Clients of the Firm, 

On September 28, 2022, the Bank of England chose to intervene in the GILTS (U.K. Treasury Bonds) market to prevent the insolvency of pension funds who were using a strategy called LDI to synthetically get exposure to credit markets. Synthetic exposure is achieved through swaps in this market, which are derivative instruments based on interest rates.  Similar to the 2008 debacle of CDS counterparty insolvency, these instruments created a solvency threat to U.K. pension funds when jump conditions in GILT yields occurred as a result of a surprise tax cut stimulus announcement in addition to aggressive Fed and BOE tightening.   

Much of modern financial risk management at large financial institutions is run by complex risk models that try to estimate risk exposures that are measured in standard deviations from the mean of historical market responses to different change conditions in the matrix of asset classes.  The models tend to break when conditions occur outside of three standard deviations.  These are defined as events that occur less than 0.3% of the time. In addition, exogenous shocks tend to break these risk models as well, events such as the Lehman collapse, 9/11 or the start of World War I.   

This month, 10-year GILT yields moved up from 2.86% to over 5%.  This is an enormous move and resulted in rapid price degradation that caused swap derivatives based on interest rates to increase significantly in value.  Since the U.K. pension funds had used these derivatives in a leveraged way to gain artificial exposure to the bond market, they incurred extremely large paper losses.  These losses were big enough to require posting of collateral to meet margin calls.  This fact, in turn, required the liquidation of other assets especially GILTS to meet those obligations causing a cascading price decline in many asset classes and exacerbating losses.  These conditions got so extreme that the BOE decided it would intervene in the GILT market to stem the financial damage and bring some order back to the trading of this sovereign paper.   

Historically, the Federal Reserve has likewise intervened on several occasions to provide liquidity and stability to fixed income markets.  These instances included buying MBS and Treasuries in the financial crisis of 2008 and again providing liquidity to MBS, Treasury and corporate debt markets in the 2020 COVID crash period.  These interventions have become quite regular in crisis moments and are a consequence of increasingly opaque derivative strategies that attempt to gain or layoff risk exposure without putting up the capital necessary for those exposures.  Leverage amplifies the issues. 

Inflationary conditions present throughout the world and the Fed interest rate increases combined with above financial system illiquidity, have caused extreme volatility in fixed income over the past weeks.  Indeed, the market is responding with some irrational selling due to forced liquidation and a reset of expectations for 2023 earnings and compressing multiples.  The result is lower stock and bond prices. 

Market conditions like this in the past have often portended both short-term bottoms as well as capitulation liquidation periods.  These periods are often followed by substantial rallies to normalize negative sentiment and to separate the quality firms from the less than stellar.  In a bear market, like the one we are currently in, large swings and multiple compression for stocks are typical as investors search for fair value in a very uncertain environment.  Ultimate low levels are very hard to determine or time as often the market overshoots to the downside.   

In times like these, a disciplined investor tries to ascertain what a reasonable or low price to pay is for the market or individual companies.  Another way to think about this is to ask the question:  Is the company cheap enough to buy given a new set of expectations and parameters around its future earnings?   Value and GARP investing use this discipline to try to judge fair value and margin of safety prices for equities.   

While the market conditions have changed quite dramatically this year and valuations of almost every asset class have substantially declined, our approach to valuation has not changed.  There are still only three choices: we can choose to buy, sell or hold assets.  These three decisions should be made in the context of your risk tolerance, liquidity needs and should be based upon sound analysis of companies and the market and not sentiment or emotion.   This is where active management and advice from the firm can be of the most value.  

There is a significant wall of worry in front of market participants today.  This wall has crushed sentiment and asset prices and created some level of systemic risk which central banks will be forced to deal with.  This period of transition to a higher interest rate world will be challenging for asset valuations, but accretive to income.  We have been referring to this time as one in which one may become income statement rich and balance sheet poor.  Dividend yields and interest rates are substantially higher than they have been during most of the past decade.   

Coming out of this transition over the coming months, there will likely be exceptional assets on sale.  We will endeavor to acquire those at reasonable or cheap prices while collecting dividends and interest as we wait for conditions, earnings and prices to improve.  We appreciate the opportunity you have given us to pursue that quest on your behalf.  We are here for you and hard at work each day in pursuit of that goal.

Sincerely,  

Peter C. Wernau 

CEO, Wernau Asset Management 

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This letter contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Wernau Asset Management, Inc. ("Wernau Asset Management) is a registered investment adviser with its principal place of business in the Commonwealth of Massachusetts. Wernau Asset Management and its representatives are in compliance with the current registration requirements imposed upon registered investment advisers by those states in which Wernau Asset Management maintains clients. Wernau Asset Management may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration requirements. This letter is limited to the dissemination of general information pertaining to its investment advisory services. Any subsequent, direct communication by Wernau Asset Management with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Wernau Asset Management, please contact Wernau Asset Management or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Wernau Asset Management, including fees and services, send for our disclosure statement as set forth on Form ADV from Wernau Asset Management using the contact information herein. Please read the disclosure statement carefully before you invest or send money.