Tuesday, April 13, 2010

Spread ‘em

I previously posted that 3.60% would be a benchmark for 2010 with respect to the Canadian bond market.

Recently, the 10-year benchmark has surged passed this yield- higher than 3.7%- and is currently sitting at 3.66%.

What does it mean to me? Do I think interest rates are clearly on a path upward? Do I need to sell my longest maturity bonds in order to avoid destruction in my net worth?

1) It means a great deal, I believe that the Canadian bond market and bond markets around the world are still sitting at the turning point created by the financial crisis.

2)I think it's wrong to predict with certainty the direction of this and that security. I think the shape of the yield curve is just as important as the nominal benchmark yields

3) I don't need to sell any of my bonds because I don't have any maturities longer than 9 years right now and I own only a moderate allocation (less than 10%) of my portfolio at those longer maturities.


At the end of March, the US Fed Reserve Bank ended its purchasing of housing bonds and other short-term bonds, and US bond markets sold off dramatically. The US 10-year yield moved from close to 3.6 to 3.98% in a matter of weeks and there was worry about the ability of the US to finance its debt with elevated rates and premature economic growth. The next week a hugely subscribed auction reinforced positive sentiments in US treasuries and the 10-year benchmark is currently trading closer to 3.84% and has been rallying to head back below 3.8%.

Canada is still tied to the US and so are all the financial markets. Thankfully, Canada is not tied to Greece and Europe. But when the fundamentals and the perception in the US changed with respect to the 10-year, it did likewise in Canada (the 1-year and 2-year have behaved in a different manner previous to the US sell-off, along with the currency).

Since the end of March, yields have moved from close to 3.5%, past my previously mentioned benchmark of 3.6%, and are now to closer to 3.65% over the past week or so.

Was 3.7% a good time to buy? Compared to December when 3.6% seemed like a lot, I suppose, but only if you are buying solely government bonds. I'll talk later about why this change wasn't the buying opportunity for corporate bonds that December 2009 was.

It all relates to a crucial factor that amateur investors, advisors and even some professionals routinely miss.

It has nothing to do with the stock market, though it is related to corporations.

The spread between all the various sectors of the corporate bond market have reacted in an enlightening fashion for the astute observer.


Clearly, the central bank has changed its intention with respect to interest rates and the Canadian dollar. The gradual ascent of the Loonie has allowed many businesses to cope with the currency exchange and to retool and increase productivity for the first time in ages. The markets have demonstrated anticipation of a 50pbs rate hike on short term Canadian treasuries within the next six months. If the economy and currency continue to enjoy a post-Olympic golden aura and the price of energy and commodities continue to rise, its possible short term interest rates could rise more than a full percent, or at least 100 bps. In this scenario 2-year could = 2.8-3.3%, 10-year = ?


The 3.6% benchmark that I called in December is important because 10-year benchmarks haven't had the same dramatic shift that Canadian 2-year yields and US 10-years have had.

The key feature to focus on is the average yield of 10-year corporate bonds and their spread from the government benchmark. Back in December, the spread was still contracting about 20 bps every three months. Meaning on average corporate 10-year investment grade bond yields were declining .2% in interest payments. Now, that spread has stopped contracting.

If you purchased a bond in the recent sell-off, you were not being rewarded any extra capital gain for keeping your money in 'riskier' corporate bonds, though the value of your bonds has held up even stronger than the 10-year government bond if you already held a 10 year bond.

This is important for my bench mark prediction, because when the 10-year reached 3.6%, it's the same moment when yield spreads on corporate and government debt stopped contracting.

While the value of long-term bonds has been decimated this month, my corporate bonds have all kept their value, suffering 1-2% declines at most. Industrial and real-estate bonds have increased in price almost 5% during this time. Will they keep rising for those wishing to build a portfolio now? It's possible, but it's better to observe and understand the market before investing.

Understanding the spread changes (or lack of) tells me that things are about to change in the bond market. My intuition tells me rates won't necessarily rise as much or as evenly as people currently think. 100bps is a lot of central bank tightening to do in 12 months. But Australia has a 4.5% short-term government rate... nothing is impossible with a resource-rich, stable, diverse, robust and productive economy- Canada, eh.

