The bond market has entered a new phase as a result of the deal to avoid the worst-case scenario of the fiscal cliff that would have shredded the U.S. economy – and Canada’s, too. So, when helping your clients invest in bonds, you have to be aware that it’s now a new game that will be played with the old rules of avoiding being in government bonds when interest rates go up, and watching risks to find good deals in corporate debt.
Some support for short-term U.S. government bond prices will continue. Monthly purchases of US$40 billion of mortgage-backed securities and US$45 billion of treasury bonds by the U.S. Federal Reserve Board (the Fed), will continue. The twist – the Fed’s program that sold short-term bills and bought long-term bonds – ended on Dec. 31, 2012.
All this will hold short-term government bond yields down and anchor the yield curve near zero at the short end. Moreover, where the U.S. goes, Canada will follow. A hike in interest rates in Canada ahead of a hike in the U.S. would drive up the Canadian dollar and impair our exports.
How long U.S. interest rates will stay down is the issue. Demand for loanable funds is likely to be suppressed by an economic slowdown following the 2% rise in U.S. social security taxes. Bank of Nova Scotia’s economics department predicts a US$1,200 annual cut in disposable income in 2013 for the average American family. This rise in taxes will take half a percentage point off the U.S.’s annual gross domestic product (GDP) growth.
Among investors, income earners raking in US$400,000 or more and joint filers making US$450,000 will see their top marginal rate rise to 39.6% from 35%. Capital gains taxes will rise by 33% to 20%. A Medicare contribution tax adds another 3.8%, pushing the top investment tax rate to 23.8%. Defence and other domestic discretionary programs will take a $12 billion hit in 2013. These measures will translate to extraction of perhaps US$200 billion from the U.S. economy and a return or retention of a corresponding amount to/in government coffers.
In Canada, low interest rates should continue because our job market remains weak, says Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax: “A serious increase in inflation of a few percentage points associated with a drop in unemployment to 6.5% from the December rate of 7.1% is not yet in sight.”
Bond watchers are following the key U.S. unemployment rate, which was at 7.8% in December 2012. A significant decline of 1.3% or more would allow the Fed to reverse its accommodative monetary policy, Roger suggests. That would imply that the Fed would stop buying government bonds. Bond prices would tumble, existing bonds would generate red ink and, in anticipation of an end to years of artificially supported bond prices, investors would stampede for the exits. That would steepen the yield curve, which, with short-term rates near zero and 30-year rates at 3.02% in the U.S. and 2.49% in Canada, already is quite steep.
Resolution of some of Europe’s problems, economic recovery in China and a retreat by stock investors from “practising safe yield,” as a monthly newsletter from Richmond Hill, Ont.-based Canso Investment Counsel Ltd. recently put it, would see interest rates rise across all classes of debt, with inflation expectations pulling up the long end of the yield curve.
Improving business conditions would cut risk premiums in high-yield bonds and push up their prices. A move to add default risk by migrating to non-investment-grade debt and away from government bonds and investment-grade corporate debt, Roger says, would be consistent with a belief that things are improving.
So, will the inherent strength of the U.S. economy – perhaps aided by increasing flows of cheap energy from unconventional gas and oil drilling and in the recognition that U.S. Congress has shown at least some ability to resolve fiscal issues – push up GDP growth and bond yields?
“You could argue that rates are as low as they are going to get – at least, on fundamentals,” says Chris Kresic, partner and head of fixed-income at Jarislowsky Fraser Ltd. in Toronto. “Any good economic news will tend to steepen the yield curve.”
The strategic implications are clear: sell government bonds, especially issues with terms of more than 10 years, to limit the effect of rising interest rates; then, move down the credit-quality scale to reduce the influence of rising interest rates and to capture the power of improving economic conditions to raise corporate bond prices.
In a climate of rising interest rates, investment-grade corporates and government bonds are bound to suffer, says Jack Ablin, chief investment officer with BMO Harris Private Bank in Chicago: “The more you think things are improving, the more you want to be in credit-sensitive bonds.”
That’s classical risk avoidance and a play on the inevitable spread compression of corporates and junk in relation to government bonds. But this time, it’s a twofer: exit what is falling, buy what is rising – and the spread will be with you.
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