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.