a little bit counterintuitive, and this isyield. People usually think of a robust yield as a good thing, but you say it can alsoflag excessive risk-taking, or at least some risk-taking. Let's talk about whyinvestors should take a look at a fund's yield.

Jacobson: Hopefully if you're really into triangulating on these different risks,you're going to see the roots of this risk, either in the duration somewhere or inthe credit-quality strata or in the sector weightings. You can usually backtrack tothem, but the bottom line is this: If you see a yield that is significantly higher thana peer group or tends to hang around the top of the peer group, you can bank onthe fact that there is some extra risk built into that portfolio, whether it's liquidityrisk, or sector risk or quality risk or what have you, it's in there. That is prettymuch the telltale sign; it's not a calculated number in the sense of a modelednumber like duration. It isn't skirting around a lot of things. That's the big numberat the end of the day that tells you whether or not there's risk in the portfolio,because there is no free lunch. So that's one that if you look at everything and youcan't see the risk, but you see it showing up in the yield, you want to ask morequestions and try to understand why it's there.

Benz: Eric, we've seen a lot of flows going into those higher-yield categories,recently emerging-markets bonds, multisector bonds, junk bonds et cetera. What'syour counsel to investors who have been gravitating to those fund types over thesepast few years?

Jacobson: I would say be really careful. Chances are you've been very fortunateand made a lot of money in those, if you've done it over the last few years. And Iwould counsel not to be greedy because we're getting to the point where these'spreads,' in other words, the amount of extra yield that these sectors are payingabove and beyond government bonds are relatively tight or narrow relative to thegovernment sector for example. That means that your margin for error just isn'tthere.

Now the good news is, is that if you talk to different managers, a lot of them thinkthat we're not yet in the spot on the credit cycle where there's a lot of risk to thosespreads blowing out, if you will, and when spreads blow out, what that means iscredit markets tend to sell off relative to the higher-quality strata. And as I say alot of managers don't think we're in that neighborhood yet.

The signs that we usually start to see are easy money, in other words, corporationsand issuers getting to sell bonds into the high-yield and leveraged-loan markets,for example with very loose terms, much less high-quality business plans, thingslike that. You're starting to see that and hear about it, trickle in there a little bit,but we haven't got into a wave of it yet, where you'd say, "Boy, this market isreally taking on a risk flavor." But that's the kind of thing that's going to start tohappen most likely over the next couple of years, and you really want to becognizant of that and don't try to squeeze out the last bit of return by piling extramoney into these areas where money has already been chasing.

Benz: Eric, well it sounds like your bottom line is if you are embracing any type ofbond fund right now, just be sure of the risks that you're taking.

Jacobson: Absolutely. The most important thing is to try as best you can tounderstand what's in your portfolio, otherwise you really got to trust your managerwho knows what they are doing and that's kind of an uncomfortable place to be ifyou don't know what you hold.


3 of 4 2/19/2013 1:25 PM

Benz: Eric, thank you so much for being here.

Jacobson: My pleasure, Christine. Great to talk to you.

Benz: Thanks so much for watching. I'm Christine Benz, from Morningstar.com.


4 of 4 2/19/2013 1:25 PM

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August 2, 2011

By ERIC DASH

Hanging over the debt ceiling negotiations in Washington has been the threat that the United

States could lose its AAA credit rating, a coveted measure of the federal government’s financial

strength. But in corporate America, the top rating long ago became an anachronism.

Scores of big corporations have lost their AAA status in recent years — only four non-financial

companies continue to hold the rating — as it became seen in board rooms as more of a

straitjacket than a path to riches. Just as many consumers relied on their credit cards to finance

a higher standard of living, companies took on more debt to reap bigger returns.

The choice did not appear to hurt them. The borrowing costs of companies with AAA ratings

and those one level below are not that far apart. Investors, in other words, do not see much

difference in quality.

“It’s like you are going from a Rolls-Royce to a Mercedes — not from a Rolls-Royce to a Yugo,”

said Chris Orndorff, a senior portfolio manager for the bond giant Western Asset Management.

“That’s nothing to be ashamed of.”

More and more, in fact, companies have found that a AAA credit rating is not something worth

aspiring to if a more conservative approach means lower profits.

Today, markets often render credit judgments before the rating agencies can take out their

pens, so a downgrade has a less noticeable effect. By that time, many of the traditional benefits

of being deemed AAA, like lower borrowing costs and reputational glow, have evaporated.

In the early 1980s, around 60 companies had AAA credit. By 2000, the number of AAA

companies was about 15. Today just four corporations— Automatic Data Processing, Exxon

Mobil, Johnson & Johnson and Microsoft — can claim those once-coveted three initials. (Five

big insurers and several government affiliated organizations can too.)

Analysts say corporate buyouts and acquisitions accelerated the trend. Many AAA companies

lost their ratings when they were taken over and their new owners loaded them with cheap debt

to help pay for the deal. Other strategic decisions also triggered downgrades.

UPS, for example, struck a long-term agreement with its union workers in fall 2007 that raised

pay and benefits but froze certain pension obligations. Soon after, the ratings agencies started

knocking down the company’s credit rating to AA because of the new pension arrangement.

AAA Rating Is a Rarity in Business - NYTimes.com http://www.nytimes.com/2011/08/03/business/aaa-rating-is-a-rarity-in-...

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“Maintaining a AAA rating is not a financial goal of this company,” a UPS spokesman said at the

time. Investors barely reacted. In the three months after the downgrade, yields on UPS bonds

responded by increasing about 0.4 percentage point from 5.32 percent. Today, with borrowers

enjoying ultra-low interest rates, the bond yields are back to their levels in late 2007.

Meanwhile, the financial crisis and deep recession laid into several of the sturdiest pillars of

American capitalism. Berkshire Hathaway, General Electric and Pfizer all lost their AAA

ratings.

Still, a funny thing happened when these companies were sent down to AA. Investors shrugged

off the change; the markets had already rendered their verdict. Borrowing costs for General

Electric and Berkshire actually fell in the weeks after they were downgraded in spring 2009,

amid a broader market rally.

“The rating agencies were late to the party,” said Mr. Orndorff, the bond investor.

Ratings for companies and countries are viewed differently, even if they are evaluated in much

the same way.

For most Americans, the prospect that the government could lose its AAA credit rating is almost

unthinkable — a blow to national pride and consumer confidence that could turn out to be

more damaging than any increase in borrowing costs.

That is why even after President Obama signed a law on Tuesday that lifted the debt ceiling,

some in Washington were worried that the plan’s spending cuts were not deep enough to

appease all the major rating agencies.

For now, all three major rating firms continue to give the United States a AAA rating. But on

Tuesday, Moody’s said its outlook was negative after putting the government on notice last

month that it could be downgraded. Fitch said on Tuesday that it planned to complete another

review of the government’s finances by the end of this month, and Standard & Poor’s has

warned that the United States might lose its rating if it did not sharply rein in the deficit.

It helps, of course, that the dollar remains the world’s leading currency, ensuring that demand

for United States debt is strong in spite of the nation’s myriad financial challenges.

But the truth is, even as the government maintained its AAA grade, the markets suggested long

ago that the United States was no longer deserving of such a high rating.

The credit-default swap market provided one clue. During the financial crisis in early 2009, the

price of insurance that would pay off if the United States government defaulted on its debt was

similar to that offered for companies ranked just above junk. Even today, the price of insurance

on a government default has been higher than that for Colgate Palmolive, the global toothpaste

giant, which has a rating two notches below AAA.

The economic data also suggests that the United States has higher debt levels than most AAA


2 of 4 4/2/2014 11:48 AM

corporate borrowers. Today, the United States debt as a percentage of the nation’s economic

output is 75 percent and could top 84 percent by 2013, according to Standard & Poor’s

research. The typical AAA-rated country has a ratio of about 11.4 percent.

