Interest rates are rising around the world. You wouldn’t know it from the stand pat position of the Bank of Canada, which continues to hold overnight loan rates to chartered banks down to one per cent. That administered rate sets the tone and the rate of interest for short bonds and many bank loans. But the bond markets in Canada, the U.S., Europe and around much of the rest of the world anticipate higher interest rates and have duly raised both the cost of borrowing and the payoff for holding bonds.
The reasons that markets are raising yields on bonds are complex. But rising yields are not only a signal to Canadian investors who want to buy fixed income assets, they also show how global debt markets see the future. Knowing why rates are rising will be important in making off-farm investments and, frankly, in not losing your shirt as the 29 year long bull market in bonds ends.
First, we need a bit of history. In 1982, interest rates were hitting double digits. You could buy solid corporate bonds that paid 16 per cent per year to maturity. Corporations were issuing preferred shares with 12 per cent dividend that the investor could put back to the issuer at any time and get cash. Then Paul Volcker, head of the Federal Reserve, broke the back of raging inflation, raising short rates to chokehold levels. The overnight Fed Funds rate went to 14 per cent. A lot of steam was taken out of the economy and interest rates began to come down.
Down they slid in an almost continuous path with a few blips such as the interest rate spike in 1991, another in 1998 when Russia defaulted on its ruble debt, and then down and down until first Fed Chair Alan Greenspan and then his successor Ben Bernanke pushed rates down to what amounts to zero in an effort to restart the U.S. economy. Needless to say, the Bank of Canada followed along in near lockstep with the Fed.
Now things are changing. Interest rates around the world are headed up because the global economy is reviving, increasing the demand for bank loans and loans from the public — bonds, in other words. Interest is the price of money, so with demand for money up, interest rates will rise.
There are also fears of default by nations, particularly in Europe, where the government bonds of Greece have been rated as junk by all three big credit companies — Moody’s, Standard &Poor’s and Fitch. Greek bonds now pay 11 per cent, which is just theoretical. Greece could default or restructure its debt, forcing investors to swap bonds due in a few years for others due in 20 or 30 years. That’s what Argentina did in 2002 in a US$70 billion default, then the world’s largest, substituting 30 year, low interest bonds for others coming that it could not afford to redeem. That’s why Irish and Greek and now Portuguese bonds have been sold off and why, with fear of default and nasty restructurings built into their prices, they are selling at half or less of their issue prices.
Finally, there is fear of inflation. The immense slack in the global economy has held inflation at bay since 2008. But prices are starting to rise. In a January 7, 2011 Global Economic Forecast, Scotia Capital’s economics department predicted that in 2011 consumer prices will rise at 2.1 per cent in Canada, 1.5 per cent in the U.S., 3.3 per cent in the United Kingdom, 4.5 per cent in China and 5.5 per cent in India. All the rates are up from 2010 and the pattern is clear — inflation is back, if not with a bang then at least with a whimper. And that inflation has to be priced into bond returns.
The trend is already clear in Government of Canada bonds. Ten year Canada bonds that have recently paid 3.2 per cent to maturity will yield 3.5 per cent by the end of 2011 and then four per cent by the end of 2012, Scotia Capital predicts. In the U.S., 10-year Treasuries that have recently yielded 3.25 per cent to maturity will pay 3.75 per cent by the end of 2011 and four per cent by the end of 2012. Each 0.25 per cent rise in rates will cut about 1.75 per cent off the price of the bond. In a low interest rate environment, that means these ten year bonds will have flat to negative returns.
In the global bond market, things are downright tantalizing. The BRICs — Brazil, Russia, India and China — have high interest rates reflective of their boom conditions, inflation outlooks and prospects are for rates to climb further this year. In mid-January trading, Brazilian government bonds were priced to yield 26.5 per cent to maturity. Take off Brazil’s 12 per cent inflation rate and the bonds offer a real return of 14.5 per cent. Russian rates at 7.7 per cent to eight per cent for 10 year bonds, and Indian 10-year bonds priced to yield 8.24 per cent to maturity show the effects of rapid economic growth.
It is hard to buy these global bonds directly from Canadian investment dealers, but you can buy global bond mutual funds and exchange traded funds that hold them.
Should you do it?
We need some perspective. Historically, the numbers reported by global fixed income funds are not encouraging. For all of 2010, global bond fund produced an average return of 3.35 per cent after fees. For 10 years ended Dec. 21, 2010, global bond funds returned just 2.72 per cent per year compounded annually. Canadian bond funds returned 5.52 per cent last year and 4.72 per cent per year compounded annually for the 10 years ended Dec. 31, 2010. Why did foreign bonds underperform Canadian issues? Risk is the reason. Bonds that offer double digit rates come from issuers with histories of default, like Brazil, or inflation worries, again like Brazil.
So where can you make money safely? Safety means you stick with government and investment grade corporate bonds that have the almost magical quality of reverting to cash at maturity.
There remains a lot of risk in European government bonds from the peripheral nations, especially Ireland, Greece, Portugal and even Spain. Europe’s recovery is uncertain as the European Central Bank, which is mandated only to control inflation, is running ad hoc stimulus programs. National debts continue to climb, rioting workers insist they won’t pay to bail out banks, and the recovery remains on shaky ground, says Chris Kresic, partner and co-head of fixed income at Jarislowsky Fraser Ltd. in Toronto.
“The European problem is that growth of real GDP is down while real interest rates are up,” Kresic says. “That implies more debt and no cure. Governments will have to issue more debt to stay afloat.” In his view, fundamentals will weaken currencies, the chances of an extended recession will make investors more concerned about corporate earnings and balance sheets, and interest rates will remain high or climb further. In other words, the high yield bonds you buy today could lose a lot of value if apprehensions about default strengthen, as Kresic says they will. His advice — stay out of trouble and avoid these high yield, high risk bonds.
But U.S. and Canadian bonds are another matter. Fears of inflation have created attractive opportunities in long issues, notes Tom Czitron, managing director and chief investment officer at Morrison Williams Investment Management LP in Toronto. There is a 3.95 per cent jump in yield by going from a two-year U.S. Treasury bond to a 30-year Treasury bond. In Canada, the boost in the two-year to 20-year spread is two per cent. If U.S. inflation turns out to be moderate, the 30-year Treasury bond will produce a good real return for three decades and offer a capital gain if some before maturity, Czitron says.
Finally, there is the vast market of non-investment grade corporate bonds. Canadian junk bonds are still a good play, says Barry Allan, president of Toronto-based Marret Asset Management Inc. For 2011 he predicts that junk should have a good year, rising on average six per cent to seven per cent as issuers’ balance sheets improve. That will be twice the gain to be expected on investment grade corporate bonds, he adds.
Nobody ever said investing is easy. But with some care, an investor can lock in a solid if unspectacular return in bonds and avoid the chaos of the stock market.
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Interest is the price of money, so with demand for money up,
interest rates will rise