Finding safety in government bonds

Yields on 10-year U.S. Treasury bonds (a.k.a. T-bonds), the bellwether of the U.S. government bond market, dropped to 1.98% on Jan. 15, down from 2.3% on Dec. 16, 2015 (when the Fed raised the overnight rate by 25 basis points [bps] to 0.50%), and down from 2.27% on Dec. 31, 2015. The BoC chose not to raise its 0.50% overnight rate on Jan. 20, aware that the collapsing Canadian dollar did not need a push into the abyss. Ten-year Government of Canada bonds, which traded with a 1.39% yield to maturity on Dec. 31, 2015, offered a yield of 1.16% on Jan. 21.

The question for bond investors is: “What is it worth to move out of equities and into bonds?” In the first week of January, the Dow Jones industrial average fell by 4.5% and the S&P/TSX composite index dropped by 4.4%. In addition, there were declines of as much as 12.3% in Mainland China stocks, 5% in Hong Kong stocks, 2.5% in Germany’s stocks and 1.9% in U.K. stocks in the first five trading days of 2016. Thus, the theme of the new year appears to be a global equities correction.

Investors are getting bolder about parking money in bonds because there is less risk now that the Fed will raise rates than there was in December, when U.S. unemployment data dropped to 5%. But that was the end of the good news, says Dov Zigler, financial markets economist with Bank of Nova Scotia in New York.

In the midst of the global stock sell-off, he says, “The odds of Fed rate hikes in 2016 are lower than they were a few weeks earlier.” And the odds that the BoC will cut its lending rate for banks in the near term are low, Zigler adds.

All of these factors add up to a sense of interest rate stability in U.S. and Canadian government bonds – and that is where money is headed in search of safety.

In spite of heavy buying of U.S. T-bonds, their yields remain attractive to global investors, says Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto. Specifically, 10-year German bunds yield 0.45% to maturity; and sovereign bonds with the same term offer 1.67% in the U.K., 0.57% in the Netherlands, 0.77% in France and minus 0.25% in Switzerland (where investors thus pay the government to store money).

How long will bonds rally is the essential question. Says Jack Ablin, executive vice president and chief investment officer at BMO Harris Bank N.A. in Chicago: “Some stock selling has been done to meet margin calls. Some of the recent bond buying has been market hedging.”

The implication is that recent trends are likely to be temporary. The stock market sell-off is a correction, not a crisis, Ablin insists.

Waiting for the end of this correction, which is rooted in the decline of global commodity and energy prices, slowing economic growth in China and a vast overhang of public and corporate debt issued during rosier times, is a matter of patience and picking the right term to maturity.

Two-year T-bonds recently paid 0.82% to maturity. Go out to 10 years, and the payoff is 1.98%. That makes the vital two- to 10-year spread 116 bps. “That’s healthy and fairly steep,” Jong says.

In contrast, the average spread between two- and 10-year T-bonds for the past 12 months was 144 bps. The reward is still there, but less because the yield curve has flattened. Go out to 30 years for T-bonds paying 2.75%, and the pickup over 10-year T-bonds is 77 bps – about average for 20 more years of patience.

Yields to maturity on two-year and 10-year Canadas are 0.39% and 1.16%, respectively. That results in a spread of 77 bps. If you go out to 30 years for a 1.93% return, the pickup is 77 bps over 10-year bonds.

To get a return on government bonds to match U.S. interest rates, a little quality erosion goes a long way. A Province of Ontario 8% issue due June 2, 2026, was recently priced at $150.92 to pay 2.41% to maturity – a pickup of 125 bps over 10-year Canadas for little risk.

Still, the investment question remains: which government – and which bonds. Investors are making rational choices by putting money into U.S. federal debt because it pays more and is more liquid than anything else in sight.

But there is risk. When global equities markets stabilize, as they will, central banks will get back to the business of raising interest rates. Duration risk in very low-yield bonds due in 10 years and longer is the catch to investing in government bonds – and taking shelter in these issues now means accepting the chance of a big loss when the market senses that interest rates are headed upward again.

For now, the best foxhole in sight is sovereign debt – and U.S. T-bonds are best of all.

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