As stocks swooned during October’s roller-coaster capital markets, something new happened in bonds: fear of further equities losses did not fuel all bonds, as stock flops usually do. Instead, money moved into government bonds – and mostly into U.S. treasuries, in particular.
There’s a new lesson in this, and it’s that investors will go for government debt, not corporate debt, in market crises. Says Jack Ablin, executive vice president and chief investment officer with BMO Harris Private Bank in Chicago: “Money will flee into bonds with each twinge of financial angst. But in these meltdowns, it seems to be government debt that the market wants.”
In the mid-October market swoon, yields on U.S. Treasury 10-year bellwether bonds dropped to 1.86% on Oct. 15 from 2.6% just three weeks earlier. The mid- October yield also marked the lowest yield level in 12 months as trading in U.S. government debt surged to an all-time high, according to reports from Bloomberg LP.
(The dive in equities markets and subsequent rise in government debt trading was the result of a perfect storm: the International Monetary Fund‘s downward revision to its forecast for global economic growth; the spread of the Ebola virus; worries about declining earnings; jitters about the conflict in the Middle East; and apprehensions about Europe sliding back into recession.)
In comparison, Government of Canada two-year bond yields dropped 86 basis points (bps) on an annualized basis, down by 11 bps from the average level seen in the first week of October. But by the end of the second week of October, yields on two-year Canadas had risen to 92 bps in a calming market.
The biggest gainers were long U.S. treasuries. The 30-year U.S. T-bond rose by four bps, which is a lot at this institutionally populated end of the market. That rise drove yields down to 2.67%, the lowest level since September 2012. Yields on the 10-year U.S. treasuries settled down to 2.22% by the end of the second week of October, capping a week with a range of 42 bps – a huge move for any week.
That’s a standard deviation of 10 in what is usually a calm market, for which a standard deviation of 1.0 is plenty, says Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto.
What’s next is the question. U.S. inflation expectations are rising, yet U.S. Federal Reserve Board insiders say that their chairwoman, Janet Yellen, is being pushed to maintain or raise quantitative easing to keep rates down and market confidence up.
“People had doubts about yield declines this year, but the bond market moves in October show that yield declines are justified,” says Chris Kresic, head of fixed-income and senior partner with Jarislowsky Fraser Ltd. in Toronto. “It’s not just a week of troubles; it’s weaker global growth than people expected. The volatility in the markets shows doubts that the recovery is self-sustaining.”
There also was a sense that investors were short in bond durations. When yields did not rise, shorts sold off and money moved. So far, the price of U.S. 30-year treasuries is up by 25%-30% year to date. The move to longer durations is the fifth-biggest rally since 1974.
But the rally has narrowed. Liquidity has dried up in corporate bonds, as investment dealers did not want to hold inventories that might lose value as money moved to more liquid government bonds, Jong says: “Investment-grade bond yields barely budged.” It wasn’t corporates yield boost the market wanted, he adds; it was liquidity.
Bond bulls who played the market right clearly made money while bond bears suffered. Leveraged exchange-traded bond bear funds took a 10.7% loss in the first two weeks of October, according to Bloomberg.
The bet remains on government bonds to appreciate or outperform corporate bonds, Jong says. Inflationary expectations have been declining and very bearish investors continue to anticipate deflation, he adds. If deflation does arrive, corporate bonds would plummet while government bonds, especially sovereigns, would thrive.
Investors are willing to pay handsomely for liquid bonds. Volatility, the alias for “uncertainty,” is the driver. In the mid-October market dive, the Chicago Board Options Exchange’s volatility index (VIX) rose by 20% to its highest level since December 2011. The VIX is up by 70% in 2014 year to date.
So, should you migrate your clients to government bonds, giving up yield for price gains in each liquidity crisis? That’s a question of holding period. For buy-and-hold retail investors, capital markets’ wobbles can be ignored, suggests Derek Moran, president of Smarter Financial Planning Ltd. in Kelowna, B.C.: “Volatility subsides. For a long-term investor, speculating in any volatile market, especially government bonds that are controlled by institutional investors, is downright dangerous.”
Moran’s advice is to ignore the liquidity trade and stick with existing allocations. For deflation hedges and a financial bomb shelter, government bonds – especially U.S. treasuries – remain best-of-breed assets.
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