Thursday, December 24, 2009

The slippery slope of the yield curve

The year end market activity and news around the world is fascinating right now.

The benchmark 10 year yields for Canadian savings bonds has moved from approximately 3.25 to around 3.6 today. The move has taken about two weeks. Central bankers have confirmed that they will set overnight borrowing rates at near zero for at least 6 months to a year, so we should expect long term interest rates to remain low. They also expect inflation to be a non-existent factor for the average citizen.

If any of that is actually true or not is only verifiable in hindsight, but for the time being, it is what the best evidence leads one to believe. If the programs and expectations of the various central banks of the world develop more or less as they are anticipating, what does it all mean heading into the new year and what will happen to the bond market?

What will this mean for the DIY bond investor?

I previously mentioned that I turned down a 5% interest 10 year corporate bond. The bond has dropped 2% in value to 98.2 and the yield has subsequently increased to 5.3%. It's not a staggering change, but it's enough of a swing and in such a short period of time that it warrants attention.

Buying long-term bonds carries the increased risk that interest rates could rise rapidly in the short term and the relative value of your bond will decrease significantly in this situation. The 100 face value of your 5% bond is cut in half when there are new bonds on the market of similar duration that offer 10% interest. Your 100 dollar investment will be redeemable before maturity for only 50 dollars. If you are unable to hold to maturity, or if the dramatic decline in price of assets causes the issuer to default, you could lose big.

That's why I turned down any 10 year bond I was offered. I did once accept a bond that was investment grade, 10 years and yielded 7.95%. I don't care what happens, that is always a healthy rate of return and it's unlikely the value will ever fluctuate greatly, but that was a lucky break.

When speaking about the average DIY investor, trying to save up for his retirement, the strategy is simple. Credit spreads between corporate and government bonds and high yield bonds have all returned to pre-crisis levels. The yield curve is as steep as it has ever been and the past two weeks have returned the bond market to one of the steepest yield curves in history. The stock market, particularly financials and commodities (as this makes up most of the Canadian economy) have mostly kept the gains made from march-august but have mostly seen much more modest to zero gains since then. Natural gas prices have steadily, if unevenly reverted back to seasonal and cyclical price increases.

In this environment the DIY investor is wisest to stay away from investing in any long duration bonds. Corporate bonds are very expensive relative to the prices available last year and up until august 2009. With the United States treasury gearing up to roll over an estimated 2 trillion dollars of debt via auctions, it is likely that this recent rise in long term yields could be a precursor to a much more significant and long-lasting rise in interest rates.

If this is true, then the next sixth months could be a period to stay on the sidelines or to stay in cashable GICs, waiting for a better opportunity to present itself (and it will). During this time, the DIY investor should just stay informed and remain interested in the news and the various bench mark prices, yields and maturities. Further research into the debt structure of the corporations you hold bonds with will help further refine your criteria and ability to spot a bargain in the corporate debt market.

And if the DIY bond investor has managed to make some money with the stock market, it might be an interesting time to take a chance on some small-cap investments and look for capital gains. Investing in large cap, dividend payers, is a good idea unless you are buying at the top of the market. Because most indexes around the world have been relatively flat since august, that makes for a much riskier investment, though there are always countless exceptions.

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