Interest rates reflect many things, but, generally, in the bond world, they frame risks of inflation and default. With the perceived risk of higher rates in the U.S., already among the highest for developed nations, financial advisors and their clients are shifting away from U.S. federal debt and into corporate debt. The Canadian market is following.
Sovereign rates tell this story from the government side. Fixed-income investors who want a conservative strategy of a decent income with the prospect of capital gains on the price side of bond investments are being forced to shop for corporate issues instead of government bonds. Investors and advisors keen to avoid red ink on their ledgers are taking on more default risk in U.S.-denominated debt, including Canadian bonds issued in U.S. dollars, to avoid duration risk where possible.
The baseline for world bond yields has been the U.S. 10-year Treasury debt (known as T-bills), which, as of early April, paid 2.35% to maturity. Yet, compared with the 10-year rates on German bunds of 0.25%, as well as with Dutch 10-years at 0.49% and Government of Canada 10-years at 1.57%, these U.S. bonds are in the same league as Italian 10-years priced to yield 2.26%. So, a bond buyer is right to ask what's going on with U.S. T-bills. Call it caution or prudence, fixed-income investors are shying away from bets on U.S. federal debt.
There is an explanation for the divergence in rates. The European Central Bank continues to buy bonds as part of its quantitative easing program, pushing up bond prices and pushing down yields. Meanwhile, the U.S. Federal Reserve Board ended its quantitative easing in October 2014, allowing bond prices to drop and yields to rise. Add in expectations that the administration of U.S. President Donald Trump may spend more on infrastructure and reduce taxes, forcing the U.S. Treasury to issue more bonds to cover the rising national debt and rising interest rates on federal debt.
The Fed has raised rates twice recently. If inflation rises above the Fed's 2% target, the central bank may raise short-term rates even faster than what has been announced - a total of three raises anticipated in 2017. Rising interest rates will reduce the market price of outstanding bonds. And, if investors take the view that inflation is going to rise faster than the Fed has anticipated, then more rate rises will be in store, with big losses for 10-year and longer bonds that institutions, for regulatory reasons, have to hold as capital. If those long bonds lose value, banks and insurance companies will have to buy even more government debt. This would strain balance sheets or tie up more capital: either way, the outlook for U.S. government bonds' total returns is negative.
THE TRUMP FACTOR
The U.S. dilemma of higher rates to come due to Fed policy on the short end and regulatory demand on the long end makes U.S. government debt unappealing, says Edward Jong, vice president and head of fixed-income at TriDelta Investment Counsel Inc. in Toronto. "We are back to 90% corporates for our clients. We are underweighted in long bonds, so our portfolio has lower duration and, of course, more default risk." The sweet spot for risk-adjusted yield is in BBB-rated corporate debt, Jong adds. BBBs, at the lower range of investment-grade debt, pay an average of 156 basis points (bps) over 10-year treasuries.
The portfolio Jong manages holds Fairfax Financial Holdings Ltd. 4.95% issue due March 3, 2025, which recently was priced at $108.87 to yield 3.65% to maturity. That's 219 bps over an eight-year Canada, which offers a recent yield of 1.46% to maturity. The Fairfax bond's rating, BBB from DBRS Ltd., reflects a good deal of debt on Fairfax's balance sheet but no doubts about its business, Jong says.
The unknown factor in the U.S. bond market and for U.S. dollar-denominated debt issued elsewhere is the Trump government. Trump has promised stimulus, but the Fed will have something to say about the inflation that is likely to result. "Whatever he gives in fiscal policy, the Fed may take back," explains Chris Kresic, senior partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto.
Trump's economic policies are not yet clear, and the stance of buyers of U.S. T-bills is precautionary rather than confident. That's a fair conclusion to draw from U.S. T-bills' comparatively high interest rates that reflect, in part, a bond sell-off. Sustaining the upslope on the U.S. T-bill yield curve is problematic, Kresic adds: "The long-term picture is that we are not going to 3% growth from 2% growth. The ingredients are not there and Trump cannot unleash the eagerness to invest that Keynes called 'animal spirits'."
The implication? The U.S. yield curve is going to be flatter than it would be with strong U.S. economic expansion. U.S. federal debt prices will drop further if the Treasury does cover rising deficits with more bond sales at what will have to be lower offering prices.
The move out of U.S. T-bills and into Canadas and bunds reflects not only lower inflation (currently 1.8% annualized for both Canada and Germany vs 2.3% annualized for the U.S.), but also a trade headed for security rather than speculation.
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