By contrast, Exxon Mobil and Microsoft each had debt-to-income ratios exceeding 20 percent,

while Automatic Data Processing had a ratio of 1.8 percent, according to Capital IQ, a business

owned by Standard & Poor’s. Johnson & Johnson had a ratio of 92 percent.

But unlike Washington, there is no threat to the AAA credit rating of Johnson & Johnson. That

Johnson, the 125-year-old maker of Tylenol and Listerine, could have a better rating than the

country in which it resides would be unusual but not a first

Toyota retained its AAA rating for several years after a sluggish economy led the rating agencies

to start downgrading Japanese government debt in 1998.

Today, a handful of European corporations, like Portugal Telecom or Helecom of Greece, have

received higher ratings than their fiscally troubled homelands. That is because a big portion of

their revenue comes from foreign customers. In the last few weeks, the ratings agencies have

made it clear that lowering the AAA rating of the United States government was unlikely to

cause any AAA-rated American company to lose its rating— at least in the coming months.

But longer-term, top-flight ratings for American companies could be jeopardized if the

government’s effort to get its own finances under control caused a slowdown in economic

growth.

“What agreement there is on the deficit, and what spending is going to be or not be, will have an

impact,” said John J. Bilardello, the head of corporate ratings at Standard & Poor’s.

A downgrade of a country rating can ripple through other entities that rely on the government

for support, potentially raising borrowing costs across the economy. These include mortgage

bonds issued by Fannie Mae and Freddie Mac, as well as debt sold by dozens of states and

counties whose local economies have strong ties to Washington. It also could affect about a

dozen insurance companies and too-big-to-fail banks, whose ratings benefit from the

perception that the government would bail them out if they ran into trouble again.

But could an American company’s credit really be more solid than the full faith and credit of

the United States? The ratings agencies may say so one day, but lawmakers and citizens might

have a reaction like that of Warren E. Buffett, after his Berkshire Hathaway lost its prized AAA

status in 2009.

“We’re still AAA in my mind,” he said.


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RELATED TOPICS M icrosoft Corp,Deutsche Bank AG

Last updated: March 12, 2009 7:00 pm

By Justin Baer in New York

General Electric on Thursday lost the pristine triple A debt rating it had safeguarded for more than half a century as Standard & Poor’sdowngraded the company, citing mounting concerns over its finance arm.

S&P, which first assigned GE a triple A in 1956, dropped the conglomerate and its lending division, GE Capital, one notch to AA-plus. Italso assigned the new ratings a “stable” outlook.

“We believe that GE Capital is under increasing earnings pressure due to the recent sharp deterioration in general economic conditionsaround the globe,” S&P credit analyst Robert Schulz said on Thursday in a statement.

“This will result, in our opinion, in rising credit losses across key segments of GE Capital’s finance portfolio.”

The move means that S&P now has only five triple A ratings on non-financial companies worldwide: Automatic Data Processing,ExxonMobil, Johnson & Johnson, Microsoft and Pfizer.

The downgrade caps a brutal year for GE in which one of the largest and most respected companies fell short of earnings forecasts,slashed its dividend for the first time since 1938 and damaged its credibility with investors.

GE’s shares jumped 13.1 per cent to $9.60 in late afternoon trading after the S&P announcement removed concerns that the agencywould cut GE’s ratings by more than one or two notches.

“This is good news,” Nigel Coe, a Deutsche Bank analyst, wrote in a note. “There was fear, albeit low-probability, that ratings could fallto AA-minus or lower.”

The deepening financial crisis has shaken investors’ confidence in GE Capital. The cost to insure $10m of the division’s debt againstdefault for five years rose to 9.25 per cent yesterday, according to CMA Datavision.

The company forecast in December that GE Capital would earn $5bn this year, and last week Keith Sherin, the company’s chieffinancial officer, said the division would be profitable in the first quarter. GE has injected $15bn in cash into the finance unit since latelast year, and its dividend cut will save an additional $9bn annually.

“We are prepared to fund the company as a double A, but we will continue to run GE with the disciplines of a triple A company,” JeffImmelt, GE’s chief executive, said in a statement.

GE will meet investors next week to share more details on the finance arm’s performance.

Additional reporting by Francesco Guerrera and Nicole Bullock in New York


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4/2/2014 Global pool of triple A status shrinks 60% - FT.com

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Average upgrade/downgradesince 2007

Interactive map

Downgraded planet

See the effect the financial

crisis has had on the world’s

creditworthiness

March 26, 2013 7:34 pm

Global pool of triple A status shrinks 60%By Ralph Atkins and Keith Fray in London

The global pool of government bonds with triple A status from the three main rating agencies,

the bedrock of the financial system, has shrunk more than 60 per cent since the financial crisis

triggered a wave of downgrades across the advanced economies.

The expulsion of the US, the UK and France from the “nine-As” club has led to the contraction

in the stock of government bonds deemed the safest by Fitch, Moody’s and Standard & Poor’s,

from almost $11tn at the start of 2007 to just $4tn now, according to Financial Times analysis.

The shrinkage, largely a result of US’s downgrade by S&P in August 2011, is part of a dramatic redrawing of the world credit ratings

map, which is encouraging investment flows into emerging markets and forcing investors and financial regulators to rethink definitions

of “safe” assets.

While US and European government downgrades have dominated headlines, the FT’s analysis highlights

the series of upgrades across much of the rest of the world – especially in Latin America.

Topping the list in the scale of credit upgrades since January 2007 are Uruguay, Bolivia and Brazil. The

biggest downgrades were in crisis-hit southern Europe, with Greece seeing the steepest drop.

The results highlight the geoeconomic changes wrought by the tensions in global financial markets since

mid-2007 and the upending of previous assumptions about the stability of banking systems and public

finances.

David Riley, global head of sovereign ratings at Fitch, said: “Five years ago, the world was a fairly predictable place. Banking crises were

typically things that happened in emerging markets. Now we’re in a world where a lot of those assumptions have gone.”

The highest credit grades are still dominated by advanced western economies but average ratings over the past six years have fallen

furthest in the crisis-hit eurozone. In contrast, the biggest average upward ratings have been in Latin America followed by newly

industrialised Asian countries.

The shifts show “where strong and sustainable growth is likely to be in the future”, said Bart Oosterveld, head of sovereign ratings at

Moody’s.

John Chambers, chairman of S&P’s sovereign ratings committee, said many emerging markets have undertaken reforms that have

improved their credit standing. “Better economic conditions have helped. It is easier to carry out reforms when the wind is on your

back, rather than in your face.”

Upgrades of emerging market economies have expanded the pool of government assets rated in the BBB

range – although the category now includes several fallen European economies. Jonathan Kelly, portfolio

manager at Fidelity Investments, said: “Emerging markets were once high risk, high return assets. They

are now mainstream.”

A further shrinkage in the pool of triple A ratings could fuel fears about a looming “collateral crunch” – a

shortage of those assets that can be used as security by banks and others when borrowing in capital

markets or from central banks.

So far most observers believe such a crunch remains a long way off, partly because central banks and

regulators have shown a willingness to rewrite the definitions of what is “safe”.



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But collateral shortages have become acute for banks in those parts of the eurozone worse hit by the

region’s debt crisis – and explain why the European Central Bank has had to authorise emergency liquidity for banks in Cyprus.

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There are nooutlooks on Aa ratingscurrently anywhere inthe world that wouldsuggest an increase inthe pool of Aaas in thenext 18 months

- Bart Oosterveld, Moody’s

March 31, 2014 3:38 pm

By Ralph Atkins and Keith Fray in London

The triple A government bond is dead. Long live the double A bond.

The global pool of government bonds given a top “risk free” rating by all three main credit rating agencies has contracted by 6 per centover the past year and by more than 60 per cent since 2007, according to Financial Times analysis.

If ratings from the three agencies are averaged, the pool of government bonds in the double A rated band has this year overtaken thetriple As to become the largest category in sovereign debt markets.

The shift highlights how the huge cost of the financial crisis and the eurozone’s debt woes have undermined the creditworthiness of theworld’s advanced economies. Governments have been forced to bail out banks while the slump in economic growth stretched the publicfinances.