Does it mean buy, sell, hold? I've said since December that holding off from buying bonds unless the deal was too sweet is prudent. The bond market has been giving the signal to wait (the signal is when you have no idea what the signal is) and I think it remains a wise strategy. Still, intuition tells me there will be periodic buying opportunities. Likely around end of May, June or July when older debt matures and corporations seek to roll over the debt, and when a rate hike is being talked about as if it's already happened in the news. As for selling, do it if you own something longer than 10 years in maturity. There is hidden risk in 20 and 30+ year debt that the average investor doesn't consider. In my opinion, long-term bonds have as much risk in this economic climate as hedge funds, mortgage backed securities, derivatives, ACBP, CDOs, etc. There are simply too many unknowns in every market place to plan past a possible 2nd Obama term. My intuition and the evidence point me to believe that interest rate hikes will be slowly incorporated into the global recovery, allowing for short and medium term bonds to simply mature before reinvestment.

But just imagine if short term rates rise to 3%, and you purchase a 10 year bond this year for 3.5%? In one year you would have a 9-year bond, yielding 3.5% when it's possible that a 3-year bond could offer a similar yield. The value of your bond would be adjusted to match the equivalent 9-year market prices and yields. If the yield curve remains steep, long term rates will rise and if you tried to sell, you could be decimated.

Just be careful, and for the love of god, don't buy a bond fund.

Wednesday, March 3, 2010

Ahead of the curve

The Globe and Mail has now reported the recent bond sale by Brookfield Asset Management.

I just learned from this article these bonds can be redeemed if the company suffers a credit rating downgrade.

That's a pretty safe feature and highlights another 'can't-lose' aspect to this bond issue which made it so attractive for individual investors.

The fact that I can report this story on my blog the day before a major financial reporting blog, with more detail and context, is due to two factors.

First, a skilled, experienced and involved investment advisor is a necessary precondition for developing a deeper knowledge of the investment community.

Second, my own willingness to follow the flow of information in fixed income markets and a willingness to interact and work with my investment advisor.

A skilled and connected advisor has years of experience working with markets and traders. They manage hundreds of millions and sometimes billions of dollars over decades. They protect the wealth of their clients during market crashes and they earn real, positive returns over the long term. In essence, they have seen people make millions and seen people go broke. They have survived and grown a large book of clients because they are stable wealth managers. They have the best ability to contextualize a clients personal needs and the financial environment within which they are living (ie. They understand better than most, through hands on experience, how the yield curve and interest rate cycles affect prices and yields for products and securities).

Having your own passion for knowing about the bond market isn't the easiest thing to have. It's something that usually happens late in life when you've finally tried every crazy scheme to make money and failed. Following the bond markets opens up a new world of medium and long-term investing where risk and return have inverted meaning compared to the mass-marketed, stock-market oriented education materials. The hidden world of Over-The-Counter (meaning corporate bonds are sold to retail customers privately- there is no central exchange to list sale prices for corporate bonds) fixed-income securities might seem to resemble a shadow cult, capable of mobilizing vast sums of money and deploying them for purposes of world domination. That might seem like something ridiculous, boring or unappealing for many forward thinking and capital gains/dividend-growth oriented individuals. The mainstream press would have you absolutely convinced half your savings must be in stocks and that bonds cannot be risked against stocks and must be kept in government securities. You must go out of your way and work to understand how you can personally take advantage of the bond market.

Without the willingness to reject a path-of-least-resistance way of thinking and investigate the real nature of the financial markets, and then applying that knowledge with a carefully selected advisor, the DIY investor will always be a day behind the headlines. Any individual who takes the time to find a skilled advisor (they can be young and well-trained, too), to educate themselves about the bond markets, and build a successful relationship with their advisor is truly ahead of the curve.

Tuesday, March 2, 2010


A-rated and BBB-rated investment-grade corporation.

5.2% interest for 6 years, a 5 year GIC yields approximately 3%. If interest rates remain relatively low, even if the bank of Canada raises its key lending rate by .25% every 8 weeks until it reaches 4% or 5%, this bond is of such a short term that it will likely never trade lower (at least not significantly lower) than it's par value.




