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BRIEFING BOOK

Data Information Knowledge WISDOM

MARTIN FRIDSON

Location: Forbes, New York, New York

About Fridson .................................................................................. Debriefing Fridson ...........................................................................

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Fridson in Forbes

"Corporates Can Handle Rising Rates," 01/27/10 ……………. "Prospects For Junk Bonds in 2010," 01/21/10……………….. “Rise Of The Bubbleheads," 01/20/10………………………….. “Back To PIKS and Tricks,” 12/11/09……………………………

"Junk On TV And Radio" 12/04/09……………………………….

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The Fridson Interview ………………………………………………….. 18

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ABOUT MARTIN FRIDSON

Intelligent Investing with Steve Forbes

Martin Fridson is the CEO of Fridson Investment Advisors, an investment management firm that focuses on corporate credit opportunities. He specializes in high-yield bonds.

Fridson is a former board member of the CFA Institute, the New York Society of Security Analysts and the Financial Management Association. He became the youngest person inducted into the Fixed Income Analysts Society Hall of Fame in 2000. The Financial Management Association International named him the Financial Executive of the Year in 2002. Additonally, Fridson serves as a consultant to the Federal Reserve Board of Governors.

Fridson has written six books including Unwarranted Intrusions: The Case against Government Intervention in the Marketplace; How to Be a Billionaire: Proven Strategies from The Titans of Wealth; It Was A Very Good Year: Extraordinary Moments in Stock Market History; Investment Illusions: A Savvy Wall Street Pro Explores Popular Misconceptions About The Markets; Financial Statement Analysis: A Practitioner's Guide and Corporate Finance: A Practical Approach Workbook. He is also on the editorial board of the Financial Analysts Journal.

Fridson got his bachelor's degree in history from Harvard College and his M.B.A. from Harvard Business School. He has been a guest lecturer at the graduate business schools of Babson, Columbia, Dartmouth, Duke, Fordham, Georgetown, Harvard, MIT, New York University, Notre Dame, Rutgers and Wharton, as well as the Amsterdam Institute of Finance.

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DEBRIEFING FRIDSON Intelligent Investing with Steve Forbes

Interview conducted by Alexandra Zendrian January 27, 2010

Forbes: Now that stocks are 70% higher than their lows, skeptical investors are starting to swing into the bullish camp. Should investors who were emphasizing bonds in their portfolios be switching out of bonds and fixed income into stock?

Martin Fridson: It all depends on assumptions, of course. I think the premise for that is that the Federal Reserve will be starting to raise rates. Even if they don’t, longer rates will start to pick up. And some of the inflationary concerns--as the quantitative easing passes, these can be the support for the intermediate-bond market. Rates will go up, performance will suffer on the bond side and, meanwhile, as the outlook continues to improve for the economy, stocks will benefit. And one comment I’ve heard recently is the favorable year-over-year comparisons because companies are now comparing quarters to a very bad, recessionary environment in 2009 compared to the still relatively good performance in 2008, maybe in the earlier part of 2008. So I think that that encompasses a lot of assumptions, reasonable ones, and I think a lot of people will come to that conclusion. Others can look at the same facts, what we now know are the facts, but come to different conclusions, particularly if you’re talking about corporate securities such as Treasuries, including the high-yield market where I’m most involved.

First of all, on the equities side, to me the notion that the favorable comparisons will be a great help seems a little off because last year’s earnings are not news. So to say that they’re better by comparison, I don’t know why that would cause stocks to go up unless their earnings are up relative to what analysts were predicting this quarter. And the other question mark is, I think, how much more cost cutting is possible? There are some people who would say we have more to go and others would say we’re pretty much done. So earnings gains are going to have to have top-line growth, with the consensus gross domestic product forecast of 2.6% for 2010.

Then on the other side, as far as other alternative investments: Yes, Treasuries may not be that appealing under the circumstances with the possibility of a rate rise. I think the consensus view is about a 50 basis points rise for the year. I guess you could say for the yield curve, that’s a hole. Given that, maybe the Treasuries aren’t that appealing, but getting into the corporates--and particularly with lower-rated corporates, the additional risk premiums related to credit--by my estimates the high-yield market should have a pretty

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good year. If we do a have a 50-basis-point rise in the Treasury rates, I still get a little over 10% return based on the projection default rate decline. Moody’s does a projection, and it’s for the U.S. market, a 3.6% default rate for 2010, which is quite a sharp drop because it was 13% last year. The numbers are already showing that if you look at the 13%, that’s a drastic drop, but in the latest quarter, it was running at under a 6% annualized rate, so we had a big spike earlier in the year, and now they’re down very sharply on a quarterly basis.

I don’t think that the Moody’s forecast is too far off-line and, in fact, the market-based model that we use is right in the same neighborhood of 3.5%, and that’s based on what percentage of the issuers are very highly default prone. So I think that the market is telling the same story.

There are others with more pessimistic views on default rates, but that’s why you have that back-up in rates, and the thing to keep in mind is high-yield rates are relatively sheltered from Treasury rate rises. Actually I’ve found that if Treasury rates rise by less than 100 basis points you’re actually more likely to have the yield rates go down than up. BofA/Merrill Lynch just did a study on where the risk premium on high-yield is and we’re still above the threshold where the high-yield market starts to become more sensitive to Treasury rate moves.

