After a year in which government bonds beat every other investment category — from the stocks of China-based companies to those of Canada-based gold-mining firms — there is doubt that public debt can do it again. The question now is whether the meagre returns on government debt are worth the risk; and, if not, where should you turn?
Repeating bonds’ gains of 2011 will be difficult. Canadian long bond portfolios returned almost 16.4% for the year ended Dec. 31, 2011. The DEX universe bond index, which blends short bonds, long bonds, government bonds and corporate bonds, returned 9.6% for the same period. It appears that no bet on a Canadian investment-grade bond was a bad one last year.
In the U.S., long-term treasury bonds had their best performance since 1995, according to Bloomberg LP. Treasuries with 10 or more years to maturity rose by 25.6%, pushed by the sovereign-debt crisis in Europe. And Standard & Poor’s Financial Services LLC’s downgrading of the U.S. Treasury’s rating to AA+ from AAA on Aug. 5 evidently had little effect after a one-day gasp at the audacity of the move, which was not echoed by Moody’s Investors Service Inc. or Fitch Ratings Ltd.
However, those clients who want to bet that government bond investments will be as rewarding in 2012 as they were in 2011 are facing headwinds. Recent Canadian and U.S. government bond returns are out of scale. Bond portfolio managers’ 12.6% gain, net of fees, in 2011 was 75% higher than the 7.2% average annual compound return for long bond portfolios for the 10 years ended Dec. 31, 2011.
These one-year numbers are not likely to persist unless there are crises that drive investors to accept even lower-running yields. A collapse of the euro would probably do it, although the odds are that the wizards of European finance will avert that outcome. A worsening recession or perhaps deflation in North America also would boost bonds, although neither scenario seems likely.
“You would have to argue that the yield would fall to 1% for 10 years to replicate last year’s performance,” says Chris Kresic, partner and co-head of fixed-income with Jarislowsky Fraser Ltd. in Toronto. “You would only see that in a deflationary or recessionary environment.
“Historically,” he continues, “real yields have been about 2.5%. So, even now, with a 2% nominal yield on the 10-year [Government of] Canada [bond], the market is pricing in 0.5% deflation for the next 10 years. The Bank of Canada’s target is 2% inflation, so I find it hard to believe you will get the deflation figure.”
For your clients who want to bet on rising inflation, they can move into real-return bonds, which returned 13% in 2011 — a little more than twice their 5.9% average annual compound return for the 10 years ended Dec. 31, 2011. RRBs are long issues that had participated in the boom; as well, they are inflation-linkers that can ride with the consumer price index.
BETTING ON RATES IS RISKY
At the opposite end of the inflation-sensitivity range are strip bonds. Priced for low inflation and low interest rates, they would be sure to generate paper losses before maturity. Convertible bonds and conventional corporate issues could participate in a recovery, propelled by issuers’ rising earnings and improving balance sheets. Yet, any bet on interest rates is risky, as the margin for error is miniscule.
Jack Ablin, executive vice president and chief investment officer with BMO Harris Private Bank in Chicago, notes that with 3.3% yield on long U.S. T-bonds at the beginning of 2011, there was a 0.5% cushion for error: “If rates went up by 0.5% in 2011, your 10-year treasury would have been underwater. But now, at 2% on a 10-year U.S. treasury, the cushion is 0.3%. If rates go up by 0.3% during the course of the year, you are underwater.”
The bet is on Europe. The endless tug of war between Germany and everybody else on how much money to pump into the eurozone’s banks and national treasuries may end with neither side actually needing to win.
Greece, with its bonds rated in the C range by S&P, Moody’s and Fitch (all of which have a negative outlook) is now seen as a writeoff. Default is priced into the ratings. The average yield on Greece’s sovereign junk is 38.5% for anyone who wants to buy. No recovery is expected in an impossible situation in which further austerity will worsen the nation’s ability to pay its sovereign debt.
But things are looking up for Italy, which still has an A+ credit rating but with negative outlook, according to Fitch. A Dec. 29, 2011, 7-billion-euro bond auction with terms ranging from three to 10 years was well received, with average yields falling to 5.62% from 7.89% at the end of November. The bellwether 10-year Italy eurobond yield fell to 6.98% as of Dec. 29 from 7.56% at the end of November.
If European sovereigns continue to gain in value, money will flow from the U.S. and Canadian bond markets to pick up appealing yields on bonds issued by Italy, France and Spain — in the expectation that problems are being resolved. And that, says Marc Stern, vice president and head of discretionary wealth management with Industrial Alliance Securities Inc. in Montreal, means that North American bond markets will underperform in what he expects to be a sell-off.
“There is only so much juice that you can squeeze from an orange,” he says. “My scenario is we have squeezed the orange dry. And unless people are looking at accepting negative returns, it makes no sense to load up on conventional government bonds. The likelihood that Canadian and U.S. conventional government bond prices will rise is smaller every day.” IE