Brookfield Asset Management has emerged from the global recession as a relatively strong company, according to recent press.

The executives of Brookfield are using their position of liquidity and prosperity to make up for previous losses and generate increased revenue and profits in the future. In order to increase profits they are buying properties from distressed and bankrupt sellers in the hopes of obtaining deeply undervalued properties and companies.

Some of the distressed properties and companies that Brookfield is pursuing carry long term debt. Servicing and repaying that debt was part of what led to the failure of these properties and corporations. Since a smaller, insolvent company cannot borrow money at any reasonable rate for any reasonable amount of time, the executives of Brookfield can use their investment-grade credit rating to roll-over the outstanding debt at a rate that satisfies the demands of fixed-income investors while keeping the debt service payments that Brookfield is assuming from rising. In this situation both the lender and borrower benefit and more economic activity is sustained overall and more money is made for all parties, than if the bond market had not been utilized.

Unless of course, the new properties and businesses that Brookfield purchases turn out to be less profitable than they anticipate. In that situation, Shareholders would realize dramatic decreases in earnings per share and suffer steep losses. Bond holders would keep their senior notes for 6 years and take their guaranteed interest payments and evaluate the company again when the bonds mature.

It hasn't been reported, but I know for a fact that this bond issue was sold out in approximately 3 minutes. That's all the time that the different banks not named RBC and CIBC had to decide if they were going to take a piece of this action. In this modern age of instant information, 3 minutes is hard to contextualize. Normally, new issues will be available for days or weeks (depending on market volatility and credit ratings). Compared with other 10 year bonds, yielding similar coupon payments that were floating around in December without a buyer in sight, 3 minutes tells you that there was zero doubt that this was an attractive investment product for any prospective buyer.

How do you get in on a deal like this? You have to have a good advisor who understands and works with the fixed-income desk regularly. Equally important, you have to work with your advisor regularly so that they are thinking about your account and your needs when new issues arise.

Tuesday, February 16, 2010

February blues... Bombardier is waiting for you to ask for less money... wait for them to capitulate.

The US indexes are at flat price levels since the beginning of the fall of '09 while the US dollar rises in value as European investors are feeling the effects of unsustainable debt levels post-meltdown.

The TSX has remained above 11000 while the benchmark 10 year government of Canada bond is trading with a yield as low as 3.35% (on February 8th 2010) and as high as 3.6% just a few weeks prior to that. It's clear that the end of the year (around Christmas) was a buying opportunity relative to the past 6 weeks and will likely be a benchmark for the year ahead among bond vigilantes.

The governor of the Bank of Canada has reaffirmed there is no need to raise interest rates because of the high value of the Canadian dollar and the weak demand from our largest trading partner, the US.

So what to do if you missed out on a chance to buy bonds when they were on sale at the end of 2009, you don't have confidence investing in the stock market and you don't consider yourself a 'gold-bug'?

Taking a look at the corporate debt market in Canada on a regular basis is a necessary ingredient to constructing a top-performing and investment grade portfolio. I've expressed often the need to wait for the right opportunity to strike and the ability to accept having missed buying opportunities. Here is a link to an article about the current pullback from borrowers who are immediately facing higher costs.

Waiting for the next right opportunity is critical. Often, unsophisticated and sophisticated investors alike will regret their inability to make an attractive purchase. Faced with this deficit of opportunity cost, the unwise investor is prone to seek out the "next-best" alternative. Be it a competitor or an 'uncorrelated' security. The unwise view their time and labour as wasted the moment they become aware of a missed opportunity. This emotional response then triggers a panic reaction, where no further time can be allowed to waste while cash is "sitting on the sidelines" and "earning you nothing". Once the emotional responses have kicked in for the unwise investor, they are on a self-fulfilling path of hasty decision making.

The "next-best" choice is one which is typically not on the radar of those who miss an opportunity but quickly becomes the sole focus of the unwise investors' attention. Because there is this view of opportunity and time already having been lost, a clear decision has to be made as soon as absolutely possible and hence little time is given to the vigorous research that was given to the original opportunity.

