SUMMER 2018

Pg1BUFFETT ON BONDS: THE ORACLE OF OMAHA OPINES ON FIXED INCOME INVESTINGDecades after Babe Ruth set down the bat, young baseball fans quizzed their elders: “Did you ever see him play?” To forestall such questions from our offspring, we visited the investment world’s holy land: Omaha. Each May, Berkshire Hathaway (the world’s eighth largest company) holds its annual meeting, where its businesses hawk their wares and Chair Warren Buffett and Vice Chair Charlie Munger field questions from the more than 40,000 shareholders in attendance. Among them this year? The Payden Economics Team. More than mere Berkshire fanatics, we sought out the Oracle of Omaha’s fixed income-related wisdom.

R-STAR WARS: A NEW HOPE FOR MARKETS AND MONETARY POLICY?A few years ago, as interest rates dipped near zero in the U.S. and into negative territory around the globe, a curious term gained prominence in some circles: r* (pronounced: “r-star”). R* is shorthand for the real natural rate of interest. The problem? Nobody knows where r* is in real-time and use of the term in modern central banking has completely flipped the purpose of a natural rate on its head. While you have to understand r* to interpret central bank speak in 2018, you should also know the origin of and uncertainty surrounding the natural rate concept.

Pg 5

Pg 11Pg 9

SPORTING SUCCESS: ARE COLLEGE ATHLETIC COACHES WORTH EVERY PENNY?After ten years of smashing success, your alma mater’s high-profile coach has stumbled. Should he or she be fired? Are Athletic Directors (ADs)—presumed to be the “boss” of the coach—as guilty as investors when it comes to chasing performance? We survey a history of college football data and find that coaching matters more than you might think. The knee-jerk firing favored by ADs/fans after one or two bad seasons is ultimately detrimental to the program’s long-term performance.

THE NAKED TRUTH: THE GLOBAL ORIGINS OF THE CLOTHES IN YOUR CLOSETWhere are your clothes made? You might be surprised, as the global export powerhouses of apparel and clothing have changed over time. We dig through the closet of macroeconomic data for various categories of garments and find that your wardrobe is truly global, with places as far flung as Morocco and Pakistan providing pieces of apparel.

1

I t’s 6:45 a.m. in Omaha, Nebraska, on Saturday, May 5th, 2018.

The air is freshly washed from rain earlier in the week. Beefy se-

curity guards with automatic rifles stand sentinel every few hundred

yards. Thousands of hopeful Berkshire Hathaway shareholders lin-

ger in an interminable line winding around the CenturyLink Arena.

Among the 42,000 strong assembled for the annual shareholder meet-

ing, your authors wait, giddy for the day’s proceedings.

The event has been called the “Woodstock of Capitalism” and, to our

eyes, was nothing short. The Friday before the shareholder meeting,

Berkshire subsidiaries and investees set up small exhibitions in the

CenturyLink Arena, hawking their wares at a discount to the visiting

masses. This year, one could find everything from a 150-foot model

train display offered up by BNSF railroad to a massive pickle hanging

above the Kraft-Heinz outpost.

Saturday brings the shareholder meeting. After an hour of waiting to

enter, a video featuring Warren Buffett versus Lebron James on the

basketball court, and the morning session of questions, we returned

to our seats for the afternoon question and answer session. Each year,

the famed Chair (Warren Buffett) and Vice Chair (Charlie Munger)

of Berkshire play host to shareholder questions for six hours.

We sat contented, with boxed lunches supplied by Omaha’s favorite

lunch spot, Jason’s Deli. Quite contented, that is, until the startling

words emanated from the Oracle of Omaha’s mouth: “long-term

bonds are a terrible investment.”

Buffett’s aversion to bonds is well known. He talks about it all the

time. However, as an employee of a fixed income manager, your author

got to thinking, “What has the Oracle had to say over all these years

about bonds?” He does manage, after all, one of the world’s largest in-

surance operations and has surely matched some liabilities with bonds

despite his professed belief in the long-term returns of equities.

Luckily for us, adoring (obsessive?) fans have compiled Warren Ed-

ward Buffett (WEB) annual shareholder letters from 1957 to present.

We combed the shareholder letter archives to ferret out any and all

mentions of bonds. In what follows, we relay the three Bond Buffetts

on display in the shareholder letters: Buffett as bond educator, Buffett

as below investment grade buyer, and Buffett as bond bear.

BUFFETT AS BOND EDUCATOR

Charlie Munger has described Berkshire as a “didactic enterprise.” It

should be no surprise that Warren often assumes a teaching tone in

his letters to shareholders when discussing bonds. Although WEB

has taken up various fixed income lessons over the years, here we focus

on the lessons dispensed as Buffett wound up his partnership (i.e.,

Berkshire pre-history).

The first WEB investor letter on record is his 1957 Buffett Part-

nership Ltd. (BPL) note. For the following dozen years, Buffett ran

various limited investment partnerships and achieved an astounding

29.5% annual rate of return versus the Dow Jones which returned

9.1% over the same time.

Fearing the end of a bull market in 1968-1969, WEB decided to shut

down his partnerships and return capital to his partners (while re-

taining a large stake in Berkshire Hathaway, the New England textile

conglomerate which would later become his primary investment ve-

hicle). As part of the wind-down, Buffett made himself available to his

partners to guide their future asset allocation.

Buffett’s partnership letter of February 25th, 1970 undertakes “a very

elementary education regarding tax-exempt bonds.” Like all good

fixed-income instructors, Buffett acknowledged up front that the dis-

cussion was likely to “be a little weighty” and that he felt as if he was

trying to “put all the meat of a 100 page book in 10 pages—and have

it read like the funny papers.”

