New Ideas Inc.
306 N. 32nd Street
Philadelphia, PA
Prepared By
Gillian E. Kelly
Dear Mr. and Mrs. Sam and Amy Kratchman,
As we discussed in your initial consultation you have recently inherited $750,000 from a
wealthy grandparent. New Ideas Inc. has put together a mock portfolio, detailing all potential
assets to be included in the portfolio, as well as a forecast of the economy, markets, etc. and why
New Ideas, Inc. will provide a higher risk adjusted rate of return than other managers. Here is a
list of your objectives to the best of my understanding:

You would like to buy a new house, valued at $900,000 outside of Philadelphia

You would like to buy a vacation house in a beach town or travel more on an annual basis

You would like to retire at an age between 60 and 67 without having to pay any debts

You would like to budget to pay for your children’s (ages 5 and 8) college education in
full to a four-year institution

Your risk aversion does not exceed 11% for the nominal rate of return on the portfolio
Given these objectives and other stipulations your have voiced during our first meetings, I
have set up a portfolio that has an estimated return of 9.413% on an annual basis. There are 3
main tactics used in portfolio strategy: Security Selection, Market Timing and Asset Allocation.
New Ideas Inc. uses all three of these tactics with our clients however asset allocation is the main
driver behind secure, sustainable return of a portfolio. Asset Allocation allows the investor to
hedge their securities among various classes of investment vehicles. Diversification is the main
element in this theory because having a mixture of assets is more likely to meet your investment
goals.
1
The following chart shows and example of the asset allocation I have chosen for you and the
benchmarks I have used to forecast performance:
Sector
Total Market:
Benchmark
Wilshire 5000
Percentage
Invested
100.00%
Dollar Value
Invested
$1,259,092.79
$1,259,092.79
Domestic Stocks:
Large Cap Equity
Mid Cap Equity
Small Cap Equity
Domestic Fixed Income
Developed International
Emerging Markets
Commodities
Real Estate
Cash
S&P 500
S&P Mid Cap 400
Russell 2000
Vanguard Total Bond Index
20.00%
19.00%
5.00%
15.00%
$251,818.56
$239,227.63
$62,954.64
$188,863.92
Vanguard Intern'tl Growth
MSCI Emerging Markets
Index
Dow Jones-AIG Commodity
Index DJC
Dow Jones Composite REIT
Index
13 week treasury
10.00%
$125,909.28
11.00%
$138,500.21
10.00%
$125,909.28
8.00%
$100,727.42
2.00%
$25,181.86
You already have a substantial amount of your wealth in Apple Stock (large cap equity)
however; I would like to diversify your stock portion of your portfolio by adding equal amount
of mid-cap stocks, which, as a sector, has returned higher in the last 20 years than other domestic
equity classes1. I have also added some small cap equity because there is a great potential of
growth among smaller companies.
I used Domestic Fixed Income, Real Estate and Cash in your portfolio to add to its
diversification. These types of instruments historically award a less-volatile return and are less
correlated and thus easy to hedge. For example cash and short term fixed income are affected
greatest by monetary policy unlike long term rates (like treasury notes or corporate bonds) where
inflation is the biggest driver of yields.
I have also added a great deal of weight into international markets. Emerging markets
have above average returns for the past 15 years but with a higher risk of volatility. Within the
past 10 years the returns have stabilized but are still seeing steady growth.
1
The Vanguard Group.
https://advisors.vanguard.com/VGApp/iip/site/advisor/researchcommentary/commentary/article?File=IWE_News
MktComm2QTR07. Retrieved 11/15/08
2
I’ve added commodities into your portfolio on the theory that return will rise in upcoming
years through the push for alternative energies. This allocation needs to be monitored on a
stringent basis because I believe presently a modest investment in oil will be beneficial on the
assumption of many economists that our dependency is not near an end. But in the near future I
believe the drive toward ethanol and other energy sources will increase the return for corn,
soybeans, nuclear energy and others. In which case, the type of commodity in your portfolio will
change.
Financial Market Analysis
From the beginning of the third quarter, 2006, through the first quarter of 2007 the spread
between the 10 year U.S. Treasury and the 3-month T-bill was negative (spread at the end of the
first quarter in 2007 stood at a negative 29 basis points)2, indicating an inverted yield curve and
predictive of a slowing economy or looming recession. Federal Reserve Chairman Ben
Bernanke argued that it resulted from global liquidity that had led to unusually heavy purchasing
of longer-term notes by pension funds, oil producing and developing nations with high
purchasing power against the dollar3. This high demand of UST increases prices and drives
yields to an artificial low (prices and yields move inversely). During this time period the Federal
Reserve was lowering short term rates as part of an expansionary policy, so aggressively, in fact,
that inflation was the main concern through the first half of 2007.
For the banking sector, the inverted yield curve reduces the margin between earnings
from investments (long term rates charged to borrowers) and expenses (short term rates; i.e.
