The transcript from this week’s MIB: Luis Maizel on EM Bonds is below.
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ANNOUNCER: This is Masters in Business with Barry Ritholtz on Bloomberg Radio.
RITHOLTZ: This week on the podcast, I have a special guest. His name is Luis Maizel and if you are at all interested in a couple of areas of asset management and allocation, you are going to find this to be really quite intriguing. He set up a firm 30 years ago to make emerging market fixed income investments, and LM Capital Group has been doing that for the past three decades.
They basically do their own due diligence, they check out all of the various bonds that they buy on behalf of clients, not relying on the traditional rating agencies and they’re essentially 99 percent owned by their employees. It’s a very interesting shop and Luis does a wonderful job explaining why emerging market debt has really become an asset class into itself given how soft actual yields are and that half of the sovereign wealth at these days, over $9 trillion, is actually holding a negative yield.
He thinks EM debt is going to be a not only a distinct asset class but it’s going to attract a lot of capital over the next decade and he’s very bullish.
So with no further ado, here’s my conversation with LM Capital Groups’ Luis Maizel.
My special guest this week is Luis Maizel, he is the cofounder and senior managing director at LM Capital Group, an emerging market fixed-income shop managing over $4.2 billion in assets, the firm was founded in 1989 and is privately held, it is 99 percent employee owned and provides a fixed income active management approach with a global macro overlay.
Luis Maizel, welcome to Bloomberg.
LUIS MAIZEL, COFOUNDER AND SENIOR MANAGING DIRECTOR, LM CAPITAL GROUP: Thank you very much, Barry.
RITHOLTZ: So you launched this firm in 1989, you’re pretty much in the middle of a giant bull market, what made you decide to go into bonds instead of stocks?
MAIZEL: I started a second firm, Barry, actually a first firm, LM Advisors which was managing money for high net worth individuals, 1984, July 18th of ’84, the US eliminates the 30 percent withholding, up to then, foreign nationals could only invest tax free in T-bills or in bank CDs. All of a sudden, they opened up the market, a lot of US brokers fly out to Mexico City and tried to grab some of that money. And my friend started to call me saying you’re in the states, we know you, why don’t you help us serve through this new market?
So we did. For five years, we were managing high net worth individuals but they were being managed like venture plans because they were mostly tax exempt, and from there we jumped into the institutional market.
RITHOLTZ: So that was 1989, but you bring a very different perspective to the management of the assets, how did growing up outside of the United States shaped your view of the world be it developed or emerging markets?
MAIZEL: Think of it as planets. People in the US think that they’re sitting in the sun, the US is the center of the universe, for us foreigners we see the US as the biggest planet but it’s part of the system so it’s very interesting to see the impact of the US on the other planets but it’s not the center of the universe, it is just the biggest planet in the universe.
RITHOLTZ: And now we have China becoming another very large planet, how is that going to impact the way the US is perceived?
MAIZEL: I think the US is still by far the most important country in the world, the Chinese just because of the sheer size of population, over four times bigger than the US would be very big but in the income per capita, they’re still very small compared to the US, and the model of growth which was export to the US makes them smaller when you are gearing to become the big when you’re far away from it.
RITHOLTZ: Quite interesting. So academic studies have shown that passive management of stocks has a tendency to outperform active over long periods of time, but the opposite seems to be true in the fixed-income department, active fixed income strategies outperform passive, why is that?
MAIZEL: Well you have a choice on what bonds you buy. The bond market basically is like a landmine, if you don’t step on a min, you’re going to do okay and the move along the yield curve will allow you to react faster to what’s happening in the economy.
The passive — the index does not take into account the macro impact that’s happening in the bond market.
RITHOLTZ: So how do you go about creating a macro overlay for fixed income investing?
MAIZEL: That has always been our approach, Barry. We analyze — for us, money is a commodity, when it is scarce, it’s expensive, when it’s plentiful, it’s cheap, so we analyze, we developed a matrix in a going from a qualitative process to a quantitative way of processing is not easy, if you put three economists in a room, they are going to come out with four different theories, probably all of them wrong, so what we try to do is doing our macroanalysis starting the growth of the countries, growing, understanding the inflation, the economic indicators, we assign a value to each of them, we created a matrix which gives us a point count and we got the trend score which allows us then to going to the benchmark we are using which the client is requesting this to use and the trend score would give us how long or short the benchmark do we want to be.
RITHOLTZ: So when you say trends, I tend to think of equity trends where a market or stock is trending either higher for a long period of time or trending lower for a long period of time, do you have the same meaning of the word trends in fixed income or does it have a slightly different meaning.
MAIZEL: I think it is pretty similar but what you’re trying to understand is the current and future needs of money. If a country is growing very fast, you know there’s going to be competition for money, if the deficit of the country is big, you know that the government is going to place bonds and is going to siphon out money from the economy, if unemployment is very high ,then you know that there’s not going to be a lot of need, there’s not going to be brick-and-mortar investment, so money will be plentiful and rates are going to come down.
So there is a trend of what’s happened in the past 12 months that will impact probably what will happen in the six or 12.
RITHOLTZ: So when we look at the great bull market in bonds in the US from the days of Paul Volcker breaking the back of inflation in the late 70s early 80s, we’ve enjoyed a – I don’t know, let’s call it 33, 35 year bull market in bonds, is that still in effect?
And second, how does that bull market in bonds in the US affect the rest of the world?
MAIZEL: We were in a secular trend towards lower rates, there was an enormous addition of liquidity into the system coming not only from the states but from all central banks, the European Union was placing an enormous amount of money in the system, so was the Bank of Japan, so was China. A couple years ago, we saw the reversal in the trend, the announcement of the reversal of the easing, the quantitative easing, and the announcement by the Fed that they were going to start raising rates created a mentality that we had he have hit bottom and we were starting to trend upwards.
