To state the obvious, risk appetite is the first casualty of a yo-yo market. Investors take a flight to safety and bonds come back in vogue. Not surprisingly, the market volatility of the past six months has caused a continued influx of capital into fixed income.
In fact, fixed income trading platform CanDeal announced it saw a record $3 trillion in volume during the month of June.
Amid this flight to safety there has been some speculation that bonds could be the next asset bubble, with investors ignoring the risks associated with a return of inflation.
Investors troubled by these concerns may find a soothing balm of assurance in the opinion of Heather McOuatt, lead manager of the Bissett Bond Fund.
“At this point I’m not concerned that bonds are the next asset bubble,” says McOuatt.
She has a few theories to support that claim: first, slowing global growth and the resultant low inflation. “We are still seeing pretty slow global growth, big output gaps, further exacerbated by sovereign debt issues in Europe, and decreasing fiscal budgets.”
Admitting inflation is a bond investor’s worst enemy, McOuatt says growth in this context will be slowing and is not going to be inflationary. “Our expectations over the short- to medium-term are for subdued inflation.”
Secondly, a controlled increase of overnight rates by the Band of Canada (BoC) bodes well for bond holders. “They (BoC) are certainly doing it in a very measured fashion,” says McOuatt while quoting the BoC governor Mark Carney as saying that the rate path is not preordained. “Therefore, we certainly aren’t expecting any significant increase in interest rate in short term.”
That is certainly positive for bonds because the longer these interest rate increases take to come online, the more time there is to adjust, and, consequently, the better it is for the bond holders.
McOuatt provides another detail to consider. About 60% of the Canadian investment grade DEX index is in the short-term bucket, which means they will be maturing between the next one and five years. “That’s a lot of time to work off the excesses in the system as these things mature and then are reprised in the current market context at the time.”
Risk aversion of the market has increased markedly in the last six months. Those caught off guard took a flight to quality, investing in fixed income products, particularly federal government bonds.
The safe haven of U.S. Treasuries, she says, will continue to be the destination for flight to safety.
“Certainly the U.S. Treasuries benefit from the safe haven status. They are going to remain the reserve currency of the U.S. dollar and that’s going to be the first place many investors go when they are putting on the flight to quality trade.”
When it comes to the crunch, many Canadian investors turn to Government of Canada bonds. Although the Canadian bond market is much smaller in size than its U.S. counterpart, the two bond markets tend to move in the same direction as the two economies are closely intertwined.
“I don’t think Canada federal bonds are necessarily more stable and safer than U.S. Treasuries, but they might not suffer quite as much volatility because the flows aren’t going to be as great,” McOuatt says.
For more on the dangers of inflation, read:
U.S., Britain will “deflate and debase”: Ferguson
Profits may be worthless: Klarman
Currency swings boost bond risks
(07/07/2010)