After a discussion of the mechanics of tax-free bonds and their ex-

pected marketability, Buffett expands on his preferred municipal bond

areas. In descending order, we hear that the BPL partners are advised

to focus first on “large revenue-producing public entities such as toll

roads, electric power districts, water districts, etc.” Warren favored

Buffett on Bonds: The Oracle of Omaha Opines on

Fixed Income Investing

«THE EVENT HAS BEEN CALLED THE “WOODSTOCK

OF CAPITALISM” AND, TO OUR EYES, WAS NOTHING SHORT.»

2

these bonds on account of their superior marketability and their rela-

tively inefficient pricing due in part to “favorable sinking fund[s]”, inso-

far as these funds introduce prepayment risk into a given bond issue.

Following the muni project bonds, Buffett described his preference for

industrial development authority bonds and suggests that the part-

nership’s “insurance company owns a majority of its bonds in this cat-

egory.” He suggests that “prejudice” against these bonds caused by un-

certainty around and changes made to their tax-exempt status made

them a “most attractive field.” Beyond the private-activity type, WEB

rounds out his muni preferences with AAA-rated public housing au-

thority bonds and, last, “state obligations of a direct or indirect nature.”

Even in fixed income securities, though, Buffett stayed true to his

“circle of competence.” He finishes his discussion of tax-free bonds by

noting that he won’t purchase the debt issued by large cities such as

New York or Chicago. He reports, “My approach to bonds is pretty

much like my approach to stocks. If I can’t understand something, I

tend to forget it.”

BUFFETT AS DISTRESSED BOND BUYER

Warren Buffett’s letters not only show his understanding of the bond

market, they also reveal many instances of his and Berkshire’s partici-

pation in more turbulent areas of fixed income: think of broad “junk

bonds” and distressed or defaulted issues. As unusual as it sounds, the

Buffett partnership letters report on various instances over the years

where the Oracle of Omaha morphed into the Creditor near Creighton.

In the early days of the partnership, before Berkshire’s emergence,

Buffett employed the principles of Benjamin Graham, finding prover-

bial cigar butt businesses and salvaging one last drag. Of special note

in this category was the workout situation brought about by Texas

National Petroleum’s sale to Union Oil in April 1962. In addition to

purchasing common stock and warrants, BPL purchased 4.1% of the

company’s 6 ½% debentures, callable at 104 ¼ at the time of the sale.

Union Oil faced little regulatory risk in acquiring Texas National Pe-

troleum. There was, however, a fly in the ointment related to Union Oil

receiving a “necessary tax ruling.” According to Buffett, “The University

of Southern California was the production payment holder (a form of

oil and gas financing) and there was some delay because of their elee-

mosynary status.” Thus Buffett entered into the trade, expecting the deal

to close.

“BERSERKSHIRE” HATHAWAY? BUFFETT'S INVESTMENT VEHICLE WEIGHS IN AS THE 8TH LARGEST COMPANY IN THE WORLD

fig. 1

Source: Bloomberg, as of 2018-05-21

$344

$378

$484

$494

$499

$529

$740

$742

$764

$916

$300 $400 $500 $600 $700 $800 $900 $1,000

Exxon Mobil

JPMorgan Chase

BerkshireHathaway

Tencent

Alibaba

Facebook

Microsoft

Alphabet (Google)

Amazon.com

Apple

Billions of USD

Market Capitalization (Billions of USD)

«MY APPROACH TO BONDS IS PRETTY MUCH LIKE MY APPROACH TO STOCKS. IF I CAN'T UNDERSTAND SOMETHING, I TEND TO

FORGET IT.”

3

And indeed, come October 31, 1962, the sale closed. The results for

the partnership were quite favorable, both on the debt and equity

purchased. Buffett reported on the debt, “On the bonds we invested

$260,773 and had an average holding period of slightly under five

months. We received 6 ½% interest on our money and realized a

capital gain of $14,446. This works out to an overall rate of return of

approximately 20% per annum.” Not bad for a fellow known for his

equity savvy!

A few other Berkshire bond purchases are worth mentioning. Follow-

ing Texaco, Inc.’s bankruptcy in 1987, Berkshire’s insurance portfolios

invested in the short maturity, defaulted bonds. Buffett reasoned that

“a worst-case” outcome with the Pennzoil litigation (Pennzoil sued

Texaco in a messy merger contest for Getty Oil) the Texaco bonds

would be “worth about what we paid for them.” The worst-case sce-

nario did not come to pass. In 1989, shareholders learned that Berk-

shire sold nearly all their Texaco bonds for a “pre-tax profit of about

$22 million.” Considering the reported amortized cost in 1987 of

$104 million, Berkshire achieved approximately 10% per annum on

their bankruptcy bet.

Texaco’s defaulted bonds may be among the least predictable pur-

chases in the annals of Berkshire bond buying, but not far behind are

the conglomerate’s 2001 and 2002 purchases of euro-denominated

retail-sector “junk bonds.” Which retailer you ask? And why euros?

The answers to both questions tickle any conscious investor in 2018.

Throughout the mid-2000s, Buffett expressed his concern on the

U.S. dollar. The massive expansion of the U.S. current account deficit

motivated the famed investor to look far afield for non-dollar bets.

The 2007 shareholder letter describes an insight many Berkshire

shareholders might have wished penetrated the equity investment

framework of WEB: “in 2001 and 2002 we purchased €310 million

Amazon.com, Inc. 6 7/8 of 2010 at 57% of par (see Figure 2). At the

time, Amazon bonds were priced as ‘junk’ credits, though they were

anything but…In 2005 and 2006 some of our bonds were called and

we received $253 million for them. Our remaining bonds were valued

at $162 million at year end. Of our $246 million of realized and unre-

alized gain, about $118 million is attributable to the fall in the dollar.

