For an off-farm investment or a loan to buy a combine, there’s hardly a more important question than where interest rates are going. Currently, they remain in a historically low range. For the future, it’s a sure thing that they are going up. But when that will happen depends on why rates are still low.
The bond market sets rates for the entire financial system. As of January 2011, Canadian rates are still dirt cheap. A one-year Government of Canada bond pays 1.35 per cent. A 5-year Canada pays 2.41 per cent and a 10-year Canada pays 3.11 per cent. Go out to 30 years and you’ll get 3.52 per cent on an annualized basis. It’s not a lot, but yields are rising.
Look outside of Canada and you find yields going up, as well. The 10 year U.S. Treasury bond yield has risen to 3.53 per cent from 2.56 per cent in November. In Europe, yields on 10-year government bonds are 2.95 per cent. Green government bonds with 10-year terms now yield 12.47 per cent, according to Bloomberg. Rates like this scream “peril.” They’re not for the timid or the weak.
The U.S. sets the tone for world bond markets. Canadian interest rates can and do vary from those in the U.S., but not by much and not for long. So the rise in U.S. rates will eventually drag up Canadian interest rates. The question, however, is why U.S. rates should rise. The country remains mired in a recession, unemployment at 9.6 per cent shows little sign of declining, and the Federal Reserve keeps pumping money into the banking system so that interest rates will remain low. The question and the answer are about risk. The issue is really which risks to worry about.
There are two main worries:
1) More interest is needed to cover rising inflation expectations. This theory suggests that the Fed’s monetary policy will work, reflate the economy, get people working and make the consumer price index accelerate to perhaps an average rate of two per cent per year for the next decade. In this argument, the economy is like a bakery shop that can turn out only 200 loaves a day. If customers demand 250 loaves, the price of bread will have to rise to ration the supply. Turned around, it means that a fixed amount of money will buy less bread or that the loaf will trade for more money. That’s pure demand pull inflation and it is the risk created by massive debt financing in the last two years.
2) More interest is needed to cover the risk of bond defaults in Greece or Ireland or others. The Euro community could shrink if one or two debtor countries decide to abandon the 10 year old currency and revert to Irish punts or Greek drachmas. Bond investors want more interest to cover the risk of default by government or devaluation by currency markets. Note that if the customers at the back of the line in the example get no bread, perhaps as a result of price controls, that governments foolishly use to control inflation, the bakery shop will have defaulted. Any country can get into this situation by issuing too much money or debt that turns into money at maturity. In this sense, the U.S. and Ireland or Greece are no different.
Bond investors have to pay close attention to interest rate trends and inflation, for with rates very low, they have little income to absorb losses by default or monetary devaluation, which is what inflation is by another name. The higher the interest rate on a bond, the more cushion there is for inflation or devaluation. Bond investors can cover some of this risk by diversifying into strong currency countries, as Canada is now, or strong economies that are seen to have little risk of default, for example, Germany and France. That’s why our bonds’ interest rates are pretty low and why German and French bonds set the floor for European interest rates. Bond investors can also reduce the losses that may be caused by inflation and devaluation by putting their money into bonds issued by supranational entities like the World Bank and the European Bank for Reconstruction and Development or huge corporations with worldwide businesses that can benefit from, say, a decline in the value of the U.S. dollar.
TIPS ON BUYING BONDS
If it seems that buying bonds is like walking into the mouth of a dragon able to eat the poor investor by burning him up (that’s the deflation part) or just chomping down (that’s the default part) well, that’s right. But there are some ways out.
First, buy high dividend stocks of companies with a record of dividend increases through good years and bad. Canadian chartered banks, major regulated utilities and major national telecom companies. Do a little research to ensure that anything you consider has strong and supportable dividends. Economic recovery should boost their businesses, adding to their ability to pay dividends and to raise them.
Second, stick to Canadian government bonds, especially provincial issues that have a tidy boost in yield over federal bonds, or Canadian corporate bonds from major issuers like the chartered banks. Or use bond exchange-traded funds with short ladders of maturities from one to five years. There are corporate and government bond funds that qualify.
Third, consider a well-managed bond mutual fund with reasonable fees. There are several well -managed bond funds available. Go to Morningstar.com or globe-fund.com to find funds with good records and reasonable fees. Pay any sales fees upfront or just buy no load bond funds. Mutual funds provide liquidity so that you can cash in a few thousand dollars at any time. They have the muscle to buy bonds for prices the individual cannot get. They do accounting for unit holders. And they are usually ready to explain their strategies.
It takes courage to stick with bonds in a market in which monetary alternatives like gold and silver are soaring, in which bonds themselves seem to be less rewarding than stocks, and in which risk is no longer seen as a bad four letter word.
But there is trouble on the horizon for stocks. The world’s bellwether market, Wall Street, is trading at 22 times expected earnings. That’s a third more than its historic average of about 15 times forward earnings. U.S. household debt has risen to an astonishing 50 per cent of U.S. GDP. On Dec. 9, the Bank of Canada has warned that household debt has risen to 148 per cent of gross household income. Meanwhile, the value of owner-occupied housing in the U.S. is once again falling. The reason: massive, court-ordered suspensions of foreclosures and the shutdown of many home markets in the U.S. pending resolution of the foreclosure fraud mess. Markets are jammed with houses that cannot be sold or bought. Owners’ liquidity is trapped in this latest fallout of the housing crisis. The implications for household wealth — the bedrock of the economy — are not good.
The good news that propelled stock markets in the U.S. and Canada to give December the best one month return the markets have had in two decades may not last. Europe is ready to supply a lot of bad news. Rather than default on its bonds or take on even more debt than the US$28,000 per capita already loaded onto their backs by loans from the International Monetary Fund and the European Central Bank, Ireland may choose to abandon the Euro outright or to delay paying debts to banks in Germany, France and the U.K. If any of that happened, those banks would suffer massive writedowns.
With all of that risk, it makes sense to buy conservative, safe Canadian government and investment grade corporate bonds. The potential gain is modest, but bondholders will get their money back in solid and spendable loonies.
Canada has one of the most solid economies in the world. It’s where I am keeping my money for now. Solid bonds that turn back into cash at maturity and dividend growing stocks make a lot of sense in a world still in meltdown.
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With all of that risk, it makes sense to buy conservative, safe Canadian government and investment grade corporate bonds