2
Federal Reserve Bank of San Francisco. http://www.frbsf.org/news/speeches/2007/0221.html. Retrieved
10/27/2008
3 Wines, Leslie. Steeper yield curve may signal improving economy. June 20, 2007.
http://www.marketwatch.com/news/story/steeper-yield-curve-stirs-debate/story.aspx?guid={675A092A-6B3C49E6-8417-7BB2D2CD19B2}. Retrieved 11/19/08
3
interest payments to depositors). This will usually validates banks to invest in riskier securities in
attempt to balance out the loss by (possibly) achieving a higher return. This often pulls the yield
curve out of inversion because if demand for liquid securities increases so will prices; yields will
decrease in the short term. I believe this is one component that pulled the yield curve back to
regular in 2Q of 2007 without a change in monetary policy by the Fed, which kept short term
rates at 5.25%.
The end of the second quarter the yield 10-year treasuries pushed to 5.116% and short
term rates remained over 50 basis points lower. This was caused because there was such large
fear of inflation that investors were adding in the predicted raise of interest rates by the Fed and
heavily sold long term securities before prices decreased. However some economists believe this
was not that case and the selling of securities should have been viewed as the first sign of the
sub-prime mortgage crisis; managers needed to hedge their portfolios, by selling notes and
bonds, to compensate for the deteriorating value of the assets in soured mortgage-backed
securities2.
Investors began to reassess their risk aversion and yields between high- and low-quality
fixed-income securities widened significantly as 2007 dragged on. The 3-month t-bill lowered
almost 70 bps in the third quarter because demand was so high for these safe securities. The
Federal Reserve lowered the discount rate by 50 bps in August and September and lowered the
Fed Funds rate to 4.75% to aid in the credit crunch’s first signs of an illiquid Commercial Paper
market, and causing concern for inflationary pressures.
As expected, in the fourth quarter for 2007 treasury yields declined, helping fixed income
investors that bet on the slowing economy, but minimizing returns of investors holding corporate
debt instruments because concerns over liquidity. Concerns over bond insurers guaranteeing the
4
credit worthiness added to the credit crunch. Even investors in high yielding bonds (junk bonds)
only saw flat returns during the 4th quarter.
Liquidity anxiety and aggressive Fed interest rate cuts started 2008 with the steepest yield
curve since 2004. The rate cuts helped long term risk-free US bonds to gain because there was a
drastic flight to quality, making UST extremely tradable. Tax free bonds declined because faith
in local governments was jeopardized due to rising foreclosures and declining property values.
The spread between high yield, high risk bonds and US treasuries widened.
In the second quarter, The Fed kept trying to stimulate the economy by lowering Fed
Funds to 2.00% however futures predicted a raise in by the end of the year4. The two- and fiveyear treasuries rose most signficantly with 104 and 89-bps changes, respectively. This steapened
the yield curve in the short term slightly. Bond prices, moving inversely with yields, fell and
caused returns for the quarter to reach negative. However this was a short-lived wave of
optimism in the economy and the beginning of a very tumultuous summer for investors.
According to Bloomberg, third quarter yields on speculative grade bonds rose to
distressed levels for the first time since 2002. By the end of the quarter, investors were
demanding close to 1,000 basis points to chose corporate high yield bonds over treasuries. For
investment grade corporate debt, investors were demanding exceeding 4.5 percentage points by
the end of September5.
After the third quarter, on the 29th of October the Fed lowered interest rate to 1.00%,
tying its lowest level in half a century. Although less than two weeks later, domestic fixed
income has saw a rise in all yields and a slight steepening of the yield cureve. The US t-bill
yield rose 0.15%, indicating a slight shift into riskier assets. The 2-year note rose 1.22%, while
4
The Vanguard Group. Global Market Currents. Second Quarter 2008.
https://advisors.vanguard.com/iwe/pdf/GlbCurrt_2Q08.pdf. Retrieved 11/15/08
5
Bloomberg. www.bloomberg.com. Retrieved 11/20/08.
5
the 10-year and 30-year bonds rose 3.72% and 4.22%, respectively. This can be viewed as an
increased confidence in the stock market or an artificial bump as inflation-sensitive investors
wait for fed funds rate cut befeore the end of the year. Contrary to the yield curve’s perception
of an improving economy, the inter-bank lending has tightened through November thus pushing
banks to further restrict lending practices to consumers.
Economic Analysis
The Federal Open Market Committee began in 2001 what turned into almost three years
of a monetary stimulus plan. After a long time of keeping the federal funds rate at a very low
level, by mid-2004, the Committee began to raise the federal funds rate and continued to do so,
on a quarter-point basis, for 17 consecutive quarters6. In late 2006, the Committee voted to not
raise the rate another quarter point and paused the rate at 5 ¼%. Tightening of monetary policy
is a tactic used by The Fed to slow the economy of the United States to a more sustainable
growth rate. The main concern with rapid growth is inflation. The slow approach of The Fed to
pause the interest rate and not lower it is so they can then monitor the inflation level and avoid a
severe downturn caused by too much volatility.