So this other line of argument that I was laying out is: If default rates come down, high-yield should do well and be very competitive with returns of both shorter-dated, fixed-income instruments and Treasuries and equities. But then the question is, all the companies have done is kick the can down the road. They have massive liquidity. Maturities have become illiquid, and that’s potentially a concern in 2012 and 2013. The sell-side firms that were talking about a lot of this, using the phrase "the wall of maturities," talking about a second peak in default rates, they’ve really pushed that scenario back because there was so much refinancing done in 2009 that companies by and large have funded out those shorter-dated maturities. So if conditions aren’t good in 2012 and 2013, no one knows if maturities will really bound up--and they’ve pushed those maturities out further by that point--then there very well could be a problem. But it’s just not really a 2010. So as long as the economy doesn’t get worse, then the companies that are already covering their interest for the most part will continue covering it, and they won’t run into the problem of not being able to roll over their debt. The default rate should really come down pretty substantially.

I think it depends on what bond you’re talking about and what assumptions you’re making. But I think there’s an equally valid thesis that precludes just the opposite. People haven’t gone into equities that much; there haven’t been inflows to the equity mutual funds. The money that went into money market funds after the Lehman collapse, at which point the Treasury came in and backstopped the money market funds because there were funds

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that broke the buck--$400 billion promptly flooded into the market. After the crisis began to fade that $400 billion came right back out to other categories but mostly high-yield bonds, corporate bonds, emerging market bonds. Nearly nothing went into equities. So at this point it’s more people staying with the corporate bonds or moving into other instruments.

How does a retail investor figure out when to flip the switch and move from bonds to equities or vice versa?

Well if you could get that perfect, you’ve really got it made.

The market, unfortunately, is going to anticipate that change that will come along. And that was the complaint of the bears all through 2009--that the market isn’t really getting better, it’s only getting less worse. We haven’t yet seen the confirmation. But the high-yield and the equity market were soaring at that point. High-yield wound up doing much better in absolute terms, with 57.5% return for the year as measured by Merrill Lynch’s high-yield index. But equities made a strong rebound, too, after the lows earlier in the year. So unfortunately, you always have to be forward-looking and try to be a step ahead. But I think that the one important signal that you should be looking for is the sign that inflation has been subdued because the factory utilization is so low. Companies are still getting pricing power, so most credit has been created in the system. You really don’t see much sign of inflation yet. As the market starts to focus on that more and the removal of that quantity, then artificial support for the bond market--that will be more of a feeling of bond rates going up.

What kind of fixed-income investments would you recommend now and what regions are you looking at bond investments in?

As a firm, we’re mainly institutionally oriented. We invest in nondistressed, high-yield bonds, distressed debt (which can either be debt or leveraged loans) and loans that are also not distressed. We can get into other areas, such as equities; equities of the same companies we’re investing in in the bond market. Those are the categories. Over time we adjust the concentration in the different categories. I think for most investors, look at funds and specialize in one of those categories. They can look at the prime rate funds on the loan side and the high-yield mutual funds. You can also look at investment-grade corporate funds. Right now our emphasis is more on the bonds than the loans, although going back to early 2009, it was quite different because at that point LIBOR was at a high level. Under more ordinary circumstances, because of the positive slope of the yield curve, it would lower more short-term rates than long-term rates. The absolute yields and returns are generally going to be higher on the bonds.

How do you feel about emerging market bond funds or those markets in general?

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It’s not an area that we are really involved in, but right now I think there is some understandable concern. The positive story on emerging markets is that they have the growth. It’s clearly higher than in the more developed countries. There are excellent opportunities for investment. The concern right now is that sovereign risk in general is coming under a cloud. Greece and Ireland to some extent, those are not the true mainstays of the emerging market sector, but there has historically been a contagion factor which is not necessarily because economic problems in Thailand cause economic problems in Brazil. But it’s sort of a pool in that sector, and the banks are lending to those countries, and when one gets into trouble, there’s a tendency to pull back. I think that that’s the real concern--the risk that you’re taking right now with more problems bubbling up on the sovereign risk front. It looks likely that Greece will likely not control it’s problem, so if you have the one and you don’t have a lot of investments in the others, you’re going to get into a lot of trouble. And right after it, they’ll probably do okay.

You wrote Unwarranted Intrusions, a book about heavy-handed government influence in the economy. What actions are of particular concern to you?

Well, of course the big thing is the involvement in the institutions. That’s an interesting case. I did deal with some of those markets issues, and right now the headlines are that President Obama will take the banks out of proprietary trading and just reduce the size of the banks. And I come down on two different sides on those. The proprietary trading, I think that is a legitimate issue. And the argument against that is that proprietary trading isn’t what caused the banks to fail--and I think that’s probably right, but that’s not the reason to do it. The reason to do it is that the safety net is for three essential functions in our economy, which are gathering and safeguarding deposits, lending, and maintaining the payment system. So it’s very costly to have a lender of last resort, deposit insurance, too big to fail doctrine, but we get something for our money as taxpayers--namely, those functions continue, and the economy continues to function. That safety net is not there to allow people to roll the dice with a put to the taxpayers.