“Relying exclusively on the so-called triple A standard to reliably measure the safety of sovereign assets seems, indeed, perilous,” theOECD warned in a report last week. But if governments with a double A rating, or even a single A were included, there was no shortageof “safe assets” in the financial system, the OECD concluded.

The FT analysis shows ratings have stabilised globally over the past year and there are signs of possible future improvement in Europe,but there is little chance of a rapid turnround in developed markets.

“There are no outlooks on Aa ratings currently anywhere in the world that would suggest an increase in the pool of Aaas in the next 18months,” said Bart Oosterveld, head of sovereign ratings at Moody’s.

To shift developed economies towards positive rating outlooks and eventual upgrades would take “primarily a change in debttrajectories – which we don’t really see happening yet”, said James McCormack, head of sovereign ratings at Fitch. “We see debt ratiosstabilising for the most part – but typically not this year.”

In emerging markets, the FT analysis shows the trend towards upgrades seen since 2007 has stalled, withmixed performances over the past year.

The Netherlands has joined the list of countries that have lost their “nine A status” – a triple A rating fromall three agencies. That reduced the pool of nine A debt by 6 per cent to $5.9tn, equivalent to just 11 per centof all government bonds rated by the agencies. Since 2007, the list of nine As has contracted by 62 per cent.

If ratings applied by the three agencies are averaged and weighted according to the size of debt markets,triple A rated government debt fell from 34.5 per cent of the total a year ago to 32.3 per cent. The shareaccounted for by double As rose from 34.3 per cent to 36.6 per cent.

Investors have become used to the shifting global credit rating map. After the US lost its triple A status from Standard & Poor’s inAugust 2011, Treasury yields, which move inversely with prices, actually fell. Other big economies with ratings in the AA bands from atleast one agency include France, Belgium and New Zealand.



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August 14, 2011 12:36 pm

By Ruth Sullivan

Far from triggering an exodus from Treasuries, Standard and Poor’s controversial downgrade of US credit from triple A to double Aplus 10 days ago is sharpening appetites, as investors continue to view US government debt as a bolt hole in volatile global markets andnewcomers pile in too.

The downgrade ranks the US below more than a dozen countries, putting it on a par with Belgium and New Zealand, according to Bankof America Merrill Lynch. Yet the US Treasury market rallied strongly last Monday, the first day of trading after S&P’s move, suggestingTreasuries were still seen as a safe haven amid panic selling on global equity markets.

On Tuesday, after the US Federal Reserve said it would freeze short-term interest rates for two years in an attempt to boost the weakeconomy, investors bought again in spite of yields on two-year government bonds falling to record lows.

By Friday, yields on two-year US Treasuries had fallen 12 basis points to 0.17 per cent since the downgrade, while yields on 10-yearnotes had tumbled 36 basis points to 2.19 per cent.

“Even at such low yields investors prefer to hold US government bonds as they are seen as less risky than equities,” says Alan Wilde,head of fixed income and currency at Baring Asset Management.

Asset managers largely agree the US downgrade, although unprecedented, did not come as a big surprise, and they expect USTreasuries to continue to be well supported as investors seek a bolt hole.

“There are no new facts about the US position and this has been known for some time,” says Peter Fisher, head of global fixed incomeat BlackRock, the world’s biggest asset manager.

“What’s different is that we now have S&P’s opinion about the US. This served as a signal to investors that the world is a more riskyplace, which caused investors to sell risky assets like equities and buy Treasuries,” he says.

Mr Fisher believes one downgrade does not change much for investors.

“Most institutional investors are used to dealing with split ratings and rely on at least three credit ratings, referencing the middle ratingor the average of the three, so with the other two major agencies maintaining their triple-A rating on the US there has been little in theway of forced selling,” he says.

When it comes to finding another shelter in global bond markets at a time of global growth concerns, the options are limited,institutional investors say.

“The US is still perceived as a safe haven but to some extent it remains that by default or exclusion,” says Willem Sels, head ofinvestment strategy at HSBC private bank. “There is no perfect alternative to the US as many triple-A rated bond markets are relativelysmall in size and the economies with the largest markets after the US – Japan and Italy – face significant issues,” he says.

Further, worries that the eurozone debt crisis is spreading from peripheral eurozone countries such as Greece and Portugal to Italy andSpain are eroding demand for government bonds on the opposite side of the Atlantic.

“The bigger issue in markets now is the lack of confidence in Europe. There is no real liquid, feasible alternative to US Treasuries,” addsMr Sels.

Fears over the possibility of France being next in line to lose its triple-A status also surfaced last week, driving French bank stocks andglobal stock markets lower in spite of all three main rating agencies reiterating the stability of its credit rating status.

Institutional investors in pursuit of safe havens are said to be looking at triple-A rated countries such as Canada, Norway, Sweden andSingapore, where they are buying government bonds in local currencies.



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RELATED TOPICS United States of Am erica,Central Banks,Federal Reserve USA

But “major institutional investors will only be able to nibble around the edges of these markets given their size”, points out Mr Fisher.

Credit Suisse maintains UK gilts will also benefit from the US downgrade because as the average maturity of UK government debt is 15years, the country has a clear commitment to reducing its deficit and sterling is regarded by some as inexpensive.

In the past week attention has also turned to S&P’s downgrade last Monday of quasi-government US agencies such as Fannie Mae andFreddie Mac that buy and securitise mortgages, and whether they might be affected more than the Treasury market. However, assetmanagers do not expect the downgrade to result in forced selling of debt from the two providers either.

“Agency debt has traded on a spread to US Treasuries so lowering the credit quality of both to double A plus should, all things beingequal, not change the pricing of agency debt,” says Baring’s Mr Wilde.

“In fact the ‘implicit guarantee’ the markets assumed to be the case is now very clearly an ‘explicit guarantee’ as the US government isfunding the government- sponsored enterprises,” he adds. However, the resilience of the US Treasury market could be tested further ifother agencies follow S&P’s example or if the rating agency makes further downgrades in the future.

Much of the desire to continue buying US Treasuries at current yields will depend on the noises coming out of the Federal Reserveabout the future trajectory of interest rates, as well as the machinations of the eurozone debt market.

But it is also possible for countries to regain their lost triple-A crowns, as Canada, Australia, Sweden and Finland have shown in thepast. However, this could take a long time and would call for significant fiscal discipline and economic growth. In the meantimeinvestors will need safe havens.

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INSIDE BUSINESS June 25, 2012 8:25 pm

By Patrick Jenkins

Moody’s downgrades again raises questions about agencies’ power

oody’s is on a roll. After downgrading large swaths of the eurozone banking sector in recent weeks, the credit rating agencyfinally came out with the most eagerly watched of its proposed rating cuts – those of 15 global banks.

Though it relented on a few of its threatened downgrades, all the banks saw some of their ratings cut. There were downgrades forshort-term debt, long-term debt, financial solidity on an independent basis and with governments’ support, compounding the barrageof bad news for the sector, especially for those with big investment banking operations.

It has been a long time coming. Moody’s signalled in February that it was planning downgrades of up to three notches for all the bigglobal banks. After all that pondering, the broad conclusion was straightforward enough – it has created three buckets of global banks,leaving only three in the top-notch category – HSBC, Royal Bank of Canada and JPMorgan. Four are in the bottom-notch – Bank ofAmerica, Citigroup, Morgan Stanley and Royal Bank of Scotland. The rest are middling. Individual banks will quibble about whichbucket they are in. But the broad idea of an ever more sharply tiered banking industry is hardly controversial.

So it is unclear why everyone seems to care so much. Yet the markets and financial media were abuzz with little else on Thursday andFriday. The mysterious appeal of the rating agencies is all the more puzzling given the reputational pasting they have taken throughoutthe financial crisis after sometimes failing to spot looming problems until they were blindingly evident to everyone else.