Currencies do matter.”

Last but not least is perhaps the biggest bond biff in the history of

Berkshire. In 2007, Buffett directed Berkshire to purchase roughly $2

billion worth of debt issued by Energy Future Holdings. If the issuer

sounds familiar it is because it was a company “formed in 2007 to ef-

fect a giant leveraged buyout of electric utility assets in Texas.”

The long and gruesome story made short: Energy Future Holdings

has since gone down in history as one of the largest utility bankrupt-

BUFFETT BUYS AMAZON (EURO DENOMINATED DEBT)! AND WINS: THE HISTORY OF AN AMAZON JUNK BONDfig. 2

Source: Bloomberg

20 €

40 €

60 €

80 €

100 €

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Bond

Pri

ce

AMZN 6 7/8 02/16/10 Euro Corporate Bond Price

Buffett Reports Buying @ EUR 57

Bond Called at Par

«BUFFETT STRESSED THAT HE HAD MADE THE

PURCHASE DECISION WITHOUT CALLING HIS ESTEEMED VICE CHAIR CHARLIE MUNGER AND

REFLECTED IN THE WAKE OF THE LOSS, “NEXT TIME

I’LL CALL CHARLIE.”»

4

cies. By 2013, Buffett reported to shareholders that the $2 billion in-

vestment had brought about a pre-tax loss of $873 million. Buffett

stressed that he had made the purchase decision without calling his

esteemed Vice Chair Charlie Munger and reflected in the wake of the

loss, “Next time I’ll call Charlie.”

BUFFETT THE BOND BEAR

As fun as the tour through Berkshire’s bond history has been, no

discussion of such a matter would be complete without mentions of

Buffett’s general dislike of, and periodic bearishness on, fixed income

securities.

The bond-bashing begins as early as 1961, a mere four years after the

Buffett partnership formed. In a discussion of the partnership’s invest-

ment style, Buffett chastised those who mindlessly sought safe harbor

in bonds: “Many people some years back thought they were behaving

in the most conservative manner by purchasing medium or long-term

municipal or government bonds. This policy has produced substantial

market depreciation in many cases, and most certainly has failed to

maintain or increase real buying power.” And, although he didn’t re-

turn to this point specifically in the following years, Buffett’s disdain

proved more prudent. U.S. Treasury yields rose steadily throughout

most of the 1960s.

Another “low-light” of the Berkshire attitude towards long-term

bond investing sprung up in 1987 and 1988. At that point in time,

after a decline in yields since the highs of the early 80s (the 10-year

U.S. Treasury reached 15.8% in September 1981), Buffett reminded

shareholders “we continue to have an aversion to long-term bonds.

We will become enthused about such securities only when we have

become enthused about prospects for long-term stability in the pur-

chasing power of money. And that kind of stability isn’t in the cards.”

(He would later provide shareholders a revisionist history of 1980s

bonds...stay tuned.)

But Warren reserved his sourest scorn for government debt until 2008

in the aftermath of the Global Financial Crisis. Whether motivated by

patriotism or superior returns, Buffett opined on his vision of finan-

cial history, relating the U.S. Treasury bond market to Internet stocks

in the late 1990s and the housing bubble of the mid-2000s: “When

the financial history of this decade is written, it will surely speak of

the Internet bubble of the late 1990s and the housing bubble of the

early 2000s. But the U.S. Treasury bond bubble of late 2008 may be

regarded as almost equally extraordinary. Clinging to cash equivalents

or long-term government bonds at present yields is almost certainly a

terrible policy if continued for long.”

Since the collapse of Lehman Brothers in September 2008, Buffett’s

ominous bubble prediction has itself burst. Indeed, an index of U.S.

Treasury securities purchased at the depth of the crisis has produced

about a 28% total return, as long-term interest rates have not returned

to their pre-crisis levels. We cannot pronounce Buffett’s preference for

equities at the depth of the crisis wrong, though. Over the same time

period, the S&P 500 returned 175%.

BERKSHIRE’S BID FOR BONDS, TO BE DETERMINED

Whether functioning as a lecturer, as an opportunistic buyer of dis-

tressed debt, or as a perennial bond bear, Buffett emerges from the

pages of his 61 shareholder letters as a capable bond investor. And, as

one often in control of large insurance float portfolios, Buffett would

be hard pressed never to dabble in debt, despite an expressed prefer-

ence for equities. Much of this has to do with his extreme bullishness

on the U.S. economy. At one point during this year’s meeting, Buffett

proclaimed, “I would love to be a baby….born in the United States

today.”

To be utterly certain, though, we send our readers off with a final

thought Buffett imparted to shareholders at the 2018 meeting regard-

ing the merits of U.S. Treasuries. Responding to a question about the

future of interest rates, the Chair mused, “I don’t know and no one

else knows.” But, he continued, “in light of the Fed’s 2% inflation target

and 30-year U.S. Treasury yields just above 3%, the average investor’s

after-tax real return per annum sums to only 0.5%. That math does

not work well for those requiring 7-8% per year.”

Buffett’s reasoning was not dogmatic. He closed his answer to the

shareholder’s question by reflecting on the history of U.S. Treasuries.

With the benefit of hindsight, the Oracle of Omaha carefully revised

his earlier dislike for government bonds in the 1980s: “I think Trea-

sury bonds have been unattractive since the 2.9% war bonds of 1942.

In the early 1980s, though, one could have purchased a 14% 30-year

zero-coupon U.S. Treasury to guarantee an appropriate return.” Even

in Buffett’s mind, there are times when bonds make sense.