But now, we have seen that stopped, I think that the issue of an upcoming recession, I don’t believe it’s going, it’s a little bit like the wolf you know everybody keeps crying the wolf is coming, we’re not accustomed to a long period without a recession but ever since globalization started in the world, the whole theory changed, the formula of the past is no longer applicable.
RITHOLTZ: So would you say tales of the death of the bond bull market have been greatly exaggerated?
MAIZEL: I think that we’re going to stay with low interest rates especially we have big deficits, if we have an easing fed, I think we can go on for several more years without a major increase in rates.
RITHOLTZ: Wow, quite fascinating. Let’s go back to 1989, you have this big set of tax changes, how much of a game changer was that for launching a fixed-income farm?
MAIZEL: Actually, the game changer for LM Capital was the growth of pension plans wanting minority money managers, you know, the change in …
RITHOLTZ: In the 1980s, that became a stronger issue.
MAIZEL: Exactly. Maxine Waters was at that time, already, you know, pushing for it, she’s still in Congress and she is still doing the same, the changing laws game for the high net worth individuals for foreigners not for pension plans but there was these big push for hiring minority money managers, actually they were carving out small pieces from the big allocations, from the big RFPs, the big funds always have been very biased towards using the PIMCOs and WAMCOs of the world…
MAIZEL: Black Rocks, but there was a desire to use African-American, Asian and Hispanic companies, so we saw an opportunity there being a Hispanic firm to pick up some of that money so that’s where we started, nowadays, it’s emerging managers, it’s no longer minority, there was a court case that stopped the use of minority, that it is discriminatory, and by now, we’re a little bit too big to be considered emerging so we have the compete on performance.
RITHOLTZ: So – well, that’s not the worst thing in the world, so when you say RFPs by big institutions your clients and potential clients are these giant funds, they put out a request for proposal and you respond with a proposal and that’s the basis of either winning the business or not, is that a fair way to describe it?
MAIZEL: That’s correct, they would get probably 30 to 40 responses, they would pick up five or six finalist and then they visit you and then they pick up three or four that present to the boards and then the board decides who gets the money.
RITHOLTZ: So what are those beauty contests as they have been called, what are they like when a firm comes in and starts kicking the tires and looking around your shop, what’s that experience like?
MAIZEL: It’s an interesting experience because you have the numbers to show for performance but they want to understand the process, they want to understand the people they want to make sure you have the back office to support it, compliance has become so important, the most interesting part for me has been that almost all the teams look identical, three men, one woman, everybody is 6’1″ weighs 203 pounds, wears Brooks Brothers suits. And in our case, we’re different, first my accent doesn’t — well it helps, I don’t think it hinders anything but I’m not the typical presenter that they normally have and I tend to joke with the boards and try to be more casual. Probably when you are a smaller firm and you own the firm, you feel that you don’t have to explain to anybody why you made it or you didn’t make the cut or did you win the business or not.
So I like to enjoy this competition, I like to — I enjoy do to be fighting against the big boys and hopefully sometimes winning.
RITHOLTZ: So is that an advantage to be relaxed and casual and informal and joke around with these people who are used to much more formal stiff, the group that you describe, sounds like they are all manufactured in the same factory and maybe that factory is Wharton or Harvard Business School but the fact that they all look so similar and speak so similarly, does this give you a tactical advantage when you’re presenting?
MAIZEL: I think that in many cases it does, in others they expect to have that and they want that traditional presenter, I’m also a product of the same school you know …
RITHOLTZ: You went to Harvard Business School, right?
MAIZEL: So then, my partner in the business went to Annapolis so you have the square American 6’1′ blah blah and you have this crazy Mexican coming in and joking with the board. So I think the combination makes them laugh and it makes you — it makes you different in their eyes and they remember you more.
RITHOLTZ: Memorable, right.
So I have a friend who is at PIMCO and he always — he is now retired but used to complain that he doesn’t have time to do anything or go to conferences or what have you because they are so busy managing a trillion dollars in fixed income and I used to bust his chops by saying, yes, but it’s not stocks, it’s bond, that’s — that stuff practically manages itself which is a joke in the middle of a giant bonds bull market, but the little tiny bit of truth and that is how much was it like shooting fish in a barrel during the fat part of that bull market? You had rates coming down from what 15 percent down to practically zero how challenging was it operating during that giant long-term trend?
MAIZEL: There are two problems managing fixed-income, one is making sure you don’t step one of mine as I said before, that you don’t buy a WorldCom Bond, or an Enron bond, or a Pacific Gas & Electric bond, on the other side you have the matter of liquidity insights, it’s not easy to be a PIMCO when you have — when you decide to move and you have to sell 500 million or $1 billion worth of a bond, you have to find another piece another buyer of the other side, it takes two to tango, and for them to find the counterparty is very hard.
For a firm like ours that we move with $10 million $20 million, you can always find the other side in a transaction and after the crisis in ’09 they allocated much less capital to the desks so they don’t have inventory, so when you want to do a transaction, you have to go out and beat it in the market and it’s very hard to find a big chunk of the same product if you want to be — have commonality in your portfolio.
RITHOLTZ: If you’re a buyer, what about if you’re a seller.
RITHOLTZ: Like my assumption is, if I have a ton of bonds to sell, I pick up the phone, I call Blackrock and they buy whatever is out there.
MAIZEL: They will not, the thing is they don’t want to allocate money to bonds, they don’t want to park money in bonds so they will only do the transaction if they want them at that precise moment and the broker-dealers will only do them if they find the buyer immediately, if not, they will just tell you there is no market for your bonds right now and I will keep you in mind and that might take three days or three weeks.
