Does the bond bull have any life left? That’s a vital question for financial advisors who don’t want to lose clients’ money, still want to buy equity portfolio insurance at a reasonable price and want to have a place to keep clients’ money for quick cash if stocks should look like buys.
The risk is that bonds could generate losses as the long bond bull market, which began in earnest in 1983, stumbles in its old age. The prevailing view, backed by recent market data, is that interest rates should at long last be rising in anticipation of economic recovery and eventual central bank moves in the U.S. and Canada.
That means that as the yield curve rises, existing investment-grade bonds – ranging from top governments to BBB+ corporates – will start to show price declines. Already, Government of Canada issues’ and the U.S. treasuries’ respective yield curves have risen, signalling the expectation of higher interest rates ahead. So, is it time to bail out of bonds?
“Government bonds are now overvalued,” says Joe Morin, vice president with Canso Investment Counsel Ltd. in Richmond Hill, Ont. “Government [bond] yields have hit historical lows, and we think they will go up. We see yields on Government of Canada short bonds of less than five years rising to 2%; and on longs, to 3.5%.”
Currently, one-year Canadas yield 1.09% to maturity and 30-year Canadas yield 2.66% to maturity.
Government bonds are sure to bleed red ink, Morin says. The downdraft on long yields, he adds, will be enough to sink real-return bonds, which are all long issues, even though inflation could be headed upward. In the U.S., 10-year treasury yields had risen to 2.4% in the second half of March from 2% in February.
Canso, which advises clients on bond strategies and manages bond portfolios, has been moving to corporates due to their higher yields.
The consensus in the market, according to Bloomberg LP, is that the 10-year U.S. T-bond will yield 2.5% by the end of 2012.
Says Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax: “The bond rally of the past three years is near the end, but we can still hang on. Bond yields remain low and will stay there for a while. There are enough problems in the world that could erupt, potentially leading to a flight to quality that would push up government bond prices. The process that will allow government bond prices in the U.S. and Canada to decline and interest rates to rise to normalized levels is not certain. I think it will happen. As long as central banks are flooding the markets with liquidity, yields will stay low. That means that risks in Europe remain a potential incentive for sustaining the flight to quality. In this environment, with central banks still trying to stimulate their economies, rates will not rise a great deal.”
The case for moving out of government bonds, which tend to respond to macroeconomic factors and be insulated from credit issues, is not without risks, says Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto: “The bond market has produced many interest rate spikes in anticipation of central bank moves to raise rates, but then rates have fallen on bad economic news. What we have is the stock market rising on recovery hope and the bond market reality that we are not out of the woods yet.”
Bonds have to be seen not as a way to make more money than a good run in stocks will offer but as portfolio stabilizers, Jong adds: “You may even have a paper loss on your bonds if interest rates rise. But, if you hold to maturity, you will be whole.”
Moreover, even if bonds fail to match their exceptional performance in 2011, they can provide a good return, says Chris Kresic, partner and co-lead of fixed income with Jarislowsky Fraser Ltd. in Toronto.
Adds Roger: “A diversified portfolio of bonds, including corporates, should still return 2%-4% this year. Most of that will come from investment-grade corporates and provincial bonds that gain prices as spreads over Canadas narrow.”
The question comes down to allocation. “I think bonds have a place in most people’s portfolio for stabilization, for income and for a cash reserve so that if stocks tumble, they can buy bargains,” says Nigel Roberts, a chartered financial analyst who heads Bluenose Investment Management Inc. in Oyama, B.C. “Interest rates will not increase substantially. Global economic growth is still slow, so my strategy is to think one year out and to buy bonds with nine-year maturities. You get the most rate pickup at that term. I am putting my clients’ money in provincials that have lots of liquidity, which many corporates don’t have in a crisis environment. Nine-year provincial bonds should give a return of 5%-5.5% for the next year. Then, I might look at selling.”
Abandoning bonds because a steady recovery is underway is quite risky. Sentiment is shifting back to doubt about the recovery. Some market-watchers are expecting further stimulus programs to suppress bond yields, Roberts adds, as U.S. Federal Reserve Board Chairman Ben Bernanke had hinted about in late March.
The bond bull, thriving on capital gains as interest rates fall, may be old but it’s far from dead. And should world crises reappear, the flight to quality government bonds could be on again. The case for reducing exposure to government issues is in the rising yield curve. The case for abandoning them altogether is a Camelot in which every nation is honourable and pays its debts. And Camelot, of course, was a fairy tale.IE
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