SOURCE

1 Niveshak, Safal (2013). “Warren Buffett Berkshire Letters 1957 to 2012.” Accessed May 7, 2018. goo.gl/oCfaux

«WE CANNOT PRONOUNCE BUFFETT’S PREFERENCE

FOR EQUITIES AT THE DEPTH OF THE CRISIS WRONG,

THOUGH. OVER THE SAME TIME PERIOD, THE S&P 500

RETURNED 175%.»

5

Nick Saban, head football coach at the University of Alabama,

caught an $11.1 million touchdown in 2017, remuneration for

his coaching efforts. Dabo Swinney, of Clemson University, scored

$8.5 million. These coaching heavyweights are not alone. In 39 of 50

U.S. states, the head coach of a men’s football or basketball team was

the highest paid public employee.1

As fans and critics no doubt know, the college sports machine in the

United States is a cash cow for participating universities. Perennial

debates rage about the justice of the National Collegiate Athletic As-

sociation’s (NCAA) resistance to pay athletes, while coaches and uni-

versities profit handsomely.

Our intent here is not to wade into those swamps of dispute. Rather,

with such eye-popping sums on the line, we wondered if the big-time

pay college coaches garner corresponds to big-time performance.

Could it be that, like investors piling into last year’s best performing

securities or funds, athletic directors, boosters, and university admin-

istrators chase performance in their coaching decisions?

We set out to explore the prevalence of well-known “investment” bi-

ases in college sports coaching. Documenting first the exponential rise

in college coach pay, then examining the drivers of the explosion, we

argue that colleges do appear to share investors’ human habit of chas-

ing hot performance. The monster paychecks doled out to recently

successful college coaches are not as safe a bet as many might believe.

So the next time your alma mater breaks the bank to recruit the big

name coach, we suggest you hope for the best and prepare for some-

thing other than the best.

CHASING WHAT DOESN’T MATTER

Everyone wants to be a part of the latest trend. The problem for

investors is that the desire to ride the tide results in substantial un-

derperformance. According to a dataset compiled by Morning-

star, investors suffer badly when it comes to timing the market:

“Over the 10 years ended 2016, the average U.S. [equity] inves-

tor…enjoyed a 4.36% return, even though the average diversified

equity fund returned 5.15%...In bondland, we found the aver-

age investor received a 2.99% return, versus 3.72% for the aver-

age bond fund.”2 The results around the world weren’t much better

(see Figure 1 on page 6).

How can the average investor in the average fund underperform that

fund’s results? The answer comes down to timing. The average inves-

tor more often buys the average mutual fund when its price is high and

then sells when the average mutual fund share price is lower, causing

her performance to suffer. The colloquial definition of this behavior

is much simpler to understand. This, dear readers, is chasing perfor-

mance.

COLLEGE GAMEDAY PAYDAY: CHASING PERFOR-MANCE IN COLLEGE SPORTS STARTS WITH PAY

The salaries, bonuses, and other pay U.S. college football coaches are

taking home today look nothing like those paltry pay-packages of

yore. Rather, these are fully-fledged, near-NFL level paychecks.

To the data, then, we go. Since 2006, USA Today has tallied and re-

ported the ins and outs of college football coach pay. And the trends

have been striking. Since the turn of this decade, the median college

coach’s pay increased 75%, or by $753,000, from just over $1 million

Sporting Success: Are College Athletic Coaches Worth Every Penny?

«COULD IT BE THAT, LIKE INVESTORS PILING INTO LAST

YEAR’S BEST PERFORMING SECURITIES OR FUNDS, ATHLETIC DIRECTORS,

BOOSTERS, AND UNIVERSITY ADMINISTRATORS CHASE PERFORMANCE IN THEIR COACHING DECISIONS?»

«OVER THE 10 YEARS ENDED 2016, THE AVERAGE

U.S. [EQUITY] INVESTOR…ENJOYED A 4.36% RETURN,

EVEN THOUGH THE AVERAGE DIVERSIFIED EQUITY FUND

RETURNED 5.15%»

6

in 2010 to north of $1.8 million. Even more striking, though, was the

boost at the top. The average college coach took home $2.3 million

last year, against a puny $1.3 million in 2010.

These numbers are, of course, a far cry from the median U.S. house-

hold, which took home $59,000 in 2016 (but up from just over

$57,000 in 2006 in real terms). But coaches’ pay looms large even over

public enemy number one, CEOs. According to the Bureau of Labor

Statistics, the median annual wage among Chief Executives was “only”

$183,000 (not accounting for bonuses).

WHY PAY TO PLAY?

We don’t suspect many of our readers will bat their eyes too much at

the claim, college football coach pay has boomed in the recent past.

Less well known is the reason why. In addition to the larger stadiums,

increased college attendance, and general wage gains, college coach pay

has flown on the wings of a most powerful commercial condor: televi-

sion and broadcasting rights.

Long-time readers will know this isn’t the first time observations

about broadcasting rights in sports have graced these pages (see the Point of View Summer 2015 edition for our article on the other football story, Manchester United). Nevertheless, in college football, the tyran-

ny of the tube has helped coaches’ wallets in a big way.

Data on TV rights for NCAA sports programs isn’t as plentiful as

the Payden Economics Team would like. Notwithstanding the dis-

claimer, sports outlet SBNation reported rough figures on the top

five per-school NCAA conference payouts, the revenue for which

mostly comes from broadcasting rights. The results are staggering.

The Southeastern Conference, better known as the SEC, paid out a

record $40.9 million per school in the 2016-2017 season (see Figure 2 on page 7).

That said, the runner-up in 2016-2017 per-school payout rankings,

the Big 10, just inked a $2.64 billion contract through 2023.3 To give

a sense of proportion, recent reports suggest a top school in the Big

10 could stand to collect more than $50 million in revenue for 2018.

