30th June 2009
Which bonds should you be buying?
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Welcome back.
Recently, I received an email from a reader, asking about how to construct a bond portfolio and for my view on US Treasuries (US government debt). As these are related topics, and affect all of our investment decisions, I thought I'd cover them both in this week's email.
The big picture
We all know that the economy is in a deep recession (although it may now just be starting to stabilize). Because of the scale of the slump, interest rates have been slashed at the short-term end of the curve, and serious attempt have been made to lower rates at the long end of the curve (10 years +) to help the real estate market (central banks have done this by buying long-dated government debt).
So at the moment interest rates in the major economies (UK, US and Europe) are around 0% for maturities up to one year and around 4% for maturities of 10 years.
I believe we could see the major economies stabilizing or maybe even growing a bit until September / October, simply because inventories are being rebuilt. After that we could see economies stagnating or even contracting again (although I think there's a 50% chance that we could be in for a double dip, which could start after the summer).
The reason is simple. Loose credit will not be back again any time soon. That will leave consumers still paying down debt and repairing their balance sheets for the foreseeable future. Remember these imbalances were built up over a number of years. That won't correct itself in a matter of just 12 months.
To stop the economy from collapsing the US and the UK have simply replaced private debt with public debt, and are issuing massive amount of government paper over a trillion dollars in the US, and more than £200bn for the UK. And this is for 2009 alone.
The implication is quite simple. The sheer volume of debt in issue makes it very likely that long-term interest rates will rise. This is already happening in the US, despite the best efforts of the Federal Reserve. Ten-year yields on Treasuries have already moved up from a low of 2% to around 3.5% last week, and went as high as just under 4% earlier this month.
There is also another more important implication. Because of these efforts to pump liquidity into the economy, inflation could return in 2010 or 2011, even if the economy remains stagnant (this is more or less what happened in the 1970s, although hopefully this time it won't be quite as bad).
Now a certain amount of inflation could actually be a good thing, simply because it will help to re-flate the economy and will help consumers and governments to erode the value of their debt.
But as you know there is a real danger that the central banks will be too reluctant to raise interest rates and that this could allow inflation to get a grip on the economy. The alternative however would be a similar scenario to Latvia (which we discussed two weeks ago - this article is available in the Events Trader archive, password: Llama) with the economy adjusting via falling salaries, higher unemployment and lower government spending.
The implications for a bond portfolio
If, like me, you think inflation could become a problem in a couple of years, then you should avoid longer-dated bonds and stay on shorter maturities of up to three years.
Bonds with shorter maturities have a smaller duration. Duration is the sensitivity of the price of the bond with respect to changes in interest rates. Therefore if interest rates start to rise on the back of an inflation spurt, these bonds would be less badly affected than the longer-dated ones.
As longer-dated bonds tend to have higher interest rates, what you could do to regain some of the extra yield, would be to look for an issuer with a lower rating in an industry regarded as strategic by a government who is likely to be supportive in the event of a crisis.
This sounds complicated, so let me give you an example Peugeot. As you know, carmakers are struggling so the yield on their paper is reasonably high. But because Peugeot is French the government is unlikely to let it fail. So I guess it would be prepared to give financial support if the carmaker gets into trouble.
Another thing to bear in mind is that spreads (the gap in the respective yields) between corporate and government bonds have narrowed considerably since the start of the year. So it might be worth waiting for a market correction, perhaps after the summer when people start to realize that the economy won't grow as expected. Last year we saw an unprecedented move, where people sold off corporate bonds in the de-leveraging frenzy, and bid up the price of government bonds as everyone was desperate to shed risk.
Please also check that the bond you are buying is senior or secured, so that in the event of a bankruptcy you will be at the front of the queue to get paid. For example, car parts supplier Visteon filed for Chapter 11 a few days before GM. Again shareholders and unsecured bondholders were practically wiped out, but senior bondholders are expected to recover between 30-50% of the face value of their bonds.
If you wanted to increase your yield you could also look at upper tier 2 bonds and lower tier 2 bonds issued by the banks. These bonds are senior to the tier 1 securities that I tipped a few weeks ago (please see the archive, password: Llama) in fact, they are even senior to the securities issued to the government as part of the bailout and as a result they yield less. But they still yield more than a conventional bond.
I'll be keeping an eye out for attractive opportunities in the bonds market, but it's worth exploring this area to familiarize yourself. It's not an asset class that attracts many retail investors compared to say, equities but that's another reason why we're likely to find interesting opportunities in the sector. Finding information on bonds is harder than for equities, but I have found these two websites particularly useful:
www.indexco.com
www.finra.org
The first contains lists of bonds, as well as delayed prices for European bonds. All you need to do is to register for free; you can then search for issuers or download an excel spreadsheet with a list of all the bonds in issue in Europe or the UK.
The second site deals with US bonds and contains a useful search engine for bonds under the section "Investors / bonds / market data bond center".
US Treasuries
After what I wrote above, you probably have guessed that I'm pretty bearish on US Treasuries, especially longer-dated maturities like the 10 and 30 years. The reason is simple. I just do not think that US interest rates will average 3.5% over the next 10 years they'll be higher.
Most of all, I do not think that the US government will be able to keep longer-term interest rates low at the same time as it tries to issue a record amount of debt. It's a simple issue of supply and demand the higher the supply, the lower the price (and in the case of bonds, the higher the yields)
In my view, the best way to profit from such a scenario is through exchange-traded funds, in particular ETFs that short bonds, and therefore will rise when bond prices fall. You might want to consider US: TBT and US: PST issued by Proshares. TBT is an ultrashort' ETF that rises by twice as much as the fall in the Barcap 20+ years US Treasury index. Meanwhile, PST rises by twice as much as the fall in the Barcap 7-10 years US treasury index.
In a nutshell if interest rates rise (and bond prices fall) these ETFs will rise in value by twice as much as the corresponding underlying index.
Because longer dated bonds are more sensitive to change in interest rates TBT will be more volatile than PST, so in my view, PST could be better suited to hedging an existing bond portfolio, while TBT could be better to make bets on the direction of interest rates.
However, because interest rates have already moved higher I would advise some caution before buying these ETFs, in particular TBT which went from a low of $35 to nearly $60 before pulling back to around $50 now. In my view, a good entry point is around $45, but be advised that the Federal Reserve is doing all it can to lower longer-term interest rates to help the recovery and to help the housing market (home loan rates in the US are set according to the value of the 30-year Treasury). Also a further contraction in economic activity might lead to interest rate cuts as people head for the door in the stock market and seek safety in the Treasury market.
So for now I wouldn't buy into either instrument but again, it's worth knowing about them so that we can profit from them when the time is right.
As usual if you have any questions you can contact me at my e-mail eventstrader@f-s-p.co.uk.
Riccardo Marzi
Events Trader
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