RITHOLTZ: So there’s a little bit of an illusion of liquidity in bonds when it is actually harder to sell them than we tend to think. If I go to sell a stock, there is a bid and an ask, I can see the spread, I know other than giant sized, I can move pretty much any stock in my portfolio. But if I have a very specific bond from a specific whether it’s a corporate or a sovereign or state and local bonds you’re saying it’s not quite as easy to hit that bid as it is with the stock.
MAIZEL: You are absolutely right, I mean that’s why there no time in sales in bonds, you never see — in the stocks you can say I put in my order at 11:14 in the morning, give me all the transactions between 11:14 and 11:15 and your order has to be there.
RITHOLTZ: No timestamp in bonds.
MAIZEL: No time stamp in bonds. You know it might be three days or three minutes later when the transaction is done and you want to have basically the same price if you are selling or buying for different clients, so you cannot buy little pieces and add it up because it becomes very complicated to allocate in the right way the different transactions.
RITHOLTZ: Quite interesting. So let’s talk a little bit about that lack of liquidity, I’m intrigued by your description of the bond market, is this something that’s relatively new? Was there always this much lack of liquidity? How has the market changed over the past 30 years since you launched LM Capital?
MAIZEL: I think that up to 2009, the market was pretty stable and there was enough money in the different broker-dealers to make a market, you know, they would buy the bond and keep it there and wait for somebody to come up …
RITHOLTZ: Meaning hold it in inventory and then when a buyer comes along, they would …
RITHOLTZ: Not so much anymore.
MAIZEL: It’s gone.
MAIZEL: You know, probably went from — Merrill Lynch went from $8 billion or $10 billion to maybe a couple hundred million.
RITHOLTZ: Is that a risk management tool or they still suffering a little posttraumatic stress disorder after the crisis? Is this smart of them or is this problematic by them?
MAIZEL: I think that they are being smarter in the way they allocate their capital, I think that the spreads in bonds are not that high for them to make sense to keep them in inventory and there being much tighter with the way they handle their money.
RITHOLTZ: Very interesting. What about the rise of ETFs which are clearly not just stocks, they’re a giant bond ETFs, how is that affecting both the way you run LM Capital and the way liquidity for specific bonds behaves in the market?
MAIZEL: I think ETFs are not the right way to play the bond market, I think that they are very big but I don’t think they impact the market that much, the problem is when it becomes a herd mentality, if everybody is selling, you magnify the problem, again, when there’s a trend to get out of the bonds you need you don’t find the buyers when there’s a trend to buy the bonds, it is hard to find the sellers. So the ETFs magnify the problem instead of making it less problematic.
RITHOLTZ: So I have a couple of questions on that, that’s really, really intriguing. So first when there’s that herd mentality like we saw in ’08, ’09, isn’t everything being sold regardless when the herd stampedes, everything seems to get run over, is that any different for bonds, stocks or ETFs…
MAIZEL: No, it works the same way but you don’t have the dramatic crashes they do selling stocks, the bargain hunters are probably not going to jump in because a bond dropped two or three-points…
MAIZEL: Two or three points is huge in bonds, in stocks, you can see moves of 10 or 20 percent.
RITHOLTZ: Right, Two to three points is a Tuesday, nothing …
RITHOLTZ: Here’s the question that popped into my head knowing that there’s no guarantee of liquidity in the future, how does that affect your process for selecting what bonds you want to put into your portfolio? You obviously have an awareness hey when the time comes there may not be the liquidity I’m hoping for if I have to move these in a emergency.
MAIZEL: That’s a very good question, Barry. What we try to do is by global issues, very big issues that a lot of people hold in their portfolios, you know, at one-time you would find a good issue of 100 or a couple hundred million dollars we go for the billion-dollar issues at least, we want the names that people want to hold in their portfolio, there are some managers that try to create alpha from buying smaller issues because the issuer is forced to pay a bit more because of the smaller size of the issue. We don’t like that, we want to have the ability to get out whenever we want.
RITHOLTZ: So the liquidity premium isn’t worth the risk to you?
MAIZEL: It’s not.
RITHOLTZ: Quite interesting.
So I’ve had this little personal theory for the past couple years that part of the reason yields are as low as they are is that there’s a shortage of quality sovereign bonds, we have been running the usual annual deficits over the past 10 years although clearly they started to tick up post crisis and most recently, and that there’s so much capital around and such a demand for quality fixed income that it gets hoovered up by all the buyers and that helps to keep a lid on rates.
Am I remotely accurate or is that a crock-pot theory?
MAIZEL: You are accurate even though deficits have not been shrinking, on the contrary, they have been growing bigger, over half of the sovereign bonds now have negative yields, $9.7 trillion mostly European bonds are negative.
RITHOLTZ: And we see Japan frequently dips into, so by negative yield you mean here under I’m going to give you a pile of money and I — you are going to give me most of it back but not all of it because the yield is actually not positive.
MAIZEL: I’m going to pay you to hold my money which makes no sense, at one time many years ago the only country that had these was Switzerland that showed that they wanted to sell the concept of safety and they said this is like a vault, money that comes in here is totally protected, so I’m going to charge you for the use of my vault, nowadays it’s Germany, it’s Japan, it’s Northern Europe, it’s $9.7 trillion so the only play there if you’re an investor is hoping that the currency because you are investing in the local currency, it’s mostly euros or yens.
Your hope is that the euro gains against the dollar or the yen gains against the dollar, but there are much better ways to play currencies than to buy bonds, to invest $1 million in bonds hoping for an increase in the value of the currency, you can do a fraction of that investment into futures and you are in the same game.