As analysts at HSBC remarked in a client note on Friday: “Broad reaction to the Moody’s downgrade has been ‘thanks, but you’re a bitlate’, which is the typical shrug-off we get to major rating agency moves these days.”

Sure enough, for all the noise there was little immediate impact on investors’ faith in the world’s big banks. Bank share prices were notobviously hit by the actions. And a glance at banks’ credit default swap shows you pretty clearly that the market has been way ahead ofthe curve – the downgraded ratings have been implied for some time by market CDS price trends.

But anyone who writes off the agencies’ relevance is ignoring two crucial areas where they still dictate – in short-term debt ratings andin collateralised funding.

Six banks had their short-term ratings cut by Moody’s at either the group holding company or operating company level. This shouldmatter less than it would have pre-crisis, as banks have moved for safety’s sake away from short-term funding of long-term liabilitiestowards better-matched financing arrangements.

All the same, banks that now have P2, rather than P1 ratings in this area, will find it tough to secure short-term funding from many ofthe investors that have traditionally bought their commercial paper. Barclays, Citigroup, Goldman Sachs, Bank of America, Royal Bankof Scotland and Morgan Stanley are all affected. However, in some cases, such as Barclays’, the downgrades have not hit the part of thegroup that issues short-term debt

Though the obvious solution – a further “terming-out” of funding, extending the duration of financing at these banks – will be popularwith regulators from a safety point of view, the higher cost of such funds can only further damage profit margins, undermining anotherregulatory aim: the build-up of capital through retained earnings.

On collateralised funding, there is a similar vicious circle at work. Banks with lower credit ratings will need to deposit more collateralwith a counterparty. At a time when secured funding is the only option for many, and banks’ collateral is already stretched to the limit,this is the last thing they need.

Might regulation be the answer? Regulators, particularly those in Europe, have been keen to clamp down on rating agencies ever sincethe crisis. But the motives have never been entirely noble. It has been governments with weak state finances and banks with troubledbalance sheets that have squealed loudest about the unfettered power of the agencies.

Investors would not be fooled by self-interested intervention. But rating agency regulation could be designed for the greater good.Evolving bank regulation provides a blueprint. Supervisors are thinking more flexibly about their rule-making with some signs they willease off on some capital and liquidity requirements in the most troubled times in order to smooth cyclical problems.


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Rating agencies could self-regulate and adopt a similar approach, avoiding the “arbitrary” and “backward-looking” decisions anembittered Citigroup accused Moody’s of last week. They could be more forward-looking to avoid compounding banks’ cyclicalproblems. And they could move more swiftly. If they do not, regulators should make them.

Patrick Jenkins is the Financial Times’s Banking Editor

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February 7, 2010

By LANDON THOMAS Jr.

Athens

DIMITRIS DAMIANIDIS is a high school teacher and a strong supporter of Greece’s socialist government.

But that won’t deter him from going on strike with hundreds of thousands of other public sector workers

next week to fight for the 28,000-euro pension that he expects to receive annually after he turns 60 next

year.

“Why should I as a worker pay for the errors in policies?” he asked, in response to reports that the

embattled Greek state will cut his pay and, by extension, retirement benefits. “The worker can’t be the

scapegoat. So we have to defend ourselves.”

As Mr. Damianidis and others on the state payroll prepare to stop work on Wednesday, fear is building that

the country’s new government may lack the nerve to cut public wages and pension payments, which make

up 51 percent of its budget.

Over the past decade, Greece took full advantage of a strong euro and rock-bottom interest rates to fuel a

debt binge by the country’s consumers and its government. Now, if Greece can’t persuade investors to buy

53 billion euros of its government debt this year, it may have to seek a bailout from its European Union

brethren or the International Monetary Fund — or, worse, to default.

The stakes are high not just for Greece but for the entire euro zone, where efforts to forge a common

economic identity are threatened by the financial crisis. Last week, the panic spread to Portugal and Spain,

and the cost of insuring their debt against a default soared to record levels as investors bet that, like Greece,

governments in those countries won’t be able to rein in bloated budgets.

“The risk of contagion is a real one,” said Scott Thiel, the head of European fixed income at the asset

management firm BlackRock in London. “Investor sentiment is now focused on countries like Spain and

Portugal, where fundamentals are weakest.” He said that for now, he saw little risk for Italy, given the

relative stability of its economy.

The euro, which has become one of the world’s strongest currencies since its introduction over a decade

ago, is now down 5 percent against the dollar this year. The euro’s decline picked up speed when the

European Commission’s statistical office revealed in mid-January that Greece had been submitting false

data to calculate its budget deficit. (Late last year, Greece stunned investors by saying that its government

deficit would be 12.7 percent of its gross domestic product, not the 3.7 percent the previous government

had forecast earlier).

Greece’s problems, and those looming over its neighbors, have laid bare the dangers of divergent fiscal and

political policies in the euro zone, calling into question the grand European experiment of squeezing 16

disparate countries into a monetary union.

“We have a centralized monetary policy, but we allow budgets and wages to move in different directions,”

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said Paul De Grauwe, an economist in Brussels who advises the president of the European Commission,

José Manuel Barroso. “Without a political union, in the long run the euro zone cannot last.”

Indeed, as core economies like those of France and Germany show signs of economic recovery, Greece,

Portugal, Ireland and Spain are just entering savage recessions. Spain, the largest of the peripheral

economies, announced last week that the number of its unemployed had reached four million — the highest

in its history — and warned that the country’s deficit might be worse than previously thought.

As growth slows and debt rises in these countries, government largess for university fees, secure

government jobs and lifetime pensions will come under increasing pressure.

So, on a continent where the culture and legitimacy of the mother state are so deeply ingrained — and now

in some cases unaffordable — a question remains: Can the European Commission say “no more” to prodigal

nations like Greece and, to a lesser extent, Spain and Portugal? And how will the countries themselves

confront the political fallout of economic distress?

“People view these welfare polices as acquired rights,” said Jordi Galí, an economist who leads the Center

for Research in International Economics in Barcelona. “If the Spanish government were to stop paying the

fees for students at universities or any move in that direction, there would be a major social uprising.”

To avoid such a possibility — and to calm the panic in the markets — the European Commission may decide

to rescue one or more of the governments. But a bailout of Greece, Spain or Portugal would not be as easy

as the United Arab Emirates writing a check to Dubai: The European charter includes a no-bailout clause.

Even if such a clause were to be overridden, much of the financial burden — and it would be huge — would

fall upon Germany, the richest member of the union, said Daniel Gros, who leads the Center for European

Policy Studies in Brussels.

“That is why it would be easier to call in the I.M.F.,” he said.

TO be sure, Mr. Damianidis is among the smallest of actors in this saga.

Yet his sense of entitlement shows how hard it will be for governments in Portugal, Spain and Italy to

persuade their citizens to accept cuts demanded by Brussels as well as bond investors.

Like many public-sector workers and civil servants in Greece, Mr. Damianidis has led a comfortable

middle-class life over his 34 years working for the state. His house is paid for, he can afford to go away for a

two-week vacation every year, and he has a daughter in a private school. His job is protected by the

constitution, and the pay of public sector workers has doubled over the last decade. Much of the increase

for workers like Mr. Damianidis is from bonuses, which the government wants to cut.

The bonuses, he concedes with a smile, have nothing to do with his skill as a high school teacher. “Over the

years, whenever workers would strike, they would in some cases get a bonus,” he said, as he sat in a local

union office here.

For decades, both conservative and socialist governments in Greece have rewarded the demands of public

sector unions with higher pay and more jobs.

In 2009, striking farmers were paid 400 million euros by the government — and this year they are back

again, having briefly closed Greece’s border with Bulgaria. Protesting dockworkers extracted big payouts

from the government in November. And the country’s tax collectors went on strike on Thursday even

though their services are needed more than ever.


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Striking is a bit of a national sport in Greece. Last month, the country’s unionized prostitutes took to the

streets, protesting unlicensed competition from Russian and Eastern European immigrants.