So someone might say, "If you’re so interested in the free markets, why would you want the government saying what lines of business companies should be in?" Well, that’s true if you’re any other business. Every economist I know of, regardless of their political orientation, acknowledges that banking is a special case where they’re not in a free market. There is this backup, and it’s correct that there should be that kind of involvement. Because if a bank goes broke, it’s not only the shareholders of the bank who suffer but the other banks--because there’s a danger of a run on the banks. And then you have a contraction of credit and an adverse affect on the economy as a whole. So it really is because of that spillover effect and because of the other parties involved that you have to

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have some system in place. You can have a system that doesn’t have that much government involvement, but the fact is that’s the system that we have.

Now the size of the banks I think is a different question. I don’t think that’s really as much the issue as making the banks control their risk properly, knowing what they’re lending against, not being put in the positions they were with the long-term capital.

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FRIDSON IN FORBES Intelligent Investing with Steve Forbes

Bonds

Corporates Can Handle Rising Rates Matthew Craft, 01.27.10, 05:00 PM EST

Rising interest rates will hurt corporate bonds, right? Not exactly.

To pay for the surge of troops in Afghanistan, stimulus spending and a possible attempt at health care reform, the U.S government relies on the world buying Treasury bonds. With estimates that Treasury sales will top $1 trillion this year, it's widely expected that China's central bank and other investors will demand more in return, pushing interest rates higher. Rising yields on government debt would punish bond prices across the board, and Americans who've stuffed their savings in high-yield bond funds in the past year would get squeezed.

There's one problem with this scenario. Over the last 20 years, that's rarely how things have worked. Recent research suggests an increase in long-term interest rates this year could even lead to lower borrowing costs for companies deepest in debt.

That turns conventional wisdom on its head. A partial explanation for the stampede of companies selling bonds in early January was that Level 3 Communications, Qwest Communications and Ford Motor Credit, among many others, wanted to lock in low rates while they still could.

Even though corporate bonds need to pay a premium over relatively safe Treasuries, yields on low-rated corporate and government bonds tend to follow separate paths, according to a study by credit analysts at Bank of America Merrill Lynch and another by Martin Fridson, head of Fridson Investment Advisors. Bank of America's report shows that over the past year Treasuries had the lowest correlation to high-yield bonds than any other security. Over 10 years Treasuries trailed just behind the VIX, a gauge of stock market volatility.

In December the 10-year Treasury yield climbed from 3.2% to 3.84% and the speculative-grade yield dropped from 9.7% to 9%. Interest rates usually rise because of a stronger economy, a climate that supports companies with heavy debt burdens, Fridson says. Last year provided an extreme example. As investors gained confidence that the financial system wouldn't collapse, they sold off safe investments like Treasuries, pushing the yield up, and moved money out of cash and into riskier investments, pulling corporate yields down.

But in other years the two have moved in the same direction. From September 1998 to February 2000, 10-year yields were up 2.25 points and speculative yields up 1.10 points. How to account for that?

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A lack of fear explains some of it. The Bank of America credit analysts note that when the yield spread between the bonds is usually under 5 percentage points, the median spread over the last 20 years, the two yields are more likely to move in the same direction. Tighter spreads imply little fear, so it seems that when investors see reason for optimism the two bonds have a connection. The Internet-crazed economy of 1998 and 1999 looked nothing like the Great Recession of 2009.

The typical junk bond pays a risk premium of 6.44 percentage points more than Treasuries, according to a Bank of America Merrill Lynch index, suggesting there's still plenty of fear around.

Bank of America sees the 10-year yield hitting 4.25% by the end of the year from the current 3.64%. If that happens and the economy improves, Fridson and others in the bond market say investors' perception of risk should shrink, which means junk bonds may fare better than U.S. debt.

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Side Lines

Prospects for Junk Bonds in 2010 William Baldwin, 01.21.10, 07:20 AM EST Forbes Magazine dated February 08, 2010

Are junk bonds a buy?

You coulda bought risk last year. You woulda made a bundle.

The junk bond market delivered a total return in the neighborhood of 57% for 2009, a blend of fat coupons and rising prices. You could have made a whole lot more than that buying common shares of the junkiest companies (see "The Risk List"). Risk taking was amply rewarded.

The big rebound has a lot of people breathing a sigh of relief. Is the debt crisis over? Far from it. As the cover story by Daniel Fisher explains (see The Global Debt Bomb), the world is still awash in debt that might not get repaid. This year will see tens of billions in corporate bonds sinking into default. There's no telling when sketchy borrowers like Venezuela or California start stiffing bondholders.

The question for investors: Am I getting adequately compensated for risk? If you own Japanese government debt, probably not. If you are buying corporate junk bonds, probably yes.

I visited two elder statesmen of the high-yield market to get their outlook for 2010. Martin Fridson and Edward Altman are, respectively, somewhat bullish and a little skeptical.

Fridson, who manages junk portfolios from the Manhattan office of Fridson Investment Advisors, has sketched out a scenario that has the category delivering a 10.8% total return this year, slightly better than the long-run average return displayed in the chart. His elaborate calculations take into account the shape of the yield curve and the value of options built into corporate bonds. Those options work against the investor. They give companies the right, if business goes well, to call in high-yielding debt and replace it with low-yielding debt. If business goes the other way, you're

Fridson is banking on a modest price gain as yields come down a bit more. He estimates that 3.6% of junk will go into default. Since bonds from sickly borrowers are already trading below par and creditors recover something in a bust, this translates into a 1.4% loss of principal. One of his holdings is a 10% bond from Energy XXI. This firm is a beneficiary of a huge gas find called Davy Jones (for more on that, see "At 89 a Wildcatter Strikes Again"). The bond illustrates what's good and bad about junk. The yield is nice. But, as always, it's a lopsided bet. Dry holes hurt lenders to wildcatters; a gusher makes someone else rich.