RITHOLTZ: So with far less risk.
MAIZEL: Absolutely. Another interesting situation is the LDI, the long-duration management of pension plans, they are buying bonds with the maturity that matches their liabilities but with bonds that are not growing in value, it’s incredibly expensive to match, I mean because they’re not growing, so you are going to pay $1 million a year 30 years from now or 1 million euros, you have to buy 1,030,000 euros in order to have a million back.
So it’s very hard to manage money against — with LDI when you have negative yields
RITHOLTZ: Quite fascinating, so your firm uses something called scenario planning to mitigate against global event risk, explain what that is and how can you actually reduce risk about events overseas?
MAIZEL: We think of all the weird things that could happen, Barry.
RITHOLTZ: All the weird things that could happen.
MAIZEL: I mean we have a scenario hopefully it would never happen but for another 9/11, we have a scenario for the bankruptcy of a money center bank, we have a scenario for oil going down to 20 or over 100, we have a scenario of North Korea throwing the bomb and we tried to play through what our reaction would be to that event so we’re not caught by surprise if god forbid, they happen. So we know that if X or Y happens, we’re going to be selling or buying the bonds whether we’re going to be shortening or lengthening our duration and we play scenarios almost I mean formally once a quarter, informally it can be any day, you are driving in and you hear the news in the radio and you say well that might cause a change in the environment, what would we do?
So we go into the conference room, everybody participates, we use the blackboard and we try to develop a response to the event.
RITHOLTZ: So you mentioned, that’s really quite interesting, so you mentioned the 9 plus trillion dollars in negative yielding sovereign debt, given those liabilities that pension funds and really just retirement accounts are going to have, where can people go to find yields without adding leverage or adding a whole lot of risk to their portfolios?
MAIZEL: That is something that’s keeping a lot of people awake at night, pension plans have a fiduciary responsibility that grows at about 8 percent per year and they’re not getting those returns from their portfolios, they need to have fixed-income it’s like the retaining wall in the portfolio and the source of liquidity if needed, but if that fixed-income is yielding say they have 20 percent in fixed income, if the yield there is two or 2 1/2 percent, the other 80 would have to generate 10 percent in order to make up what they’re not making in fixed income.
So they’re going more and more to private equity, to venture capital, areas that are definitely much riskier and we can see what happened in ’09 that the drop in value of individual accounts or pension plans was dramatic. They are looking for alternatives in fixed-income, for example bank loans which in reality just high-yield with the floating rate, they’re doing more and more high-yield and moving down in the rating to the Cs (ph) which again is very dangerous or in new asset classes, it becomes much more interesting which is emerging market debt.
And one-time the sovereign bonds in the emerging countries, countries like Mexico, Colombia, Brazil, China, South Korea, we’re paying 300 to 400 basis more than the comparable risks in the US…
RITHOLTZ: But down though, hasn’t it?
MAIZEL: It has come down a lot but you can still find very, very good corporate names in the emerging world, both in local currency and dollar-denominated that can give you a very sizable pickup and allow your fixed-income portfolio to be closer to your needs in terms of growth than what you get from the traditional US-based core fixed.
RITHOLTZ: So if I’m a US investor and I’m not happy with 2 1/2 percent yield on traditional treasuries, how much additional risk am I assuming going to either emerging market bonds on a sovereign basis or EM bonds on a corporate basis to pick up another 200 basis points, is that a fair amount?
MAIZEL: At least, to be honest, if you ask me, I don’t think you are picking any additional risk, I think that if you buy a company that’s solid investment grade in their own country and that generates let’s say you bought dollar-denominated bonds and they generate the dollars to pay you back both interest and principal, so they don’t have to buy them in a tough time when the currency could have devalued, you are taking no additional risk.
Let me give an example, BIMBO, the Mexican bread company, almost 65 percent of their sales are abroad, they are the largest producer in 14 countries and are present in about 55 countries where they sell bread. I’s a staple it’s a company that’s been in the market for 100 years they are AA plus in Mexico, their paper is yielding almost 5 percent.
MAIZEL: That if I took away the name and showed to the financials, you would say this is a AA company in the US and it would be paying maybe 310, 320, so you’re picking up 200+ over against a gray paper in the US and almost 300 over against the US equivalent from a treasury bond, so you really are gaining a lot in a company that basically has no risk.
RITHOLTZ: So how much of this is just a home country bias? If you live in the US, you tend to buy US stocks and bonds, if you live in Germany, you tend to buy German stocks and bonds and the same is true in Australia or wherever, how significant is that to that giant gap between domestic and emerging-market yields?
MAIZEL: That pride of national product used to be very prevalent, it’s no longer there, the markets have become so global that buyers in Singapore or Berlin or in New York are buying from everywhere.
RITHOLTZ: So what accounts for that 200, 250 basis point difference in yield?
MAIZEL: If the perception of things that happened in the late 90s in the beginning of the 2000s where one country got in trouble and all the other countries got in trouble, it has to have more work done to understand what you are buying.
In the US and even attributed to the rating agencies in the US has dropped a lot after 09 but here you see an A rated bond, and you don’t get too much into analyzing whether they would pay you back or not, you believe if Standard & Poor’s and Moody’s said it’s going to take it for granted …
RITHOLTZ: I’m assuming or I’m guessing that you don’t put a lot of stock in with the credit rating agencies, say you guys do your own due diligence in all of these?
MAIZEL: Absolutely and remember that emerging and just taking back into credit in emerging countries 80 percent of the companies are still run by the founding family that took them public in order to create liquidity and for estate purposes.
