As I write this column, the Down Jones Industrial Average has hit its lowest level in a dozen years. The Toronto Stock Exchange is off 450 points on the day. European and Asian markets have fallen badly. Gold is off one per cent and oil is down 10 per cent on the day and the world is looking pretty sad. There is no recovery in sight for stocks, though it is bound to happen one day. Fears of deflation stalk major world stock markets. Banks and trust companies, credit unions, caisses populaires and money market funds have cut their payouts to just one or two per cent on savings accounts and barely three per cent on GICs. What to do? Take a look at long bonds.
For the 12 months ended January 31, 2009, Canadian fixed income mutual funds — to use an example — were up 1.34 per cent and one index, the Citigroup World Government Bond Index, was up 21.8 per cent for the 12-month period. That beat every other asset class, including precious metals equity funds, which were down 37.3 per cent for the period.
Bond fashions change more often than what’s on the catwalks in Paris, but right now, long corporate bonds with terms of 10 to 30 years are hot — and with good reason.
In a sign of more relaxed credit conditions, institutional investors such as pension funds and insurance companies are buying back into the market for longterm debt. In fact, long corporate bonds with investment grade ratings are offering returns so high that they beat the historic average returns of equities. The reason — long bonds were sold off in the fall of 2008 as investors rushed to buy short-term government debt, which is considered to have the lowest risk of any asset. That opened up opportunities in corporate debt.
We are speaking only of investment grade bonds, for high-yield debt — alias “junk” — has a high and climbing default rate and a miserable recent history of performance. For the 12 months ended January 31, 2009, junk bond funds lost 13.5 per cent. Junk will make a comeback some day, but not in the midst of a meltdown in stock markets.
Today, investment grade corporate bonds with single A ratings on average have recently traded for 225 basis points — 2.25 percentage points — over Government of Canada 30-year bonds for a net return of 5.78 per cent to maturity. Compare that to stocks. For the two decades ended January 31, 2009, the MSCI World Index returned 4.7 per cent per year compounded annually and 4.9 per cent in Canadian dollars compounded annually. The S&P/ TSX Composite returned 4.5 per cent compounded annually in the same period. Moreover, returns on investment grade bonds are fairly certain. Returns on stocks are not. In other words, when you buy a long corporate investment grade bond, you can lock in a return for the term of the bond that will beat the historic average of major Canadian and U. S. stocks.
It also pays to go long. Using Bell Canada bonds as an example, the five-year 6.00 per cent issue due June 15, 2014 has recently been priced at $95.76 to yield 6.97 per cent to maturity. The 23-year, 7.30 per cent issue due February 23, 2032 has recently been priced at $87.84 to yield 8.51 per cent to maturity. And the 44-year, 9.25 per cent issue due May, 15, 2053 has recently been priced at $91.00 to yield 10.17 per cent to maturity. Bell is an A-level credit and the time spread quite properly shows the rewards of taking on long-term interest rate and credit risk.
CANADIAN BANK DEBT
Bond returns vary by sector. The sector hardest hit in the downturn has been financial services. As a result, discounts on bank debt have been extensive and deep.
Canadian banks have been put into the same category of financial basket cases as many U. S. banks, but “are in far healthier condition,” says Chris Kresic, a bond portfolio manager at Mackenzie Financial Corp. in Toronto. “When the markets do see that Canadian banks are in better shape than foreign banks, Canadian bank bond prices will rise.”
Moreover, bank bonds with the richest yields, Tier 1 debt, are still priced to yield as much as 10 per cent per year to call. Tier 1 bonds are perpetuals, and issues with low coupons may not be redeemed. The holder is at risk of having to keep the bonds forever. But recent perpetual issues with double-digit coupons that were needed to entice nervous investors are almost certain to be called.
Other desirable bonds include regulated utilities and pipelines that have rate review processes that assure levels of cash flow adequate to pay bond interest. For example, a Terasen 5.55 per cent due September 25, 2036 has recently been priced at $85.00 to yield 6.7 per cent to maturity. As well, TransCanada Corp’s single A rated 8.05 per cent due February 17, 2039 was recently priced at $103.75 to yield 7.73 per cent to maturity. And the BCE Inc. 5.0 per cent bond due February 15, 2017 recently priced at $90.40 to yield 6.57 per cent to maturity, is also a fair value.
“The sweet spot for long bonds is at 30 years,” says Sunil Shah, who runs big bond portfolios for Sceptre Investment Counsel Ltd., in Toronto. His argument is that the bond market has been starved for long-term issues by companies reluctant to stretch their obligations out for three decades.
SAFETY VERSUS GROWTH
Still, there is a downside on long bonds, for buying long bonds means giving up the theoretically unlimited gain that goes with common stock investing. Which do you want? asks Kresic. “Do you want common shares with an upside or bonds with a return superior to stocks’ longterm return and a promise to return your money? If you are tax-ambivalent or in a sheltered account, you can get about 10 per cent on Tier 1 bank debt or 6.5 per cent on the common shares’ dividend. After tax, the bonds and the stock come out about even, so the decision point is safety versus growth.”
For off-farm investments, long
corporates make some sense. There is potential risk when interest rates rise. When that happens, government bonds that have no credit risks will fall in price as their old, relatively low coupons lose appeal. The market will drop their prices until their yields match those of new bonds.
But long corporates with mid-single figure coupons bought at today’s relatively low prices will tend to hold up well. Their issuers will be making more money in a recovery. That will tend to support higher credit ratings. In fact, given their scarcity and returns that are beating stock long run returns, they could be the big winners in years to come.
Andrew Allentuck is author of Bonds for Canadians: How to Build Wealth and Lower Risk in Your Portfolio, published in 2006 by John Wiley & Sons Canada Ltd. He also writes Financial Facelift, a personal finance column, for the Globe and Mail.