I admit it, I am a market junkie. I spend most of my waking hours thinking about world risk markets. But then our clients pay me to think and worry about this stuff. I have an excuse. Understanding how the many parts and players fit and move together and against one another is what makes this field so fascinating, all consuming, daunting and incredibly humbling. It is truly the biggest Rubik's Cube ever designed.
Like the most unruly child in a family, stock and commodity markets have been demanding most of the world's attention this year. But in our management firm, about half of our investable assets are allocated to fixed income, so we do need to pay a lot of attention to what is happening in the world of interest rates, credit spreads, and overall price trends. In recent weeks bonds have slowly picked up their boil on the back burner.
We noticed prices for the highest quality issuers spiking in October. Bonds that we already owned were enjoying nice gains, but capital we needed to reinvest on the fixed income side was becoming harder and harder to place. Prices have climbed so high, and yields have dropped so low that bonds worth buying on our rules have literally dried up.
Admittedly we are very picky and have a couple of key buy rules about fixed income: all individual issuers must be investment grade or higher; we never pay more than par and wherever possible buy at a discount to par. We also manage the duration (think weighted term to maturity) in accordance with our outlook on interest rates. When it comes to corporate bonds we seek to minimize company specific risk (that’s why we call it “fixed income”, the interest payments need to be paid to us, otherwise there is nothing “fixed” or stable about the “income”), so for corporates we prefer corporate bond ETFs over individual company issues. We also know that corporate bonds and preferred share prices follow the equities cycle. Their prices drop with equities and their prices rise with equities. In times of crisis all “risk assets’ fall together.
Over the past few months we have seen this normal correlation to equities play out in preferred shares, where prices have plummeted with common share prices across the board. With bonds we have seen a rather incredible and unsustainable trend. In the past few weeks, the fear bubble has driven US government bond holders to pay more than they are worth just for the “peace” of holding them, as explained in this article yesterday:
Investors buy US debt at zero yield:
“In the market equivalent of shoveling cash under the mattress, hordes of buyers were so eager on Tuesday to park money in the world's safest investment, United States government debt that they agreed to accept a zero percent rate of return.
The news sent a sobering signal: in these troubled economic times, when people have no gain is tantamount to coming out ahead. This extremely cautious approach reflects concerns that a global recession could deepen next year, and continue to jeopardize all types of investments.”
In Canada we have seen a similar theme in soaring bond prices with one year Government of Canada T-Bills offering a paltry 1.3% as of yesterday. I can recall similar challenges when searching for high quality yield back in 2004-2005 when Canadian government bond yields offered a meager 2.7%. But 1.3% is truly a new low. Meanwhile even longer term 10-year government issues are offering less than 4.3%. And governments around the world will inevitably be pumping out new bond issues in the New Year to make up for budget deficits aggravated by simulative spending. With real interest rates already steeply negative, we have to be concerned with the pick up in inflation and interest rates this will breed again down the road. Overpaying for bonds now will surely be painful to capital two or three years in the future. All bubbles burst eventually. This bond bubble is unlikely to be an exception.
We are sorting through preferred shares and corporate bonds again for fixed income options. The yields are looking better than they have in many years, and we have many targets on our radar. Their price risk here lies in the length and depth of this economic downturn. We know it will be longer and deeper than most we have seen. We suspect that credit spreads may widen further for some time yet. This means corporate bonds and preferred shares are at risk of getting cheaper still before prices bottom. But the further we get through this downturn, the more low-risk rewarding homes we will find for our cash, and that is truly something to get excited about.
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Paging Ms. Park
Question: Why would someone buy a government bond for 1.3% when they could get a GIC for 3%. Is it for money that isn't covered by CDIC? thanks- kettlehead
K, GICs are a retail product, offered at a premium retail rate to attract bank deposits. Yes they are a good option for inidviduals looking for guaranteed deposits. Institutional players can't use them and the CDIC coverage is no help on amounts over 100k. Another factor of late has been pure risk aversion where even retail players are afraid of the banks and solvency concerns, so they have been going to the higher credit of the governement bonds. They are selecting return of capital as a priority over returns on capital.
Danielle, I'd like to hear your thoughts on the Long Bond here.
It's turned on a key cycle and broken out into territory not seen
for some time. Could the Fed be buying the futures?
1982 was and ideal time to buy bonds. The 20yr US treasury note was yielding 14%. The holder would receive 140. each year, and the total return was enhanced by the increase in bond price as yields moved to 4% in 2000.
Today we have the opposite. the fed funds rate is .25%, the lowest in history. The 20yr US treasury bond is yielding approx. 2.3%, far under its average of about 8% since the early 60's(prior to this time yields were not directly related to inflation). At a CPI of about 2.5% this 20yr bond should be yielding at least 3.7%. A bond bubble, as money is moving to the “safe haven” of US treasuries, or the market is pricing in deflation.
I would like to take advantage of this in the near future as interest rates can only move to 0.oo and invitably can only move higher afterwards. Unfortunately in Canada there is not a Can gov't bond bear ETF to buy. There is the Horizon bond bear ETF, but I do not like it. It works well if the trend in bond prices continues in a steady trend down, however if there is volatility and since the ETF is rebalanced daily, the ETF price can actually decline even though bond prices are declining.
Danielle, just wondering if you know of a way for the retail investor to profit from decresasing bond prices? Henk
If you sold bonds short you could potentially make money once rates begin to increase. But I would not recommend that regular folks try this. The issue is how long rates will stay low (a complete unknown at this point, especially with present deflation) and when you sell anything short you have to worry about perfect timing and maintaining liquidity while you wait for your speculation to turn out. Be careful. D
Great interview on Financial Sense! Rob Arnott is also talking about corporates in this week's Barrons. In your post above , you seem to be making a list of preferreds and corporate bonds for when you perceive the time to be right. You can cherry pick, but small investors only have access to funds and unit trust shares. I've been reading various prospectuses on corporate bond funds, but they all track certain indexes. How can people of moderate means invest in these asset classes, since the price for individual issues is beyond us?
I would be very careful with the ETF family mentioned above.
If you compare the bull and bear charts with the underlying
asset you will see that they consistently fail to pay up.
Retail investors are not asking for much. Just a clean play without
the lying and cheating!
We must really understand what is happening to our country nowadays. We all know that we are currently facing economic crisis that’s why we must finds ways on how to cope up with the present situation. Debt collectors are a shrewd bunch. They’ve been labeled with about every epithet under the sun, but that doesn’t deter them from trying every legal trick in the book. There are reports that they’ve gone a bit too far this time. An increasing number of reports and accounts are coming in about collectors going after next of kin, to collect on the debt incurred by a relative after the person who owes has entered into a state known as being dead! The credit card debt and other debt owed by people has been called in to the deceased’s relatives, which they are not legally required to pay. Some have actually begun doing so, taking out payday loans to afford it. That is a low blow, even for debt collectors; calling in the debt of a no longer living person to their survivors.
That's what we know best: get into debt and never find our way back out. I recently contacted a credit card merchant to get some info about this option. I was amazed to see how many details are being omitted just to get us sign their contracts.
cheers for the info. It was a good read.
merchant services