The first quarter exemplified an inverted yield curve as mentioned earlier. By March,
investors saw a slow start to the year- GDP growth was 1.1% but the cost of capital was still high
at 5.25%7. Historically, when the cost of borrowing is higher than the GDP growth it is
indicative of turbulent times in markets that depend on leveraged assets (real estate i.e.
mortgages) for two main reasons. First, the market value of such assets is tied to the strength of
the economy: GDP growth. Second, because GDP is a measure of the return on capital; if the
6
Federal Reserve Bank of San Francisco. http://www.frbsf.org/news/speeches/2007/0221.html. Retrieved
10/27/2008
7
St. Louis Fed. http://research.stlouisfed.org/fred2/data/FEDFUNDS.txt. Retrieved 11/15/08
6
cost of capital is higher than the return, investors’ cash flows suffer and begin to liquate those
markets, inevitably below book value.
US stocks returned 6.1% in the second quarter of 2007, up from 1.4% in first quarter.
(MSCI US Investable Market 2500 Index). Economic growth was up to 4.8% prompting
inflationary pressures and long term investors to anticipate a rate increase by the Fed. Main
concern by mid-year was not a possible recession but the risk of global economic overheating.
Month of volatility started in the fixed income markets as bond yields rose to almost 5.5%, the
highest in five years8 amid pressures that China and other nations would cut back purchases of
US treasuries due to the sliding value of the dollar. By the end of the second quarter and the start
of the third, investors began to predict the crises in the housing market due to a high rate of
defaulted loans. This also brought concern to the equity markets and Wall Street’s exposure to
mortgage backed securities.
In the third quarter; US equity market returned a 1.6% gain but the bond market returned
2.8%, up from the negative returns of last quarter. This flight to quality came on the heels of the
subprime and MBS market crisis. Also in the third quarter, what many economists see as the
first sign of crisis is Bear Stearns banned hedge fund withdraws from two sub-prime backed
funds.
By the end of 2007, what started in the third quarter accelerated in the fourth; flight to
quality increased, UST yields continued to fall and the Fed continued to lower the Fed Funds rate
at each meeting ending the third quarter at 4.00%.9 Global overheating was no longer an issue
and the world economy started to see the implications of the subprime mortgage crisis across all
8
The Vanguard Group.
https://advisors.vanguard.com/VGApp/iip/site/advisor/researchcommentary/commentary/article?File=IWE_News
MktComm2QTR07. Retrieved 11/15/08
9
http://research.stlouisfed.org/fred2/data/FEDFUNDS.txt. Retrieved 11/15/08
7
markets. The Bureau of Economic Analysis (BEA) singled out four industries in 2007 that they
predicted would cause the largest percent of economic slowdown in the United States.
According to preliminary industry accounts statistics those industries include: finance and
insurance, real estate, construction, and mining. In 2008, the BEA found economic analysis to
confirm their predictions. These groups accounted for nearly a quarter of real GDP in 2007,
however they accounted for nearly 80 percent of the economic slowdown. Informationcommunications-technology industries continued their double-digit growth for the fourth
consecutive year, increasing 13.2 percent in 2007. These industries accounted for 3.9 percent of
the economy but for 22.3 percent of real economic growth10.
First Quarter 2008
If it wasn’t obvious before January, the Fed’s emergency meeting to cut rates amid the
Bank of China’s announcement to have over $8 billion in sub-prime write-offs, followed by
another cut one week later definitely drove the economy into emergency mode. Over the course
of the first quarter the combination of Federal Funds rate decreasing from 4.25% to 2.25% and
the uncertainty of the future strength of the economy causing investors to move into quality
instruments, contributed to driving US treasury yields lower. The Fed also lowered the discount
rate from 4.75% to 2.5% and opened the discount window to all investment banks after Bear
Stearns informed the Fed of their solvency issues. The Fed helped save Bearn Stearns from
filing for bankruptcy when JP Morgan was able to buy the company to prevent
illiquid/essentially “frozen” markets. This was the government’s first wave of its “bailout”.
The Lehman Bond Aggregate Index boasted 2.2% return as prices rose to match the
falling yields and investors fled to quality. Unfortunately the US stock market is not faring so
well and suffered near double-digit losses in the first quarter posting a -9.4% loss to the MSCI
10
http://www.bea.gov/newsreleases/industry/gdpindustry/gdpindnewsrelease.htm. Retrieved 10/27/2008
8
US Investable Market 2500 Index. It isn’t surprising seeing that stock markets worldwide tried
to weather a credit crisis, slowing economic growth, rising commodity prices, the declining
dollar and disappointing earnings.11
High energy prices took a toll on consumer confidence and the credit crisis started to
spread into all markets, this resulted in reduced discretionary spending. Job growth has been
slowing over the past couple of years; technology and outsourcing driving this in the US. 2008
started out with exceeding high reports of job losses (76,000 in January and February and 80,000
in March alone). The Bureau of Labor Statistics reported the unemployment rate to be at 5.1%
in March. The Institute for Supply Management had surveyed manufacturing and
nonmanufacturing firms and concluded a contraction in business activity; however, the
weakening dollar has kept GDP growth positive with increased exports. Consumer prices rose at
a 3.1% rate for the first quarter of 2008 that compares to a 4.1% increase from all of 2007.
