A Chilling Prospect

Investment News has a story about a Department of Labor investigation into a JP Morgan Chase (JPMC) stable value product that was included as an investment option in several 401(k) plans.  The DOL is working to determine whether JPMC breached its fiduciary duties under ERISA by investing as much as 13% of the fund's assets in private-mortgage debt that was underwritten and rated by JPMC.  According to the story, "[t]he Labor Department could be examining whether the fund holds investments that are inappropriate and whether such risks were disclosed...."  What seems most obvious is that JPMC is at risk of being found having engaged in self-dealing in violation of its fiduciary duty to act in the sole interest of plan beneficiaries.

The most chnilling aspect of the story is that "[i]f the DOL finds that the firm violated ERISA with respect to the investments within the fund, plan sponsors and advisers who recommended it to 401(k) plans could be on the hook for failure to perform the proper due diligence."  That is, since JPMC violated ERISA in managing the fund, employers and advisors may have violated ERISA for failing to uncover JPMC's activity.  A successful due diligence defense will hinge on the nature and availability of the disclosure, the discovery by plan fiduciaries, and the actions taken upon discovery of the activity.  Other factors that may affect the determination: the relationship between the advisor and JPMC, the relationship between the advisor and the administrator, the relationship between the administrator and JPMC, and the compensation mechanism of each of the service providers.

There was a time when an advisor could rely on the information routinely provided by service provider and money managers to satisfy their due diligence responsibilities.  As advisors have gotten closer to employers and their retirement plans and accepted fiduciary status, whether they knew it or not.  As this story indicates, a fiduciary, the advisor assumes responsibilities requiring investigation far beyond the standard management interviews and review of SEC filings.

The aspect of this story that is truly chilling is that there are forces at work to impose a fiduciary duty on advisors covering all of their client relationships.  There are advisors that embrace the opportunity to work this closely with clients and have structured their practices accordingly.  However, not all clients need or are willing to pay for such a high level of service.  Nor are all advisors prepared to conduct business in such a manner.

Desperate Measures For Desperate Times

The low interest rate environment is leading investors -- and their advisors -- to desperate measures in an attempt to meet retirement income objectives.  An article in Investment News addresses the dilemma faced by retirees and their advisors whose plans are being foiled by flat equity markets and plummeting interest rates.  Three solutions explored are immediate annuities, high yield bonds, and preferred stocks.

An immediate annuity can be a valuable tool to allow a client to meet objections in the short term while allowing capital markets to do their job and provide a reasonable rate of return for risky assets.  Of  course, an investor will forgo the opportunity for increasing income from the capital devoted to the annuity.  However, this assurance of lifetime income frees the remainder of the portfolio to address the risk of inflation.  Absent the annuity, the portfolio runs a real risk of failing to last the lifetime of the retiree.

The article acknowledges the incremental risks of high yield bonds and preferred stock.  Here is how one advisor addresses the risk:

“We invest in a high-yield ETF with 10 or 20 bond positions that have low management fees, which eliminates the need for us to investigate the company,” said (the advisor).
 
“We’ve been in junk bonds since 2009 and they’re great performers. Unless the entire economy implodes, I think they are a fairly good buy,” (the advisor) said. “The risk is that the issuer can default, which we assess beforehand.”

Very scary stuff.  While an ETF provides liquidity for the junk bond position, its pricing will reflect the marketability of the underlying bonds, and if one of the holdings (about 5% if there are twenty holdings) defaults, that pricing will wilt.  The period since 2009 has seen very positive results for high yield bonds, it has been an unusual period.  The assumption that an economic meltdown would be necessary to have a negative effect on high yield bond returns is unduly optimistic, especially in such a concentrated portfolio.

Of course, the two holdings can work very well together.  The inflation protection of the increased coupon of the high yield bonds offsets at least a portion of the cost of living risk of the annuity, and vice versa.  Which is the whole idea of diversification.

