Gravitas: Bond Math

October 20, 2023 | Michael Newton


The Newton Group Insights

Some great fixed income commentary appeared this week and I will paraphrase. As investors snap up long-dated Treasurys following a historic rout that has seen the price of some issues cut in half, some traders are using esoteric “bond math” to justify making big contrarian bets. Their reasoning is as follows: at current yields investors theoretically have more to gain from a rally than they have to lose should prices deteriorate further. In a post following a Bloomberg News story from earlier this week, Rich Falk-Wallace, the CEO and founder of Arcana and a former portfolio manager at Citadel, offered an explanation about how the relationship between bond yields and bond prices leads to the prospect of “asymmetric” returns. That is, investors will profit more from a 50-basis point drop in yields than they would lose from a 50-basis point rise. Bond yields move inversely to prices. In a spreadsheet shared with MarketWatch, Falk-Wallace calculated what these theoretical returns might be for a 30-year bond with a 5% coupon. According to his calculations, a 50-basis point decline in the yield on such a Treasury bond would result in a total return of 13%, while the opposite would lead to investors brooking a loss of 2.6%. To be sure, this kind of bond market theory has little bearing on where prices are ultimately headed. Many other factors, including inflation expectations, underlying U.S. economic data, concerns about mounting U.S. debt, and signs that investors are demanding a higher term premium are having a much bigger impact on prices, analysts say. And just because something looks cheap doesn’t mean it can’t get cheaper. Calculating these potential returns relies on two concepts that investors use to quantify and describe the relationship between a bond’s yield and price. This is where things start to get complicated. The first of these concepts is known as duration, which can be described as the change in the price of a bond for every one percentage-point move in the yield. The concept of duration does an accurate enough job at approximating changes in bond prices. But it fails to account for the fact that a bond’s price sensitivity also changes as yields rise and fall. That is where the concept of convexity comes in. It accounts for the fact that distribution of potential returns is curved, not linear, which gives rise to the prospect of asymmetric returns. Falk-Wallace illustrated this concept in the chart below.

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Portfolio Notes

(+) indicates a positive development, (-) indicates negative, and (~) indicates neutral

(SOLD) Solar Stocks

We were very fortunate this week as we sold Sunrun, SolarEdge, and Enphase on Thursday before a big rout in solar stocks. Solar power stocks fell hard in Friday trading following a warning from solar-equipment maker SolarEdge Technologies that demand in Europe has slumped significantly. SolarEdge, Enphase Energy, Sunrun and SunPower, which are solar developers, were all down. Rooftop solar stocks have struggled in recent months. U.S. demand has waned because of high interest rates and less-generous state solar policies. SolarEdge makes a piece of equipment called an inverter that turns direct current from a solar panel into alternating current that can be used in a home. The company cut its guidance for third-quarter revenue to a range of $720 million to $730 million, down from a previous forecast of $880 million to $920 million. Wall Street had been expecting $909 million. The positions were previously owned in the Core ESG+ Portfolio.

(~) Bank of America (BAC-US) topped estimates for third-quarter profit on stronger-than-expected interest income. Earnings per share: 90 cents vs. expected 82 cent estimates. Revenue: $25.32 billion, vs. expected $25.14 billion. Bank of America was supposed to be one of the biggest beneficiaries of higher interest rates this year. Instead, the company’s stock has been the worst performer among its big-bank peers in 2023. That’s because, under CEO Brian Moynihan, the lender piled into low-yielding, long-dated securities during the pandemic. Those securities lost value as interest rates climbed. That’s made Bank of America more sensitive to the recent surge in the 10-year Treasury yield than its peers — and more similar to some regional banks that are also nursing underwater bonds. Bank of America had more than $100 billion in paper losses on bonds at midyear. The situation has pressured the bank’s net interest income, or NII, which is a key metric that analysts will be watching this quarter. Bank of America stock has fallen 18% this year through Monday, trailing the 10% gain of rival JPMorgan Chase. Owned in US Portfolio.