With concessions and accessions, the country’s budget has become bloated. In Parliament, for example, the

administrative staff has increased to 1,500 from 700 in the last few years, even though the number of

members of Parliament has remained the same. Last year alone, 29,000 public-sector workers were hired

to replace 14,000 who retired, according to the finance ministry.

“There is no end,” said Stefanos Manos, a former minister for the economy in the 1990s and a persistent

critic of what he considers spending abuses in Greece. “The hiring and the spending is uncontrollable.”

The pressing question now is whether the new prime minister, the lifelong Socialist George Papandreou,

can break this cycle of appeasing various constituencies. This will determine his success as a reformer, to

say nothing of Greece’s ability to rein in public expenditures and meet its target of a budget deficit of less

than 3 percent of gross domestic product by 2012.

Mr. Papandreou, a political scion whose father and grandfather were also prime ministers, took office late

last year. Since then, he has been sending mixed signals about his commitment to budget austerity. He and

his finance minister, George Papaconstantinou, have called for unpopular sacrifices like a public-sector

wage freeze, an increase in the price of gasoline, smaller bonuses for workers like Mr. Damianidis and a

crackdown on tax evaders.

But other moves have demonstrated less fiscal restraint. Soon after the election last year, he signed off on a

1.6 billion euro “solidarity handout” to low-income Greek families. He has also said he will hire 2,000 new

workers in the country’s energy department. His government also approved a measure giving borrowers a

12-month grace period to pay overdue debts and mortgages.

Mr. Papandreou’s disparate policies may be a result of having a wide range of advisers. He has sought

counsel from Joseph Stiglitz, the economist who has written critically about International Monetary

Fund-style policy demands like sharp spending cuts, and Gary D. Cohn, the president of Goldman Sachs.

Mr. Cohn has positioned his firm to be the leading underwriter of Greek debt — a role that will require it to

convince investors that Greece will institute the same budget-tightening measures criticized by Mr. Stiglitz.

“What we learned in Asia in 1997 was that the advice of cut, cut, cut made recessions worse,” said Mr.

Stiglitz. He said he has advised Mr. Papandreou to look for ways to stimulate the economy, such as

increasing credit to small businesses, and said he believes Europe should be more aggressive in coming to

Greece’s aid.

Through a spokeswoman, Mr. Cohn declined to comment on his work with Greece.

SITTING in his art-bedecked office here in Athens last month, Mr. Papaconstantinou dismissed talk of

bailouts and bankruptcy and argued that only a center-left administration like the ruling Socialist party

would be able to reach a deal with Greece’s trade unions.

“We are not asking for blind trust; we just need a few months,” he said. Mr. Papaconstantinou said he

would be making a trip next month to the United States and Asia, aiming to persuade investors outside of

Europe to buy Greek debt. But he made clear that there was no commitment on the part of China or any

other country to buy Greek bonds. Goldman Sachs has also said that it has not made a formal pitch to

China.


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Mr. Papaconstantinou conceded that the debacle over the underestimate of the budget deficit had been a

huge blow to the country’s credibility. He said that the official in charge of the office that gave the wrong

figures had been let go and that legislation would be passed to make the office independent. It is currently

part of the finance ministry.

Timothy Allen, a spokesman for Eurostat, the European Union’s statistical agency, said that there was no

evidence of any similar inaccuracies in other countries. Nevertheless, as a result of the Greek imbroglio,

Eurostat will now be given new audit powers to examine data from other European Union members.

After the debacle, the three main rating agencies downgraded Greece’s debt. Critics of the agencies say they

should have anticipated the problem, not reacted to it.

“They’ve been behind on absolutely everything: Enron, WorldCom, mortgage debt and C.D.O.’s,” said

Jonathan Tepper, a partner at Variant Perception, a research house based in London.

Ratings agencies defend their record, saying that throughout the last decade, Greece has been rated below

all other euro zone members.

Greece’s government, meanwhile, has made bold promises to rein in spending, but the more than one

million public workers may not accept that the state can no longer meet its commitments.

As he dispensed lunchtime glasses of Greek brandy to his colleagues after an organizational meeting in a

small union hall here, Panagiotis Vavougios, the 80-year-old head of the powerful, 200,000-strong retired

civil servants union, was not in the mood to compromise.

“It is not the workers that should be blamed for this; it is bankers and large capital,” Mr. Vavougios said.

“We will take to the streets.”

Niki Kitsantonis contributed reporting.

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JULY 31, 2013, 8:58 PM

Banks Find S.&P. More Favorable in Bond Ratings

By NATHANIEL POPPER

The Wall Street ratings game is back.

Five years after inflated credit ratings helped touch off the financial crisis, the nation’slargest ratings agency, Standard & Poor’s, is winning business again by offering morefavorable ratings.

S.& P. has been giving higher grades than its big rivals to certain mortgage-backed securitiesjust as Wall Street is eagerly trying to revive the market for these investments, according toan analysis conducted for The New York Times by Commercial Mortgage Alert, whichcollects data on the industry. S.& P.’s chase for business is notable because it is fighting agovernment lawsuit accusing it of similar action before the financial crisis.

As the company battles those accusations, industry participants say it has once again beenmoving to capture business by offering Wall Street underwriters higher ratings than otheragencies will offer. And it has apparently worked. Banks have shown a new willingness tohire S.& P. to rate their bonds, tripling its market share in the first half of 2013. Its biggestrivals have been much less likely to give higher ratings.

“The general consensus was that these changes have let them get their market share back,”said Darrell Wheeler, a bond analyst at Amherst Securities.

Standard & Poor’s said the “methodology used and the conclusions drawn by The New YorkTimes are flawed,” though it declined to elaborate on what those flaws were.

In its response to the government lawsuit, the company said that its ratings had always been“uninfluenced by conflicts of interest.”

But David Jacob, who ran the S.& P. division that rated mortgage-backed bonds until 2011,said that in his time at the company, after the financial crisis, he saw employees adjustingcriteria in response to business pressure.

“It’s silly to say that the market share doesn’t matter,” said Mr. Jacob, who is now retired.“This is not God’s holy work. It’s a business.”

Along with its chief rivals — Moody’s Investors Service and Fitch — S.& P. was criticized foroffering top-flight ratings to subprime mortgage securities, which made those bonds appearmore attractive to investors before the crisis. The agencies had an incentive to offer higherratings because banks choose which ratings agency grades each bond. The flaws in thesystem became apparent when many bonds with the highest ratings ended up plunging invalue, inflicting enormous damage on the economy.

The government, though, chose in February to file suit against only S.& P., accusing it of

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relaxing its rating methodology before the crisis to win business.

The methodology and motivation of the ratings agencies are important because they playsuch a vital role in the financial system. Many investors are allowed to buy only bonds thathave been rated AAA by S.& P. or one its two largest competitors, Moody’s and Fitch. Banksoften adjust the riskiness of their investment products to satisfy the agencies.

But the agencies have long been accused of tailoring their ratings to the banks to win morebusiness. Before the crisis, the biggest problems involved ratings of bonds tied to subprimeresidential mortgages. More recent concerns have come about since S.& P. made anapparently benign change last September to the criteria it uses to rate bonds backed bycommercial real estate mortgages, which is now the hottest portion of the mortgage bondmarket.

The company said at the time that the change was not designed to win more business. Beforethe change, though, S.& P. was lagging, in part because of tougher standards it put in placeimmediately after the crisis.

Since the change, the company has been much more likely than its big rivals to offer higherratings on the commercial real estate bonds, according to the analysis for The Times. On halfof the deals that it rated since last September, S.& P. has given at least a portion of the deal ahigher rating than the other agencies rating the same deals. Before the change in standards,it rarely offered higher ratings.

Some investors buying the bonds worry that the willingness of some agencies to give betterratings is encouraging banks to issue lower-quality bonds.

“When one agency loosens up on something, it forces others to as well,” said EdwardShugrue, the chief executive of the bond investing firm Talmage.