RITHOLTZ: Go back a second, I want to make sure I caught that statistic right, in emerging-market nations, 80 percent of the businesses or of the publicly traded businesses?
MAIZEL: Of the publicly traded businesses.
RITHOLTZ: Are still run by the founding family.
RITHOLTZ: That’s amazing.
MAIZEL: It’s incredible there was a radio company that went public here in YSC (ph) and governance I mean the 11 board members last name was Aguirre (ph), it was all brothers nephews and nieces and the New York Stock Exchange did not like it, they say you know this is not good, ESG wise (ph) it’s horrible governance when the whole families and the board does not work.
RITHOLTZ: But that’s pretty typical you are saying.
MAIZEL: It is so what you have to understand besides the financials is who those families are so you need to do social analysis, you have to understand whether you’re funding a new plant or you are funding a new G5 that …
MAIZEL: You know …
RITHOLTZ: A new Gulfstream versus a new bread making plant.
MAIZEL: Exactly, you want to understand that they are investing your money into something that would be productive and create more wealth for the shareholders or the bondholders and that’s something that would bring more satisfaction to the founding family.
RITHOLTZ: That is really fascinating, I had no idea, I’m learning a lot today.
So I think people have changed the way they view and think about debt over the past 30 years, how do you see that — well first of all, do you agree, do you see the perception of debt having changed in society and how does that affect building a bond portfolio?
MAIZEL: At some time, debt was seen as a bad thing.
RITHOLTZ: I bet, and now some of that’s a little bit of a holdover from the Great Depression generation who never want to risk having a bank call something away from them.
MAIZEL: Exactly, having debt meant that you were at risk, nowadays, debt makes sense for corporations, they don’t dilute their shareholders, their EPS are higher and management is basically paid by — their bonuses are based on the value of their stock, so if you can borrow cheaply and buy back stock or do things without selling more equity, the performance of your equity would probably be better, so it’s become a tool of growth without dilution.
And I saw once it the CFO of Merck being interviewed and he said — they asked him why did he borrow $2 billion when he had in cash almost $11 billion, and he said you know at 230 for a three year paper, I could and being a tax-deductible, I could not sleep if I didn’t take out that money.
RITHOLTZ: So in other words the way the tax laws a set up around debt versus equity the corporate management is incentivized to borrow versus using cap.
MAIZEL: Exactly, I mean it makes a lot of sense to borrow and then buy back stock dividends are not tax-deductible, companies were borrowing or are borrowing below what they are paying in dividends so if they retire that stock, then they’re making money in the spread.
RITHOLTZ: That is quite fascinating.
Can you stick around a little bit? I have some more questions for you.
RITHOLTZ: We have been speaking with Luis Maizel of LM Capital Group.
If you enjoyed this conversation, well be sure and come back for the podcast extras where we keep the tape rolling and continue discussing all things fixed income and emerging-market related. You can find that wherever finer podcasts are sold, Apple iTunes, Bloomberg.com, Stitcher, Overcast et cetera.
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Welcome to the podcast. Luis, thank you so much for doing this, this is really an interesting conversation, I sometimes will chat with people — who do have on the show this week? Oh, I have Luis Maizel, he’s a you know, emerging-market bond manager, and I will get that yawn back from them and it’s like well tell me when you have somebody interesting on, but this is really fascinating stuff, there is so much more to emerging-market bond analysis and I think the average stock jockey really appreciates and you are expressing it in a way that I find it intriguing.
There are a few questions I did not get to during the broadcast portion that I have to run through, let me let me run through those before we get to our favorite questions.
I’ve heard over the years that bond investors are the smart money, that’s where the bond vigilantes come from, why is that? Why is bond investing considered “the smart money”?
MAIZEL: I would say smart money, it is the safe money, it should be the safe money, nowadays with leverage and with what’s happening in the markets, you need to have a portion of your portfolio ready for events that might alter the value of the whole portfolio.
I mean you have situations like the unicorns that the more money they lose, the more valuable they are.
RITHOLTZ: That’s literally true, there was a column and in Bloomberg that all of all the past 18 months of IPOs the worse the financials were the better the first day IPO pop was.
MAIZEL: What you need to see it is that bonds have much more meat in them it’s less hope and it’s more reality, so when you say smart money, it means people have to analyze that you are lending to somebody there would pay you back, I mean let’s take Lyft for example, we don’t know what’s going to happen with Lyft five years from now, I would not buy a bond from Lyft at five year paper because – as I didn’t buy a Tesla bond. B
You know, if I buy a Tesla stock, I’m betting that electric cars or self driving cars are going to do very well, their bonds did very poorly you know, they came at par, they’re now trading at 88 cents on the dollar so it’s a situation where leverage is dangerous when you’re not making any money. Bond analysis requires much more substance than stock analysis.
RITHOLTZ: So what about risk mitigation, what sort of tools you use to control the risk you have?
MAIZEL: Well we stress the portfolio based on if rates move up 100 bps 200 bps, we do it in either direction, we try not to concentrate the one industry, we personally impose some restrictions to our portfolio, we don’t do casualty insurance for example.
RITHOLTZ: Why not?
MAIZEL: We don’t want to read about a tsunami and all of a sudden, it turned out that the bonds of the company we hold were ensuring every single house that was destroyed by the tsunami.
RITHOLTZ: So that’s pretty much just a straightforward geographical diversification approach?
MAIZEL: We don’t do newly deregulated industries that saved us from Enron from WorldCom, we never did the airlines for example.
RITHOLTZ: Wait, back up a sec, newly deregulated industries are a higher risk bonds than is widely perceived?
