Bond markets have moved into a bull phase without precedent. In mid-September, yield for U.S. Treasury bills fell to two basis points, indicating that investors were willing to park their money for months for virtually no return.

Although this is odd behaviour, it makes sense in a market shocked by the destruction of trillions of dollars of shareholder wealth and vastly diminished expectations for corporate earnings. For advisors and their clients, it is a new mood of ultra-conservative portfolio management.

The mantra of this market is “return of capital is more important than return on capital.” Thus, prices of short and, therefore, riskless government bonds are soaring. For example, a 30-day Canada T-bill offered a yield of 1.3% on Oct. 3, down from 1.8% on Sept. 28.

In contrast, credit-sensitive bond prices have fallen drastically. Returns on the least promising bonds, such as non-investment-grade debt, are now pushing 15% on an annualized basis, according to the Merrill Lynch master II high-yield index. That is a new record for the category. In this race, the best-performing bonds have clearly been those without credit risk.

“Political leaders and monetary policy-makers have painted themselves into a corner,” says Edward Jong, senior vice president with MAK Allen & Day Capital Partners Inc. and portfolio manager of frontierAlt Opportunistic Bond Fund. “We are going to have a sustained bond boom, as Japan had in the 1980s, which, in fact, has continued to the present day. On Oct. 8, the U.S. Federal Reserve Board cut rates to 1.5% and the Bank of Canada cut rates to 2.5%. This is the tip of the iceberg. Their next cuts could be 50 bps, followed by 10-bps increments in order to save their ammunition.”

Rate cuts offer evidence of the willingness of central banks to help capital markets. They make existing bonds with fixed coupons more attractive, and this tends to raise their prices. As well, interest rate cuts that reduce the yields of new bonds make stocks more attractive on a relative valuation basis. Stocks with dependable dividends, including preferred shares, tend to rise in price. Even shares of companies that have no dividends seem more appealing because the opportunity cost of share ownership tends to decline. Lower interest rates also reduce financing costs on bank and bond debt, increasing the likelihood or the amount of company profits.

There are also technical factors that make rate cuts bullish for bonds. When the central bank cuts short rates, the short end of the yield curve drops and — if the long end stays put or drops less — the curve steepens. Steepening yield curves tend to forecast economic recovery.

Playing the current global financial malaise for fixed-income profits is going to be different this time around. As Jong notes, there has been a major drop of about 7% in the iShares Canadian corporate bond exchange-traded fund since its peak in March. Meanwhile, the iShares Canadian government bond ETF is down by just 2.4% at the time of writing, an odd move that can be explained as a shift in investor preference to short-dated government bonds from long bonds in a process of migration to less risky credits.

In a market driven by fear, investors and asset managers are giving a great deal of weight to liquidity. Thus, on Oct. 14, the London interbank offered rate, which is the rate at which banks charge each other for overnight loans, was 4.64%, more than double the 2% it was on Oct. 2.

In this market, with short-term safety a paramount motive for many investors, taking on some time risk in long bonds pays handsomely. As Brad Bondy, vice president of fixed-income with Genus Capital Management Inc. in Vancouver, notes: “The steepening of the yield curve is not done. The yield spread on the 10-year U.S. T-bond vs the two-year T-bond, now about 200 bps, has a way to go. In 1992 and 2003, we had spreads of more than 250 bps.”

The risk of going long to make the most of what are likely to be falling interest rates is exposure to technical market risk, says Tom Czitron, head of income and structured products with Sceptre Investment Counsel Ltd. in Toronto: “There will be a big supply of bonds to be sold in Canada and the U.S. That will force bond prices down and yields up.” That process, he adds, will push up yields on new bonds and make existing long bonds less attractive, lowering their prices.

@page_break@In Czitron’s view, the risks of going long are too great. Moreover, he notes, there will be a recovery some day and with it, rising interest rates. His advice is to stay with bonds that have terms of less than five years, for that is where safety lies. This applies to government bonds of any sort, including treasuries, Canadian federal and provincial bonds, and Maple bonds issued by foreign governments or government-backed banks, such as Germany’s Kreditanstalt für Wiederaufbau, which aptly means “Bank for Reconstruction.” A KfW 4.375% issue due July 2018 that was recently priced to yield 4.65% at maturity offers 120 bps of yield over a Canada bond of the same term that pays 3.45% to maturity.

Bond booms can have terrific staying power. The last major boom, driven by the Fed and the BofC acting in concert at the beginning of 2002, pushed overnight administered rates down to 2.25% from the mid-double digits in the early 1980s. In that 20-year period, the nominal return on U.S. long-term T-bonds was 12% a year, compared with nominal stock returns of 14.1% in the same period. Of course, bonds were much less volatile and did not suffer major losses in the stock market collapse of Oct. 19, 1987 — nor during such events as the fall of U.S. hedge fund Long-Term Capital Management LP in the autumn of 1998.

So, will this bond boom last two decades? As long as equities markets remain morbid, bonds will thrive. Satyajit Das, one of the world’s pre-eminent experts on risks in the financial system, has said that the present crisis is “the end of the beginning, not the beginning of the end.” His view is that the unwinding of credit pyramids will take years and create massive losses in the value of equities. That will make government bonds attractive.

Getting your money back in a secure bond that reverts to cash is appealing. The bottom line is that “right now, for yield, you take a risk on highly rated corporates,” says Aron Gampel, deputy chief economist at Bank of Nova Scotia in Toronto. “For the highest safety, you buy short-dated governments. And that is not going to change until there is an economic recovery, which is possibly years away.” IE