Altman is a professor at New York University and a consultant to investment firms. He doesn't make return forecasts, but he notes that yield spreads over Treasuries are already meager by historical standards and thus unlikely to go lower. He does forecast default rates. Expect 5% to 8% of junk bonds to go bad this year, he says.

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Should you have money in junk? Some, yes. Go in with your eyes open.

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Bubbles

Rise Of The Bubbleheads Matthew Craft, 01.20.10, 05:00 PM EST

If you worry the Fed is fueling a bubble for low-rated debt, a bond guru has a name for you.

What do you call financial experts who cry "bubble" when the price of an investment moves steadily higher? Martin Fridson, a noted observer of debt markets and a bond fund manager, has resurrected a name for them: "bubbleheads."

Fridson's particular problem is with those who see a bubble in high-yield bonds, which returned 57.5% last year and have already gained 2.2% this month, according to a Bank of America Merrill Lynch index. The case for a bond bubble parallels the one made popular by economists and Chinese officials who say that the Federal Reserve's low-interest-rate policy has encouraged borrowing at short-term rates to speculate in Asian real estate, emerging-market stocks and gold prices. Similarly, they say, the flow of money into high-yield bonds has pushed the market so high and so fast that it's bound to fall. Harvard economist Kenneth Rogoff, newspaper editorial writers and economic

Fridson thinks the term "bubble" is too easily abused and that a speculative bubble has formed around calling things bubbles. A bubble implies people are picking up a product to sell it at a higher price, passing it on to "a greater fool." Investors, by contrast, are buying high-yield bonds to savor the 8% payout. At an average 97 cents on the dollar, prices for low-rated corporate debt may look rich, says Fridson, head of Fridson Investment Advisors. But these bonds are likely to take a hard hit only if the economy goes into another tailspin, Fridson says. That is, if the "double-dip" scenario plays out.

Plenty of prominent economists have recently warned that the economy could begin shrinking again, including Paul Krugman and Martin Feldstein. Those who see a bond bubble assume this is destiny, Fridson says, but that's far from the consensus view.

Even if it's driven by speculative fervor, the flood of money into the high-yield market has allowed companies to refinance more expensive debt and push other due dates into the future, which makes them better able to handle a turbulent economy. Some 75% of speculative-grade bond sales have been used to refinance debt in the past 12 months, Fridson says. Stone Energy, CMS Energy and Brocade Communications have tapped the markets for this purpose in recent weeks (see "The New Bond Boom").

This refinancing wave has led rating agencies to lower their projections for companies missing payments. Moody's expects 3.6% of low-rated debt to default this year. At that rate, and with yields on Treasury bonds rising 50 percentage points, the high-yield market may return 8.5% this year, Fridson estimates.

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Others worry that when the Federal Reserve begins hiking interest rates, bond prices could collapse. That fear also seems misplaced, Fridson says. The Federal Reserve is likely to lift the federal funds rate only with clear signs of growth. If the economy escapes another recession and the feared double dip, the weakest companies would be better off.

A story in Bloomberg last week quoted Fridson saying that the "bubbleheads" weren't looking at the current state of the bond market but basing their views on a pessimistic outlook for the economy. Afterward Fridson searched around to see if anyone had made it into print before him with the same use of "bubblehead," as in a person who "erroneously characterizes a fundamentally justified price gain as a bubble." He found others using the moniker for a submarine crew and for Christopher Cox, the former Securities and Exchange Commission chairman.

In June 2005, however, CNBC's Jim Cramer used the term in a similar way to Fridson, except he wasn't defending a "fundamentally justified" rise in prices. Cramer, hailing the soaring stock of house builder Toll Brothers on The Street.com, called those folks worried about a speculative housing boom "bubbleheads." The bubbleheads clearly won that round. At the time, shares in Toll Brothers had jumped over $100 before splitting in half. Toll's shares opened Wednesday at $19.43.

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Bonds

Back to PIKS and Tricks Matthew Craft, 12.11.09, 04:45 PM EST

The corporate bond market pulls its boom-time clothes out of the closet.

With credit cheap and investors starved for yield, a few of the scarier features from the last credit bubble have reemerged. Companies with weak credit ratings and the heaviest debt loads are finding ever more credit. Two bubble products have also returned: loans with weak restrictions and payment-in-kind notes, which permit companies to make interest payments with bonds instead of cash.

To Eric Felder, head of credit trading at Barclays, the reappearance of a product from the credit bubble, such as a bond with a PIK switch, does not signal a new credit bubble and that bond buyers are suddenly heedless of danger.

"You can't say a PIK bond is a sign things are going too far," Felder said, during a discussion with reporters on Thursday. The companies that have recently sold PIKs are strong enough to carry their debts, he said.

Credit JohnsonDiversey, a commercial cleaning supplier, and their bankers at Goldman Sachs for bringing them back. On Nov. 20, Goldman Sachs found buyers for $240 million in JohnsonDiversey's PIK toggle notes. The notes carry a B- rating, three steps into the junk category.

This week, Wind Acquisition sold $625 million in PIK bonds. The cash will support Wind's owner, Naguib Sawiris, in his bid for Wind Hellas, a Greek mobile phone company.