MAIZEL: Management, let to give an example Pacific Gas & Electric or the Pacific companies, they were running a utility they were selling power and all of a sudden they were deregulated they went out and bought the Thrifty Chain of drugstores.
RITHOLTZ: Wait, so when was PG&E and California utilities deregulated?
MAIZEL: In the 90s and they found out that selling Crest toothpaste was not the same as selling power, two years later, they sold the company at a loss of $1.5 billion and had their bonds downgraded because of it. If a manager was running an airline and he had specific routes he could not move from them, all of a sudden he’s competing with Joe and his brother who bought three planes and are doing the small series, it became very dangerous to compete in that market, we saw every major airline go to bankruptcy.
Communications you had the big Ma Bell, you knew the big Ma Bell was the safest company in the world.
RITHOLTZ: Right we don’t orphan stock.
MAIZEL: When they broke them up, you know, they ended up, I mean the WorldComs came up in the world and WorldCom ended up going broke, so it’s another one of the areas we don’t do.
And the third one is nuclear power and it’s not for environmental reasons, if some idiot forgot to close a valve, the plant might end up in a different state.
MAIZEL: As WUPS (ph), the Washington state utility had a major problem with the nuclear plant, 3 Mile Island is another example, we don’t want to take the risk of an error creating a situation where our bonds would dramatically change in rate.
RITHOLTZ: So if I were to go around the country and look at the utilities that have nuclear power plants on their books, their bonds are to be trading at a discount to nonnuclear utilities or is this just specific to your shop?
MAIZEL: That is specific to LM.
RITHOLTZ: Does anybody else do that?
MAIZEL: I don’t know, but for us that risk mitigation is very important and then we overlay our scenario planning, so we try to avoid anything that we would have to get out very quickly if something happened, I don’t think you are paid enough to take a little bit of an additional risk, if you were paying me another 300 bps, I mean 3 percent more in interest to take additional risk, I would consider it, if you pay me five bps .0 5 of a percent more, it’s not worth it.
RITHOLTZ: Now worth it.
So you had mentioned the rating agencies, clearly they did a terrible job during the financial crisis, we later learned that their whole business model had shifted from the bond buyers paying their fees to the issuers paying their fees and it became a payola pay for play sort of situation, and if I walk into one of them– if I walk into S&P and they don’t give me the AA rating I want, I’ll just say no thanks and I’ll go across the street to Moody’s and I will be able to purchase whatever rating I want.
So given that, do you put any consideration and to serve with the rating agencies do either whether they cover a bonds or country or an industry or a specific upgrade or downgrade, how important is that?
MAIZEL: Well, we do follow them, we do read what they print, and we do take into account their rating because they have good analysis, after ’09 they’ve strengthened their analysis. I think that in the case of the mortgage, they just did not understand the product so it was not only the pay to play but it was also lack of understanding how the different tranches would behave in a crisis.
But first of all, the change in rating is not that impactful anymore, when you went from a triple B to a triple B minus, the bond at one time would drop three points, now it might drop a quarter of a point.
RITHOLTZ: Now, how much of that is due to the fact that they did such a terrible job when they were needed in the last crisis?
MAIZEL: It does impact what’s happening but the perception of whether you cover your needs three-point two times or three times or 2.9 does not make that big a difference, even in the case of – and now Triple Bs are the vast majority of bonds, you know, they are borderline between investment-grade and high-yield…
RITHOLTZ: Low investment grade.
MAIZEL: That’s the nicest way of saying junk.
RITHOLTZ: But they are still considered an investment grade, they are investable for anyone whose charter or portfolio policy statement says only investment-grade.
MAIZEL: Exactly but most pension plans for example do they have a bunch of noninvestment grade bonds in their books and one time, you would think that that change would eliminate basically who could buy those bonds and ever since Michael Milken in the 80s, he created in the industry for noninvestment grade points and he did not invent the high-yield bonds he just invented who could buy them. He went to the thrifts, he went to the savings and loan, he went to the insurance companies and then the pension plan said well let’s make that also an asset class which we can invest.
RITHOLTZ: So let’s talk about those pension funds for a moment, you mentioned during the broadcast portion that their allocation has been gearing more towards alternatives like venture capital and private equity and hedge funds up because they’re looking for a higher total expected return which they’re not just they apparently are not getting from stocks and bonds? But they also haven’t been getting them from the alternatives, they’ve been — they are expensive, I like to jokingly say come for the high fees, stay for the underperformance.
But in all seriousness they have built out 10, 20, 30 sometimes even 40 percent of their total portfolios with these alternatives and they’ve slapped a very high expected return, six, eight, 10 percent on these, why is that? How can they just say even though we have decades of data showing that these are not going to get eight percent, we’re still going to put an expected return of eight percent on this, what does that do to the allocations?
MAIZEL: They were getting those results years ago…
RITHOLTZ: In the ’80s and ’90s years, sure.
MAIZEL: There was not that much competition.
MAIZEL: There’s been so much money that has gone into alternatives that now they are competing for deals and the yields are lower.
RITHOLTZ: That is just market efficiency isn’t it? You can’t have these big fat margins without attracting other people to say I’d like a little bit of that.
MAIZEL: I tend to joke saying that hope is not a strategy.
MAIZEL: And a lot of the buying of private equity and venture is hoping that in the future they would be worth much more. If you own stocks or you own bonds the value is there everyday, you know, you run a statement, you check what the value of your stocks are you can find out the value of your portfolio every day.
If you have private equity you have no clue how much is it worth. When it goes public, when there’s a liquidity event, then is when do you know what happens, but it might take five or 10 years and you never know the real value of your investment and you can always put any increased value you want and it would show as though you’re doing well and you might or might not get that value that you put in your statement.
