Bond markets have reacted negatively to plans to rescue certain major players in the global financial system. Treasury bills rose as a U.S. financial crisis bailout plan was announced, while longer-term bonds fell in anticipation of the higher inflation the plan was sure to create.
For advisors and their clients, the question is whether to snap up apparent fixed-income bargains; the primary concern appears to be safety.
Although prices of U.S. Treasury bills due in a year or less rose in the last week of September until there was almost no yield to be had, the U.S. 10-year bond showed a minor gain of four basis points of yield on Sept. 26 vs a week earlier. Canadian bonds have also shown price declines, with yields on the 10-year Canada up by two bps in the week leading up to Sept. 26. Compared with prices on Sept. 5, before Freddie Mac and Fannie Mae were bailed out, yields are up 20 bps in the U.S. and 25 bps in Canada, almost parallel moves in pricing the countries’ respective benchmark 10-year bonds.
The bond market has shown increasing default anxiety as yield spreads on credit-sensitive bonds have widened. Canadian financial services bonds’ yields have widened to 240 bps over Canadas, while non-financials have widened by a similar amount. “Credit-sensitive bonds in Canada are moving in sympathy with the U.S., even though our banks do not have the same severity of problems as U.S. banks,” says Edward Jong, senior vice president with MAK Allen & Day Capital Partners Inc. and portfolio manager of frontierAlt Opportunistic Bond Fund in Toronto. “But it is not yet time to buy. If yields were to rise, then today’s apparent bargains would produce losses.”
Global capital markets were saved from collapse by moves announced Sept. 18 by major central banks to pump liquidity into trading floors, to stop short-selling of financial services companies, to take over 79.9% of the shares of giant insurer American International Group Inc. and to loan the company cash at 8.5 points over the London interbank offered rate.
The loan saved AIG’s complex risk-management operations and preserved the market in credit-default swaps, an essential part of the management of potential bond defaults. But the rescue has left a question: will the huge infusion of cash to buy mortgages and derivatives that no institution wants eventually become inflationary?
Bond markets have focused on the Sept. 7 announcement that the U.S. Federal Reserve Board would rescue global debt markets by taking over mortgage insurers Freddie Mac and Fannie Mae in a debt swap. The total cost of the takeover is unknown, but the insurers have US$5 trillion of debt on their books.
Not all of that debt will go bad and have to be replaced with government cash. Still, the figure represents about half of the US$10.8-trillion national debt authorized by Congress. It is also about a third of the country’s US$14.4-trillion gross domestic product.
Governments financing buyouts will have to issue more bonds. If the supply of bonds outruns the demand for bonds, bond prices will have to drop. “Fear of new issuance is the bond market’s way of expressing fear of the consequences of debt relief,” says Tom Czitron, managing director for income and structured products with Sceptre Investment Counsel Ltd. in Toronto.
The structure of interest rates will be set by the way the cost of the bailout is financed. A hint arrived on Sept. 17 in an announcement from the U.S. Treasury that it would set a first US$40 billion auction of debt acquired in the Fannie/Freddie bailout. The auction would be for T-bills that will mature in 35 days.
The announcement represented an unprecedented action in which the U.S. Treasury will be selling debt securities, such as bonds, for the Fed. Selling short bills is a way to test the waters; selling long bonds sets immovable markers. You would not expect the Treasury to dump US$5 trillion of debt on the market in one day. If the financing is done over a period of months, the market could easily absorb it, says Chris Kresic, senior vice president for fixed-income with Mackenzie Financial Corp. in Toronto: “The market can eat a few hundred billion [dollars] of debt easily.”
The long-term effect of the bailout is now a vital issue for advi-sors and fixed-income investors. It is ironic that in a credit crisis that can be laid at the feet of the U.S. housing market, it is U.S. bonds that are being seen as the last and best refuge. “People are fleeing to the most creditworthy borrower in the world,” says Richard Gluck, a principal in charge of global bonds with Trilogy Advisors LLC in New York, “the U.S. government.”
@page_break@In coming months, the bailout will be seen as more of a hat trick than as a solution, argues John Carswell, president of Canso Investment Counsel Ltd. in Richmond Hill, Ont. The Fed will use the additional debt that the Treasury is acquiring — that US$5 trillion — to print more money, he says. That is inflationary, and when people realize that the Fed is pumping up the money supply, inflationary expectations will rise. That will tilt the yield curve upward and steepen it as the inflationary risks are recognized.
For now, there are bargains to be had in high-quality quasi-government bonds that were sold off in the rush to safety. For example, 10-year Greater Toronto Airport Authority 4.85% bonds due June 1, 2017, have been priced to yield 5.5% to maturity, about 200 bps over Canadas of the same term. And Canada Mortgage Bonds guaranteed by the Government of Canada, such as the 4.8% issue due June 1, 2012, have been priced to yield 3.47% to maturity; the boost over five-year Canadas, which yield 3% for the same term, is due to the fact that the CMBs have the word “mortgage” in them.
So, what is ahead? Investors can bide their time, holding T-bills or other short-term government obligations, waiting for markets to normalize or plunge and take advantage of extraordinary spreads on everything but government debt.
“The present financial crisis is a scary proposition,” says Caroline Nalbantoglu, senior financial planner with PWL Advisors Inc. in Montreal. “But we have been there before and come out ahead in every case.” Her advice: be calm and be patient.
Adds Carswell: “It’s safe enough to be invested in those GTAA issues, in federal bonds with terms of three to five years and in Canadian federal agency bonds.”
And when the present credit crisis ends, bonds sold with deep discounts and high yields should generate hefty capital gains. IE
Tailoring bond strategies in trying times
Although the U.S. restructuring plan is scary, rewards are available for those who are patient and remain calm
- By: Andrew Allentuck
- October 15, 2008 October 31, 2019
- 09:52