The long predicted end of the three-decades-old bond bull market is not yet at hand. For now, interest rates on bellwether 10-year federal government bonds, the returns for which rose appreciably last year, are going nowhere. Rates have not risen as expected because inflation has not picked up; economic recovery has stagnated in both the U.S. and Canada, and demand for loanable funds has languished. Yet, in this range-bound market, bonds offer a low-risk way to generate income.
The official view, though, is that interest rates are headed upward in the longer term. For example, the 10-year Government of Canada bond, which recently yielded 2.51% to maturity, should yield between 4% and 4.5%, suggests Scott DiMaggio, director of Canadian and global fixed-income services with Alliance Bernstein Holding LP in New York. He adds that the U.S. Treasury 10-year bond, which has recently yielded 2.76% to maturity, should have a 5% yield to maturity. But those forecasts are five years out to 2019.
In the meantime, bonds in both countries are holding their value, with yields oscillating in a range of 2.3%-2.8% – as though forecasted interest rate increases are only distant risks, says Benoît Poliquin, chartered financial analyst and lead portfolio manager with Exponent Investment Management Inc. in Ottawa.
This range is characteristic of a slow economic recovery. What’s stopping a breakout from the band is the lack of movement in economic fundamentals.
“Interest rates would soar only if inflation picks up,” DiMaggio explains. “And that would mean that the slack in the U.S. and Canadian economies would have to end.”
For now, however, interest rate stagnation has its rewards. The prospect of balanced federal finances, which is what former federal Finance Minister Jim Flaherty promised in the Feb. 11 federal budget, means that there will not need for issuing much new long bonds. Yet, pension funds will continue to want long bonds to match their own obligations – as will insurance companies with long tails of risks. That long market view is another prop in the support of bond prices. In fact, DiMaggio says, there could even be a small inversion at the middle to the long end of the yield curve.
In the U.S., an inversion in the yield curve is not likely, for the U.S. Federal Reserve Board has to keep on supplying bonds to the market to roll over the massive federal debt carried over from the bank rescues of 2008-09. Yet, DiMaggio adds, without a pickup in inflation to push up the prices of goods and services and subsequent corporate profits, high-priced stocks have more risk than bonds that face flat yield curves. In this market, with interest rates going nowhere for perhaps a year or two – or even longer – bonds remain a reasonable investment if interest rate risk can be hedged.
With interest rates on bellwether 10-year government bonds now bound within a range, says Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto, you can buy an investment-grade corporate bond and sell a government bond of the same term for your clients.
For example, a Loblaw Cos. Ltd. 4.86% issue due Sept. 12, 2023, recently priced to yield 3.97%, would be the bond you’d buy along with selling the Canada 1.5% issue due June 1, 2023, which was recently priced at $92.83 to yield 2.37% to maturity. When the yield on the Canada bond rises to 2.7%, the price would be $90.25.
This short trade, Jong notes, thus would pay the difference of $2.58 and also eliminate duration risk on the Loblaw bond. The same strategy, he adds, would work on U.S. corporates matched to U.S. treasuries of the same term.
This strategy means that your clients can add term to 20 or 30 years, pushing yields on investment-grade corporate bonds into the range of equities returns. As long as the buy is matched to a short on a government bond of the same term, Jong notes, the trade should work.
Global bonds are in much the same position, with their prices supported by weak national economic recoveries. In Europe, the outlook for rising interest rates is dim. On Feb. 23, European Central Bank (ECB) president Mario Draghi said the bank was ready to add stimulus if the outlook for inflation continues to decline. His goal is to avoid the deflationary scenario in which people and companies postpone purchases in anticipation of dropping prices.
Delaying purchases forces companies to cut their prices, rewarding those who wait. Vendors then would have to dump more products, exacerbating the deflation spiral. This scenario is not out of the question, as eurozone inflation declined to an annualized rate of 0.8% in early February – less than half the ECB’s 2% target rate.
Draghi’s language was guarded but clear: “We are not seeing strong, unambiguous developments.” His worry is that dropping prices, signalling caution by consumers, also appeared following the implosion of Lehman Brothers Holdings Inc. in 2008.
The ECB, the Fed and the Bank of Canada do not move in lockstep, but they tend to work in the same direction. Soaring interest rates are not in the picture just yet.
Fears of outright deflation in Europe are echoed in the problem of disinflation in Canada and the U.S. The prospect of strongly rising interest rates, which would devastate bond portfolios, is not in sight.
Thus, Jong says, trading on the range with short positions when yields drop or using shorts to cover duration risk on investment-grade corporate bonds to get a yield pickup over governments are low-risk ways to generate income.
Moreover, if interest rates do not move upward by a great deal, the profit on the short trade plus the coupon on the bonds held long can generate the kind of profits that were possible early in the bond bull market. Short/long trades are more complex than buy-and-hold, but the potential profits in low-risk investing make them potentially worthwhile.
“This,” Poliquin says, “is putting recovery pessimism to work.”
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