Energy prices advanced at 8.6%, in comparison to the 17.4% increase of 2007.12 Perspective at
the end of March was that both the CPI and energy prices were on target to reach an all time
inflationary high this year.
Poor sector returns continued to drive forecasts toward an inevitable recession. The
biggest loser was surprisingly not financials but rather information technology. This puts large
woes into investment outlooks because the last recession was excentuated by downtern in
technology spending that lasted until 20028. Energy stocks even took a loss in the first quarter of
over -7%. This was surprising due to the sharp rise of oil prices. This was unnerving because at
this time, economists felt the energy sector would be a main factor in recovery in up-coming
months.
11
The Vanguard Group. Global Market Currents. First Quarter 2008.
https://advisors.vanguard.com/iwe/pdf/GlbCurrt_1Q08.pdf. Retrieved 11/15/08
12
http://www.bls.gov/cpi/cpid0803.pdf
9
Second Quarter 2008
Slowing growth and rising inflation took main concern in June. Investors learned in May
that unemployment was at a 4-year high, while consumer confidence fell to its lowest point since
1992. All these factors contribute to the suspected scenario of stagflation.13
US equities market were again in the red, returning -1.5% with the 1-year return equaling
-12.3%. Investors are continuing to liquite their positions in the equity markets and putting their
assets in safer securites, however, the Lehman Aggregate Bond Index showed a negative return
for the 2nd quarter at -1.0% but the 1-year return is above 7.0%. The bond market was battling
conflicting pressures through the first half of 2008. Many financial services firms are caught in
the middle of the credit crisis and couldn’t raise capital because they were so highly leveraged it
was against their bond provisions to issue more debt. The only market with liquidity was for US
treasuries. By 2008 both households and financial services debts exceeded 100% of income and
GDP, respectively14.
Risk spreads continue to increase as the market questions government entities Fannie
Mae and Freddie Mac. Home foreclosures continue to rise above 250,000 a month and accelerate
13
The Vanguard Group. Global Market Currents. Second Quarter 2008.
https://advisors.vanguard.com/iwe/pdf/GlbCurrt_2Q08.pdf. Retrieved 11/15/08
14
Steidtmann, Carl: Deloitte Investment Advisors. Economic and Market Review. Second Quarter 2008.
http://www.deloitte.com/dtt/cda/doc/content/dtt_dr_emr2q2008.pdf. Retrieved 11/15/08
10
the de-leveraging process of households. Analysts predict as many as 3% of homeowners could
lose their homes this year.
In May, rebate checks gave disposible income a boost but many surveys indicate that
citizens believe most of that will be absorbed by increasing energy prices. Oil prices soared 38%
over the course of the third quarter.
Financials are down 16.4% and massive write downs have put a need for fast capital but
investors are risk adverse to this failing sector. Rising commodity prices are putting a large
pressure on all places of the economy, even the consumer staples sector that usually fairs well in
economic slowdown. Proctor and Gamble fell 13% on the inability to pass costs off to
consumers. However the S&P 500 earnings per share report shows that the economy still has a
(slower) steady growth.
Third Quarter 2008
Bankruptcies and frozen credit markets caused investors to suffer the most volatile
quarter in history. The S&P 500 posted +/- 1% on over half of the trading days between June and
September. Equity investors fled to the biggest names of the S&P to ensure safety. The top 50
corporations returned 0.44% while the remaining 450 returned -8.40%15.
Global governments and central banks took unprecedented action to try and improve
liquidity and curb skepticism in the security markets. The Troubled Asset Relieve Program
(TARP) was first denied and not passed through the House of Representatives. The Dow
crashed nearly 800 points, and the S&P fell 9% only to recover more than half that value in the
next 24 hours. The TARP gave the US Treasury the right to inject over $700 billion into the
financial services sector. The intent was to create a market for toxic securities and sustain
15
American Century Ivestments. Quarter in Review.
https://institutional.americancentury.com/institutional/pdf/quarterly_reviews/in_market_commentary_3Q08.pdf.
Retrieved 11/20/2008.
11
solvency. As mentioned earlier, the credit crisis started with the Commerical Paper market in
late 2007. At this time, the government agreed to buy Corporate Commercial Paper from main
street businesses, essentially squashing the suggestions that the US government is only helping
the wealthy Wall Street corporations.
The Fed also is now allowing corporations to borrow money from the discount window.
