Bond investors prepare for bear market

(June 2007) The renewed threat of inflation in Canada poses a hazard for traditional bond portfolios, while the rise of huge investment funds in emerging economic superpowers is about to unleash a flood of liquidity into the global fixed income market, analysts predict.

Dr. Sherry Cooper, executive vice-president and chief economic strategist at BMO Financial, says that a bull market in bonds that started in 1982 is starting to subside. Over the past two decades, cheap labour provided by emerging markets has steadily reduced prices in developed nations like the U.S. and Canada, driving down inflation and interest rates.

In addition, during the period, bonds have experienced steady growth because emerging markets like China have had a huge trade surplus and invested their excess reserves in treasury bonds, particularly U.S. ones to stabilize their currency against harmful speculation. Cooper says almost three-quarters of China’s $1.2 trillion reserve is invested in dollar-denominated assets.

The result of this is that the U.S. Treasury Bond market is now heavily dependent on investment from emerging economies like China, Russia, India and those in the Middle East to prop up the prices.

Cooper says the scales have been tipped. These nations have accumulated enough money to avoid runs on their currency and are now out to accumulate other assets. This has driven up inflation as demand for commodities in particular has increased in order to fuel the continued growth of their economies.

This doesn’t mean that there’s going to be a massive sell-off of treasuries, Cooper says, but she thinks that inflation here has bottomed out and can only go up, diminishing existing bond values and increasing yields over time.

“The big rally we saw since 1982 is behind us. I don’t think we’re going to see a dramatic increase in yields, because inflation still remains low,” she says. “I do think current yields in U.S. 10-year treasury bonds could move above 5% — they are already at 4.86%. Canada’s at 4.44%, and we could see Canada at 5% or higher by the end of next year.”

This trend could be accelerated by the rise of sovereign wealth funds — massive government pools of capital used for higher-risk investing. China has recently set aside $3 billion to fund a 10% stake in the Blackstone Group, signalling its intent to get into higher-return investments, Cooper says.

Cooper refers to a recent report in Barron’s magazine that estimates the current value of sovereign wealth funds to be $2.5 trillion US, with the potential to top $12 trillion within eight years. This floating excess capital has the potential to dramatically increase world inflation.

Guy Le Blanc, vice-president and director of fixed income at Franklin Templeton Investments, oversees the company’s flagship Bissett Bond Fund, which has more than $3.8 billion in assets under management. He says the rising inflationary pressures have already thrown bond investors a curve ball they weren’t expecting.

“As a bond fund manager, it’s almost been hell for us in a sense, because yields have been rising much faster than we anticipated. We’ve seen corporate spreads widen, and investment is almost flat,” he says. “On a year-to-date basis, it is now down 30 basis points as of May 28.”

Le Blanc says he was expecting yields on Canadian 10-year bonds to stop at 4.3%; instead, they are near 4.5%. He doesn’t personally expect Canadian bond yields to top 5% this year but doesn’t rule it out completely because of the Bank of Canada’s growing concerns about inflation.

“To see rates reach 5% on a 10-year Canadian bond, you would definitely need the Bank of Canada to do two or three rate hikes,” he says.

There is a silver lining, though. Le Blanc says government and blue-chip bonds are considered a relatively safe investment not only because their payouts are virtually guaranteed but also because the inverse relation between yield and dollar value means investors have two different ways to capitalize on earning value.

Le Blanc thinks that right now is not a good time to be a holder of bonds, but it is a good time to buy them. “If someone comes along and puts new money in the bond market, the yields are around 4.5%. The downside risk is much lower than it was earlier this year.”

Diversity has also slowed the downturn in bonds. A higher Canadian dollar has made buying Maple bonds — foreign-issued bonds, denominated in Canadian dollars — quite attractive. Investors are capitalizing on the rise of the Canadian dollar to realize greater gains. Le Blanc says Maple bonds are also a way to get access to higher-quality issuers.

“When I compare the Canadian corporate market to the U.S., our corporate universe is much smaller. There are some sectors in Canada that we barely have any companies to invest in,” Le Blanc says. “The Maple market is a good way for us to diversify our corporate bond portfolio. There are not too many AA or AAA issuers in Canada.”

Le Blanc also says you have to put a downturn in bonds into context. He says the primary reason retail investors buy bonds is for stability to offset the volatility of the equities in their portfolio. Bond funds are designed so that both gains and losses are relatively small.

“If you look at the equity market, they’ve been on a tear for the last two or three years, but they’ve been volatile,” he says. “We feel we’ve had a really bad market in bonds because we’re down 30 basis points on the year, but in the equity market, you can lose 3% or 4% in two or three days.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(06/01/07)

Mark Noble