Suffice to say, the dollars “rushing” through the door find their way

into larger coach salaries.

Source: Morningstar

5-Ye

ar R

etur

ns

0%

2%

4%

6%

8%

10%

12%

Asia U.K. Canada U.S.* Australia Europe**

Average Investor Average Fund

*U.S. are 10-year returns **Europe proxied by Luxembourg

AVERAGING DOWN: AVERAGE MUTUAL FUND INVESTORS’ 5-YEAR RETURNS UNDERPERFORM THE AVERAGE MUTUAL FUND AROUND THE WORLD

fig. 1

«THE AVERAGE COLLEGE COACH TOOK HOME

$2.3 MILLION LAST YEAR, AGAINST A PUNY $1.3

MILLION IN 2010.»

7

JUST ANOTHER MEAN COACH?

You just watched your alma mater’s rival hoist up the conference tro-

phy while your team struggled to obtain bowl eligibility, despite a rich

history of success. The appropriate response from any fan, seemingly,

is an automatic sharpening of the pitchfork and breaking out the head

coach effigy.

After all, considering the inordinate paychecks he has been pulling

down in recent years and the fact that your team plays for what could

be considered the best conference, “Your State University” ought to be

the ones with the hardware.

But, is paying up for that “can’t miss” coach who has performed well

in the past worthwhile, or is that just a university drinking its own

Gatorade? Professors from the University of Colorado and Loyola of

Chicago, in a paper entitled, Pushing ‘Reset’: The Conditional Effects of Coaching Replacements on College Football Performance, question the

wisdom of jettisoning the coach for another big name.4

The study compared the on-field results of teams that changed head

coaches to similar programs that retained their head coach. The re-

search showed both an improving trend of teams that performed es-

pecially poorly and a tendency for mediocre teams to perform slightly

worse upon replacing their “failed” coach. While a new coach turning

around a 0-12 team may make a great story, teams performing espe-

cially poorly will tend to improve based on the fact that many football

games come down to a few points in either direction.

That is, a relatively small number of plays not going a team’s way one

year may cause a team to appear worse than they are, given the discrete

nature of wins and losses (you either get a notch in the win column or

the loss column—regardless of how close the game was). As a result,

the bottom teams in sports leagues often have a few bad breaks—but

that’s a trend that will correct itself in the long term, and firing a coach

is probably an overreaction, much like selling a stock when it falls in

price for a few days.

In the end, it’s relatively unlikely for a team to be at the bottom of a

league year in and year out, regardless of whether it makes a coaching

change or not. In fact, mediocre teams perform worse when a new

coach takes over due to the process of onboarding a new coaching

staff, such as recruiting efforts tending to have a lagged effect and get-

ting the new coaching staff ’s system in place.

WORTH THE EXPENSIVE PRICE TAG?

“Regression to the mean” isn’t the only reason that new college coach

pay might not positively impact performance. A 2012 study found

Source: SBNation, ESPN

USD

Mill

ions

*Per-school payouts are estimates of sports-related broadcasting revenues and represent full-share schools only

$40.9

$34.8 $34.8

$29.0

$27.0

$20

$25

$30

$35

$40

$45

SEC Big 10 Big 12 Pac-12 ACC

THE POWER 5 NCAA CONFERENCE SCHOOLS COLLECT BIG ON TV DEALS: 2016-2017 SEASON PER-SCHOOL PAYOUT*

fig. 2

«IS PAYING UP FOR THAT “CAN’T MISS” COACH WHO HAS PERFORMED WELL IN

THE PAST WORTHWHILE, OR IS THAT JUST A UNIVERSITY

DRINKING ITS OWN GATORADE?»

8

that while “an unpredictable $1 million increase in football spend-

ing improves the probability of winning an individual game by 3.5%

- 7.0% (at the 95% confidence interval)…coach compensation…is not

indicative of future success.”5 That is to say, a school that spends a lot

generally on their athletic programs may be able to drive better results

on the field, but it won’t be the coach alone that moves the needle.

Regression to the mean, combined with the findings suggesting that

“college football coach salary [alone] has no impact on the probabil-

ity of winning,” a worried fan might want to know, “Why do teams

change coaches so regularly?”6

ONE THING’S FOR SURE: INSECURITY

If job security is your thing, football coaching at a university is not

your thing. Indeed, as of 2018, “The average [college football] head

coach has been on the job for [only] 26 months.”7 That is roughly half

of the average U.S. employee’s job tenure of 50 months.8 Although

names like Nick Saban, Bobby Bowden and Bear Bryant may be easy

to recall, there are a host of others that are out the door faster than you

can re-furnish the head coach’s office.

Athletic directors wanting to save their own jobs and fan bases jos-

tling with their rivals often use the risky opportunity of a new coach

as a way to incite hope off the field for a team that may otherwise

been hopeless on the field. Don’t underestimate the desire to have

a scapegoat to blame for on-field underperformance and a hero to

herald when the team’s fortunes shift. Hope springs eternal that the

next head honcho might be the next Urban Meyer or Dabo Swinney,

the one coach destined to return a sports program to its prior glory.

Chances are the gamble will pan out for fans just as well as investors

fare chasing the latest hot mutual fund: tackled for no gain.

SOURCES

1 “Who’s the Highest-Paid Public Employee In Every State?” ESPN, March 30, 2017.

2 Russel Kinnel. “Mind the Gap: Global Investor Returns Show the Costs of Bad Timing Around the World.” Morningstar, May 30, 2017.

3 Ourand, John and Michael Smith. “Big Ten Formally Announces New Rights Deals Through ‘23 With ESPN, Fox, CBS. Sports Business Daily, July 25, 2017.

