In a month or so, market strategists at hundreds of financial service companies will be fine-tuning their forecasts for 2012. As they gather around the boardroom table, they would do well to hark back to this time last year, when they issued their prognostications for 2011.
Back then – and it seems like a long, long time ago – the economy was set to pick up and interest rates were to rise. While their stock market forecasts varied, most market watchers agreed on one thing: Long-term bonds were strictly for losers, because when interest rates rise, bond prices fall.
Look how things turned out. Long-term government bonds have handed investors a return of more than 11 per cent (including capital gains) so far this year, while long-term investment-grade corporate bonds racked up about a 7 per cent return. Stock prices, meanwhile, soared to an April high and then tumbled, leaving the S&P/TSX composite index well below where it started the year. The Dow Jones industrial average, although it has bounced back, is still slightly below where it was in January, as is the Standard & Poor’s 500 stock index.
“The long end has done quite well recently in terms of return because of [investors’] flight to safety,” says Rob Bechard, head of ETF portfolio management at BMO Asset Management Inc. Indeed, long-term U.S. Treasuries have been the investment of choice for global investors recently despite being downgraded by rating agency Standard & Poor’s. That’s because investors perceive the securities, and the U.S. dollar, as a haven. Long Canadas, too, are attractive to people seeking sovereign debt of countries with relatively strong balance sheets and economies. As investors rush to buy bonds, their prices rise and their yields drop.
Further depressing long Treasury yields was the Federal Reserve Board’s Operation Twist, in which the American central bank sold shorter-dated securities and bought longer-dated ones in an attempt to hold down long-term mortgage rates. Bond yields influence mortgage rates.
What hawk-eyed investors and traders are wondering now is if the lower – 7 per cent versus 11 per cent – return on corporate bonds so far this year means the sector has room to run. With yields to maturity in the range of 5 per cent, is it time to buy 20-year investment-grade bonds?
Maybe. Traders who leap into the long bond market now would be very gloomy about the global economy, market watchers say. Feeling the hot breath of a bear market on their necks, such traders would be betting that long-term interest rates have even further to fall because the economy is in the grip of recession or worse. If rates were to fall further, and even slip into negative territory after subtracting inflation, bond prices would bounce, netting a tidy gain for those savvy enough to buy and sell at the right time.
But it’s a dangerous game. You can be right about the direction and wrong about the timing, which can be costly if you are investing in futures or other levered products. You could be wiped out overnight because long duration bonds are far more sensitive to interest rates than shorter-term securities.
Bear in mind, too, that juicy corporate yields are only partly a result of the flight to safety of government bonds and Operation Twist, Mr. Bechard says. “There are two factors at play.” The counterpoint to falling long-term yields is widening credit spreads – the difference in yield between long corporate and long government bonds. The spread grows larger as economic prospects worsen because of the potential, however slight, of a troubled corporation to default on its debt. So what looks like a bargain is really just a risk premium.
So how can pessimists participate in the corporate bond market?
