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Advisor Stocks Sedate government bonds offer protection with significant upside

Since the beginning of 2019, 10-year U.S. Treasury bonds and 10-year Government of Canada bonds have produced gains that are are more typical of stocks having had a good run.

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Prices of existing government bonds have been soaring as investors take money out of the white-hot stock markets to cut back on their exposure to equities or prepare for the next recession. The motives for getting in on the bond bull are precautionary and, for investors who think central banks in Canada or the United States are either going to lower interest rates or not increase them before late 2020, participatory.

Since the beginning of 2019, the 10-year U.S. Treasury bond has generated a price increase of 5.45 per cent; add in the average year-to-date yield to maturity of 1.19 per cent and you get a total gain of 6.64 per cent. Similarly, the 10-year Government of Canada bond had a price gain of 4.4 per cent since the beginning of the year; add in the average year-to-date yield to maturity of 0.85 per cent and you get a total gain of 5.25 per cent. These numbers are more typical of stocks having a good run than of normally sedate bonds.

Some investors are worried about the state of capital markets in the U.S. and Canada. The current economic expansion in both countries, which began in March, 2009, is the longest on record. The so-called Great Recession morphed into today’s Great Expansion. The Dow Jones Industrial Average closed at 27,198 on July 30 and the S&P 500 index hit 3,013 the same day after reaching new record highs earlier in the month. Meanwhile, interest rates for 10-year U.S. Treasury bonds are hovering a little above their post-Second World War lows. That’s a reflection of both the currently low inflation environment and investors’ eagerness to get protection for when stocks take an inevitable deep tumble.

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Government bonds offer security, but making money from bond interest is difficult. Central banks’ interest rate manipulation, such as quantitative easing, has pushed interest rates to very low levels. In turn, these low government-set interest rates in almost all major financial markets have pressed yields of 10-year senior government bonds in Europe, Canada and the U.S. close to zero and in the case of Germany and Japan to below zero. But interest rates are not what is driving bond prices upward. Rather, the rush for safety is.

The safety factor is that there’s currently no case for central banks to increase interest rates, says Mark Chandler, managing director at RBC Capital Markets in Toronto. There’s not a lot of excess demand for goods or services, nor unsatisfied demand for labour in senior economies, he explains: “We have low and stable inflation.” In this environment, sedate government bonds serve as insurance for a portfolio – and investors have been paid handsomely for holding them.

And it’s not just government bonds that are hot. Bond equivalents – as some investors regard solid dividend stocks, such as utilities, which have dividend yields of 3 per cent to 7 per cent – are also thriving. In the 10 months since August, 2018, when the S&P 500 index hit a previous high, share prices of utility stocks have risen by 13.3 per cent. Although that performance is significantly better than that of bonds, it’s also a red flag; the last time utilities turned in such strong performance was January, 2008.

The outlook for government bonds is rosy. Existing bonds with relatively high coupons are going to be more appealing if interest rates fall. Moreover, cuts in short-term interest rates are coming, predicts David Rosenberg, chief economist and strategist at Toronto-based Gluskin Sheff + Associates Inc. In previous recessions, the U.S. Federal Reserve Board has cut short-term interest rates by an average of 500 basis points (bps), which is not possible with the Fed’s current overnight rate of 2.75 per cent, and never less than 200 bps. If the Fed were to cut interest rates by that 200 bps figure, the overnight rate would drop below one percentage point and prices of existing bonds would soar further.

The strong year of returns for government bonds that has pushed yields very low has created distinctive hazards. Currently, the yield curve is relatively flat. That makes inversions, in which short-term rates are higher than some long-term rates, more likely. Historically, most times a recession has taken place in the U.S., the yield spread between two-year and 10-year Treasury bonds turned negative a few months before gross domestic product growth sagged. The yield curves in the U.S., Canada, Switzerland and the U.K. have all shown brief inversions this year. Thus, the bond market is predicting falling stock prices.

There are several ways to create protection from cratering stock markets. Shorting stocks is one way. You sell the stocks at the current price then buy back the shares at a lower, future price. The trouble is, to do that, you have to borrow the stocks and pay interest on the loan for the shares. “Going short is costly,” says Brett House, vice-president and deputy chief economist at Bank of Nova Scotia in Toronto. “You cannot continually short because of the cost of carrying those positions.”

That leaves sovereign bonds as a haven. They have no carrying cost and are just about failure proof as they’re backed by solid governments. You could say they’re the safest way to buy some protection for investors’ portfolios.

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Although bond prices will tumble when interest rates rise, that’s not a near term risk, says Chris Kresic, head of fixed-income and asset-allocation at Jarislowsky Fraser Ltd. in Toronto. “A one [percentage point] or two percentage point rise in interest rates is not in anybody’s forecasts right now.”

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