This allows companies to borrow at a significantly lower rate however there are many
regulations that come with the government’s money16. Coinciding with the United States’
‘bailout’ plan, other central banks are creating relief with government intervention. By the end
of the third quarter Central banks worldwide coordinated cuts in target interest rates. These
incentives failed to help the companies (formerly) known as: Fannie Mae, Freddie Mac, Lehman
Brothers, Merrill Lynch, Washington Mutual, and Wachovia. Also AIG accepted government
intervention. On September 14th the US government announced it will not bail about Lehman
Brothers. The bankruptcy of Lehman Brothers caused a large money market fund to ‘break the
buck’ meaning that the net asset value per share was less than $1. The US Treasury then
implemented a program to support money market mutual funds.
US stocks are returning (1-year) -21.1% (-8.6% on the quarter). Lehman Aggregate Bond
Index held at -0.5% for the quarter, and is still in the black at 3.7% 1-year17. This indicates
investors were keeping all instruments in short term cash-like instruments and also keeps bond
yields near zero. The market has made very high-risk spreads and low-to-zero return on risk free
assets.
Institute for Supply Management’s reports manufacturing has shriveled to its lowest level
since 2001 indicating a looming recession. Exports were down from July but are still 15%
16
The Vanguard Group. Global Market Currents: Third Quarter 2008.
https://advisors.vanguard.com/iwe/pdf/GlbCurrt_092008.pdf. Retrieved 11/16/08
17
MSCI US Investable Market 2500 Index. As of September 30, 2008. Retrieved 11/16/08
12
higher than last year.and are no longer saving GDP growth measures from entering into the
negatives.
The dollar value has started to gain on the Euro and the British pound thus decreasing
values of exports so few think a recession is not near. Partially this is due to the exponential loss
in international equity markets, -21.9% for the quarter and -30.3% for the one year return (MSCI
ACWI ex US). In developing countries, there were large losses in the 3rd quarter due to plunging
commodity prices, especially oil which reached its bubble burst, and is well under $70 at this
point, after hitting a peak in July. Gold prices also lost about 20% of its value in the 3rd quarter
after trading above $1,000 an ounce. Some believe the end of September marked the bottom of
the recession and see the election as a ‘fresh beginning’. Although some see many other
corporations being brought down by the credit crisis and without a bouy because they aren’t
eligble to participate in the government bailout plan.
Fourth Quarter 2008
The focus during the start of the fourth quarter was details of the bailout plan. The
deadline for banks to apply for the TARP program was extended to Novemeber 15th for nonpublicly traded instituions18. This could broaden its scope to over 4,000 banks. The government
further indicated that financing arms’ of automakers would not be included in the over $700
18
http://biz.yahoo.com/ap/081031/financial_meltdown.html?.v=23
13
billion plan. However signals of another $100 billion could be allocated to purchase bad assets,
such as auto loans, so they can remove them from their balance sheets.
Volatility was again the theme of October. The best week in 34 years when the Dow rose
144 points on the 31st could not come back from a $2.5 trillion loss for the month of October
(17.7% loss)19. The first days of the month, the Dow lost 2,400 points and there were only 3
days when the change in volume (negative or positive) didn’t reach triple digits.
The bailout package changed in November. The US Treasury will no longer buy toxic
assets from troubled financial institutions. This made investors and citizens uneasy about
effectiveness of government intervention. The market continues to lose faith in the potential to
“turn it all around”. If toxic/unvaluable assets are still on the balance sheet of nearing-bankrupt
companies, how will the $700 bailout plan save them from re-entering the crisis of past months?
As for economic indicators, CPI was down 0.3% for October. This was a good report for
those questioning inflationary pressures, however this can be seen as a negative report for the
status of consumer confidence. The CPI will not rise if the demand for products decreases. Oil
continues to fall irregardless of OPEC’s consensus to cut production. Prices held under
$60/barrel for the first 2 weeks of November. This helps retailers because they are not as quick
to pass the savings on to consumers as they were to raise prices with the bubble in July. Thus
their margin for profit continues to grow. Imports and exports both recorded losses, -4.7, -1.9%
respectively. The dollar has been gaining on the Euro and Yen so the export loss is expected
because international consumers lose purchasing power, however the import decrease was
surprising to most economists. It proves that domestic demand trumpts what should have
happened.
19
Dow Jones Wilshire 5000 Index. October 31, 2008.
14
The corporate landscape continues to flood the market with bad news. Company layoffs,
rising unemployment and drop in retail sales all remind people of economic slowdown.
Consumer staples and discount retailers are the only industry showing postitive earnings, but
even their bottom line is squeezed by higher costs and lower demand. McDonalds sales in the US
was +5.3%, in the EU was +9.8%, and in Asia was+11.5%. AIG is asking for a new life line of
$150 bil which leads investors to doubt the solvency of the company.