The credit quality of sales is dropping quickly. Dig into the junk pile and you'll find CCC-rated companies on the third rung from the bottom. Such companies accounted for 20% of all U.S. junk bonds sold in November, up from 11.5% in October, according to BofA Merrill Lynch Global Research. During the first half of the year, the only CCC-rated issuer to sell bonds was Ford Motor's vehicle financing arm.

The most recent was Pinnacle Foods, the maker of Vlasic pickles and Hungry-Man frozen dinners owned by the Blackstone Group. On Dec. 9, it sold $300 million in CCC-rated notes to help pay for its $1.3 billion acquisition of Birds Eye Foods.

The positive spin on this trend is that a greater range of companies can find buyers for their debt at lower rates. More of them are able to survive the recession as a result.

"Whatever the underlying causes for all this may be--a topic for another day--if there's ever a good time for a corporate borrower to have a bottom-of-the-barrel credit rating, this is it," wrote Martin Fridson, head of Fridson Investment Advisors, in a note this week. "Small business is still having a

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tough time obtaining credit, but for the medium and large companies that have access to the public bond market, a CCC rating is no obstacle."

In the market for government debt, the Treasury held two auctions bond dealers called disappointing. It sold $21 billion in 10-year notes at 3.44% and $13 billion in 30-year bonds at 4.5%--both fetched higher yields than expected.

It's a tough time of the year to sell longer-dated debt, bond analysts say. Investors are closing up their annual books, and even the collection of 18 banks and brokerages that make a market for U.S. government debt (from Nomura Securities to Goldman Sachs and Morgan Stanley) have cut back. On Dec. 9, the day of the 10-year auction, Treasury market volume was 72% of the 10-day average, according to RBS, another primary dealer.

The exception was the auction for $40 billion in three-year notes on Dec. 8. It came a day after Federal Reserve Chairman Ben Bernanke said the U.S. economy faced "significant headwinds," which ended speculation of an imminent rate hike. The 1.2% yield for the notes was the lowest since January.

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Junk On TV And Radio Matthew Craft, 12.04.09, 03:10 PM EST

Investors pick up beaten-down broadcasters.

The jubilant rally in corporate credit looked like it was going to pass by radio and television broadcasters, those old media companies dependent on advertising dollars. But Clear Channel, Univision and others under the traditional media tent have recently seen their fortunes change.

Investors finally got around to buying bonds in heavily indebted broadcasters. The industry's speculative-grade debt led the rest of the junk bond market in the past month, returning 8.58% in November, according to a BankofAmerica-Merrill Lynch index. Overall, junk bonds returned 1.7%.

Despite speculation that it wouldn't survive, Clear Channel, owned by the private equity firms Bain Capital and Thomas H. Lee Partners, has seen its notes maturing in six years leap from 53 cents on the dollar a month ago to a recent 70. Univision, also owned by a group of private equity firms and shouldering a weighty debt pile, has bonds coming due in five years that trade at 104 cents on the dollar and still yield 9%.

Broadcasters with weak credit ratings now trade at 80 cents on the dollar, up from 30 cents at the start of the year. Call it a sign of a budding economic recovery or maybe more evidence that investors will grab yield anywhere they find it.

Some are returning to health. During its earnings call last month, Univision reported stronger profits and sales – largely from television advertising and transmission fees. Clear Channel has been trimming its debts, and its stake in Clear Channel Outdoor is expected to boost revenue. In recent reports, credit analysts have argued that advertising sales will creep higher as the economy recovers over the coming months.

This brighter outlook isn't the whole story. Martin Fridson, head of Fridson Investment Advisors, says the junk bond market's returns over the past month were almost entirely provided by rising prices for distressed debt, bonds from those companies most likely to default. Higher prices don't mean struggling companies are that much healthier, Fridson notes. Some of their newfound popularity is a result of investors putting their worries aside and scooping up anything with a high yield. Broadcasters, in other words, were among the last to get pulled from the bargain pile.

How hungry are investors for yield? The spread between junk bonds and Treasury debt is one measure: The smaller the spread, the greater the appetite for risk. The spread shrunk to 740 percentage points on Thursday from 760 at the start of November – a steep descent from 1784 on January 3.

Falling rates on corporate debt keep companies tapping credit markets to refinance other debts, spread out their bonds' due dates or simply raise cash. In the past week, Hanesbrands, Dynegy and Norcraft Companies sold new issues in the speculative-grade market. Goldman Sachs is marketing bonds from JDA Software Group, a sale expected to close next Tuesday.

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Coming weeks should see fewer sales, as bond buyers close out their books before the end of the year and the window for new borrowing shuts.

Government borrowers are still at it. Next week, the Treasury will auction $74 billion in a mix of bonds: three-year notes on Dec. 8; ten-year notes on Dec. 9; and 30-year bonds on Dec. 10. It will also sell $61 billion in three-month and six-month bills Dec. 7.

