This is a story of bonds that get tainted by association or that just lose their lustre. Investors holding them have to accept paper losses or sell them, usually on unfavourable terms. The bad news is that it can happen to most kinds of bonds. The good news is that there are a few classes of bonds that are immune to being trashed by association.
This year, with corporate defaults rising, stocks plummeting, and a worldwide recession or worse developing, investors have been extremely reluctant to hold any bonds that could produce losses. The rush to safety has been so strong that on a couple of days in 2008, investors bought U. S. Treasury bills — bonds with maturities of less than one year — at prices in excess of redemption value. The terrified buyers were thus paying a premium to bond dealers to hold their money in these riskless assets.
Meanwhile, over at the dealers’ desks, bonds issued outside of Canada in Canadian dollars for the Canadian market — Maples as they are called — went from darlings to deadbeats.
Maples became a highly desirable bond class in 2005 when a regulatory change allowed pension funds and insurance companies to buy them. By 2006 and 2007 they were hot. Billion of dollars were put on the market each month. The names on the bonds included leading global banks including Royal Bank of Scotland, Goldman Sachs Group, Bank of America and Deutsche Bank. Mixed in were issues from smallish banks with big hearts. Iceland’s Landsbanki Islands HF is an example. They were rated A to AAA and some, including issues from government backed banks such as Germany’s Kreditanstalt fur Wiederaufgebau (KfW for short) and Norway’s Kommunalbanken AS, were AAAs. Insurance companies and other investors who wanted AAA bonds had been unable to get them in Canada, for our banks were mostly just single As. Moreover, because the Maple names were not well known in Canada, they came to market with substantial yield premiums over Canadian bank bonds of the same terms. It seemed downright dull not to load up on bonds issued by the world’s biggest banks but with the yields of lower quality debt.
Then the world ended. In the summer of 2008, Iceland’s financial system went into freefall. The Landsbanki Islands 4.40 per cent issue due January 2010, which had traded at Can$99.90 per $100 face value on December 31, 2007, had fallen to C$8.58 per C$100 face value by the same date in 2008. By the end of January 2009, it had no bids and for now, the bonds cannot be traded.
A few other Maples are in junk territory, which has tarnished the whole sector. Even strong Maples, those issued by state-backed banks and supranational agencies with AAA credits, are trading with yield boost of 125 to 230 basis points over Government of Canada bonds of similar term. The market is feeble, buyers are few, and the insurance companies that used to be the big buyers of Maples are not biting.
Maples are not the only bonds that have gone into hibernation. The entire market for structured products — Canada’s ill-fated Asset Backed Commercial Paper, for example — has soured. Much of this debt, sold as what amounts to synthetic bonds, is good. But as Edward Jong, senior vice president at MAK Allen & Day Capital Partners Ltd., and portfolio manager of the FrontierAlt Opportunistic Bond Fund notes, “Structured products were casualties of the fall of Lehman Brothers in 2008.”
They still trade, but the spreads — the difference between what the seller wants and the buyer has to pay — have widened.
For example, a Golden Credit Card Trust issue, which holds Royal Bank Visa accounts receivable due April 2013 that has a 5.421 per cent coupon and a AAA rating, has recently traded at 2.6 percentage points over a Government of Canada bond of similar term that pays 1.9 per cent to maturity. Triple-A credit card receivables used to trade with interest premiums of just 0.2 percentage points. The present premium is a payoff for taking on the seller’s fears, which might — who knows — materialize in today’s difficult economy.
FIXED FLOATERS IN DOUBT
Fixed floaters are fixed interest bonds, often issued by chartered banks, that can be called by the issuer at a given date. If not called, they will float at a rate set by a formula, such as Canada’s bankers acceptance (BA) interest rate plus two percentage points, or something like that. Today the BA rate is about 70 basis points, so if the issuer fails to call a fixed floater, it will become a 2.7 per cent bond. The bond market has set 6.0 per cent or so as the absolute lowest yield expected on bank subordinated debt, so to make this bond trade, the price will have to fall to half of face value at issue.
The fixed floater market does not usually have had to worry about what if there is no call. But in mid-December last year, Deutsche Bank failed to call one of its FFs. Had it called, it would have had to replace the cash it paid out at a higher cost. Indeed, DB had the right to skip the call, but by doing so, the entire FF market went into freefall.
WHAT TO BUY
Investors can avoid bonds that turn into poor traders. The key, says Michael McHugh, a portfolio manager at Dynamic Funds in Toronto, is to buy only bonds that are parts of large issues. “They are the well-known ones, Government of Canada issues or issues from the larger provinces,” he says. “You want issues in hundreds of millions of dollars, not small issues in tens of millions. A low coupon bond in a billion dollar issue will trade with a smaller spread than a small, high coupon issue.”
The present bond market is focused on security, simplicity, and transparency. If a bond doesn’t have those attributes, you can buy it with a huge yield boost and take on its trading risks, or you can skip it and go with straight shooter bonds that should be easy to trade.
Andrew Allentuck’s latest book, When Can I Retire?, was recently published by Penguin Canada.