RITHOLTZ: So the nonpublicly traded assets give people the ability to mark to — not mark to market but mark to hopes and dreams, is that what you are suggesting?
MAIZEL: It’s not that bad but the answer is yes, you know, it’s…
RITHOLTZ: We used to call it mark to make believe in the middle the crisis but it’s not — we’re not suggesting that, you’re saying it gives them a little bit of accounting flexibility.
MAIZEL: Exactly. I think that things are worth what a buyer is willing to pay.
I mean I think that if you asked 10 people what their house is worth, you’re going to get 10 responses that are higher than the actual market.
RITHOLTZ: But that’s an emotional bias, that makes some sense.
MAIZEL: It makes — it is the same as when they’re valuing companies.
RITHOLTZ: Endowment effect is certainly present.
MAIZEL: You know you want to believe that everybody is going to see the same that you are seeing and the buyer even if they perceive that the value is the same as you do, they are going to fight to get it lower.
RITHOLTZ: They still want a discount, of course.
MAIZEL: Absolutely, nobody likes to pay retail.
MAIZEL: So you are really thinking, hoping that you are going to get the values you are putting down in the statement and that does not necessarily going to happen — sometimes you are going to be very pleasantly surprised, but most of the time you won’t.
RITHOLTZ: So I used to joke with a friend who was at a pension funds about what I perceived as their absurd expected returns on their alternatives and the response was we need seven or eight percent, so I used to say well let’s assume you get 2 1/2 percent from your bond portfolio and get five percent from you equities and I’m up, there is your seven and a half percent and it took him a moment to realize well, that is not how you do a blended portfolio but it’s every bit as ridiculous as expecting 10 percent from asset classes that haven’t returned that sort of number for 20 or 30 years.
MAIZEL: You’re right, but you are always kicking the can a little bit further away so probably by the time the pension plan runs out of money you will …
RITHOLTZ: Right. So I mean that you say that half jokingly but we know that’s true, government state and local governments have done that with their police pension funds and the fire pension funds and their teacher funds that by the time it’s really problematic the politicians responsible for that, they are long out of office, it’s someone else’s headache, how can we realign the incentives so that were not just kicking the can down the road or is that just human nature and this is what’s going to happen?
MAIZEL: Look at the State of Illinois they have excellent managers managing the money and pension plans and their underfunded by I mean they probably are funded 40 percent or 35, it’s politicians that have not wanted to raise the contributions that are trying to be reelected so they don’t pressure the public workers to give more of their salary to the pension plan and you know it’s now a huge problem because they are running out of money.
RITHOLTZ: So there are certain states that have high taxes and big state spending but seem to have their budgets and their pension plans more under control. California comes to mind, New York comes to mind, amongst the states a little better or a lot better up clearly Chicago and Illinois have problems I hear about problems in New Jersey and Connecticut, both have pension issues, how significant is good to be for funding in the next 20 to 30 years?
MAIZEL: It is a huge problem.
MAIZEL: Look at Detroit, Detroit had to file for bankruptcy because of the pension plan.
RITHOLTZ: So now what — so now if you’re a company and you file for bankruptcy, judges have a tendency, courts have a tendency to say before you even get to the creditors, employee compensation, salary and pensions is sacrosanct, we don’t touch that, what happened in Detroit with the employee pensions post bankruptcy?
MAIZEL: Some of it were cut down, and (inaudible) bankrupt states cannot by law.
MAIZEL: But you know they got to the point where there were about to sell the paintings from the museum in Detroit in order to pay pension plans, the CB (ph) is being revitalized and they hope that eventually they are going to pull out. But again, to me, hope is not a strategy.
RITHOLTZ: Right. So we know that post hurricane, Puerto Rico has had, let’s phrase that a little differently, post hurricane it was revealed the precarious state of Puerto Rico was finances sort of like Greece to the EU, Puerto Rico managed to borrow at rates that were more suitable for the US than for Puerto Rico, they’re not a state, they’re not a city, they are a territory what happens with that situation, are they going to be able to get a refinancing, is bankruptcy even an option for a non-state non-city territory?
MAIZEL: Well first they can go to bankruptcy with the state-owned enterprises but Puerto Rico had a big problem even before the hurricane.
MAIZEL: And you know, their electric company had been in trouble paying back even before the hurricane so they are still fighting it, they are still fighting with bondholders and the public workers are crossing their fingers that their pension would be there when they need it.
RITHOLTZ: They were suffering a brain drain before the hurricane because if you’re in Puerto Rico and you’re making X and you could just take a plane to Florida or Texas or wherever you want to go because you’re a US citizen, you can get a job with that skill and make one and a half or 2X, they seem to have lost a lot of really talented people.
MAIZEL: They have even though they created a lot of incentives for people to go live in Puerto Rico.
RITHOLTZ: Very low taxes.
MAIZEL: Very low taxes, the first year, you pay I think three percent.
RITHOLTZ: Three percent income tax.
RITHOLTZ: That’s not too shabby.
MAIZEL: A lot of big, big money managers…
RITHOLTZ: That is federal income tax, not estate and so instead of a top rate of 37, your top rate is three.
MAIZEL: Yes, hedge fund managers have moved to Puerto Rico.
RITHOLTZ: The weather is not too bad either.
MAIZEL: It’s not too bad, good beaches.
RITHOLTZ: So I only have you for a limited amount of time, let me get to some my favorite questions I ask all of my guests.
It adds a little bit of a sort of cinéma vérité when I move off mic and people can tell that I’m doing that, I kind of like that, especially at the end not during the broadcast portion.
But let’s jump to these questions. We will call these our speed round.
So what was the first car you ever owned, year, make, and model?