Immediately after the crisis, the agencies themselves moved to tighten their standards. S.& P.offered top positions to Mr. Jacob and his partner, Mark Adelson, from the consulting firmAdelson & Jacob, both of whom had called for more scrutiny of bonds.

The two quickly pushed inside the company for tougher standards for the bonds that were atthe root of the financial crisis. This alienated many banks, and the agency was rarely chosento rate the mortgage-backed bonds. The company rated only 22 percent of the bonds issuedin 2011, down from 80 percent in 2006.

Inside the company, Mr. Jacob said, “People weren’t happy with losing market share.”

A spokesman for the company said it rejected Mr. Jacob’s assertions and noted that he didnot raise his concerns when he was at the company.

S.& P. ran into particular trouble in August 2011 after it backed out of rating a bond beingissued by Goldman Sachs and Citigroup because of internal disagreements about how to ratethe bonds. It was in the months after that episode, when no banks would hire S.& P., that thecompany pushed out many of the employees who had been instituting tougher standards,including Mr. Jacob and Mr. Adelson.

At the same time, the company began working on new criteria for rating bonds tied tocommercial real estate.


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When S.& P. released the new standards in September 2012 it was not immediately clear ifthey would result in higher ratings. The document describing the changes left many of thespecifics vague.

But the company quickly managed to win the job of rating a number of smaller bonds. And ineach of the first five deals where it was chosen, Standard & Poor’s offered higher grades thanits competitors to at least a portion of the multilayered deals, according to the data fromCommercial Mortgage Alert. The pattern has not slowed down more recently. On each of thefive most recent deals that Standard & Poor’s rated, it gave better ratings than the otheragencies.

The company’s numbers stand in particular contrast to Moody’s, which has not given thehighest ratings to any deal it rated over the last two years. Fitch, the third big ratings agency,gave higher ratings on only 8 percent of the bonds it rated over the last year.

S.& P.’s willingness to give higher ratings makes it look more like the three smaller ratingsagencies that work on bonds tied to commercial real estate: Kroll, DBRS and Morningstar.They were all more likely to give higher ratings than Fitch and Moody’s. Even among thosethree, though, only Morningstar was more likely to give higher ratings than S.& P., accordingto the Commercial Mortgage Alert data. Morningstar gave higher ratings than competitorson 52 percent of the deals it graded.

Joseph Petro, an executive with Morningstar’s ratings business, said that it won fewer overallcontracts than other agencies because it applied tougher standards in the preliminary phasesof the process, which are not publicly visible.

Several bond investors said that ratings mattered less than they did in the past because thefinancial crisis taught them to do their own analysis before putting their money down. That isparticularly true for bonds backed by commercial mortgages, which are popular with moresophisticated investors.

But Mr. Shugrue said that the little things being allowed could turn into steps toward muchbigger problems.

“You can see that we are slipping our way back to 2007,” he said.


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January 22, 2009 8:22 pm

By Paul De Grauwe

tandard & Poor’s has downgraded Greece, Spain and Portugal and has warned Ireland that it might suffer a similar fate. Do I hearthis right?

Is S&P still in the business of producing risk analyses? Should the rating agencies not have gone out of business after they told us foryears that the risk associated with the ballooning debt of banks and large companies was nothing to worry about? How can theseagencies, which were systematically wrong in the past, have any credibility in whatever risk analysis they make?

Yet, remarkably, they are alive and well, and their credibility seems to have been restored. The rating agencies are now believed by themarket when they warn us of risks associated with a number of eurozone governments’ debt. As a result, the interest rate thesegovernments have to pay on their borrowings increases.

In the recent past, the market believed the same rating agencies when they put a stamp of approval on the exploding debt of privatecompanies. As a result, these companies could finance themselves in the markets at ever lower interest rates. It led to disaster.

In statistics, a distinction is made between type I and type II errors. A type I error occurs when a hypothesis (eg a company is risky) isrejected when it should have been accepted. A type II error occurs when a hypothesis (a company is risky) is accepted when it shouldhave been rejected.

The rating agencies made systematic type I errors in the past. They had an excessive faith in the soundness of the private companiesthey were rating and failed to identify massive risk-taking by these companies, until the crisis erupted. There is no reason to believethat agencies that have excelled at making type I errors could not equally excel at making type II errors. In fact, we have every reason tobelieve that they will do so. Having made systematic type I errors, they are now more likely to make type II errors – finding risks wherefew exist. In the past, they were over-optimistic; they now react by being over-pessimistic.

Government debt in the eurozone has declined steadily since 2000 (from 69 per cent of gross domestic product in 2000 to 66 per centin 2007). The government debt of Greece, Ireland and Spain has declined even faster than in the eurozone as a whole. Two of them,Ireland and Spain, had a level of government debt that was about half the German and US levels in 2007.

True, since the eruption of the crisis, government debt in these countries has been increasing fast. But US and UK government debt isrising equally fast. No warnings have been issued against the US and the UK.

Thus it appears that the rating agencies are not only over-reacting and crying wolf (a type II error), they are also being highly selectivein their over-reaction. Some countries’ governments are singled out, while others are not, for reasons that are obscure.

We are all subject to biased beliefs. The problem arises when such beliefs affect the analysis of rating agencies, which have considerablepower in moving markets and in rewarding some and punishing others. The rewards and punishments distributed by rating agencieshave huge implications.

If ratings are given objectively, there is no problem; on the contrary, they provide the right incentives for all who are in the process oftaking risks. But the rating agencies have been systematically wrong in handing out rewards and meting out punishments. In the past,they gave incentives to take too much risk; today they give incentives to take too little, thereby exacerbating the crisis.

It is time to mete out punishment to rating agencies. Ideally, after so much incompetence, one would like to shut them down. But this isunlikely. My proposal would be to borrow from the approach adopted towards the tobacco industry.

Just as cigarette packets must carry information alerting consumers to the dangers of smoking, so we could oblige the agencies to issuehealth warnings with their ratings.

The wording could be as follows: “Scientific evidence has shown that this rating is likely to harm you. If it is favourable, it is likely tohave overlooked your weaknesses, thereby making you complacent and harming you. If it is unfavourable, it will harm you even if youdo not deserve it.”

As with cigarettes, such a warning might reduce our addiction to ratings, and we would all feel better.


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The writer is professor of economics at the university of Leuven and the Centre for European Policy Studies

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ENCORE

Updated Dec. 6, 2009 12:01 a.m. ET

We all make mistakes. The key, of course, is catching them early and correcting them before thedamage is irreversible.

Retirement planning, with all its moving parts -- finances, families, health care and legal issues --presents lots of opportunities to get things wrong.

With that in mind, we asked some pros to talk about themore common mistakes they see these days from clientswalking in the door.

1 Misreading Bonds

Lawrence Glazer, at Mayflower Advisors in Boston, meetswith retirees who are hesitant to own stocks because theydon't want to lose money. But they don't have the sameconcerns about bonds.

"It's a fallacy to think you can't lose money in bonds," hesays.

A bond is basically a loan to an issuer who promises to payinterest on the loan, and ultimately return the principal toinvestors. One risk is credit risk -- that the bond issuerwon't make its interest payments, or even be able to returnall the borrowed money.

As investors in Lehman Brothers debt found out last year,outside of government-backed debt, defaults can and dohappen.

A more common risk is that bond prices fall, most commonly as interest rates rise. The degree to whichbond prices rise or fall depends not just on the kind of bond but also on the maturity. Longer-term bondsare generally more prone to price swings than short-term debt.

With interest rates so low these days -- a U.S. Treasury two-year note yields just 0.7% -- many investorsare stretching for higher yields on debt with longer maturities and greater credit risk, such as junk bonds.

In a rising-rate environment, losses on even "safe" debt such as U.S. Treasurys "may come as a shockto investors," says Mr. Glazer.

2 Overspending

Marc Rosenthal

By TOM LAURICELLA

Retirement Planning Mishaps - WSJ.com http://online.wsj.com/news/articles/SB126005568785878569#printMode

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"People show up, in their 50s, with no retirement plan and $500,000 saved up and think they are going toretire and spend $5,000 per month," says Ronald Myers, a financial planner in Fort Lauderdale, Fla. Buteven if they earn 8% a year on their investments, at that rate they would run out of money in 10 years.

