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.
Cory’s Chart Corner
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