MAIZEL: 1966 Dodge Dart.
RITHOLTZ: They were — my sister had one of those, all right, it was a ’66 or ’67, those cars could not be killed, they were 300,000 mile cars from the ’60s.
MAIZEL: I wish it had been my sisters and not mine.
RITHOLTZ: So you had a problem with it.
MAIZEL: I did not like it…
MAIZEL: It’s what my father gave me.
RITHOLTZ: It wasn’t the prettiest car but they were kind of indestructible for that era.
MAIZEL: They were.
RITHOLTZ: Tell us the most important thing that your friends and family don’t know about you.
MAIZEL: I love red wine that’s my passion and I’m a collector.
RITHOLTZ: Very interesting. Who are some of your early mentors who helped to shape your view of the fixed-income markets and investing?
MAIZEL: Leontief, a Nobel Prize winner professor at Harvard, and before I really – got to know him, Dave Roth (ph).
RITHOLTZ: Before you got to know him, not after.
MAIZEL: Not after. And a I would say that the mentor was my father not in terms of investing but in terms of values, hard work is the only thing that makes you do well.
RITHOLTZ: Makes a lot of sense.
Tell us about your favorite books, what are you reading, what do you recommend that other people read, fiction and nonfiction, investing related whatever?
MAIZEL: In fiction, I love Demille, Nelson Demille, I love the series by Ken Follett and in nonfiction I’m reading now a great book of the woman that ran the spy network for the French in the second world war, Madame Fourcade, and Yuval Harari, the Israeli guy that’s part historian and part philosopher, “The 21 Questions for the 21st Century” is an amazing book.
RITHOLTZ: Really, the same guy who wrote “Sapiens.”
MAIZEL: “Sapiens” and then “Homo Deus.”
RITHOLTZ: Right, which was a little darker than “Sapiens.”
MAIZEL: Yes, and now the “21 Questions for the 21st Century” is a great book.
RITHOLTZ: I’m going to put that one on my list, the Ken Follett series he’s had a number of different series, which one are you referring to?
MAIZEL: Both “The Pillars of the Earth” one about the building of the Cathedral and then the one that takes them through the three wars…
MAIZEL: I mean his writing is amazing, I love historic novels.
RITHOLTZ: That’s really quite interesting. Tell us about a time you failed and what you learned from the experience?
MAIZEL: When I was living in Mexico and I found the smoking withdrawal system from WaterPik so I flew to Fort Collins a negotiated with them, the representation in Mexico, brought it to Mexico and then found out that Mexicans did not want to stop smoking, so it was not a good business I just thought that I could carry over what was happening in the US to Mexico and you have to understand local mentality and local desire.
RITHOLTZ: Is that still true, are Mexican still big tobacco smokers relative to what it was like 30 years ago?
MAIZEL: It is lower but it’s much bigger than in the US.
RITHOLTZ: I mean it’s for– I grew up in a — I’ve never been a smoker, my parents were smokers, they eventually stopped but in the United States, it’s falling off the cliff.
Like it is almost noteworthy when you see someone in the street with a cigarette, I’m not even talking about vaping, an actual tobacco cigarette it’s almost like you know of a rarity it’s like spotting a wild unicorn.
MAIZEL: In Mexico you cannot open a restaurant without a terrace for smokers.
RITHOLTZ: But they are not allowed to smoke in the restaurant.
MAIZEL: No, but that is not a part of the restaurant.
RITHOLTZ: That’s amazing.
What you do for fun? You mentioned red wine, what else you do to stay busy out of the office?
MAIZEL: Traveling, reading, watching sports on TV and playing some golf.
RITHOLTZ: What sports do you watch?
MAIZEL: I watch basketball and I watch golf, my wife says that I would watch (inaudible) if they show the tournament.
RITHOLTZ: What has you most excited about the bond market these days? What are you enthusiastic about?
MAIZEL: I love the idea that emerging market that has become an asset class and almost everybody’s not pursuing it, we have been at it for 30 years and I think one of the stronger firms in the country on it.
RITHOLTZ: So if a young college grad or a millennial came up to you and said they were interested in a career in fixed income, what sort of advice would you give them?
MAIZEL: Try to go beyond what you read in the in the financials, I mean reading financials is one thing understanding what the company does or who runs it is probably more important than anything.
RITHOLTZ: And our final question what you know about the world of bond investing today that you wish you knew 30 years ago when you first launched the firm?
MAIZEL: That the trend toward lower rates was going to last 30 years, I would have made a ton of money I would boy have bought only 30 year paper.
RITHOLTZ: It wasn’t obvious back then that this was the start of a three decade long bull market?
MAIZEL: No, we were coming out I mean from the Jimmy Carter days with big inflation and globalization have not taken over yet so boom and bust was still part of the story of the economy in the US, the economy in the US has changed so much, you know, it’s no longer that globalization, there’s a crisis all you do is call your supplier and say in China or in Mexico, and tell them they will ship the next six months you don’t have to shut down the plant.
RITHOLTZ: Quite interesting.
We have been speaking to Luis Maizel of LM Capital Group, if you enjoyed this conversation, well, be sure and look up an inch or down an inch on Apple iTunes or wherever you have access this podcast and you could check out any of the other 250 podcasts we have broadcast over the past five years.
We love your comments, feedback, and suggestions, write to us at MIBPodcast@bloomberg.net, I would be remiss if I did not thank the crack staff who helps put these conversations together each week, my producer/ audio engineer is Madena Parwana, Taylor Riggs and Michael Boyle are our bookers, Atika Valbrun is our project manager, Michael Batnick is our head of research. I’m Barry Ritholtz, you’ve been listening to Masters in Business on Bloomberg Radio.