Needless to say, an investment that is not prudently researched and investigated is not called an investment, it is called speculation. Unwise investors doom themselves to poor returns because of a failure to properly understand the nature of what they are investing in and the current market conditions within which they find themselves. The sophisticated and experienced investors of this world take a different perspective on the nature of the time they devote to selecting their particular investments.

To the wealthy and powerful, the reality is that most deals- be they good, bad, awful, average or fantastic- most deals simply cannot be finalized. Staying power is a necessary precondition to achieving your objectives for this reason. If you seek to create a sustainable development project, if you wish to run a hedge fund or sell commercial real estate- the only way to truly be considered a success is to be able to self-perpetuate your operations indefinitely and withstand the missed opportunities that occur. Staying power is a tool for a successful life, investment career or business because of the dynamic nature of society, where opportunity is continually (though irregularly) available.

back to the Canadian bond market:

My investing strategy with respect to provincial, municipal and inflation-protected bonds has shifted dramatically from last year. At the height of the financial meltdown, provincial bonds with a 10 year maturity were available with interest rates approaching 6%. Currently the yield on most provinces is around 4% for a 10 year bond. Consequently I'm enjoying a period of my life where I would rather trust my savings and investments with bonds in investment-grade corporations rather than governments. The current situations with Europe and Greece and Dubai have all confirmed the ongoing frailty of the entire global system of finance and the frugality with which every investment must be vetted. Canadian government and agency debt (though safe) is extremely expensive (meaning substandard future returns) relative to historical standards.

Strategically, I'm currently holding more interest bearing cash (no money market funds of any kind, just cashable GICs or equivalents that offer total security, liquidity and some positive return, however minimal by historic standards). I'm watching as companies like Bombardier are waiting for the right time to enter the bond market. Some will be forced to come to the market for various reasons and it will be interesting to see how willing corporations will be to sell bonds. If it's possible to gain 5-7 year bonds from corporations like bombardier that are paying close to 8.5% in coupon payments, it is a tempting offer- just not for Bombardier shareholders. It would mean that they would be forced into setting aside millions of dollars of extra cash for interest payments, which would have an overall effect of reducing earnings for years.

Rising interest rates are bad for borrowers (corporations and individuals alike) and good for lenders. While you might face a financial statement that has dropped in value if you already own a large amount of bonds, if you have a lot of cash on hand, you will not have to realize any losses and your entire principal is still promised to be returned upon maturity.

Typically I would anticipate that corporations and governments alike will begin to capitulate throughout the remainder of the year. Credit is like the blood flowing through the organism that is the global economy. Greece, Dubai, Europe, America- They all run consistent deficits. The only way they can remain functional states is through selling bonds every year (corporations typically sell bonds for extra 'no questions asked' cash that they can use for any purpose management deems fit). As complex rescue packages, austerity programs and corporate downsizing all continue to improve short-term growth, they can't overcome the reality of historic losses and record debt that require significant financial restructuring.

The lesson should be self-evident as it is a self-reinforcing principle of human psychology and behaviour. As time goes on, and the difficult choices and legislative reforms are slowly and bluntly moved forward, the negative environment will continue to reinforce lenders' attitude that the inability to fully resolve debt increases the risks associated with that debt. Increased risk requires increased reward; it's as simple as that, it's why I find myself largely waiting out the winter, and why corporations are leery of selling bonds when they see their competitors are now required to pay more to borrow. The only problem is that enterprises need credit just like cells need blood. Eventually, every corporation and state with debt will seek out financing as a necessity of its daily or future operations. If you are patient enough to wait, you can seize an opportunity to buy bonds that clearly benefit the lenders, while simply satisfying the need of the borrower. The prime caveat is that you need to also have the confidence your borrower will be able to pay every coupon on time and ultimately repay your principal on the date of maturity.

You should be aware that in the above situation, an investor in common shares, or someone who now buys an ETF that mimics the major indexes, will likely see zero earnings growth, zero capital appreciation and a small dividend that increases at or below the level of inflation.