With little inflation to drive interest rates, bond yields are stagnating. So, what’s a financial advisor to do?
A fairly recent moniker for the Canadian and U.S. economies is “lowflation” because of the persistently low single-digit inflation figures. Forget disinflation – we’ve been there; ditto stagflation. In this environment, a question arises: how can you help clients invest for income and safety when headline inflation is in the low single digits and there is scant yield in government bonds to provide a cushion when interest rates rise?
Interest rates are due to rise, says Dov Zigler, financial markets economist with Bank of Nova Scotia in New York. The market still expects the U.S. Federal Reserve Board to hike interest rates further, but perhaps by less than the Fed has implied it might, he says: “The Fed is cautious, after all.”
For now, investors are buying bonds for safety, not yield. On the first trading day of 2016, Jan. 4, the yield on the 10-year U.S. Treasury bond fell to 2.245%, down from 2.273% on the preceding Thursday, the last trading day of 2015.
You and your clients now have a clear choice: accept the expansionary view of the Fed, which interprets the decline of unemployment to the Fed’s 5% target as a sign that the Great Recession of 2008 is over; or accept the idea that world equities markets are dropping.
Belief in the first case justifies a bullish view of stocks. Belief in the second case implies buying into government and investment-grade corporate bonds for safety.
A path of low returns
Government bonds appear to be on a path of low returns for a long time to come. That means those bonds offer an intrinsically high risk of losses if the yield curve rises. “You have only about 25 basis points [bps] of a rise in yield before you have your annual coupon wiped out,” says Jack Ablin, executive vice president and chief investment officer at BMO Harris Bank N.A. in Chicago.
Investors who buy low-yield bonds take on duration risk; but the odds of interest rates rising seem slight. The Fed is alone in raising rates – and even its announced plans to raise interest rates further now are in doubt.
For most developed countries, inflation rates are below their central bank’s target rates. In the U.S., the consumer price index inflation rate projected by the Fed is 1.3% for the next five years – below the 2% target. Thus, the 10-year U.S. T-bond that is priced to yield about 2% provides a modest reward for buyers (before taxes).
In Canada, where the Bank of Canada has a 2% centre point in its 1%-3% target inflation range, the 1.18% yield to maturity of 10-year Canada bonds provides a small reward above the 1.2% average headline inflation rate prevailing in 2015.
Europe’s inflation rate is below the European Central Bank’s 2% target.
No country other than the U.S. appears ready to raise interest rates. Only Russia, Turkey and Brazil, which recently reported inflation rates of 15%, 8% and 10.5%, respectively, need tightening of interest rates by their central banks.
The question is where to put clients’ money on the yield curves for Canada and Europe, and even for the U.S., that imply diminished expectations of growth, low inflation and low premiums for extending terms to maturity.
“I foresee a flattening of the yield curve,” says Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Ltd. in Toronto.
Curve is fairly flat
The yield curve for Canadas already is fairly flat and implies little term premium for going long. Canadas pay 0.57% for five years. They offer 61 bps a year more to go to 10 years and another 81 bps for stretching term to 30 years.
In the U.S., five-year T-bonds pay 1.49%, then add 57 bps a year for going to 10 years and a further 78 bps for going to 30 years. These are normal term spreads; but in absolute dollars, these spreads are no way to make a living.
Investment-grade corporates, alternatives to low-yield government bonds, offer large yield boosts for an equal term.
“You are well compensated for going into corporate [debt],” says Chris Kresic, senior partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto. “We would go with corporates with terms of 10 years or less.”
Yields at 10 years show the gains. A Canadian National Railway 2.75% issue due Feb. 18, 2021, and rated A by DBRS Ltd. recently was priced at $104.63 to yield 1.8% to maturity – a pickup of 1.23% over the five-year Canada bond.
At 10 years, a BCE Inc. strip due Dec. 15, 2026, with an A (low) rating from DBRS recently was priced at $63.50 to pay 4.2% to maturity – a 3.02% boost over the 10-year Canada that pays 1.18% a year to maturity.
These corporate bond yields offer a cushion to compensate for losses generated by rising interest rates. These yields are an answer to lowflation and, indeed, a way to beat it. Add up the attributes and the prize goes to taking on modest credit risk rather than the high duration risk of loss that goes with very low interest bond.
Success comes down to balancing the credit risk in investment-grade corporates with terms of 10 years or less, which is very slight, with the chances of loss on low interest bonds when interest rates rise, which is substantial.
“We’re suggesting weighing corporate credit risk over duration risk in this space,” Ablin says.
© 2016 Investment Executive. All rights reserved.