Calm has returned to debt markets in Canada and the U.S.; fears that the Dow Jones industrial average would collapse, the U.S. Treasury might default on its bonds and that top corporate names in the bond market would become insolvent have all been put to rest. Bond markets around the world have left panic behind and returned to their normal state of angst.
In the rehabilitated bond market of 2010, inflation and deflation are driving the structure of interest rates. One school of thought argues that inflation \u2014 driven by the massive printing of money by central banks seeking to reflate banks, and the economy generally \u2014 will rise from moderate levels to double digits as the economic recovery gains speed. An opposite school of thought claims that the recovery is feeble and incomplete and that \u2014 as Canada, the U.S. and much of the rest of the world follow the second down leg of a \u201cW\u201d recovery pattern \u2014 a decline in the consumer price index will result.
So, which of these two scenarios will it be? \u201cWe see inflation not being a big concern,\u201d says Alex Koustas, an economist with Scotia Capital Inc. <\/b>in Toronto. \u201cWe see the recovery as being rather muted and, therefore, not an inflation driver. As to deflation, we don\u2019t see any repetition of the Japanese experience, in which prices have declined.\u201d His conclusion: the CPI should rise moderately for the next few years.
Patricia Croft, chief economist with Royal Bank of Canada<\/b>\u2019s global asset-management division in Toronto, notes that although both the Bank of Canada and the U.S. Federal Reserve Board want to achieve a 2% core inflation rate, their respective economies will actually have rates below that target.
\u201cCore rates are lagging indicators; and in each country, rises in the core rate will be held back,\u201d Croft says. \u201cIn the U.S., it will be the weak recovery as the cause. Here, it will be the strength of the Canadian dollar.\u201d
Scotia Capital predicts that core CPI, which excludes food and energy price variations, will rise by 1.5% in 2010 and by 2% in 2011 in Canada; and by 1.4% and 2.1%, respectively, in the U.S. This assumes that the recovery will be weak in both countries, with economic growth doing little more than making up for losses suffered during the recession.
With subdued economic growth, low inflation and low interest rates, bond returns have become very thin at the short end of the yield curve \u2014 and that\u2019s an environment in which there is not a lot to gain by trying to chase yield on government bonds. Thus, it\u2019s better to seek substantial gains in credit-sensitive bonds for which the boost is larger. This means a client seeking the security of bond returns has to decide on a portfolio blend of government and corporate debt.
Government bonds that have virtually no default risk in native currencies vary mainly with changes in what the market sees as future changes in interest rates. Investment-grade corporate bond prices vary with anticipated interest rate changes and the perceived ability of borrowers to pay interest and repay the principal on time. The mix depends, of course, on what you judge to be a prudent mix of risk and return for your clients.
A portfolio committed entirely to riskless Treasury bills will have virtually no return, so taking on time risk and credit risk is the only way to make any significant money.
Short-term interest rates \u2014 specifically, 91-day T-bill rates, recently 0.12% in Canada and virtually zero in the U.S. \u2014 will rise by 50 basis points to 100 bps beginning in the second quarter, says R\u00e9mi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. <\/b> in Halifax.
This is likely to result in a flatter yield curve, as long rates aren\u2019t likely to rise much in the wake of low inflation and a weak recovery \u2014 but they aren\u2019t likely to fall, either. Even though current long rates may not seem compelling, pension funds and insurance companies will continue to buy long-dated bonds, thus supporting prices on what amounts to a technical basis.
A flatter yield curve implies that there will be reduced premiums for going long in government bonds and a higher premium for taking on corporate bond risk. As such, Seamark is reducing its weighting of long bonds in its portfolios while still retaining some issues, such as the Government of Canada 8% issue due June 1, 2027, with a yield to maturity of 4.06%; the Ontario 6.5% issue due March 8, 2029, with a yield to maturity of 4.84%; and the Province of Quebec 9.375% issue due Jan. 16, 2023, with a yield to maturity of 4.72%.
@page_break@Picking bonds by the issuer\u2019s nationality requires forecasting currency changes. The loonie is expected to continue to appreciate against the U.S. dollar, says Sacha Tihanyi, a currency strategist with Scotia Capital in Toronto.
The reasoning for that prediction is that weak U.S. growth will keep interest rates relatively low, thus continuing the downward pressure on the greenback. That means buying U.S. federal debt could turn into negative returns after the currency adjustment.
(It should be noted, however, that some analysts believe the US$ will rally against most currencies and stay even with the C$, which is supported by high resources prices. Should this happen, there wouldn\u2019t be losses on U.S. federal debt.)
Being aware of all these risks is important, as protection of capital is the main driver of bond investing. Noting that consensus forecasts suggest that interest rates will rise in 2010 and that there will eventually be a stronger recovery, Nigel Roberts, a chartered financial analyst and president of Bluenose Investment Management Inc. <\/b>in Oyama, B.C., suggests the better part of prudence is to stay short.
\u201cI would say that five years\u2019 duration is about right. That is a good risk-to-reward place to be,\u201d says Roberts. He notes that he can get that kind of duration by building bond ladders or using laddered exchange-traded funds, such as Claymore 1- to 5-Year Laddered Government Bond ETF (with a management expense ratio of 0.15%) or Claymore 1- to 5-Year Laddered Corporate Bond ETF (MER: 0.25%). Roberts also likes quality municipal bonds, such as the B.C. Municipal Finance Authority 4.9% issue due Dec. 2, 2014, with a 2.87% yield to maturity. That\u2019s a 35-bps premium over five-year Canadas. Other strategies get the same result. Barbell-shaped allocations of short and long issues accomplish the same yield averaging as a ladder with fewer bonds.
Spreading out time risk by using ladders or a combination of short and long maturities in barbells also provides a chance to roll into the higher bond yields that would accompany an inflation surge.
The data do not support anything similar to a return to the double-digit inflation rates of the 1980s \u2014 or even to the high single-digit rates of the 1990s. Nevertheless, as Caroline Nalbantoglu, a senior financial planner with PWL Advisors Inc. <\/b>in Montreal, suggests, it is always difficult to predict the future: \u201cI would not go longer than six years. Beyond that, there is a lot of duration risk.\u201d
One way to protect your clients from potential inflation is to invest in a special niche of inflation-protected government bonds, such as Canadian real-return bonds or U.S. Treasury inflation-protected securities, which, argues Chris Kresic, senior vice president for fixed-income at Mackenzie Financial Corp. <\/b> in Toronto, have a place in portfolios. The break-even rate \u2014 at which the returns on the inflation-protected bonds equal returns on conventional bonds \u2014 require inflation to average 2.5% for RRBs and 2.25% for TIPS.
Inflation expectations lie behind the pricing of RRBs and TIPS. \u201cIf inflation expectations rise above the break-even rates, new buyers would overpay and create a profit for existing holders,\u201d Kresic says.
So, if pension funds and insurance companies are starved for long bonds, as they often are, they will pay high prices for RRBs and TIPS. If and when that happens, holders of these bond issues will have inflation protection and additional return on the price they paid.
Looking ahead, there are varying scenarios for inflation-adjusted bonds, Kresic says: strong growth with inflation, in which inflation-linked bonds should beat nominal bonds; recession with zero inflation \u2014 in that case, nominal bonds are better than inflation-linked bonds; or recession with deflation, during which inflation-linked bonds such as RRBs and TIPS would suffer a declining payout and drop in price. In reality, the most likely scenario is slow growth with inflation, which is what\u2019s expected for the U.S. and Canadian economies over the next few years. So, Kresic says, RRBs have a place in your clients\u2019 portfolios.\tIE<\/b>
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