Part of the equation is having a realistic spending budget and matching that with a sustainable withdrawalrate. Most financial advisers recommend a 4% annual withdrawal rate.

But Mr. Myers says retirees often don't factor in two other variables. The first is inflation. "At a 4%inflation rate, your expenses are going to be double in 20 years," he notes. Medical costs -- a bigexpense for retirees -- are rising much faster than the overall rate of inflation.

Second, retirees often don't allow cushions for unexpected big expenses or hefty investment losses."You'd better understand what's going to happen if your accounts go down in value," Mr. Myers says,"and whether you're going to be able to adjust on the fly."

3 Forgetting Names

A big concern for many retirees is ensuring that when they die or are incapacitated their property andsavings go to the intended recipients and that decisions are in responsible hands. That means keeping awill, health-care proxy and the beneficiaries on retirement accounts and insurance policies up to date.

But many people wrongly assume that a will takes care of all those things, says New York attorney PhilipBouklas. In fact, the laws and regulations are much more complicated. For example, parents will oftenadd one child to their bank or investment accounts for convenience. But irrespective of what it says in awill, when the parent dies the account passes to just the child whose name is on the account.

Another common misstep Mr. Bouklas sees is not naming a beneficiary on a retirement account.

When the account holder dies without a designated beneficiary, the account is distributed to the estateand passed on according to the will. But to do so, the estate has to take the distribution from the accountin a lump sum and pay income taxes. That's less beneficial to the heirs. If they were named asbeneficiaries, heirs would be able to draw down the account slowly over their lifetime.

4 Failing to Talk

"People don't like to talk about their own mortality and their own infirmities," says Bernard Krooks, a NewYork attorney who specializes in elder law. "I have a bunch of clients who say they're not going to die," hejokes.

It's not just what will happen in the event of death that families should discuss, but also long-termhealth-care plans. People often assume that they'll have plenty of time to make arrangements forlong-term care or discuss care-giving plans with their children. But a stroke or accident can happen atany time.

These discussions should even include unpleasant conversations, such as a parent explaining to a childwhy a sibling is getting a bigger share of an inheritance. It may not be an easy conversation, "but it's lesslikely to result in problems after the fact," says Mr. Krooks.

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WEEKEND INVESTOR

We puncture some dangerous misconceptions—and set out a plan for investorsto follow now.

Feb. 21, 2014 6:28 p.m. ET

Are bonds a portfolio's bulwark or its Achilles' heel? Investors can't seem to decide.

Over the last seven months of 2013, amid rising interest rates and falling bond prices, skittishinvestors yanked $18 billion more out of bond funds than they put in.

Then, as stocks faltered in the first six weeks of 2014, investors put in over $28 billion more tobond funds than they withdrew.

Adding to the confusion: Wednesday's disclosure that Federal Reserve officials are debatingwhether to raise interest rates sooner than expected. The yield on the 10-year U.S. Treasury hit2.75% on the news, up from 1.62% in May. (Bond yields move in the opposite direction ofprices.)

After three decades of a mostly smooth and steady bond market, investors aren't used to therecent volatility. That could be leading some to abandon their portfolios' primary defenses rightwhen they need them the most, experts say.

"Bonds are thought of as a safe haven, but even the safest harbors have waves," says Martin

Federal Reserve Chairwoman Janet Yellen and governor Daniel Tarullo at a meeting earlier this month.Getty Images

By JASON ZWEIG And JOE LIGHT

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Leibowitz, a managing director of research at Morgan Stanley and co-author of "Inside the YieldBook," considered by investors to be one of the best books ever written on bonds.

Like all areas of investing, the bond market is rife with popular beliefs that are only partly true atbest and misleading at worst. If you want to stop lurching from one wrong-footed bond trade toanother, it pays to separate myth from reality.

Here is a guide to some of the most dangerous misinformation about investing in bonds andbond funds—along with practical steps you can take to invest wisely on the basis ofmore-accurate evidence.

Myth No. 1: Bond investors will suffer huge losses when interest rates rise.

Long-term U.S. Treasury bonds lost 12.7% last year as rates rose roughly one percentagepoint. And many Wall Street strategists expect rates to climb this year as the Fed changescourse.

Yet losses on that scale across a wide variety of bonds are unlikely. To see why, you need abasic understanding of what pros call "duration."

That measure—available from your fund's website or, if you buy individual bonds, from yourbroker—shows the approximate percentage change in the price of a bond or bond fund for animmediate one-percentage-point move in interest rates.

The duration of the Barclays U.S. Aggregate Bond Index, the broadest benchmark for the fixed-income market, was around 5.6 years this past week. Thus, if rates rise one percentage point,the Barclays Aggregate would immediately fall in price by approximately 5.6%; a half-point risewould knock the index down in price by 2.8%, and so on.

"For big losses to occur, interest rates would have to rise enormously," says Frank Fabozzi, abond expert who teaches finance at EDHEC Business School in Paris and Princeton University.


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To incur a 20% loss on a bond fund with a duration of 5.6 years, for instance, interest rateswould have to rise instantaneously by approximately four percentage points. Even a 10% losswould require an immediate—and historically unprecedented—jump in rates of roughly twopoints. (Long-term U.S. Treasurys have a duration of more than 16 years, which is why they areso sensitive to rising rates.)

At today's low rates, "you should have lower expectations for total return and yield, but the extentof the potential negative returns has been exaggerated," says Matthew Tucker, head of fixed-income strategy at BlackRock's iShares unit, the largest manager of exchange-traded funds.

That is because, as rates rise, you get to invest the income thrown off by your old bonds at thenew, higher yields. As a bond investor, your total return is the sum of any price changes and theincome the bonds produce.

Imagine that interest rates rise by a quarter of a percentage point. That would immediately knockabout 1.4% off the price of a bond fund with a duration of 5.6 years. But it also would add aquarter-point to the yield of fresh bonds coming into the portfolio, making up over the longer termfor the short-term decline in price.

In recently published research, Morgan Stanley'sMr. Leibowitz has shown that so long as a fund (oreven a "ladder" of individual bonds assembled tomature at equally spaced intervals of time)maintains a moderate, five-to-six-year duration, theportfolio's annual total return should convergetoward its original yield. That assumes that you holdthe fund or ladder at least six years.

Remarkably, he found that outcome will occur underalmost all possible scenarios, regardless of howmuch interest rates change.

As a result, Mr. Leibowitz says, "if you are determinedly a long-term investor, you can getthrough a period of intervening turbulence" comfortable in the knowledge that any losses inmarket value will be offset over time by the extra income from higher rates.

All this points toward a simple strategy: Ignore the harum-scarum rhetoric about a bond-marketbloodbath. For government and investment-grade corporate bonds and bond funds with aduration less than 10 years, that scenario is just a myth.

So long as you keep your duration short—and stick with high-quality bonds—you should be in nodanger of anything greater than a temporary, single-digit loss.

Ask yourself what is the worst loss you are willing to withstand on your bond investments foreach one-percentage-point rise in interest rates. If that maximum loss is 5%, then you want abond or bond fund with a duration of five years, slightly shorter than that of the BarclaysAggregate. (The average intermediate-term bond fund, according to Chicago-based investmentresearcher Morningstar, has a duration of 4.9 years.)

You can get higher yield than the current 2.3% offered by the Barclays Aggregate Index—butonly if you are comfortable with higher duration. The Vanguard Long-Term Corporate Bond ETF,

Wesley Bedrosian


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for instance, yields 5%, but its duration is 13.4 years—meaning that a quarter-point rise in rateswould trigger a 3.4% short-term decline in price.

Myth No. 2: Investors who need income must own "bond alternatives."

These alternatives include real-estate investment trusts, master limited partnerships, preferredstock, dividend-paying common stock, business-development companies and bank loans.