Cap Rates Lower Than Advertised

REIT.com interviewed Paul Curbo, portfolio manger for INVESCO, about market conditions for commercial real estate.  The article (and video) include a number of insights into the various sectors of investment real estate.  What caught my eye was the discussion of cap rates and the examples he cited:  apartments changing hands at 5% cap rates, and 4% in California.  While the fundamentals are entirely different today than they were then, this pricing is reminiscent of  the frothy markets 2006 and 2007.  Curbo's observation that a development pipeline will provide immediate value add is true as long as pent up demand for units continues.  At the rate that units are being built and mothballed construction is being restarted, that backlog will not exist for long.

Another Note Program Halts Interest Payments

Investment News has a story about Thompson National Properties (TNP) suspending payment of interest on a program that raised capital in 2008 and 2009, just as TNP was getting started.  The program, TNP 12 Percent Notes Program LLC, was intended to provide working capital for TNP.  The only assets of the program were loans to TNP and affiliates.  TNP provided no credit enhancements or guarantees.  If I remember correctly,  investors are members of the LLC, and the LLC made the loans.  Of course, an affiliate of TNP is the Managing Member of the LLC.

I don;t believe that investors have any immediate recourse, other than to remove the Managing Member, and install one that will act in their interests.  That would take a lot of time and money, and if TNP's forecasts are accurate, interest payments would be flowing again.

On the other hand, Tony Thompson has faced a lot of adverse conditions, has worked hard to resolve them for the benefit of investors, and has made a lot of money for investors and himself along the way.

The comments on the article are very interesting.  They reflect just how polarizing an figure Tony Thompson is.  Tony has just as many fans as he does detractors.

Now The Fed Is Getting In On The Action

I have mentioned before about the proposal to insulate money market funds from runs that would have an adverse impact on markets.  The proposal would have money market funds either 1) have a cushion provided by the management firm, or 2) allow the NAV to float.  Next, the Financial Stability Oversight Board stepped in to say that is the SEC didn't adopt the proposal, it would require the commission to enforce it..

Now, the Federal Reserve has stated its intention of using its bank regulatory powers to accomplish the same objective.  According to Investment News, the Fed is considering reclassifying the funds provided by money market funds to a riskier category.  this would make money funds a less attractive option for funding, possibly limiting the investment available to the money market funds.  Of course, all would be well if the money funds would drop their opposition to the SEC proposals.  Wink,wink, nudge, nudge, knowwhatImean?

Last time I said it's going to happen.  Now it's time for money fund companies to figure out how they will comply.  As a money fund with a floating NAV is not much of a money fund, I expect more than a few funds to announce that they will have the 3% (or so) equity buffer.  Expect any fee waivers that these funds enjoyed to be dropped, and fees to increase once interest rates increase sufficiently to cover them.

Wells Foregoes Fee on REIT II

On June 29, The Rational Realist reported that Wells REIT II had announced that it will not pay to internalize its advisor.  This is a big deal, as the internalization fee was the big payday for a syndicator, and it wasn't subject to such uncontrollable factors as performance.  Wells Real Estate Funds is forgoing probably between $150 and $200 million.

This is not an altruistic move.  Leo Wells is a very charitable man.  However, he is very quick to tell you that Wells Real Estate is not a non-profit organization. 

Nor is this an indication of some newfound backbone by the Board of Wells REIT II.  REIT boards are filled from a good ole boy network, and Leo Wells is the definition of a good ole boy.

Forgoing the internalization fee is the second move that the wells organization is taking to address an issue tat is much bigger to Leo Wells: slumping sales.  at its core, Wells Real Estate Funds is a sales organization, not an investment organization, not a real estate organization.  Every decision is made through a lens pointed at sales trends.  Wells Timberland's capital raise was an enormous disappointment.  The raise for its Mid-Horizon Value-Added fund has been lackluster.  Core Office REIT was on a run rate of about $1 million per day raising just $225 million through December 31, 2011 and $282 million through March 31, 2012.  In May, Wells made wholesale changes in its senior sales personnel.  Now, Wells II has reduced its fees.

What has not happened is the renunciation of internalization fees for the Core Office REIT.  I guess Wells is hoping that the market will pick up the implication that no more internalization fees will be charged.  Their market prospects would improve much more significantly if the Core Office REIT would just adopt that position.