Stagflation has reared its ugly head once again. The situation in 2008 is reminiscent of the state of the world in 1973, when the Organization of Petroleum Exporting Countries raised the price of oil to US$50 a barrel. With oil recently trading north of US$140 a barrel, up from an average price of US$56 in 2006, the comparison to the 1970s is irresistible.
The 1970s episode of stagflation defined the problem: low or zero economic growth, as measured by gross domestic product, accompanied by high inflation driven by energy prices.
For central banks, the dilemma then — as it is now — was to decide whether to fight inflation by raising interest rates or to fight the economic slowdown by lowering them. In the 1970s, they chose the former, and for advisors and investors alike that decade became one of the worst bond markets in history, deflated by soaring interest rates.
The U.S. Federal Reserve Board’s federal funds rate rose to 19.2% on an annualized basis in June 1981, while the Bank of Canada’s bank rate hit 21.03% in August of that year. Managed by Paul Volcker, then chairman of the Fed, and Gerald Bouey, then governor of the Bank of Canada, the two central banks focused on fighting inflation and succeeded in breaking the back of rising prices, creating a bond market that generated huge gains for the next two decades.
Will that happen again? First, we need a reality check. Canada’s GDP is expected to rise by 1.3% in 2008, down from 2.7% a year earlier. The U.S. GDP is expected to rise by 1.3% as well, down from a 2.2% growth rate in 2007. These forecasts by Bank of Nova Scotia’s economics department indicate that the principal measure of inflation, the consumer price index, will rise by 2.3% this year and 2.4% next year in Canada, while in the U.S., it is expected to rise by 4.2% this year and 2.7% next year.
Compared with the disaster of the 1970s, this is stagflation lite. But it could get worse. News media carry stories anticipating the demise of the U.S. auto industry. Indeed, General Motors Corp.’s stock has recently traded at lows not seen since the 1950s.
“People wonder if we are going back to the 1970s,” says Patricia Croft, chief economist for Phillips Hager & North Investment Management Ltd. in Vancouver. “What is common is that in both cases, we have a weak economy, rising energy prices and rising food prices. But there are key differences. First, central bank policies are different; they plan to resist inflation. Second, in the 1970s, workers had appreciably stronger unions than today and were able to pass through their costs of living in the form of wage increases. That set off a wage/price spiral. This time, central banks accept stagnation.”
In a climate in which central banks have a bias in favour of raising interest rates, it is not wise to hold long bonds. Instead, Croft suggests, it is useful to stay with short-term deposits, bank accounts, short bonds, Treasury bills and other instruments that can capture rising interest rates.
Real-return bonds, which raise their prices and payouts as the CPI rises, can generate profits in a climate of rising interest rates. RRBs should be priced in proportion to changes in the CPI.
Edward Jong, senior vice president at MAK Allen & Day Capital Partners Inc. in Toronto and portfolio manager of frontierAlt Opportunistic Bond Fund, says the market for RRBs is heavily influenced by insurance companies and pension funds, which use them for insurance against inflation.
RRBs work best when the actual inflation experienced by the market exceeds the inflation premium built into the price of RRBs at purchase. Long RRBs have a basic interest rate of about 1.6%. They then add an inflation premium of about 2.4%, for a total return of 4%. A 20-year Government of Canada bond has a current yield to maturity of 4.12%. So, the RRB will only be advantageous if inflation turns out to be more than 2.4%.
RRBs have been winners thus far this year. For the 12 months ended May 31, the DEX RRB overall index produced a 10.05% total return, far above the DEX universe bond total return index, which produced a far more modest return of 6.6%.
@page_break@The difference in return was caused by two factors, Jong says. One, corporate bonds in the universe index vastly underperformed conventional government bonds because of credit concerns; and, second, RRB prices rose out of fears that the Fed would abandon its inflation-fighting stance in favour of stimulating the flagging U.S. economy.
Beyond RRBs, which promise to track the CPI but make no specific promises of return, there are “step” bonds — also called “steppers” — that promise to raise payments on fixed schedules. Ontario Savings Bonds are an example of this type, which is aimed largely at the small-investor market. If interest rates should decline, the step bonds can be called, depriving the holder of getting a really good return. Their appeal, which is a knowable future interest rate, has to be balanced with the call feature, which can limit their return.
For clients who want to participate in rising interest rates without the certainty of stipulated future rates, there are floating-rate bonds. “Fixed floaters” are often issued by chartered banks. For example, on May 28, TD Bank Financial Group came out with a fixed floater Series S bond that pays 5% to a first reset date on July 31, 2013, and then pays the five-year Government of Canada bond interest rate, plus 160 basis points.
Resets happen every five years; interest is payable quarterly. The issuer can redeem at par at any five-year reset date. Chances are strong that the bonds would be called, so the floating interest rates would not be paid, says Michael McHugh, vice president and fixed-income portfolio manager with Dynamic Mutual Funds Ltd. in Toronto.
Chartered banks also issue pure five-year floaters with no call feature and a quarterly reset. They don’t have the fixed floaters’ five years of yield protection.
For example, a Scotiabank floater issued at the end of June carries a yield boost of 80 bps over the bid side of Canadian bankers’ acceptances, for a net yield of 4.03%, on an annualized basis, for the next three months.
If rates rise, the pure floaters will track them. If rates should fall, however, floaters’ payouts will go down. In that case, the fixed floater will have worked out better. Those who think interest rates will rise can take a risk on the pure floater. Those who figure it will be temporary but want some downside protection can take the fixed floater.
Tough decisions, surely. But nobody ever said that fixed-income investing during a period of stagflation would be easy. IE
Choosing bonds with an eye on stagflation
Making the right moves will be tough, as governments steer between stimulating the economy and high inflation
- By: Andrew Allentuck
- July 28, 2008 October 31, 2019
- 14:54