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THE FRIDSON INTERVIEW Intelligent Investing with Steve Forbes

Bubbleheads Steve Forbes: Well Marty, nice to have you with us. You have described people who think that another crash is coming in the high-yield market -- what we call a junk-bond market or Treasuries -- "bubbleheads." And by the way, you called the market in 2007. You told people to take your winnings off the table in the high-yield market. But you were in the market last year and when the thing turned, especially for junk bonds, turned very dramatically. Why are those who are skeptical “bubbleheads”? Martin Fridson: Well, I think that if it turns out that there's a return to financial crisis of course that will be tough for almost every kind of financial asset other than Treasury bonds. But I think there is some tendency to say that just because the market had such a good year it must be inevitably headed for a fall. I don't think that's the case. I think that the default rate will continue to decline during 2010. We won't achieve anything like the 57% return of 2009, but compared to other assets as alternatives in the market, should be a reasonably good year. So I think it's only in the case of an exogenous shock, oil-price spike or something of that nature, that you could say after the fact that prices were too high. Forbes: Now, you're predicting less than a 4% default rate, and also since a lot of those bonds are priced very low anyway, principle is only going to be a less of what, 1.5%? Fridson: Yes, something on that order. And bear in mind that the issues that default this year are already trading at low prices. Fitch actually put on some research just recently showing that there was almost no decline in the price of bonds that defaulted during 2009 from where they were priced on January 1st. So the default losses should be coming down. One thing that's not well understood is that the default rate is already down very sharply. The peak on a quarterly basis was actually way back in the first quarter of 2009. So the four-year statistic is a little bit misleading. It was in low double digits for the full year. But by the fourth quarter, by our reckoning, it was down to about a 6% annualized rate. So getting down to four or a little bit less is not as big a stretch as people might imagine. Forbes: Have these people who are worried about bubbles underestimated the fact that many companies have refinanced and therefore pushed out the day of reckoning, so to speak? Fridson: Well that's absolutely right. And it's not to say that it might not be important in the future, but there was a tremendous comeback in the finance, and specifically in the bond market. The loan market has only more recently begun to revive. But through 2009,

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there was a pretty robust new-issue market for high-yield bonds. And a lot of the debt that was too mature in 2010 or 2011 was refinanced, pushed out further. So that shouldn't be too much of a problem. The bulge is now more out in the 2012 and beyond period. So if companies can cover their interest in the low-growth environment that we're in currently, they won't run into problems by and large as a result of being unable to roll over their debts. Bank Loan Blues Forbes: You have, under your writ, that you can invest in loans. What do you see happening for bank loans, particularly for commercial real estate? Fridson: Well, that's going to remain a tough area. And it's not something we're too involved in. We have a broad mandate and we can get involved in those others. But our specialty is more in the corporate-bond area. But commercial real estate is typically a lagging factor in the economy. So it's one of those things, like unemployment, that people continue to point to and to say that well, here is evidence that the economy is not doing well. And from the standpoint of someone heavily invested in that area or who is not employed currently, that's an accurate statement. But it's not out of the ordinary that you see the commercial real estate still having difficulty with the GDP already beginning to move up. Forbes: You mentioned 57% return last year. And a lot of individual issues were even more sensational, especially in the REIT area and some other areas. What kind of general return are you kind of anticipating this year? Eight percent, 10%? Fridson: Yeah. We could be somewhat north of 10% if we do in fact get the default rate down to 4% or below and we don't see a backup in the underlying Treasury rates. Now that was a concern, quite a bit of a concern, going into the year because of all the reasons you can point to -- the removal of quantitative easing, tightening by the Federal Reserve, inflationary fears. But year-to-date, it's going the other way. And I don't know if that will last through the whole year. But the impact of rising Treasury rates probably has been muted already because of the retrenchment that's occurred. The greatest sensitivity is to default rates. And if the default rates are significantly higher then I'm expecting that will make a cut into the returns. But the important thing to keep in mind is high-yield bonds are comparatively insensitive to the rise in Treasury rates. So that's a one of the great benefits. A Spike In Interest Forbes: I was going to ask that. Why is that? Fridson: Well, it probably sounds a little counterintuitive, but actually in periods when rates have risen by 50 basis points or less, you've actually had high-yield yields go down more often than they've gone up. And the reason for that generally is that the rise in

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interest rates reflects a stronger economy. So the risk of default is actually coming down. And that offsets any underlying effect of the pure interest-rate effect going up. Forbes: Now why won't interest rates go up? You mentioned the Fed has done a lot of easing. Huge budget deficits as they used to say, as far as the eye can see. I've got big eyes these days. Why wouldn't there be a spike in interest rates? Fridson: Well, I think there will be. I'm fairly pessimistic about the inflationary picture. And if we have a big upsurge in inflation, interest rates will surely rise because people don't want to be getting paid back in less valuable dollars without getting compensated for that. But it’s a question really of when. And currently the operating rates in U.S. factories are so low that there really isn't very much pricing power for companies. So that inflationary concern is muted and certainly with high unemployment, the wage pressure is not what it would be otherwise. So while I think it's a very serious problem, that the spending is at the level, the deficits are at the level they are, currently, there's just not the ability to raise prices. And here in the U.S. we're benefiting from the dollar as the flight safety for everywhere else that they're worried about, partly because of problems we've created. But in a strange way, we're benefiting from that. Forbes: So, in terms of inflation itself, what you're saying is when you buy bonds, particularly high-yield bonds, enjoy the returns while you can. But this is almost a month-to-month, year-to-year kind of thing. You're not looking three years, five years. You're just saying this year, okay, but then after that, beware. Fridson: Yeah, I would say that that's right. I think that the problem may get pushed out even further, not in a healthy way, but being an investment manager, we have to deal with the realities that we see. I have some expectation that the Fed will, in fact, find it difficult to begin raising interest rates or even something that might be less provocative, which is the idea of draining liquidity from the system by paying interest on reserves held by the banks. Even that, I think we'll run into a lot of resistance by Congress if you still have unemployment at 9% plus. Now when I mention this to people, they say, "Oh, but the Fed is independent." And I just look at the recent wrangling over the re-nomination of Ben Bernanke and say, "How can you make that statement?" And clearly, the Fed is subject to political pressure. And I'm afraid they will delay that necessary tightening too long. But the rates will stay low as a result. Forbes: Now what do you see happening with the economy? Do you see jobless growth? Or will joblessness come down but not to the levels we saw in the late '90s and parts of the last decade? Fridson: Well we may have some structural issues that will cause unemployment to remain higher than historical levels for a prolonged period. What seems clear is that it's not going to come down very rapidly. We actually have moved, compared to the last recession, fairly swiftly towards at least getting back to job creation. That seems like it's not far off. But how quickly and how eagerly companies will hire is another question. So,