Fixed Income Portfolio
I believe we are at the bottom of the financial crisis. I predict things will turn around
within the next 6-9 months in which case interest rates will rise and prices will fall in the fixed
income markets. So I have selected bonds that have a duration shorter than the Lehman
Aggregate Bond Benchmark (currently at 4.39). Your portfolio will have a significantly lower
credit quality than the Lehman Benchmark. Lehman breakdown: 79.2% in AAA rated bonds;
5.4% in AA, 8.2% in A, and 7.2% in BBB. Your portfolio has 11.76% in AAA, 17.65% in AA,
30.88% in BBB, and 39.71% in CCC or junk bonds. This agrees with my predictions that
interest rates will rise in the near furture, thus the lower-quality, high-yields bonds will beat the
benchmark. Current yield on your portfolio equals 6.58% and convexity is over 23. Below is a
chart showing your portfolio to the Lehman Aggregate followed by details about your bond
portfolio:
Lehman
Aggregate
Portfolio of Fixed Income
YTM
Current Yield
Duration
Convexity
15
13.324%
6.008%
3.6398
20.0993
0.020%
0.080%
4.39
n/a
Corporate Bond Analysis 1:
USEC Inc. CCC rating since initial evaluation on 2/26/2007
Commercial power plants use low enrichment uranium to produce fuel to generate
electricity. USEC Inc. is a leading supplier for US plants. One kilogram of uranium can produce
about 20 trillion joules of energy (2×1013 joules); as much energy as 1500 tones of coal.20
Commercial nuclear reactors began using enriched uranium in the 1960s when the U.S.
government transferred some of its capacity from military to civilian use.
In the early 1990s, USEC was created as a government corporation in order to restructure
the government’s uranium enrichment operation and prepare it for sale to the private sector.
USEC went private with an IPO July 28, 1998. USEC Inc.’s subsidiary, United States
Enrichment Corporation, operates the only uranium enrichment facility in the United States.
USEC’s core business is to supply low-enriched uranium or ‘depleted’ uranium. But they also
provide services and transportation of uranium for the global market.
USEC is the U.S. government’s executive agent for the Megatons to Megawatts program;
a 20-year, $8 billion, commercially-funded nuclear nonproliferation initiative of the U.S. and
Russian governments. This unique program is recycling 500 metric tons of weapons-grade
uranium taken from dismantled Russian nuclear warheads (the equivalent of 20,000 warheads)
into low enriched uranium used by USEC’s customers to generate electricity21.
I chose this bond to add to your portfolio because USEC Inc. is forward-thinking,
innovative, and is pioneering the effort into alternative energy. The long-term outlook for the
nuclear industry continues to strengthen as government policy, public acceptance and
environmental concerns about climate change have encouraged utilities to begin the process of
20
21
Emsley, Nature's Building Blocks (2001), page 479. Retrieved 11/18/08
http://www.usec.com/quickfacts.htm
16
building new nuclear reactors in the United States for the first time in four decades. The US
Nuclear Regulatory Commission has indicated that nearly 36 new applications for construction
of nuclear reactors are expected by 201222.
According to financial analysis, USEC has historically had very strong liquidity ratios.
The debt within the Cash Flow Statement is mostly long term so their current ratio is more
similar to that of a AAA company. What appears to be a severe cash flow problem (TIE and
Cash Flow Adequacy ratios) is explained clearly in the company’s annual report. Basic synopsis
is that they have fixed-price contracts for the electric power they purchase (they are one of the
largest industrial consumers of electric power in the US). In 2008 where it appears their cash
flow problems began, the fuel cost adjustment has increased over the base contract price by 13%
through September 3023. They have a very low liabilities-to-asset ratio which secures repayment
if they default. More so most of their assets are short term and thus very liquid. USEC Inc also
does not have a large amount of outstanding debt so I do not foresee repayment as an issue.
The current yield and yield to maturity is significantly higher than what can be achieved
in US treasuries (a common characteristic of low-grade junk bonds). However I feel this is a
safe investment because most of their book of business is with US government subsidiaries:
Department of Energy and Gaseous Diffusion Plants (GDPs). They also do not have any
competition in that they are they only uranium enrichment facility in the United States.
I chose this bond to analyze because it is in an unpopular, under-discovered industry. I
wanted to create a fairly aggressive portfolio so I focused on low coupon bonds with higher
convexity than competitors. I believe interest rates will rise (there is not much room to go down
from 1.00%) so I want to keep the maturity under 7 years.
22
23
USEC Annual Report. http://usec.com/SECfilings. Retrieved 11/19/2008
USEC Quarterly Report. http://biz.yahoo.com/e/081105/usu10-q.html. Retrieved 11/18/08
17
Corporate Bond Analysis-2
Molson Coors (TAP): BBB rating since initial evaluation on 11/16/2007
Molson Coors Brewing Company (MCBC) originated as Adolph Coors Brewing
Company in 1873 and changed its name to Molson Coors in 2005. The company produces and
sells beer and other beverages. Common brand names are Coors, Molson, Blue Moon Belgian
White Ale, Keystone, George Killian’s, Amstel, and Heineken, and others. According to the
company website, MCBC is the fifth largest brewer by volume with 42.1 million barrels sold in
2006, 56% of that sold in the United States.24 Coors Light is its best seller and recorded about
45% of its sales volume.
