Profit
taking in bonds may be prudent
Last week’s
column gave a run-down of the theories shaping our bond market. This week,
we’ll shift gears to my thoughts on what investors should do with their bond
holdings today.
As noted
last week, today’s interest rate structure has an embedded expectation of
higher rates in the future. That’s not a hard pill to swallow given that
interest rates are at forty-year lows. At the same time, I do not expecting
rates to rise fast and furiously.
Current
interest rates on Canadian bonds and treasury bills can be viewed at the Bank
of Canada’s website, on its “rates” page (http://www.bankofcanada.ca/en/rates.htm).
Yields on
short, mid, and long-term bonds have risen in Canada over the past year, by
0.77, 0.23, and 0.27 percentage point over the past twelve months. (Actually,
rates dropped like a stone after 9-11, and then rose from November 2001 through
March 2002; before subsequently falling significantly between March and
November of this year.)
The sharp
drop in rates since early spring has been a nice shot in the arm for government
bonds – one of the few safe havens in this difficult market. And it really just
caps a longer-term downward trend that has been underway for some twenty years.
(I admit I was premature in expecting a rate hike early this year.)
U.S.
interest rates are so low that there simply isn’t much room to fall; though
rates haven’t fallen as much domestically. I was wrong early this year, but
that makes further falling rates that much more unlikely going forward –
particularly if you think the economy will even make a modest recovery.
Bottom
line: It would be prudent to consider
taking some money off of the table from profits made in government bonds. The
streak is unlikely to continue at its recent pace.
One of the
things many investors keep a keen eye on is the gap between yields on corporate
bonds, as compared to government bonds (i.e. corporate spread). It really
represents the “risk premium” that the market is placing on the credit
worthiness of corporations. As the spread widens, it’s usually a sign that
investors are nervous about credit quality and opting instead for the safety of
government bonds. That’s exactly what we’ve experienced.
In Canada,
the “corporate spread” is about 50 per cent higher than its historical average
over the last business cycle. In the U.S., the gap is even large due to the
more severe economic downturn experienced by our American neighbours.
This may be
a sign that corporate bonds are undervalued. Sure, the economy can get worse
and corporate bankruptcies could accelerate; but my gut tells me the worst is
behind us.
Corporate
bonds are riskier than government bonds; so limit exposure to no more than
about 30 to 50 per cent of total bond exposure. Also, investing in corporate
bonds through a mutual fund is the best way to invest in this class of bonds.
Good funds include TD Canadian Bond, Trimark Advantage Bond, and PH&N High
Yield Bond ($25k minimum).
What do
behavioural trends tell us about the fate of the bond market? My guess is that
it’s signaling an end to the bull run on bonds.
If you’re a
typical Canadian investor, you’ve been shunning stocks and socking your savings
away in bonds – but that’s a more recent trend. For the three years ending
December 31, 2000 mutual fund investors put more than $5 billion in domestic
and foreign bond funds – about 4.5 ten per cent of total net mutual fund sales.
During that same period, stock funds dominated – grabbing fully 80 per cent of
the money flowing into mutual funds.
However, as
would be expected, poor stock market performance has rained on that parade. In
calendar 2001, bond funds accounted for nearly ten per cent of all money
invested in mutual funds (while stock funds’ market share halved). Further,
during the first nine months of this year, nearly 30 per cent of all new money
invested in mutual funds was directed to bond funds.
For the
first nine months of this year, money invested in bond funds rose 80 per cent;
while stock fund sales were nearly cut in half. Trouble is, mutual fund
investors have traditionally had poor timing – particularly with bond funds.
I’m not
trying to build a case for a roaring stock market going forward. In fact, I
think there exist many individual stock opportunities, despite the still
expensive stock indexes. However, government bond yields have fallen so much
because investors have bought them in droves to hide from other riskier assets.
As a
result, current government bonds look expensive at this time, compared to both
stocks and corporate bonds. For more aggressive investors, I would suggest
reducing exposure to government bonds, in favour of corporate bonds and, to a
lesser extent, stocks. For more conservative investors, reducing government
bond exposure remains a good idea, but putting the proceeds in a combination of
cash and corporate bonds may be a better idea.
I realize
whenever I give timely advice, it amounts to market timing. However, my advice
usually relates more to valuations, and the relative opportunities available,
rather than simply looking at charts and graphs.
Dan Hallett, B.Comm., CFP, CFA is the Senior Investment
Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.