Inflation Or Deflation? The Risks Depend On Your Outlook

For fixed income investors, inflation or deflation is important. It makes a massive difference whether consumer prices will rise or decline. If they rise, then an income stream from a bond or from a preferred stock will lose purchasing power over time. If we have sporadic or even steady deflation, an income stream will gain purchasing power in the years ahead.

For inflation, pick corporate bonds and high-yield bonds. For deflation, pick government bonds. And if you are not sure, get a blend or a manager who can handle the problem.

The bond market is acutely sensitive to price trends. Today’s low bond yields imply that prices will not rise a great deal in coming years and even decades. So the fixed income investor’s choice comes down to picking from a limited range of low-interest alternatives.

The base rate for all interest-generating investments is set by Government of Canada bills and bonds. At time of writing, rates go from 80 basis points (there are 100 basis points in one percentage point) at annualized rates on a one-month Canada Treasury Bill to 1.19 per cent for one year, 1.35 per cent for two years, two per cent for five years, 2.70 per cent for 10 years and 3.38 per cent for 30 years.

You can do better than these rates by investing in provincial bonds, which are usually liquid and readily available from investment dealers; in corporate bonds that can be hard to buy if they are not actively traded; and, in a variety of mutual funds and exchange traded funds. Even some Guaranteed Investment Certificates are better deals.

COMPARING THE OPTIONS

Let’s take a look at what’s available these days. Each type of investment has advantages and each has distinct risks.

Provincial bonds have been sold off by mainly foreign investors fearful of any debt that is not backed by a government with the power to print money. You can get a Government of Ontario 6.5 per cent issue due March, 2029 currently priced at $130 per $100 face value that will pay 4.16 per cent per year to maturity. Or you could buy a Government of Ontario 4.7 per cent issue priced at $107 per $100 face value that will pay 4.25 per cent to maturity. These bonds offer about 75 to 87 basis points over federal bonds, a nice pickup, but each comes with a guaranteed capital loss and exposure to a long period in which inflation is likely to creep back. These superficially appealing bonds turn out to be long shots that will eventually bring tears to the eyes of their holders. On the other hand, Ontario and other provinces have the power to tax. Outright default is an exceedingly remote possibility. And if deflation does happen, interest rates will drop and these bonds will be all the more appealing. In this scenario, they would gain value.

Corporate bonds look better. You can buy a Bombardier 7.35 per cent bond due Dec., 2026 priced at $102 per $100 face value for a 7.14 per cent yield to maturity. Looks good, but Bombardier is a massive borrower, has no taxing power, operates in highly competitive industries building planes and trains, and could be winner or victim in the next 16 years.

Alternatively, you could buy a Manulife Financial Capital Trust issue due Dec. 31, 2019 with a 7.405 per cent coupon recently priced at $110 per $100 face value to yield 6.01 per cent per year to maturity. Manulife, once the darling of the Canadian insurance industry, has been defrocked. Its shares have crumbled and it is now seen for what it is — a guarantor of stock prices embedded in insurance products. If world stock markets crumble — that is a deflation scenario — then Manulife’s total capital would shrivel, its bonds could lose value, and holders would be sure to lose badly. On the other hand, chances of outright default are slight.

If the ups and downs of the corporate bond market seem to contradict the idea that bonds should be quiet guarantors of wealth, well, you’re right. You can skip bonds altogether and put your money in Guaranteed Investment Certificates. The range of returns, according to Fiscal Agents, an Ontario company that monitors all issuers across Canada (see www.fiscalagents.com) is modest. The average return per year for all issuers across Canada is 2.57 per cent for five years. GICs are usually not cashable until maturity or, if cashable, charge a penalty for early payout. Their illiquidity means that they are immune from the forces of inflation or deflation. But their low payouts make them surefire losers when compared with alternatives likely to do better.

WHAT THE EXPERTS THINK

Christine Horoyski is senior vice-president at Aurion Capital Management Inc. in Toronto and portfolio manager for several bond funds that operate under the Aurion and Dynamic flags.

“We think that the potential returns on corporate bonds, about four per cent to 4.5 per cent next year, and on provincial bonds where you can pick up 50 to 75 basis points on Ontario issues over federal bonds, are attractive. We think high-yield bonds can produce an eight per cent return in the next 12 months. And we think that active management is vital to getting those returns and managing risk in this low-yield environment. We think we can add enough value to justify the fees,” she says.

Dynamic Aurion funds have an impressive near-term record but no long-term performance to judge. However, a Dynamic Advantage Bond Class Fund F class Portfolio turned in a 9.16 per cent return for the 12 months ended August 31, 2010, far above the 6.75 per cent average return of Canadian bond funds in the period. Adding corporate bond exposure beyond the average of the class helped the fund beat the mob of also-rans, says Michael McHugh, the fund’s lead manager.

As the risk of bond default rises, potential returns soar. This is the arena in which junk bond managers become heroes or villains. Among the heroes is Francis Chou, manager of the Chou Bond Fund, which generated a 30.5 per cent return for the 12 months ended August 31, 2010. He was able to buy bonds that others had sold off in desperate fear of default. Those bonds, including an issue from Overstock.com, went into his portfolio at 65 cents on the dollar and now trade at 98 cents on the dollar. He bought bonds from Wells Fargo &Company, a huge American bank, at the bottom of the credit crisis in 2008 at 50 cents on the dollar. Those bonds now trade at $1.02.

What’s ahead? Chou says that the next year won’t produce such spectacular returns. Moreover, even if deflation breaks out, he figures that inflation will come back. “Governments have added huge amounts of liquidity to the money supply that, when the crisis is over, all prices are going to rise.” Chou says he does not know when inflation will roar back. If and when it does, all bonds will lose value. On the other hand, he has a spectacular record of gains. But there are also losses: Chou Bond Fund was up 42.45 per cent for 2009, lost 37.7 per cent for 2008 and lost 2.65 per cent for 2007. High risk goes along with high yield in the junk bond sector.

It’s tough enough to make money. With bonds, you are unlikely to lose it — unless you put too much money on the wrong level of risk or stretch yourself out so long that what you did not expect to take place will happen. Stay fairly short, keep your risk exposure moderate or at least no more than you can tolerate, watch your tax exposure and you’ll be able to sleep well at night.

AndrewAllentuckisauthorofWhenCanI Retire?PlanningYourFinancialLifeAfter Work,publishedlastyearbyVikingCanada

About the author

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Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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