Bonds are due to be transformed as the world economy recovers. Today\u2019s most sought after credits \u2014 government bonds, particularly short terms \u2014 will wind up as also-rans as corporate credits take centre stage.
So, clients should be thinking about potential bond purchases and should be prepared to buy, probably in the spring, before it becomes clear to everyone else that the economic recovery is starting. The signals to watch for are a decline in interbank lending rates and a revival of the commercial markets.
The stage for recovery is already being set. Central bank rates have fallen to 50-year lows, to 1.5% in Canada, to 0.25% in the U.S. and to 1.5% in Britain. But corporate debt, at 8% on average, is paying more than the historical return of stocks. This inequality can\u2019t go on forever.
Getting ready for the turn of the market requires a mindset that is ready for the turn. And it\u2019s that change of attitude toward risk that is the tough part. As Patricia Croft, chief economist with RBC Global Asset Management<\/b> in Toronto, notes: \u201cThe bond market [now] is all about risk aversion.\u201d
There are many risks. Corporate defaults are still rising; the credit crisis is not over, by any means; and yields on safe government bonds continue to fall. And then there\u2019s the prospect of a few quarters \u2014 or, perhaps more, if you are a pessimist \u2014 of deflation. That means reduced corporate earnings and less money generated to cover interest due on corporate bonds. Government bonds with no credit issues grow in relative value in a deflationary environment.
Monetary policy-makers are struggling to avoid deflation by getting the global economy moving again. There is a global race to cut central bank rates to as close to zero as markets will think credible. But not quite zero. If rates actually get there, monetary policy has run out of fuel \u2014 and the markets will know it.
Economists think this will work, although when it will happen is far from clear. According to Aron Gampel, deputy chief economist of Bank of Nova Scotia<\/b> in Toronto, it may not start until mid-2009 \u2014 at the earliest. The bond market, he says, will move into a new phase three to six months before trailing economic indicators such as retail sales and consumer confidence turn upward.
On balance, he thinks, the move will happen later in 2009, coincident with the beginning of economic recovery. \u201cWhen the fear factor moderates,\u201d he says, \u201cthe corporate market will be ready.\u201d
A return to risk-tolerant investing has to happen. Notes Jeff Rubin, chief economist of CIBC World Markets Inc. <\/b>in Toronto: \u201cAggressive central bank cuts have pushed real interest rates into deeply negative territory at the short end of the yield curve.\u201d In his view, that can\u2019t last.
However, the prospect of deflation could keep rates low longer than most experts expect, warns Edward Jong, senior vice president at Toronto-based bond manager MAK Allen & Day Capital Partners Inc. <\/b> and portfolio manager of frontierAlt Opportunistic Bond Fund.
But assuming deflation doesn\u2019t last, says Jong: \u201cThe market has to move back to providing a net positive return for holding debt. It is inevitable.
\u201cAs the Government of Canada 10-year bond rate approaches 2% from its current level of 2.9%, the economy is bound to find some traction,\u201d Jong adds. \u201cCorporate bonds will look more attractive. I would be a buyer at that time and wait for real gross domestic product and other lagging indicators of performance to catch up. I would be early; that\u2019s the time for the best pickings.\u201d
Those who recognize the opportunities will be able to pick bonds with yields to maturity that will be at post-Second World War highs.
Migrating out of riskless government short bonds into longer issues that are sensitive to interest rate changes and to credit concerns requires that investors balance the possible gains with the potential losses. (Investors should note that both rating agency downgrades and actual defaults rose in 2008.)
But when the recovery comes, interest rates will rise and bond credit quality will improve. Then corporate debt prices will be more sensitive to credit quality gains, explains Jong, and prices should rise.
Rotating out of riskless government debt to risk-bearing corporate debt and inflation-linked bonds is a timing problem. Spreads on corporate debt, from AA-rated bank senior debt to junk, are at historical highs. U.S. corporate debt yields, for example, were about 600 basis points more than the U.S. 10-year T-bonds in early January.
@page_break@Those levels provide sufficient premiums for defaults, says John Carswell, president of bond strategy and management firm Canso Investment Counsel Ltd. <\/b>in Richmond Hill, Ontario: \u201cYou are being paid for the risk and the wait to recovery.\u201d
More worrying for corporate bondholders is the declining recovery rate on distressed debt \u2014 that is, bonds in default. November data from Moody\u2019s Investors Service Inc. <\/b> indicate declining recovery rates, particularly on subordinated debt.
But that doesn\u2019t mean avoiding corporate debt. It is reasonable to buy it, even now, but you should stay with senior debt. In a deep recession, the bottom of which is not even in sight, it does not pay to trawl the bottom.
The canary in the coal mine of bond defaults will be trends in high-yield bonds. Barry Allen, president of Marrett Asset Management Inc. <\/b>, a Toronto-based specialist in the high-yield market, says it is too early to plunge into junk. \u201cThe Merrill Lynch master II high-yield index, which is the base index of the business, is now at 1,642 points over treasuries,\u201d he says. \u201cIts yield, 21.8%, is an historical high.\u201d
But that is not a \u201cbuy\u201d signal \u2014 at least, not yet \u2014 because, Allen says, the credit market remains very much challenged.
A leading indicator of risk acceptance would be a decline in the London interbank offering rate \u2014 LIBOR, for short \u2014 which is the price banks charge one another to borrow U.S. dollars overnight. \u201cWhen the LIBOR rate falls to 25 bps,\u201d says Mario De Rose, a fixed-income strategist with Edward Jones & Co. <\/b> in St. Louis, \u201cthat would be a signal to switch from risk avoidance in government bonds to risk acceptance in investment-grade bonds.\u201d
By early January, the LIBOR had already fallen to 44 bps from 164 bps in the midst of the credit crisis.
The move in bond prices that will result from closing spreads will be huge. As the recession deepens, the potential gains on recovery grow. The old saw that \u201cthe night is darkest before the dawn\u201d will be prophetic when markets return to normal and inflation re-emerges as a concern for investors. Then, having inflation-compensating bonds such as corporate debt, U.S. Treasury inflation-protected securities, real-return bonds and junk will be appropriate \u2014 even potentially hugely profitable.
To get ready for the recovery, De Rose suggests that your clients should stretch out maturities. \u201cThe average investor could move from hiding in short-dated governments,\u201d he says, \u201cto 30% in a ladder of one- to five-year government and investment-grade bonds, rated A or higher to provide liquidity.
\u201c[That 30% would] take advantage of rising current yields,\u201d adds Re Rose. \u201cThen, 40% in governments and investment-grade corporates with terms of five to 15 years, to optimize risk and return over time. And 30% in long bonds to get the biggest bang for the buck, as markets begin to price up the future stream of bond interest payments.\u201d
In the high-yield market, in which risk gets a better reception, Allen suggests the signal will probably be in reduced spreads on bank bonds.
If the market reads an upturn on bank debt as a \u201cbuy\u201d signal, it will be time to move into a range of credit-sensitive bonds.
When this happens, investors could put 5% in high-yield bonds. Today, Allen notes, U.S. high-yield bonds are paying 21.5%, according to the Merrill Lynch master II high-yield index.
TIPS, which are the U.S. equivalent of Canadian RRBs, now pay the same as U.S. five-year bonds: about 1.5%-1.7%.
\u201cBut, if you think that inflation will return, \u201c says De Rose, \u201cit\u2019s a good time to buy inflation-linked bonds because you are getting inflation protection for free.\u201d
De Rose suggests a 5% portfolio allocation to RRBs.\tIE<\/b>
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