Sunday, November 21, 2010

Why bonds are NOW so risky!


When looking back over the last century, we have experienced in Canada an average inflation rate of around 3.3% per year (Oct 2010 rate is 2.4%). This is based on data retrieved from Statistics Canada. The graph in figure 1 shows how inflation varied overtime. As you can see, the fear of us in 2010 being in a deflationary environment similar to that of 1930-1934 is clearly a gross exageration. But there were some major recessions where we actually got zero or near zero inflation as in 1939, 1953, 1974, 1994 and now again. Some of those recessions were quite severe, but during other severe recessions such as 1982-1983, inflation did not get even close to zero.

There maybe even a pattern observable where we alternate between periods of low inflation and of high inflation. These patterns seem to occur every 30 or so years, subdvided more or less 50/50 into a period of low and one of high inflation. Right after the 2nd World War (when there was lots of government war debt) and during the 1970-1980 period when there was lots of government debt and high commodity prices due to the oil shocks, we had very high inflation. It seems these are self propelling cycles of ever increasing inflation, commodity prices, taxation and interest rates. And now after an, in excess of 15 years long, period of low inflation we seem to be starting another period of high inflation. We are these day a lot more global oriented and when the U.S. or China experience high inflation and have high government debt, many other countries do so as well

Look at the relation between Inflation and interest rates in the figure below where the latter is expressed as the yield on 5 year bonds of the Government of Canada.

Do you see a pattern? I do. High inflation means high interest rates. However, the spread between the 5 year bond yield and inflation varies. In 2009, we experienced even the rare case where inflation was higher than interest rates. This also happened during the 1982-1983 recession. That was not a very pleasant economic time either. The difference between the 5 year bond yields versus inflation represents real interest for 5 year term loans to the highest quality borrower in the country –our government.

Some investors feel that there is a relationship between interest rates and the Canadian Dollar. This may be true for the short term, but as the graph below shows, over the long term there is no direct relationship between them.



However, there is a relation between the federal government debt/GDP versus Real 5 year bond rates (i.e. inflation was taken out).

So in simplistic terms, interest rates are strongly affected by inflation rates and government debt. When government debt increases, lenders interpret this as a deterioration of creditor quality and thus they want a higher risk premium. Also they want the principal of their loans protected against loss of purchasing power (inflation). On the other hand, currencies are more reflected by the comparison of the economies of different countries. These economies are affected many other factors than just the  inflation rate and  government debt levels. Consequently exchange rates do not correlate very well with interest rates.

In recent years, investors have focused on cash flow, yield and dividends. Many of those investors perceive government debt as the most secure form of debt, but they seem to overlook two significant factors. First, the quality of the government debt deterioration in one country versus another and second, governments that push their own currency lower compared to others. With the first factor, interest rates may rise because of the higher default risk of one country versus another. The second factor reduces the purchase power of the debt principal of one country visa vie that of another. Thus over the last decade U.S. debt devalued nearly 40% when compared to Canadian dollar denominated debt and the chance that interest will rise in the U.S. is higher than that in less indebted Canada (Canada's lower default risk). Meanwhile investors have poured billions of their cash in 'short term' U.S. treasuries for little interest return and a high risk of losing purchase power. This has created a high risky investment that many experts describe as a 'time bomb'.

Canadian bonds are not free of risk either. If the earlier described periods of higher inflation and associated increases in commodity prices, interest rates, taxes and government debt will come to pass again, even Canada will go along for the ride (although to a lesser degree than the U.S). Even if you would invest in Canadian bonds risks are high. To illustrate this, let's use one of the tools that was presented on this blog early on in February: Godfried's tiny bond calculator.

Canadian 5 year bond yields are currently at its lowest ever, around 2.25% (and so are Canadian mortgage rates based on these yields). If we bought a 5 year Government Bond with a principal of $100 right now, it would return $2.25 per year interest or $11.25 over the entire 5 year term. Say that the economy is recovered 2 years from now and inflation is back at 3% and real bond yields are at similar levels as during the low government debt years of 2003-2005 at 2%, then the 5 year bond yield would be 5%. A 5%, 5 year $100 government bond would deliver interest of $5 per year or $25 over 5 years. Would you still prefer your 2010 bond paying 2.25%? Of course not! In fact the tiny bond calculator shows that if you would want to sell your 2.25% bond, which would expire then in 3 year's time, it would be worth only $92.43.

But government debt will likely be still on the rise as well, so Canada's creditor quality may in the near future deteriorated too. In fact, just a poorer investor perception due to what is happened south of the border may decrease Canada's perceived credit worthiness. Taxes will likely increase as well and in response to all this real interest could easily creep up to 4%. Now your bond value drops to $87.34. Survivable but with interest on your bond of 2.25% and inflation of 3% you are not even keeping up with purchase power.On an after tax basis, your interest rate has dropped to only 1.35%; while in real terms and after tax  it is now -1.65%.

Thank the higher powers that you did not buy a 10 year bond! Because, in that case, after 2 years your bond would have been worth: $71.28. If we reach the interest rates of the old high government debt years plus a bit higher inflation, chances are that yields would have gone as high as 8 or 9%. If that was 5 year into your 10 year bond term, the value of your bond would have fallen to 73.29 and you lost over 25% of the original value in order to earn an interest rate of 2.25% in one of the 'safest' investments available. Oops, 25% down, we're getting close to the stock market losses of 2007 – 2008 that scared so many investors into the bond 'safe haven' in the first place. Finally if within 5 years we got back into the inflation madness of the 1980s, interest rates could climb as high as 15% and the value of your bond would be 56 cents on the dollar. Any one wants a 30 year bond?

Nobody knows whether we will be going back to high interest rates, high government debt, higher taxes and high inflation. But right now, chances are much more likely for higher than for stable or falling interest rates. Thus medium and long term bonds of the U.S. and even Canadian bonds should be avoided; the downside is way higher than the potential upside.

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