Look to global government bonds

The need to shop outside the North American and mature European bond markets is evident, given the record-low bond yields on Government of Canada and U.S. treasury bonds. In early June, 30-year Canadas paid a miserly 2.65% a year to maturity, barely above the Bank of Canada’s 2%-2.5% target inflation rate. And 30-year U.S. treasuries paid 3.35%. Similarly, 30-year German bunds paid 2.34% and 30-year U.K. gilts paid 3.35%. These rates offer scant margin over each country’s long-term consumer price index (CPI) forecast trends.

U.S. treasuries continue to command high prices in a market obsessed with short-term safety of principal, notes Brent Schutte, market strategist with BMO Private Bank in Chicago: “Treasuries are the most liquid instruments in the world, and they look better than even the best euro-denominated credits. Investors are taking on the risk of rising rates producing negative returns because they don’t think it’s going to happen anytime soon.”

Sovereign-bond interest rates remain hostage to the glum outlook for the global economic recovery. Barclays Global Macro Daily’s May 1 research note provides a sense of the market, predicting slowing growth and declining interest rates in Europe. Indeed, the European Central Bank (ECB) announced on June 6 that it would leave its key interest rate at the historical low of 0.5%.

Backing the ECB’s stance are feeble economic reports on industrial activity from European purchasing managers, as well as high unemployment levels holding at 27% in Greece and 26.7% in Spain. Meanwhile, in the Far East, the HSBC purchasing managers index dropped in April from the level it held a month earlier.

The implication of all this is that interest rates on senior government bonds are going to remain low. That said, a few distant markets offer positive long-term yield.

Australia’s 10-year government bond pays 3.26%, with the country’s CPI forecast to rise by 2.6% next year – but there is currency risk if the Aussie dollar tumbles.

Furthermore, moves by the Bank of Japan (BoJ) in April to pump money into that country’s sovereign-bond market, in which 10-year issues now yield 0.84% in a deflationary environment, have pushed yield-seeking investors to take on more emerging-market sovereign bonds. Stimulative moves by the BoJ caused volatility in exchange rates, and the yen remains weak.

Brazil’s 10-year government bonds pay 9.9% against forecasted inflation of 6.5% in 2013, while Mexico’s 10-year federal bonds pay 7.79% against forecasted inflation of 4% in 2013. Both are investment-grade sovereign debt. Swapping in and out of the relevant foreign currencies diminishes the apparent gain, but clients still can get positive real returns.

Taking a trip down the credit-quality list, Italy’s 10-year government bonds have been recently priced to pay 3.89% against forecasted inflation of 1.7%; Spain’s 10-year bonds are priced to pay 4.24% against forecasted inflation of 1.9%; and Ireland’s state bonds pay 3.48% against a recent annualized rate of inflation of 0.49% -an anomaly likely to rise to 2.1% by the end of the year.

Interest rates on each of these nations’ bonds have dropped by about half in the past 15 months. In turn, returns on these sovereigns have been spectacular. Italy’s state bonds, for example, have produced a 26% total return since November 2011 as investors have cashed in on what appears to have been excessive pessimism.

Going down the list to global junk bonds, a new issue of Rwanda’s B-rated, 10-year government bonds, with its coupon yield of 6.875% against current inflation of 3.25%, was heavily oversubscribed at its launch at the end of April.

But that’s less than the 7.4% interest rates at which Italy’s state debt traded in late 2011, and Italy had – and has – better credit than war-torn Rwanda. Yet, the fact that these emerging-market bonds attract interest is evidence of how hard it is for the bonds of most mature governments to keep pace with inflation.

Even moving to the senior debt of globally recognized companies is not very rewarding. Apple Inc.’s US$17-billion offering at the end of April was priced to yield 2.415% in the 10-year tranche. (There also were tranches at three, five and 30 years, as well as floating-rate bonds set to pay 0.05% over the three-month London interbank offered rate, which is at 0.43%.)

This poor yield shows how stingy compensation is for debt investors, even in global megacap corporate debt. The 10-year Apple bond pays only half the post-Second World War average return of 5.1% for investment-grade corporate debt. Yet, investors were nevertheless prepared to lay out US$50 billion in the vastly oversubscribed issue.

Whether other issuers will be able to pay less than Apple is anybody’s guess, but there is not much more room for rates to drop further. Says Barry Gordon, president and CEO of First Asset Capital Corp. in Toronto, which produces and manages fixed-income exchange-traded funds: “There is a mathematical floor for bond yields: zero. And we are heading for that again.”

Adds Chris Kresic, partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto: “The world economy is not reviving. We are in a slow-growth world with deleveraging.”

That, in a nutshell, shows the cleaving of the sovereign bond world: U.S., Canadian and other senior bonds offer safety – and not much else – while global sovereigns offer positive real returns, but with currency risk.IE

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