A time for bond buyers to play it safe

The bond market has been putting on a performance worthy of the Cirque du Soleil. Interest rates have levitated upward, although in anticipation of what is far from clear.

The U.S. Federal Reserve Board recently indicated its intent to raise its overnight rates; and where the Fed goes, the Bank of Canada (BoC) eventually will follow.

Yet, the Fed’s overnight rate still remains at zero and the BoC rate, at 75 basis points (bps), is not about to rise anytime soon, given reports of Canada’s weak economic growth in the first quarter.

Some interest rate changes are taking place, but they are market-driven, not engineered by the central banks. Negative yields on 10-year German eurobonds, which prevailed in January, suddenly soared in April, amid a massive sell-off of German government bunds, to 0.54%. In early June, yields hit 0.93% on the 10-year bund; yet, despite this sell-off, these bonds remain the best bankroll in Europe.

Meanwhile, the yield on 10-year U.S. Treasury bonds, which was at 1.95% to maturity at the end of April, jumped to 2.32% at the end of May.

Government of Canada 10-year bonds (a.k.a. Canadas) offered 1.78% to maturity at the end of May, up from an average of 1.58% at the end of April. The path to normalization for rates is the vision, but making money in a market with no direction is tough.

“The hesitation in this market is on the part of the central banks, and that is what is causing volatility in the market,” says Edward Jong, vice president and head of fixed-income for TriDelta Investment Counsel Inc. in Toronto. “No one wants to take a long-term risk in a market in which central bank moves are so difficult to time.”

What comes next is being parsed out of the Fed’s Open Market Committee minutes and Fed chairwoman Janet Yellen’s pronouncements. The widespread expectation is that the Fed will engage in short rate rises of perhaps 25 to 50 bps.

On May 22, Yellen said that the Fed would begin raising rates later this year if the economy improves by as much as she expects. Her words were a balance of intent to begin normalization and a caution that unemployment is not quite low enough nor is acceleration of business quite brisk enough to begin the rate rises that tantalize the market and engage fixed-income portfolio managers.

Rate rises have to come. But portfolio managers are playing it safe by averaging terms and yields or taking shelter in the middle of the yield curve.

Beste Alpargun, vice president and head of fixed-income for Seamark Asset Management Ltd. in Halifax, expects that the Fed will not make its first move until late 2015 and that bond prices will remain static until Yellen and her colleagues make a clear commitment to rate normalization.

“Bond prices will be range-bound until the Fed makes up its mind,” Alpargun explains.

Her strategy for a market holding its breath is to make no commitment in term. “At this stage, laddering terms of one to 10 years is playing it safe,” Alpargun explains. “There is lack of conviction at the Fed. Without its leadership, Canadian rates are stuck.”

There is little chance that Canada will take its own initiative on the trend of interest rates. The BoC may hold rates down for a quarter before following the Fed upward, but convergence, if not congruence, is the history of Canadian monetary policy.

Just when the Fed will make up its mind about a rate increase is the question. The Fed’s dilemma is, of course, to avoid tipping the U.S. economy back into recession with a premature hike. Yet, as Chris Kresic, senior partner and head of fixed income at Jarislowsky Fraser Ltd. in Toronto, notes: “There is no need for the Fed to have rates at emergency levels when there is no longer an emergency.”

He notes that weakness in Europe and consequent upward pressure on the U.S. dollar has delayed the start date for the Fed’s rate rises.

“We expect the Fed to raise rates by 50 basis points this year and the eventual top end of the range to be closer to 2% than the 4% to 5% level that, pre-2008, was the norm for 10-year to 30-year [U.S.] treasuries,” Kresic says. However, he adds, he is not holding his breath for that to happen.

Would a move to raise rates destabilize markets? No, Jong says: “A 25 basis point move is anticipated and already being priced in. Inflation is not an issue in Canada or the U.S. [Economic] recovery is happening, as expected, so there should be no drama in the rises ahead. Janet Yellen will raise rates when she is convinced the recovery cannot slip back into recession.”

For now, Jong’s strategy is to avoid risks at the short and long ends of the yield curve. He chooses to be at the belly of the curve, with an average term of around 10 years, and to take credit risk to boost yield. “I am using a ‘bullet’ strategy,” he says.

Ten-year Canadas pay 1.78%, give or take, and senior provincials of the same term pay 2.25%. But a typical corporate bond, such as the Genworth MI Canada – which offers a 4.242% coupon and matures on April 1, 2024, and is rated AA (low) by DBRS Ltd. and BBB+ by S&P Inc. – recently was priced at $102.99 to yield 3.84% to maturity.

“You want to avoid being at the low end of the yield curve when rates start to rise aggressively and certainly not be at the 30-year end, with all the duration risk that entails,” Jong says. The extra return provided by corporate bonds covers a good deal of duration risk, he adds.

Don’t expect a cakewalk to the next plateau of recovering rates, however. Ahead in coming weeks are such hurdles as the on again/off again threat of Greece’s default.

The bond market has discounted Greece’s state bonds by 40%, giving the 10-year sovereigns an 11.43% return to maturity. That’s a 1,089-bps premium over the German bund of the same term that on May 28 was yielding 0.54% to maturity.

Playing it safe with term ladders and good corporate bonds is virtually a “Goldilocks” buying strategy. That means not being too timid at the front end of the yield curve and not too risky at the long end, with the middle being just right.