Bonds are about the only sure thing going these days. Gold is tumbling and has turned into a commodity, which is no place to be in a world consumed with fears of a global recession; stocks are for shorts with the guts to hang on for the one-day rallies that characterize this market. But investing in debt, especially public debt, is paying off with low but certain returns and modest levels of risk.
The trend-setter for the G-7 group of nations is the U.S., which has taken on perhaps US$1 trillion of obligations. The U.S. has promised a US$700-billion bank bailout and has agreed to buy shares in commercial banks. It has also promised to take on the uncertain costs of guaranteeing money market funds and commercial paper, and to raise the insurance limits on individual chequing and savings accounts to US$250,000.
You and your clients will be given an opportunity to buy debt on a double-bang basis. First, central banks and treasuries will have to cut prices and raise yields to get the debt sold. Moreover, there is a strong likelihood that G-7 nations and, for that matter, the former Asian Tigers (South Korea, Taiwan, Thailand, etc.) and the BRIC group (Brazil, Russia, India, China) will cut their interest rates, as well. Those cuts will tend to push up the prices of existing debt if there is a good chance that rates will go lower still. This will happen in Canada as much as in the U.S.
The current consensus is that the U.S. Treasury will spread out the US$1-trillion debt along the yield curve from short-dated 30- and 90-day T-bills to 30-year bonds. No one is sure, for the Treasury has not announced how it will do the job. However, says Peter Kotsopoulos, executive vice president with McLean Budden Ltd. in Toronto: “The bond market anticipates huge amounts of supply. The issuance will be geared toward the shorter end of the curve, and that may push up yields.”
Analysing the effects of a US$1-trillion sale of government debt in an indefinite period is speculative. Yet, there are some solid facts to go on, so the exercise is helpful if not definitive.
Selling this much debt at weekly auctions will require that the usual US$20-billion inventory at least double. The U.S. Treasury would then be able to dispose of the US$1-trillion surplus in 50 weeks, a good time frame for the project.
T-bills and bonds are sold at discounts, so the spreads will have to widen. The amount of widening will vary with the bond terms, but the effect will be to push up yields all along the curve.
The cheapest way for the U.S. Treasury to sell the debt would be at the short end of the yield curve, at which rates for 30-day T-bills have floated in a range of two to seven basis points. That kind of cost is approximately nothing, says Ed Jong, senior vice president with MAK Allen & Day Capital Partners Inc. and portfolio manager of frontierAlt Opportunistic Bond Fund in Toronto: “Guys are willing to take seven bps annualized rather than go into commercial paper.”
The commercial paper market, frightened by the prospects of overnight defaults of banks, wants 3%-4% for short-term paper.
MAKING A PROFIT
Jong argues that if the U.S. Treasury can sell debt for what amounts to no cost at the short end, it will do it. The whole bailout will cost next to nothing and, if the U.S. Treasury’s purchase of toxic debt — priced on a mark-to-market basis that reflects current fear rather than eventual sale of foreclosed homes — is done well, the U.S. Treasury will make a profit.
Even if the U.S. Treasury finances short and lends long at higher rates, it can make money, Jong notes. In this scenario, there is nothing for bond investors, except for institutions that are happy with a couple of bps and can pass on their dismal returns in higher insurance prices and lower pension fund returns.
There is another scenario in which market considerations suggest that the U.S. Treasury will sell debt all along the curve. Financing short is a risky business, for economic conditions may improve and reduce the fear factor that has held U.S. T-bill rates down.
@page_break@“If the flight to quality weakens, then short-term yields will rise,” argues Michael McHugh, vice president of Dynamic Funds Management Ltd. in Toronto. If the flight to quality does subside, he says, the U.S. Treasury will have to face rising refinance costs. Moreover, it needs a steep yield curve to encourage lenders to take on long-term obligations.
In this scenario, there is no movement on the yield curve at the short end, which cannot go any lower than almost zero. Then, in McHugh’s view, there will be some sales of 10-year T-bonds to foreign central banks. As well, there will be sales of long bonds to insurance companies that always need 30-year debt to match insurance policies and expected pension claims.
The steepening process would have limits. As Sunil Shah, vice president and portfolio manager for fixed-income products with Sceptre Investment Counsel Ltd. in Toronto, notes, the prospects for higher rates along the curve have to be tempered with the realization that there are macroeconomic forces that will tend to restrain rate rises. “There are strong deflationary forces in the economy now, globally and nationally,” he explains. “We see steepening, and it will be led by expectations of U.S. Federal Reserve Board cuts in rates.”
Moreover, he adds, Canada will do what the U.S. does: “We will follow the U.S. on an almost one-for-one basis in any future monetary moves.”
As long as the U.S. Treasury debt is spread out along the curve, the premium that can be earned for going from the short end to the middle of the curve is likely to grow. The spread from two to 30 years, at the time of writing, was 205 bps. But it could rise; in the 1990s, it rose to 300 bps on more than one occasion. Such growth in yield potential, Shah says, would reward every posi-tion on the curve.
The long end of the yield curve is a question mark. Deflationary fears based on slowing or negative economic growth and deleveraging imply that interest rates will not rise much at the long end of the yield curve.
Advisors and bond investors who want the security of government debt have a limited set of choices: take next to nothing in T-bills; take on limited risk in the two to 10-year range of terms; or buy long bonds with the higher risks that go along with making long-term bets. IE
Government debt presents a limited set of choices
Treasury bills and bonds offer little yield in all time horizons, but they do represent safety in very tough times
- By: Andrew Allentuck
- November 11, 2008 October 31, 2019
- 09:42