"None of these things are substitutes for the safest bonds," says Larry Swedroe, director ofresearch at the BAM Alliance, a nationwide group of investment advisers based in St. Louis.Some of these assets, like REITs and MLPs, "have good diversification characteristics and canplay a role in a diversified portfolio," he says. The other popular bond alternatives, he warns,provide extra income in good times—but won't act like bonds during bad times.

While recessions are bad for stocks, they are good for bonds. In 2008, U.S. Treasurys were theonly major asset that went up in price. Everything else collapsed in the financial crisis—includingthese bond alternatives, which are highly sensitive to economic downturns.

In 2008, for instance, bank loans lost 28%. In the fourth quarter of 2008 alone, REITs lost 40%,MLPs 20% and high-yield bonds 18%, says Mr. Swedroe, even as five-year U.S. Treasurysrose 7.5%.

"When you get a bear market in stocks," he says, "many of these things act like stocks, too." Asa result, "you have a much bigger loss in your overall portfolio" than you would have if you hadstuck to government bonds.

"There's one thing that never really gets talked about in the discussion about 'bond alternatives,'"says Fran Kinniry, an investment strategist at financial-services giant Vanguard Group. "Ifsomeone is offering you a higher yield, you have to expect your risk to go up by the sameproportion."

Instead of taking on more risk in the pursuit of more income, consider a technique for reducingyour risk and raising your income at the same time.

You can generate higher income from your existing portfolio by selling off small slivers of yourstocks or stock funds in regular increments. This way, "you can manufacture homemadedividends," Mr. Swedroe says. Work with your accountant to sell the shares that cost you themost first; that will minimize your capital-gains tax bill.

The next time someone tries to sell you on the virtues of "bond alternatives," just remember thatan investment is either a bond or it isn't. And if it isn't, then it either belongs somewhere else inyour portfolio, or nowhere at all.

Myth No. 3: Municipal bonds and funds are safe diversifiers for a stock portfolio.

When it comes to municipal bonds, think nationally, not locally.

Single-state municipal-bond mutual funds hold more than $148 billion in assets, according toMorningstar.

But bonds issued in your home state, as well as the funds that hold them, can harbor risks thatmight offset some of their tax advantages.


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For starters, your job, the value of your home and even the quality of your children's schools candepend on the health of your local economy.

If you lose your job in the midst of a local housing slump, the value of municipal bonds issuednearby isn't likely to tide you over. As Detroit's recent difficulties show, just when you would mostlike your municipal bonds to hold their value, they may be suffering as severely as your jobsecurity and your home value.

Furthermore, many municipalities are counting on investment returns of 7% or more to help themfund future benefits for public employees. If the stock market performs poorly in the future, suchmunicipalities could have to cut benefits, raise taxes or take on more risk to fund theircommitments.

Therefore, says Allan Roth, a financial adviser at Wealth Logic, a firm in Colorado Springs,Colo., "if stocks don't have a gangbuster decade, there's going to be a lot of stress on the abilityof municipalities to meet their obligations."

That, in turn, creates an implicit link between the riskiness of stocks and municipal bonds, Mr.Roth says. As a result, he says, you should diversify your muni holdings nationwide, rather thanconcentrating them in your home state. And bear in mind that municipals make up approximately10% of the total U.S. bond market. Many investors use munis for 90% or more of their bondexposure, Mr. Roth says; he advises that anything over about 30% is excessive.

Minimize your exposure to single-state funds and to expensive closed-end funds that use"leverage," or borrowed money, to buy munis. Stick to low-cost, intermediate-term national fundsthat hold munis from a variety of states, like the Vanguard Intermediate-Term Tax-Exempt mutualfund or the iShares National AMT-Free Muni Bond ETF, which charge 0.20% and 0.25% inannual expenses, respectively, or $20 and $25 on a $10,000 investment.

Myth No. 4: Actively managed "go anywhere" funds will outperform in a bad market.

Mutual-fund companies have lately been hawking a purported antidote to rising rates: so-calledgo-anywhere bond funds.

Also called "nontraditional" or "unconstrained" funds, go-anywhere funds invest, well, just aboutanywhere, including in bonds in the U.S. or abroad, floating-rate bank loans and sometimes evenstocks.

The idea: By roving far and wide, an active bond manager can limit the pain investors will feel asinterest rates rise.

The pitch is working. Last year, investors poured a net $55.3 billion into nontraditional bondfunds, according to Morningstar, more than they did from 2010 through 2012.

But the more nontraditional a fund gets, the more investors might be blindsided when theirinvestment doesn't act anything like what they have come to expect from bonds, saysMorningstar senior analyst Eric Jacobson.

Go-anywhere funds, the majority of which launched in the past couple of years, also haven't yetproved that they can deliver on their promises. In the past 12 months through Thursday,nontraditional bond funds have lost 0.2% on average, while the Barclays Aggregate index hasbeen flat. In the last three years, go-anywhere funds have risen 2.4%, an annual average of 1.4


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percentage points less than the index.

Of course, some funds have fared better.

The Goldman Sachs Strategic Income Fund, whose "A" shares have an expense ratio of 0.99%,has returned 4.8% annually over the past three years. Portfolio manager Michael Swell says thatthe fund has succeeded with a strategy that isn't tied to the fate of interest rates.

While bonds have stagnated, Mr. Swell has made money by using options to give his portfolio aduration of negative two years. Unlike the typical bond fund, Mr. Swell's fund should go up—notdown—if interest rates climb.

However, if the stock market tanks while the fund's duration is negative, falling interest ratescould punish Mr. Swell's fund even as a traditional bond fund will benefit—a potential risk that hedoesn't deny. Mr. Swell says he doesn't recommend that investors put more than half of theirfixed-income allocation into unconstrained funds.

For many people, even that much might be too much. Says Mr. Jacobson: "When you replaceyour conventional bond holdings with [go-anywhere funds], you are giving up a very, veryvaluable piece of insurance in your portfolio."

Myth No. 5: Individual bonds are better than bond funds.

Many investors worrying about the risk of rising interest rates prefer to hold individual bonds.This way, they figure, they are assured of getting 100% of their principal back so long as theyhold to maturity—with no risk of suffering interim losses in market value.

It is true that if you hold a given bond until it matures, you will receive 100 cents back on thedollar (ignoring inflation and the possibility of default). It also is true that mutual funds and ETFsgenerally don't have a fixed maturity date and will therefore fall in price whenever interest ratesrise.

But your individual bond also falls in value when rates rise; you just don't see it, since you aren'trepricing it daily. If you did have to sell it on the open market, it would drop in price by the sameproportion as a bond fund with similar sensitivity to interest rates. But only the fund will reflect thatchange in its daily price. So the bond isn't safer than the bond fund; that is an illusion.

Individual bonds have at least one disadvantage compared with funds: what Mr. Kinniry ofVanguard calls "cash drag."

Imagine that you own a $10,000 corporate bond paying 4% annual interest in two equalpayments a year. Every six months, the bond generates $200 in interest income. Bonds aren'tavailable in such small denominations, so most likely you will deposit the income in a bankaccount earning less than 1%.

In a fund that yields 4%, however, you can reinvest your income into more bonds earning4%—and if interest rates rise, those reinvestments will buy new bonds at even higher rates.

Given today's paltry returns on cash, a bond fund yielding 4% will generate greater total incomeover time than an individual bond yielding 4%, because of the power of interest-on-interest.

Bond funds, which typically hold hundreds of securities and can trade them cheaply, also offer


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better diversification and lower trading costs than most investors are likely to be able to get onan individual bond.

Therefore, Mr. Kinniry says, unless you have roughly $10 million or more, bond funds are abetter deal. Just make sure you keep your ownership costs at rock-bottom. If you are payingmore than about 0.5% in annual expenses, you probably are overpaying.

In a low-interest-rate world, the last thing you want to do is to pay high fees.

Write to Jason Zweig at [email protected] and Joe Light at [email protected]

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