The crisis of 2008-09 sent investors on a mad search for safety and a huge number of them sought refuge in bonds. Fixed income led mutual fund sales since the crisis, driving the price of bonds higher and yields lower. Some have suggested fixed income poses a threat as the next bubble.
“Most of my counterparts and I really don’t subscribe to the concept of a bond bubble,” says Tom O’Gorman, director of fixed income, Bissett Investment Management and co-lead manager, Bissett Bond Fund. “The movement has been led by what has happened in the U.S. and it doesn’t exhibit the characteristics that we’ve seen with, say, internet stocks, where people started pricing them with new methodologies.”
He says the run-up in bonds was a rational market response to fears that another recession could follow the end of government stimulus in the U.S. Even the Federal Reserve was mulling the dangers of deflation, and its actions suggest that the U.S. central bank will do everything in its power to avoid a Japanese-style calamity.
“It’s not unusual to see a flight to quality. The flows in 2010 were primarily to fixed income, and not to equities. In August, rates did hit their lows, when the Fed started talking about (another round of) quantitative easing, or QE2.”
A combination of low interest rates and quantitative easing has thrown the fixed income world into turmoil, as non-market actors take a dominant role in the market. How and when the Fed exits its position as bond-buyer of last resort will have a huge impact on the market.
O’Gorman says that demographics may lend some support to fixed income prices, as aging baby boomers head into retirement and seek lower-risk yield.
“Our outlook for corporate fixed income is pretty positive, because fundamentals are pretty strong and supportive for bond holders,” O’Gorman says. “Coming out of the crisis a lot of companies took the opportunity to right-size their cost structures and they built up cash balances.”
While some corporate issuers may be in strong positions, economic problems remain a concern south of the border where policymakers are struggling to balance economic stimulus with debt containment. While the new Congress claims to be focused reducing spending, the Federal Reserve remains committed to staving off deflation.
“Aside from the U.S. impact on what happens in Canada, you have to look at what drives interest rates; its monetary policy, inflation expectations and your fiscal situation,” O’Gorman says. “In all three cases, Canada stands in a significantly better position than the U.S. and certainly Europe.”
He says the Bank of Canada is not likely to raise its rates in the near-term and that core inflation is running below 2%. With inflation even cooler in the U.S. and the loonie hanging around parity, the Bank of Canada will not want to get too far out in front of the Federal Reserve on raising interest rates.
“We’d be worried if inflation were to rise and the stimulus coming from the U.S. were to overheat things,” says O’Gorman. “We’d probably change how we position ourselves, expecting both the Fed and the Bank of Canada to start increasing short-rates. That would certainly be a headwind, but it is not our base case.”
Rex Chong, vice-president of Invesco Trimark, and leader of the company’s fixed income management team, sees those challenges strengthening in next couple of years.
“Whether its government bonds or corporate bonds or high yield bonds, I think the bond investing asset class will have some very strong headwinds,” he says. “We’ll certainly generate our share of returns, but they’ll be much more muted than what we’ve seen obviously in the recent past.”
Taking a longer view than just 2011, Chong points out interest rates must rise, which will drive down the value of low-yielding recent issues.
“Don’t get me wrong, I’m not advocating that rates should be up 200 basis points from where they are now, but I do think we put a lot of faith in the authorities to pull back the liquidity they’ve provided on a timely and scalable basis,” he says. “That is not a bet that I want to put a lot of money on—there are a lot of smart people that run the fed, but let’s just say that no one’s that good.”
Around the world, sovereign bonds have either proven to be no safe haven (as in Europe) or have seen a massive run up in price, as investors flock to the safest issuers. Investors are deeply conflicted, seeking yield but also demonstrating an aversion to risk.
On the sovereign debt front, Chong looks forward to the day when “rational minds” will develop a workable plan for the debt problems of Europe and he expects matters will come to a head early in the year.
“There are some bond maturities in some of these countries that need to be dealt with, and they represent what I would call kind of soft deadlines for the policymakers to get more definitive in providing a process and plan that the market can digest and get comfortable with,” he says.
These soft deadlines will force policymakers to act before the spring, but Chong warns that there is no near-term resolution for these debt woes. In the meantime, investors can expect a bumpy ride.
“There is an inordinate chase for yield, whether it’s below investment grade or investment grade. Not too long ago you had companies raising money in the bond market at 1%. I think Microsoft raised money at less than 1%,” Chong says. He believes that investors are so desperate for yield and safety that they are willing to park their capital in investment grade corporate debt, despite the low yield.
“I don’t care how good a company it is, I don’t think there’s a lot of profitable risk-reward buying something where your coupon is less than 1%,” he continues. “They’re chasing it because they think those companies are rock solid, and their coupons are not at risk, which is probably right. But at what price? You’re paying a high price by only satisfying yourself with a .75% coupon.”
Investment-grade companies have taken advantage of rock-bottom interest rates issuing hundreds of millions of dollars in low-cost debt, often with no plans for the capital they raise. With their balance sheets shored up with cheap debt, the options for deployment include strategic purchases, dividend payments and stock buybacks—all of which favour equity investors.
“That in itself should snap you in the head and say maybe it’s not so good as an investor to buy into this thing,” he says. “If it says no other thing to you, it says buying the equity may be a better risk reward.”
O’Gorman’s agrees that corporate issuers appear more interested in placating their shareholders than their bondholders, pointing to George Weston Ltd. as an example; on December 15, the company announced a $1 billion special dividend to shareholders.
“All other things being equal, paying a big dividend like that is bond-holder negative,” he says. “We’d rather see the money go toward productive things that are going to help the operation, however in the case of Weston, they have even more cash than they have debt, so it’s not going to result in a downgrade.”