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unfortunately, the unemployment rate should remain elevated, probably at least through 2011. A Strong Bond Forbes: What bonds would you recommend investors to buy right now? Fridson: Well, the quality is a consideration. The lowest quality within high-yield has done the best through now. That may start to change. But in a comparatively stable year -- the interesting thing is that when the total return on the high-yield index as a whole has been anything over 5%, the triple C's have tended to outperform and that's not a high target to hit. So it'll probably be the case, even though you can make an argument of the lower-tier paper being overvalued currently as a result of some changes on the demand side, the greater participation of leveraged hedge funds than in years past, that effect doesn't seem to be going away soon. So the high-yield sector of the corporate-bond market I think still is attractive. The investment-grade sector is still at comparatively wide, historical spreads. So I think that could be a good performer there. Forbes: So it's almost across the board. Fridson: Yeah. The only thing is, you do have greater interest-rate sensitivity the higher you go in quality. So, if you are more concerned about rates going up sooner, that would be a disadvantage of being in the higher-quality paper. Forbes: So the higher yields are going to do well because they've gotten their houses in order, been able to refinance, and in even a semi-buoyant economy means that they're going to have an easier time financing their paper, servicing their paper. And of course, bigger companies have turned their balance sheets into fortresses. They're in far better shape than the U.S. government certainly, it seems. Fridson: Yes. Well, I think there have been some caution and some notion of stockpiling some cash which is an indication of still some caution about the market. And the consumer is probably the biggest factor in that, with the unemployment rate still high. There is concern about the consumer coming back as strongly. So I think companies are holding back on the investment to meet new demand and also getting their funding locked in just in case the environment is less favorable later on. So yeah, their balance sheets are in fairly good shape right now. Stocks Versus Bonds Forbes: Now on these companies, high-yield companies, would investors do better buying the underlying common instead of the bonds themselves? Fridson: Well that's always the issue. People point to the fact that --

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Forbes: Look at Ford Motor Company. Down to a buck a share a year ago. Now $10, $11 a share now. Fridson: Oh, absolutely. If things go well, you're certainly going to make more money in the stock than in the bond. A bond gives you better downside protection. So I think that the unusual thing about this year -- of course, it depends on your outlook for the stock market -- but the way I see it, the slow growth in the economy is going to be a damper on stock performance. Companies have probably reached the end of the line in most cases on the cost-cutting that has caused their earnings to grow. So now they need the top-line growth. And if it doesn't come, I don't think it's going to be a robust year for stocks. So getting current yield of close to 9% on high-yield bonds with the potential of at least a little bit of appreciation may wind up looking very attractive relative to the other options. The Biggest Wild Card Forbes: You'd mentioned earlier exogenous factor, something that outer space hits. Not quite going to outer space, what impact do you think things like Greece, Portugal and perhaps sovereign defaults in the United States from some states or municipalities or authorities, government authorities? Fridson: Yes, I think that's absolutely the biggest wild card in the deck right now. And we've seen that in past years, 1997 as an example with the East Asian currency prices, and 1998 with the Russian default. Sovereign risk is something that's always lurking out there. And the worst of is it that you can't necessarily trust the numbers being put out by the country. So you don't really know how bad it is. And there's the very serious risk of contagion where countries complain bitterly that they say, "We're in good shape.” But unfortunately, the pool of capital available to the developing countries in general contracts and even those who have done a better job managing their finances will suffer. And you can very well have a spillover to the developed world and the world economy in general. So I would say that's the greatest uncertainty and potential for shock that I can see out there. Putting numbers on it, of course, is very difficult. Partly a matter of how other countries will respond, and there seems to be a game going on in Europe right now of, "Well, we're not going to let you fail, but we also want you to step forward and do some things to correct your own problems. So we're not going to commit ourselves to how much we're really going to come in to bail you out." Forbes: You take any solace from Dubai? The world seems to be surviving that one. Fridson: Yeah. I think that actually is encouraging. When it happened, it was really the Friday after Thanksgiving. We had agreed to make a conference call just in case something happened. And that was prophetic.