4 E. Scott Adler, Michael J. Berry and David Doherty. “Pushing “Reset”: The Conditional Effects of Coaching Replacements on College Football Performance.” Social Science Quarterly. Volume 94, Issue 1, March 2013, Pages 1-28.

5 Mirabile, McDonald and Mark Witte (2012). “Can schools buy success in college football? Coach compensation, expenditures and performance.”

6 Ibid.

7 Barnett, Zach (2018). “Re-ranking the longest FBS coaching tenures from 1-to-130: 2018 edition.” Football Scoop.

8 https://www.bls.gov/news.release/pdf/tenure.pdf

«A 2012 STUDY FOUND THAT WHILE “AN UNPREDICTABLE

$1 MILLION INCREASE IN FOOTBALL SPENDING

IMPROVES THE PROBABILITY OF WINNING

AN INDIVIDUAL GAME BY 3.5% - 7.0% (AT THE 95%

CONFIDENCE INTERVAL)…COACH COMPENSATION…

IS NOT INDICATIVE OF FUTURE SUCCESS.”»

«AS OF 2018, “THE AVERAGE [COLLEGE

FOOTBALL] HEAD COACH HAS BEEN ON THE JOB

FOR [ONLY] 26 MONTHS.”»

*The area of the country is a visual approximation of the share of exports. For precise values, refer to the numbers provided. Numbers might not sum to 100 due to rounding.

Sources: MIT Observatory of Economic Complexity - Standard International Trade Classification Data, UN COMTRADE, Payden Calculations

11

A few years ago, as interest rates dipped near zero in the U.S. and

into negative territory around the globe, a curious term gained

popularity: r* (pronounced: r-star). R* is the mathematical notation

for the “real natural rate of interest”—the short-term interest rate

adjusted for inflation that prevails when the economy is operating at

its full potential (when the economy is “in equilibrium”).

Why should investors care about an arcane bit of mathematical nota-

tion accompanied by a jargon-filled definition? Investors should un-

derstand r* since it gets bandied about a lot as the culprit behind the

current low interest rate environment and central bank policy. But, in-

vestors should also know that modern central banking has flipped the

notion of an equilibrium, natural rate completely on its head. What

originally was a way to think about how the economy functions (and

dysfunctions) has become a method by which central banks aim to

manipulate the economy.

Since r* discussions are obscured by jargon, we think an analogy is

warranted: the simplest way to think of r* is like cruise control in a car.

With headwinds or an uphill journey, the car’s system will add more

power to maintain the same speed as before (i.e., the central bank

would add stimulus). Similarly, if the car is flying downhill, the car

will brake, slowing the vehicle (i.e., the central bank would withdraw

stimulus).

The problem with the above analogy? Unlike your automobile’s cruise

control settings, r* is an unobserved factor! As such, unobserved fac-

tors leave open the possibility of a slew of different estimates—par-

ticularly in real-time and at critical economic turning points. Hence

our title: “R-Star Wars.” Just like the mysterious “force” in Star Wars, r* is unknown, but looms large in the macroeconomic universe. In the

«WHY SHOULD INVESTORS CARE ABOUT AN ARCANE

BIT OF MATHEMATICAL NOTATION ACCOMPANIED

BY A JARGON-FILLED DEFINITION?»

% R

ate

Source: Federal Reserve Bank of San Francisco

-1%

0%

1%

2%

3%

4%

5%

6%

7%

'61 '63 '65 '67 '69 '71 '73 '75 '77 '79 '81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11 '13 '15 '17

United States Euro Area United Kingdom Canada

THE GLOBAL DECLINE: THE LAUBACH-WILLIAMS NATURAL RATE OF INTEREST ESTIMATES AROUND THE WORLD

fig. 1

R-Star Wars: A New Hope For Markets and Monetary Policy?

12

end, investors and policymakers must, at best, take a leap of faith. May

the force be with you.

“A LONG TIME AGO IN A GALAXY FAR, FAR AWAY...”

We can trace the r* concept back to an earlier notion: the “natural”

rate of interest, developed by the Swedish economist Knut Wicksell

around 1898. For Wicksell, the Yoda of interest rates, the natural rate

of interest was the rate of exchange between present goods (say, “a bird

in hand”) and future goods (“two in the bush”) in a world without

money (a barter economy). In other words, the “natural rate of inter-

est” is an implicit return on capital invested (e.g., “give up a bird today

for two birds tomorrow”).

In the words of Wicksell, the natural rate is “the real yield of capital in

production.”1 It’s important to note that Wicksell viewed such a rate

as implicit, rather than a merely theoretical concept.

Once money was introduced to the Wicksellian system, Wicksell sur-

mised that, “The rate of interest at which the demand for loan capital

and the supply of savings exactly agree...more or less corresponds to

the expected yield on the newly created capital.” As such, Wicksell saw

the natural rate as an “equilibrium” from which observed nominal rates

could not deviate for too long without economic consequences.

What consequences, you wonder? For example, if the nominal inter-

est rate offered by a bank were lower than the implicit rate of return

on capital investment, why not borrow and produce (a 19th century

“carry trade,” if you will)? But, the carry trade carried consequences.

The deviation from the implicit, “natural” rate would set off a misal-

location of resources, which would later need to be reversed. In short,

Wicksell’s theory was an early version of the story as to how banks

caused the “boom and bust” of economic cycles as observed interest

rates deviated from “equilibrium” rates.