There are several factors that contributed to my decision to add Molson Coors to your
bond portfolio. First are there very public efforts to reduce costs ($250 million Resources for
Growth initiatives) and strengthen the brand name. Part of this effort was combining synergies
with other developed companies. In 2007 they announce that effective July 1, 2008 Molson
Coors and Miller Brewing will combine the US and Puerto Rico operations. They exceeded their
synergies plan of $175 million and ended the program with over $180 million in savings.
They’ve initiated a Global Strategies Team that focuses on developed market penetration. One
of their main areas of interest is to develop markets in Europe, especially Ireland. In 2007 their
net sales growth was near 6% and refinanced ¼ of their debt reducing non-operating expenses by
over $26 million annually24.
Financial analysis indicates the Molson Coors is a leading competitor in its industry and
posed above-average numbers for liquidity, debt, and ratios. The liquidity ratios are above
averages for the industry and their main competitor however many of their current assets are tied
24
Molson Coors Company Website. http://www.molsoncoors.com/. Retrieved 11/20/08.
18
up in inventory. Their debt ratios are significantly lower than the industry meaning if they were
to go bankrupt you can be assured repayment of principal in the case of liquidation. The
company has reduced their interest expense significantly in 2008 after initiatives to redesign their
capital structure and write off ¼ of their debt, as mentioned earlier. This negatively affects the
cash flow ratios, and is possibly what make this company the lowest of investment grade ratings.
It appears they under-budget for their minimum required cash flows, which sits uneasy with
investors looking for high-grade bonds.
This follows my portfolio strategy of an aggressive fixed income portion. Molson Coors
has a low coupon, high convexity to its peers. I expect interest rates to rise in the near future (69 months) so I want to keep the maturity of the heaviest weights in my bond portfolio less than 7
years.
Additional Bonds
Wal-Mart Corporation: S&P AA rating since 8/29/01, Moody’s Aa2 rating since 3/7/96
Wal-Mart is a discount retailer that operates in different capacities worldwide.
Stores offer general merchandise, grocery merchandise, financial services and products,
pharmaceuticals, gasoline stations, and photo processing services through supercenters, discount
stores and Sam’s Club Stores.
I selected this bond to add to my portfolio to add some stability and hedge to the riskier
bonds I’ve selected. This is considered a safer instrument then the other bonds in your portfolio
(as given by the credit rating). Its higher credit rating means you can expect the yield will be
lower. It also has a lower convexity, and a higher coupon. This is cash flow oriented and
focuses on reinvestment. This is a tactic used when the future is uncertain and the investor wants
shorter time in a fixed payment.
19
Cash
I have liquidated $12,000 worth of t-bills to reallocate and diversify the total portfolio.
The remaining $25,000+ will satisfy my strategy of keeping of 2% of the total portfolio in cash.
This instrument also helps to balance out my aggressive fixed income portfolio. Here is a graph
of the current yield of 3-month t-bills with the pre-existing wealth:
Date
11/19/2008
CF
Capital
Gains
Beginning
Current Savings
Balance
$37,416.05
($12,234.19)
($21,350.58)
Aggregate
Savings
$25,181.86
Yield
0.70%
Ending
Balance
$25,225.92
$3,875.34
($775.07)
Real Estate and Commodities
I chose to allocate 8% of beginning wealth into real estate and 10% into commodities.
That constitutes for $100,727.00 and $125,909 respectively. I chose to put 50% of the real estate
allocation ($50,363) into Cohen and Steers ETF (NYSE: GRI). This investment seeks to
replicate the Cohen & Steers Global Realty Majors index. The fund normally invests at least
90% of total assets in common stocks and other equity securities that comprise the index, which
may include American depositary receipts, American depositary shares, global depositary
receipts and international depositary receipts. The index consists of the largest and most liquid
securities within the global real estate universe25. You already have a large percentage of your
portfolio in international markets, however, I believe that international real estate is a good
investment at this time because the real estate market in the US is essentially frozen with the
credit markets. Investing in international real estate will further diversify. This will be one part
of your portfolio we will closely monitor to re-allocate once we see an opening in global credit
markets. The remainder of the allocation toward real estate will go in a Vanguard REIT Index
25
Cohen and Steers Global Realty ETF. http://finance.yahoo.com/q/rk?s=GRI. Retrieved 11/21/08.