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One of my colleagues had the idea we should speak on Friday. And it looked pretty threatening at that time. They fortunately were able to get some help from their friendly neighbor in Abu Dhabi. Not every country is in such a fortunate situation. But I think it does point out that if the environment in general is favorable, the panic can be contained. So these types of events have a differential effect depending on what the overall environment is like at the time. Forbes: What kind of odds would you put on a contagion? Do what the weather people do – 30% chance precipitation, 60% chance -- realizing Greece for all of its problems is part of the E.U., as is Portugal, as is Spain, as is Ireland. Fridson: Right. I think that the risk of default is pretty low at Greece and it appears that even the risk of downgrading to our type of territory, not that we would be buyers of the sovereign debt at that point, but to speculative grade rating also seems to be fairly small. But I think the possibility of the problem spreading and concern affecting other countries that even, again, some of the developing countries ultimately, I would say you probably have to assign something like a 20% probability to that just to be responsible and say that it is one of those events that has been very serious in the past. Could A State Default? Forbes: And here in the United States, do you really think a state may default or will they find some way to work it out? Fridson: I think ultimately they'll find a way to paper it over. But we're only creating moral hazard as we go. And I think that's a very serious problem because historically one of the saving graces in our system was that the states had to balance their budgets. They didn't have the ability to print money like the federal government. And now, we're sort of sending them the message that, "Well, you can live beyond your means because we'll come and bail you out if you don't." And clearly, some of the states have spent very irresponsibly, have created sort of legacy payments. And that has to be reined in. The fiscal situation in a number of the states is very serious. And they'll either have to take some very severe austerity measures or come hat-in-hand to the government. And it's not clear that we'll have the political will to resist that demand if it comes. Forbes: One of the factors you look at in terms of making investments outside the United States is creditor protection laws. What about the U.S. itself? What impact long-term, or even short-term, the tearing up, in effect, of creditor contracts with General Motors, Chrysler, not to mention the mortgage markets where people won't buy mortgage-backed securities unless you're the Fed precisely because you don't know what the rules of the game are? Fridson: Well it's a great question. And it came up just this week in a panel that I was on with some restructuring experts and those who are involved in fixing companies that are bankrupt or nearly so.

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And with the passage of some time since the GM and Chrysler event, they seem to be universally of the view that that was, as one of them put it, a 50-year storm. Don't expect to see further problems. Said that there had been other unionized companies since the GM and Chrysler debacle that had failed, had not been bailed out. So perhaps it was a unique situation. I hope that's the case because it is quite a serious issue. I mean, I don't know if everyone is as steeped in history as I know you are. And I don't know if everyone realizes that the United States is here because Alexander Hamilton worked out a bankruptcy resolution for the states. And a central feature of that proposal was that the creditors had to be paid off at face value, even if they had bought the debt in the secondary market at a deep discount. It's an issue that goes all the way back to the founding of our republic. And if you were to undermine that in a serious way and creditors didn't have the confidence, you deal a very severe blow to the ability of the system to operate. Mortgage Moral Hazard Forbes: What's your feeling about the mortgage market? Because with Treasury muddying the waters there between home equity loans and what we used to think of as a first mortgage, that certainly is unsettling, isn't it? Fridson: Yeah. I have been concerned about the moral hazard right from the beginning there. The idea has been brooded about that we'll only help the deserving homeowners. And good luck trying to figure out who they are. Forbes: Hamilton never made that mistake with states. You know, you're all the same. Just get it over with. Fridson: No, that's right. And I think that is a very serious issue. I was disturbed right from the beginning of the financial crisis when that idea came up almost immediately, that we would somehow abrogate those mortgages. And it's a serious issue. And you can't be indifferent to the plight of people who potentially lose their homes, but what tends to get overlooked is the effect on future financing and the cost that will be incurred there. So it's the old problem, the classic issue in economics, what's seen and what's unseen. And you do have to try to look ahead and say, "How effective a mortgage market will we have in the future," as you say, “if people don't know what their rights really are?” Unwarranted Intrusions Forbes: Final question. You wrote a book a couple of years ago, a very, very prophetic one, Unwarranted Intrusions: The Case Against Government Intervention in the Marketplace. And you make the case that it's hard put to find a real example of where government meddling has done more good than harm. Since this book has been written, government meddling has increased geometrically. What impact do you see on that?

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Fridson: No, I don't think much good can come out of it. The most appalling thing to me was having written about the government-sponsored enterprises -- Fannie Mae and Freddie Mac -- and pointed out all the problems, to me really, it just conceptually, and the idea that we're taking taxpayer money to subsidize well above-average-cost homes. I mean, the average cost of a house is $200,000. And they've raised the ceiling on Fannie Mae and Freddie Mac loans to $700,000. What is the public purpose there with so much money being siphoned off? And the most remarkable thing, well one of many remarkable things about the housing crisis was that the immediate response of Congress was, "We have to rev up Fannie Mae and Freddie Mac again," after they had finally begun to rein them in. That was their immediate response. And so it's hard to be optimistic about Washington coming up with very good solutions to any of our problems in light of that event. Forbes: Yet that seems to be the habit. Fridson: Yeah. Well, I think it's understandable that people look that way because there's a lot of money. And I think in fairness, the business world has to look at itself and say, "We're part of the problem. If we're going to look to Washington to solve all the problems, we can't very well blame others for doing that." And there clearly has been some tendency to say, "We've got foreign competition. We've got cost problems. We haven't managed our business well. So let's look for a solution from government." It's not intellectually honest to criticize others for asking for handouts if you're, yourself, lining up at the trough. Forbes: Yeah, virtue is easier to preach than practice. Marty, thank you very much. Fridson: It's been a pleasure.