(-) Crown Castle (CCI-US) delivered a slight top and bottom line miss in Q3 driven by revenues which missed consensus expectations. Site rental revenues of $1.58b grew 1% (organic 3.9%), as Tower revenues declined slightly, offset by 4% growth in Fiber/Small Cell. Despite the slight miss to consensus in Q3, management reiterated 2023 financial guidance. Of greater importance, the company also introduced initial 2024 guidance. Management’s expectations for 2024 organic Tower revenue growth of 4.5% excluding Sprint cancellations, 13% from small cells, and 3% from fiber largely fell in-line with consensus and was consistent with management’s recent communications and should give confidence in the long-term top-line growth algorithm. CCI and the overall towers sector have been hit by a deceleration of 5G buildout activity by carriers as well as concerns over rising interest rates. Despite the lackluster near-term growth profile and lack of identifiable catalysts in the near term, we note that the long-term fundamentals of the towers business remain very much in-tact, as towers remain vital infrastructure to enable the continued proliferation of data with favourable long-term growth potential, and benefit from a stable oligopolistic competitive dynamic that enables strong pricing power and attractive economic returns. Additionally, we believe that much of the headwinds and negative sentiment are already captured in the company’s valuation and does not take into consideration the potential for upside should the company’s investments in fiber and small cells come to fruition. Owned in US Portfolio.

(+) Coterra Energy (CTRA-US) has gained about 8% in October, building on the stock’s 6.9% advance in the third quarter as crude oil prices rallied. Coterra’s stock rise was supported by a big jump in natural gas futures early in the month — though some of that move has faded. More generally, sentiment around exploration-and-production companies like Coterra has been boosted by Exxon Mobil’s takeover offer for Pioneer Natural Resources, which some in the marketplace believe could spark additional consolidation in the energy sector. Additionally, the Israel-Hamas war has heightened geopolitical risk in the global oil market, placing some upward pressure on prices. Owned in Opportunity Portfolio.

(-) Intuitive Surgical (ISRG-US) reported a mixed quarter, as the company continues to see pressure on its bariatrics business due to the rise in GLP-1 obesity drugs. This used to be the company's largest source of procedure growth. Bariatric procedures grew double-digits (slightly below 17% y/y) despite the GLP-1 concern, while China trends were inline. ISRG is a global leader in surgical robotics with a well-entrenched ecosystem. ISRG is an established category leader in surgical robotics with a portfolio of diverse platform offerings for multi-port (da Vinci), single port (SP), and endoluminal (ION) surgery. As many as +11MM da Vinci procedures have been performed globally since 2010. The industry has high barriers to entry due to which there has been limited competition to date; and ISRG is on track to launch a new multi-port system along with advancing its diversified platforms with indication and/ or geographic expansion. Owned in Opportunity Portfolio.

(+) Microsoft (MSFT-US) CEO Satya Nadella on Friday shared a letter to the shareholders in which he highlighted LinkedIn’s significant milestone along with shedding light on the company’s performance in gaming, search, security, and its vision for the “new era of AI.” In his letter to shareholders, he said that Microsoft “delivered strong results in fiscal year 2023,” with record revenue of $211 billion and over $88 billion in operating income. He also revealed that LinkedIn surpassed $15 billion in revenue for the first time this fiscal year. The Microsoft CEO outlined the company’s vision for a “new era of AI,” saying he believes that AI, with natural language as its universal interface and a powerful reasoning engine, will reshape every software category and business across the globe. There are two breakthroughs coming together to define this new era of AI. The first is the most universal interface: natural language. The second is the emergence of a powerful new reasoning engine. He mentioned that more than 1 million organizations now count on their comprehensive, AI-powered solutions to protect their digital estates, and the security business surpassed $20 billion in annual revenue. He said that Microsoft’s Xbox Game Pass has been changing how games are shared, played, and watched, and the purchase of Activision Blizzard is going to make the tech giant an even bigger player in the gaming world. Owned in Core, Cash Flow, US and Core ESG+ Portfolios.

