Today the Federal Reserve raised interest rates by 25 bps. With inflation so high, it almost certainly would have been 50 bps if not for the concerns over the economy related to the impact of the Russian/Ukraine war, which is exasperating things materially. There has been some very positive dialogue from both Ukraine and Russia in terms of finding a middle-ground solution on the key issues. There are a lot of interests at play with this war, so I don’t pretend to know what will happen. We own companies that for the most part, are the primary beneficiaries of higher interest rates. These are banks and insurance companies. They will start benefitting immediately and if we see a few more hikes this year, the benefits compound.
We also saw a very favorable development for our investments in Assured Guaranty, MBI, and Puerto Rico bonds, with the Title 3 settlement of a large percentage of Puerto Rico’s defaulted bonds. For AGO, 39% of its non-paying Puerto Rico insurance exposure at year-end 2021 has now been removed. The remaining credits are either paying and in good shape, or are subject to settlement agreements that still must be finalized. I’d expect the rest to be resolved this year. Municipal finances are very healthy due to the stimulus of the last few years, so the insured books’ have never been better. For newer clients that aren’t familiar with what we did with Puerto Rico bonds many years back, we bought bonds with strong legal protections for 5-23 cents on the dollar when pessimism was extremely high. As the legal process evolved, prices rocketed higher and now go for between 50 and 100. Most of these bonds have returned around 400%, so obviously we wish we did more. If we get distress in fixed income, which seems like a decent probability, we will look to execute similar distressed investment opportunities.
I haven’t discussed MBI much, but they are a former competitor of AGO that is now in runoff, as it doesn’t have a high enough credit rating to write new business. I believe they will be acquired this year, as the Puerto Rico overhang gets removed. The stock trades at $15.55 and I think an acquisition could occur at $15-18 per share. We aren’t in the stock, but instead have sold puts. The December $10 puts, sell for $1.35. This means that if the stock expires above $10, we will make 15.6% on the maximum risk in just 8 months. The stock could drop by 44% before you would lose a penny at expiration. Our portfolios’ are filled with these types of trades, which is why I always harp on waiting till options expire to see the full benefits of the strategy. Right now volatility is sky high, as it goes down and time goes down, we should make a lot of money.
I’m not going to sugarcoat the the macroeconomic outlook. It is ugly and there are a lot of headwinds. Pessimism is very high, which is being reflected in many stock prices, but I definitely wouldn’t say the market is cheap by any means. Bonds and 60/40 portfolios are getting killed, as both stocks and bonds have been dropping. In these types of markets, stock selection and our use of options provides us with a huge advantage. The best case outlook to preserve the global economy is this war ending soon, which would reduce the pressure somewhat on commodity prices. If not a recession is a very good probability, but it isn’t assured. We are well positioned for either outcome, but obviously are praying for peace. If the market really tanks, we should continue to lose dramatically less than the indices, and we’ll end up owning stocks at simply sensational values, positioning us well for the next 5 years. If you have friends or family that are getting hurt in mutual/index funds like so many are, please don’t hesitate to refer our services, as I firmly believe you will be providing them with a great service. These next 10 years are not going to be good for most index funds in my opinion. I wouldn’t be shocked if the indices are flat, or return less than 3% per annum, given the starting valuations and inflation/interest rate risks that will pressure those valuations. We appreciate all of you greatly and thank you very much for your trust in these challenging times. I’ll do my best to keep you posted as we go!