20
Fund Investor Shares. This is a no load fun that aims to track the return of the MSCI® US REIT
Index, a gauge of real estate stocks26. The Vanguard Index slightly outperforms the benchmark
in the 1-month, 1-, 3-, and 5- year returns. The following chart exhibits important information:
Fund Size
$7.2 billion
Minimum Investment
$3,000.00
Total Expenses:
*expense ratio
0.20%
*redemption (if < 1 yr)
1.00%
Beta
1
R2
1
Performance Benchmark
MSCI US REIT Index
Mgmt Tenure
Gerard O'Reilly since 1996
For the commodity portion of your portfolio, I suggest including 33% of the $125,909 in the TR
Price Latin America Fund (PRLAX). The investment seeks long-term capital appreciation. The
fund normally invests at least 80% of assets in Latin American companies27. It invests at least
four countries at any time. I chose this fund because the 5-year average return exceeds 20%.
There is some volatility in developing markets like Latin America. However the rates of return
have began to settle in the past five years and the sharpe ratio is increasing indicating a higher
return for less risk. Below is a chart showing relevant data:
Fund Size
Minimum Investment
Total Expenses:
*expense ratio
*redemption (if < 1 yr)
Beta- 5 year
SD- 5 year
R2- 5 year
Sharpe Ratio
Performance Benchmark
Mgmt Tenure
26
$2.26 billion
$2,500.00
1.20%
1.00%
1.66
30.49
79
0.7
MSCI US REIT Index
Gonzalo Pangaro since
1/31/2004
The Vanguard Group.
https://personal.vanguard.com/us/JSP/Funds/Profile/VGIFundProfile0123Content.jsf?tab=0&FundId=0123&FundI
ntExt=INT#hist::tab=0. Retrieved 11/21/08.
27
Yahoo! Finance. T. Rowe Price Latin America Fund. http://finance.yahoo.com/q/rk?s=PRLAX. Retrieved 11/21/08.
21
The remaining 70% of the commodity allocation, I would suggest putting in the DowJones Commodity Index Total Return (DJP). The investment seeks to link to the Dow JonesAIG Commodity Total Return index and reflects the returns that are potentially available through
an unleveraged investment in the futures contracts on physical commodities comprising the
index plus the rate of interest that could be earned on cash collateral invested in specified
Treasury Bills28. This helps to diversify your commodity exposure and is backed by actual
assets.
Please review this report and notice the propensity for New Ideas Inc. to provide a higher risk
adjusted rate of return than other managers. Of course all asset allocations are subject to
discussion if you feel your risk tolerance has changed or you need further assistance in
understanding the portfolio.
28
Yahoo! Finance. Dow Jones Commodity Index Total Return. http://finance.yahoo.com/q/pr?s=DJP. Retrieved
11/20/2008.
22
Additional Sources
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
Yahoo! Finance. www.finance.yahoo.com. Retrieved: 9/30/2008-11/22/2008
Bank Rate. www.bankrate.com. Retrieved: 10/18/2008-10/28/2008
MSCI/Barra. www.mscibarra.com. Retrieved: 10/20/2008
Vanguard. www.vanguard.com. Retrieved: 10/18/2008- 11/21/08
Federal Reserve Bank of St. Louis. www.frbsl.com. Retrieved: 10/17/2008
Case Shiller.
http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/.
Retrieved: 10/17/2008
Coldwell Banker. www.coldwellbanker.com. Retrieved: 10/22/2008
Securities Industry and Financial Markets Association. http://investinginbonds.com/.
Mergent Bond View.
http://bv.mergent.com.ezproxy.library.drexel.edu/view/scripts/corporate/index.php.
The Vanguard Group.
https://advisors.vanguard.com/VGApp/iip/site/advisor/researchcommentary/commentary/artic
le?File=IWE_NewsMktComm2QTR07. Retrieved 11/15/08
Federal Reserve Bank of San Francisco. http://www.frbsf.org/news/speeches/2007/0221.html.
Retrieved 10/27/2008
Wines, Leslie. Steeper yield curve may signal improving economy. June 20, 2007.
http://www.marketwatch.com/news/story/steeper-yield-curve-stirsdebate/story.aspx?guid={675A092A-6B3C-49E6-8417-7BB2D2CD19B2}. Retrieved 11/19/08
Bloomberg. www.bloomberg.com. Retrieved 11/20/08.
Federal Reserve Bank of San Francisco. http://www.frbsf.org/news/speeches/2007/0221.html.
Retrieved 10/27/2008
http://www.bea.gov/newsreleases/industry/gdpindustry/gdpindnewsrelease.htm. Retrieved
10/27/2008
http://www.bls.gov/cpi/cpid0803.pdf
Steidtmann, Carl: Deloitte Investment Advisors. Economic and Market Review. Second Quarter
2008. http://www.deloitte.com/dtt/cda/doc/content/dtt_dr_emr2q2008.pdf. Retrieved
11/15/08
American Century Ivestments. Quarter in Review.
https://institutional.americancentury.com/institutional/pdf/quarterly_reviews/in_market_com
mentary_3Q08.pdf. Retrieved 11/20/2008.
Emsley, Nature's Building Blocks (2001), page 479. Retrieved 11/18/08
http://www.usec.com/quickfacts.htm
23