MACRO ENTERS THE LUKE SKYWALKER ERA

In the 20th century, the Obi Wan Kenobi of rates, John Maynard

Keynes, made mention of a “neutral” or “optimum” rate of interest in

his famed Money, Interest and Employment. However, the more mod-

ern use of the term r* to denote the “neutral rate” comes from the Luke

Skywalker of r*, John Taylor, the Stanford professor famous for the

eponymous Taylor Rule. According to Taylor’s 1993 formulation, “r*

is the short-term real interest rate that, in the long run, is consistent

with aggregate production at potential and stable inflation.”2

In the words of Ben Bernanke, “many factors affect the equilibrium

rate [r*], which can and does change over time. In a rapidly growing,

dynamic economy, we would expect the equilibrium interest rate to

be high, all else equal, reflecting the high prospective return on capital

investments. In a slowly growing or recessionary economy, the equi-

librium real rate is likely to be low, since investment opportunities are

limited and relatively unprofitable.”3 (Editor’s note: at first he sounds downright Wicksellian!)

Importantly, it’s not the central bank that determines the equilibrium

rate. “The bottom line is that the state of the economy, not the Fed,

ultimately determines the real rate of return attainable by savers and

investors,” Bernanke writes.

What role then for central bankers? The central banker’s role is to cali-

brate its policy rate (e.g., the federal funds rate) with the neutral rate in mind. Bernanke, speaking on behalf of central bankers the world over,

writes, “The Fed influences market rates but not in an unconstrained

way; if it seeks a healthy economy, then it must try to push market

rates toward levels consistent with the underlying equilibrium rate.”

Letting your foot off the gas when the car is humming along downhill;

punching the gas when the car needs a boost uphill. Or, if you like, the

Fed is the all-knowing Jedi, helping the market channel the force that

is already there.

So while central bankers and academics today often pay lip service to

Wicksell’s legacy, r* and Wicksell’s natural rate have less in common

than meets the eye. Here’s the critical difference: central bankers see

the natural rate as a monetary policy “North Star”—something to be

estimated with sophisticated economic models and deviations from

which central bankers ought to exploit in order to steer the economy!

Wicksell, on the other hand, viewed the equilibrium rate as an im-

plicit return on capital investment, deviations from which were the

fount of other economic problems.

FUMBLING AROUND IN THE DARK, LOOKING FOR THE LIGHT SWITCH (LIGHT SABER?)

History aside, central bankers now view the equilibrium rate as an

unseen “policy goal”. But the problem of doing so goes beyond forgot-

ten roots about monetary history. In the words of Janet Yellen: the

natural rate “is something we are uncertain about and have to find out

over time.”4

Well, that’s an understatement.

In an influential 2003 paper, economists Thomas Laubach and John

Williams estimated r* as high as 5% and as low as 1% in the time

between the 1960s and 2000. Recently, Laubach and Williams re-

estimated r* and saw it drop to around 0% over the last few years.

Economists might be as accurate as stormtroopers who never seem to

hit their target despite carrying laser blasters. Even the authors admit

13

the r* estimates are “very imprecise and are subject to considerable

real-time mismeasurement. ”5

While uncertainty remains and estimates vary, academics, central

bankers and commentators sure seem confident on one thing: the

neutral rate has plunged in recent years.6 For example, in 2014 Larry

Summers stated that the approach “demonstrates a very substantial

and continuing decline in the [equilibrium] real rate of interest,”7 and

Nobel Prize-winning economist Paul Krugman, writing in 2015,

opined that “the low natural rate is as solid a result as anything in real

time can be”.8

The Fed, collectively, appears to believe r* is about 0.8% in real terms and

2.8% in nominal terms as of the latest set of projections released with the

March FOMC meeting, down from closer to nominal 4.5% in 2012.

But, due to the uncertainty, just like we might fumble around in a dark

room looking for a light switch, careful not to knock over a water glass,

vase or lamp in the process, policymakers will move slowly as they ad-

just nominal policy rates. Hike too quickly and too far, the U.S. central

bank may accidentally trip a wire than ignites financial volatility (a la

the Mexican peso crisis in 1994 or the Russian crisis in 1998). Such

thinking is likely to weigh on policymakers’ views in 2018 and beyond.

The phenomenon is not just confined to the United States. While es-

timates differ by region, Canada, the euro area, and the U.K. all fea-

ture lower estimated levels of r* over the past decade, with the most

recent estimates the lowest in three decades (see Figure 1 on page 11).9

Since the trend is global, what do the developed economies have in

common? A slowdown in trend real GDP growth is evident in many

advanced economies in the last decade or two. The weighted aver-

age of estimates of annual trend growth rates for the U.S., Euro area,

U.K., and Canada fell from 2.5-3.0% to 1.5% over the past decade. In

theory, slower trend growth is associated with a lower demand for sav-

ings to fund capital investments needed to sustain growth, implying a

lower level of r*.

But, why the slowdown? Two main reasons come to the fore in most

research (see Figure 2): a slowdown in workforce and productivity

growth. Fewer workers entering the workforce—and producing less

when they do—drives the slowdown in underlying trend growth.

% C

hang

e Ye

ar-O

ver-

Year

Source: Congressional Budget Office, Payden Calculations

0%

1%

2%

3%

4%

5%

6%

1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014 2018 2022 2026

Potential Labor Force Productivity Growth Potential Labor Force Growth

THE RECIPE FOR GROWTH = MORE WORKERS + MORE PRODUCTIVE WORKERS: BREAKDOWN OF U.S. POTENTIAL GDP GROWTH

fig. 2

«THE PHENOMENON IS NOT JUST CONFINED TO THE UNITED

STATES. WHILE ESTIMATES DIFFER BY REGION, CANADA,

THE EURO AREA, AND THE U.K. ALL FEATURE LOWER ESTIMATED

LEVELS OF R* OVER THE PAST DECADE.»

