The Cinderella Effect: Bonds Dance As The Global Economy Sinks

As I write this column, a curtain of pessimism has descended on the much of the world economy. In early August, stocks in the U.S. and Canada, Europe and Asia collapsed following the downgrade of the debt of the U.S. Treasury from triple A to triple A minus by one rating agency, Standard &Poor’s.

In the midst of this pervasive fear of worse to come, two asset classes are thriving. Gold, which went through US$1,800 per ounce in the second week of August, is likely to continue to soar. Investment grade bonds, which are being snapped up by investors who would rather have a solid promise of income than a roll of the dice in stocks, are breaking records of their own.

Mutual fund returns tell the story. For the three months ended August 2, 2011, the top performing fund categories were, in order of performance: health care equity, up 5.76 per cent after years of horrid performance; Canadian long term bonds up 3.59 per cent; Canadian inflation protected fixed bonds, up 3.40 per cent; global bonds, up 2.22 per cent; Canadian bonds, up 1.81 per cent; and, Canadian short term bonds up 1.07 per cent. Five out of the six top fund categories were bonds. It’s a Cinderella performance by what is usually seen as a dowdy asset class.

The reason that bonds have, in fact, been beating the pants off stocks, is that the environment for stock growth is down right poor. The promise of bonds — a return of capital at maturity — is more attractive than the chance of capital gains.

In the U.S., the bellwether for the global economy, the unemployment rate for July, 2011, was 9.1 per cent. Add in discouraged workers who no longer seek jobs and the true unemployment rate is probably about 12 per cent to 15 per cent.

In Europe, home of the never ending sovereign debt crisis, unemployment, especially youth unemployment, in Spain and Greece, is shocking. A fifth of people ages 16 to 24 are currently unemployed in the U.K. Unemployment is 44 per cent in the same age range in Spain, 36 per cent in Greece and 31.5 per cent in Ireland.


In this climate, investors have stopped worrying about inflation. Today, the name of the game is security. Investors who want to buy or add to their bond positions have a wide range of choices in investment-grade issues.

Government of Canada bonds carry AAA ratings and are regarded as bulletproof by investors around the world. A Canada issue due June 1, 2023 pays 2.90 per cent to maturity, and 3.32 per cent for an issue maturing June 1, 2041.

Yields go a good deal higher in corporate bonds. For example, Greater Toronto Airport Authority bonds offer 2.96 per cent to maturity on June 1, 2017, 3.48 per cent for an issue maturing Nov. 20, 2019, and 4.44 per cent for the issue maturing Dec. 3, 2027. The GTAA is a business that runs Canada’s largest airport. It has monopoly pricing power and the standing of a quasi-government. You could say that these rates of return are pretty crummy. After all, why take a low single digit return when stocks will eventually recover?

The answer is that, for now, the market is saying that things are going to get worse. The recovery that was supposed to happen has been derailed. Moreover, central banks have used up their ammo and have few tools left to jump start their economies.

Interest rates in Canada, still one per cent for the Bank of Canada’s overnight rate, 0.25 per cent in the U.S., and 1.5 per cent for much of Europe, are still at or near historic lows. The recovery that was supposed to have been happening seems limited to investment bankers’ bonuses. Banks, flush with money, are afraid to lend. The situation seems like a remake of a John Steinbeck tale of the depression. The cars are newer, but for those who have been unemployed for periods of more than two years, the hopelessness is the same.


In this climate of dismal economics and fearful investors, it is tough to find bond bargains. Rémi Roger, vice president and head of fixed income at Seamark Asset Management Ltd. at Halifax, says that there is already a good chance that prices of Government of Canada bonds are already too high. “Canada’s housing market did not collapse, as the American market did — we just had a pullback. We did not have a macro recession as deep as that of the United States, but Government of Canada 10 years bonds, which now pay 2.64 per cent have rallied too far.”

The rule of thumb is that a ten year Government of Canada bond should be priced to yield the inflation rate, about 2.3 per cent, plus one per cent for risk. That means that the 10 year Canada should be price to yield 3.3 per cent. In reality, investors have bid up prices so much that their interest is one per cent less.

Corporate bonds offer high returns along with more risk than Government of Canada debt. “Our view is that inflation will eventually rise and current rates, which are in some cases lower than they were in the 2008 liquidity crisis, are not going to compensate holders,” says Tim Hicks, vice president at Canso Investment Counsel Ltd. at Richmond Hill, Ont. “We prefer attractively priced corporate telecom and cable companies where there is a good spread. For example, a Rogers Communications 6.56 per cent bond due March 22, 2041 has recently been priced to yield 6.2 per cent. And there is a Shaw Communications bond with a 6.75 per cent due Nov. 9, 2038 that yields 6.7 per cent to maturity. These bonds pay enough interest to cover risk and normalized inflation in a 3.0 per cent to 3.5 per cent range,” Hicks says.

Whether bonds are a buy or overpriced depends ultimately on whether one takes he view that the world economy will worsen or recover. For now, the flow of news is largely negative and the implications are for careful investors to head for safety. In this climate, the cautious are willing to pay dearly for protection. Bank and utility stocks, many down 10 per cent to 15 per cent in the summer correction, offer attractive yields in the range of 3.5 per cent to 5.5 per cent, which beats bonds and then gets better with the dividend tax credit that adds a quarter to the cash yield. But with stocks go volatility and, for the pessimistic, downside price risk. Negotiable bonds also have price risk, but it is measurable with precision and easily priced into the return to maturity.

In the end, the logic of buying bonds is protection of principal and guarantee of return. As one bond trader said, the market is costly and so deserves caution. “If you haven’t bought into long government bonds already, it’s too late to start. And if you are holding long government bonds, it is probably too early to sell.”

That goes for bond funds too, though it can be argued that nimble fund managers in the case of managed portfolios should be able to stay ahead of trend. A review of the long term record of established bond funds should provide an insight into how well the fund does when bond prices fall, as, eventually, they will.

In general, of course, the way to avoid paying too much for government bonds is to buy senior corporate bonds or funds of those bonds.. You get security — though not quite the level of Government of Canada bonds — and the boost that goes with corporate debt. With that security goes the ability to sleep a little better at night. In turn, that gives the bond holder the psychological power to hold on to stocks that will eventually recover.

AndrewAllentuck’sbook,WhenCanIRetire? PlanningYourFinancialLifeAfterWork,was publishedearlierthisyearbyPenguinCanada


“If you haven’t bought into long government bonds already, it’s too late to start. And if you are holding long government bonds, it is probably too early to sell”

About the author


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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