(+) Shopify (SHOP-T) RBCCM has reviewed data from several third-party sources and has concluded that there has been a strong uptake of Shopify Plus, Pay and POS. More specifically, websites using Shopify Plus are up +37% Q/Q (following +54% Q/Q last quarter), Shop Pay websites (payment adoption) increased +21% Y/Y (up from +18% last quarter), and monthly active users of Shopify POS are up 63% Y/Y (an increase from 46% Y/Y last quarter). The takeaway from this is that Shopify is seeing strong new merchant adoption of its product offerings, and the plan to up-sell existing merchants has been working. This also comes after Shopify raised its prices of the Core plan up 34% on average, with total merchant growth still tracking in-line with previous trends. This all leads to RBCCM having increased confidence that in Q3 Shopify will meet or exceed RBCCM’ outlook for monthly recurring revenue, an important figure to watch. All in all, despite a difficult consumer and softening macro trends, Shopify continues to see robust traction with its merchants, commitments to new services, and improved profitability. SHOP currently trades at 9x FTM EV/Sales (below pre-COVID average). Owned in Core Portfolio.

(new) SolarBank (SUNN-T) The stock of renewable and clean energy project developer and asset operator is up more than 300% since it began trading on March 2nd, 2023. SolarBank develops and operates solar photovoltaic power generation projects in Ontario, Maryland, and New York state. It has more than 100 solar power plants under management and a development pipeline of more than 700MWp of potential solar projects. SolarBank is shifting its business model from a "develop to sell" strategy toward the ownership of renewable projects as an independent power producer. From March 14th to September 27th, four SolarBank insiders bought a total of 82,213 common shares on a direct ownership basis at an average price of $4.62. New position in Core ESG+ Portfolio.

(-) Tesla (TSLA-US) The electric vehicle maker’s shares tumbled this week after the company missed earnings and revenue expectations for the third quarter. Several Wall Street analysts lowered their price targets on the company following the disappointing results, citing more margins pressure likely ahead. Tesla has cut prices several times in recent months to help drive sales volume as interest rates rose, the economy slowed, and EV competition heated up. So far this year, volumes have jumped about 45% from last year, but the average price fell about $10,000 to about $44,000. Owned in Core ESG+ Portfolio.

(+) Taiwan Semiconductor (TSMC-US) reported a third-quarter revenue decline of 14.6% year-on-year to $17.28 billion, beating the consensus of $17.07 billion. EPS of $1.29 beat the consensus of $1.17. TSMC looks to spend $32 billion on growing and upgrading capacity in 2023, the lower end of a previously projected range but beating the analyst consensus of $30.5 billion. CEO C. C. Wei acknowledged seeing early signs of demand stabilization in the PC and smartphone markets, the most significant segments for TSMC's business, during the conference call. He expects healthy growth in 2024, Bloomberg reports. In the long term, TSMC is spending heavily on global chip plants. The company's $40 billion Arizona site was on track to start production in 2025's first half, while a Japanese plant is likely to begin mass output in late 2024. Owned in Opportunity Portfolio.

Weekend Reading

Bonds have proven to been a very bad hedge against inflation, says Wharton's Jeremy Siegel Jeremy Siegel, professor emeritus of finance at University of Pennsylvania’s Wharton School of Business, joins 'Squawk Box' to discuss the latest market trends, why he believes equities are poised for a year-end rally. YOUTUBE

Google’s AI Is Making Traffic Lights More Efficient and Less Annoying Google is analyzing data from its Maps app to suggest how cities can adjust traffic light timing to cut wait times and emissions. The company says it’s already cutting stops for millions of drivers. WIRED

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Henry George and Land Value Tax Land Value Tax is a compelling and relatively unknown economic philosophy related to land taxation. Henry George popularized it in the late 1800s and fans of his work are known as Georgists. OSBON CAPITAL

The Techno-Optimist Manifesto by Marc Andreessen We believe in the words of David Deutsch: “We have a duty to be optimistic. Because the future is open, not predetermined and therefore cannot just be accepted: we are all responsible for what it holds. Thus, it is our duty to fight for a better world.” a16z

The Roman Empire Fallacy The unbearable pain of seeing too far into the future. ALCHEMY

Larry Fink: Be optimistic on transformational technology Larry Fink is the CEO of Blackrock, one of the largest asset management companies in the world with over $10 trillion in assets. It was very interesting to see him also refer to the rally in Bitcoin as a flight to quality and compared it to treasuries and gold. YOUTUBE

Millennium Bridge workers hang straw bales after ancient bylaw triggered Repairs to footbridge mean straw must be dangled to warn oncoming shipping of work going on beneath. THE GUARDIAN



“People worry about the riskiness of stocks, but bonds can be just as risky.”

- Peter Lynch.