14

CUTTING THROUGH THE JEDI MIND TRICKS

Call us cynics, but we doubt it’s a coincidence that neutral rate theo-

rizing exploded in popularity and academic interest after 2003—just

as interest rates hit rock bottom levels (the federal funds rate bot-

tomed at 1% in June 2003 and remained there for 12 months). Much

like the “force” in the Star Wars movies, which conveniently appears

with a hero when needed for the plot to make sense, r* explanations

have been conjured up as well to explain low rates.

Sure, it makes sense to have a monetary policy “North Star” for central

bankers and investors thinking about interest rates, but a key problem

looms: nobody knows what the neutral real rate is in real-time. It’d be

a lot like navigating your vehicle without the benefit of a speedometer.

Perhaps more importantly, long-term trend growth seems to mat-

ter for estimates of r*, but nobody knows where underlying growth

trends will end up either. In fact, you may be surprised to learn that

estimates of potential growth having been moving higher in recent

quarters, at odds with the most recent estimates of r* (see Figure 3).

Although slow-moving, both workforce and productivity growth

could move higher in the years ahead. Don’t be surprised if estimates

of r*, too, are revised higher in sympathy. In fact, investors should

think about r* but not be too confident that it will remain forever low.

In the end, there is a “new hope” for investors.

SOURCE

1 Knut Wicksell. “Lectures on Political Economy.” Translated by E. Classen, and edited, with an introduction, by Lionel Robbins. New York, A.M. Kelley, 1967.

2 Michael Kiley. “What Can The Data Tell Us About the Equilibrium Real Interest Rate.” No 2015-77, Finance and Economic Discussion Series, Board of Governors of the Federal Reserve, 2015.

3 Ben Bernanke. “Why are interest rates so low?” Brookings, March 30, 2015.

4 “Equilibrium Real Interest Rate: Theory and Application” Remarks by Vice Chairman Roger W. Ferguson, Jr. To the University of Connecticut School of Business Graduate Learning Center and the SS&C Technologies Financial Accelerator, Hartford, Connecticut, October 29, 2004.

5 Bordo D., Michael, John H. Cochrane, Amit Seru (2018. The Structural Foundations of Monetary Policy. Stanford: Hoover Institution Press.

6 Taylor, John B., and Volker Wieland. “Finding the Equilibrium Real Interest Rate in a Fog of Policy Deviations.” Hoover Institution Economics Working Papers, April 2016.

7 Lawrence H. Summers, “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound, Business Economics, 2014.

8 Paul Krugman, “Check Out Our Low, Low (Natural) Rates,” The Conscience of a Liberal blog, The New York Times, October 28, 2015.

9 Three Questions on R-Star, John Williams, FRBSF. John C. Williams. “Three Questions on R-star.” Federal Reserve Bank of San Francisco Economic Letter, February 21, 2017.

% C

hang

e Ye

ar-O

ver-

Year

These two lines have been diverging…

Source: Federal Reserve Bank of San Francisco, Congressional Budget Office

0%

1%

2%

3%

4%

5%

6%

'62 '66 '70 '74 '78 '82 '86 '90 '94 '98 '02 '06 '10 '14 '18

Laubach-Williams Natural Rate of Interest Potential Real GDP

“WALL STREET, WE HAVE A DISCONNECT”: U.S. LAUBACH-WILLIAMS NATURAL RATE OF INTEREST VERSUS POTENTIAL U.S. REAL GDP

fig. 3

Payden & Rygel’s Point of View reflects the firm’s current opinion and is subject to change without notice. Sources for the material contained herein are deemed reliable but cannot be guaranteed. Point of View articles may not be reprinted without permission. We welcome your comments and feedback at editor@payden-rygel.com.

US DOMICILED MUTUAL FUNDS

DUBLIN DOMICILED UCITS FUNDS

CASH BALANCEPayden/Kravitz Cash Balance Plan Fund

EQUITYEquity Income Fund

GLOBAL FIXED INCOMEEmerging Markets Bond FundEmerging Markets Corporate Bond FundEmerging Markets Local Bond FundGlobal Fixed Income Fund Global Low Duration Fund

TAX-EXEMPT FIXED INCOMECalifornia Municipal Income Fund

U.S. FIXED INCOMEAbsolute Return Bond FundCash Reserves Money Market FundCore Bond FundCorporate Bond FundFloating Rate FundGNMA FundHigh Income FundLimited Maturity FundLow Duration FundStrategic Income FundU.S. Government Fund

EQUITYGlobal Equity Income FundUS Equity Income Fund

LIQUIDITY FUNDSEuro Liquidity FundSterling Reserve FundUS Dollar Liquidity Fund

FIXED INCOMEAbsolute Return Bond FundGlobal Bond FundGlobal Emerging Markets Bond FundGlobal Emerging Markets Corporate Bond FundGlobal Government Bond Index FundGlobal High Yield Bond FundGlobal Inflation-Linked Bond FundGlobal Short Bond FundSterling Corporate Bond FundUS Core Bond FundUSD Low Duration Credit Fund

For more information about Payden & Rygel’s funds, contact us at a location listed below.

FOLLOW USwww.twitter.com/paydenrygel

LOS ANGELES 333 South Grand AvenueLos Angeles, California 90071213 625-1900

BOSTON 265 Franklin StreetBoston, Massachusetts02110617 807-1990

LONDON1 Bartholomew LaneLondon EC2N 2AX United Kingdom+ 44 (0) 20-7621-3000

MILANCorso Matteotti, 120121Milan, Italy +39 02 76067111

PAYDEN.COM

LOS ANGELES | BOSTON | LONDON | MILAN

OVER 30 YEARS OF INSPIRINGC O N F I D E N C E W I T H A N UNWAVERING COMMITMENT TO OUR CLIENTS’ NEEDS.