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Bond investors are waiting in the wings for stocks to correct. Canadian shares have been on a remarkable trip. Driven by high commodity prices and flourishing bank profits, Canada has been one of the world's leading stock markets in the last 12 months. The worry now is that the good times cannot go on forever.
The market pros know it. Otto Spork is president of Sextant Capital Management in Toronto. His Sextant Strategic Opportunities Fund produced a 117 per cent gain in 2006, top for all alternative strategies funds in the period. It was also the leading hedge fund for the first quarter of 2007 with a 27per cent gain. “We are starting to get concerned about corrections,” he says. His specialty, small caps, are at risk in today's hot market and he has been taking profits on gold, a bellwether resource stock.
Bonds go up when stocks go down for a variety of reasons. First and foremost, investors tend to head for safety and bonds, with their promise of an exact return at the date of redemption, appeal to nervous stock players. As well, the impetus to diversify drives stock investors to lock up their gains in another asset class that has not thrived as much as equities. The SC Universe Bond Total Return Index delivered a 6.5 per cent return for the 12 months ended April 30, 2007, a modest performance in comparison to the S&P/TSX Total Return Index, which rose 20 per cent in the same period. In contrast to stocks, bonds have had a lacklustre year and are relatively cheap in terms of recent performance in comparison to shares.
A correction in stock market gains is in the cards, says Bob Marcus. President and chief strategist of Majorica Asset Management in Toronto. A shrewd observer of the bond market and a gifted trader, he suggests that the crisis on subprime loans is worse than lenders and central bankers have acknowledged. As subprime mortgages issued to unqualified buyers roll over from interest rates that prevailed in 2002, 2003 and 2004, interest payable will rise substantially, he notes. Borrowers who were able to pay mortgages when they took just 20 per cent of their disposable income will find that they have to pay 70 per cent and even 80 per cent of their net. Many will walk away from their houses, leaving lenders with homes they will have to sell in a glutted market. Bank earnings will suffer, people will buy less and the effects are likely to spill over into Canada, Marcus says.
A stock market reversal is likely under these conditions, Marcus reasons. When stocks are headed down, then bonds will be one of the few ways to make money in the market.
An investor with quality bonds should see some compensating portfolio gains, says Tom Czitron, Managing Director and Head of Income and Structured Products for Sceptre Investment Counsel Ltd. in Toronto.
“If there is a sustained correction, then bonds would do well,” he explains. His choice - federal and provincial bonds if only because, in a correction, there tends to be a flight to quality.
The remaining issue is what term of bond one should buy. Suggests Brad Bondy, Vice-President of Investment Operations for Genus Capital Management Inc. in Vancouver, formerly director of research for the company, “you need to consider what is making the market drop. If the cause is a deepening recession in the U.S., I think the investor should focus on the short end of the yield curve. The curve is very flat and has an inversion in the two-five year range. A normalization, which is inevitable, would generate bond gains.”
The most likely current scenario is a drop in short rates, Bondy adds. If the Federal Reserve Board and the Bank of Canada start dropping rates, short bonds with two-to-five year terms would do well. A bigger bet would be to buy 20 to 30 year bonds that tend to move a good deal more than short bonds when rates change, but there is also much more risk in long bonds. The plan, after all, is portfolio risk reduction.
There are other bond strategies, each with a different set of risks. For example, one could buy U.S. Treasury bonds. At the time of writing, 5 year T-bonds yield 4.8 per cent to maturity compared to 4.4 per cent for 5 year Canada bonds. The extra yield on U.S. bonds is attractive, but the U.S. dollar could weaken further. Similarly, an array of global bonds may offer higher interest yields than Canadian federal and provincial bonds, but in each case, there is a risk that the high flying Canadian dollar could rise against the foreign bonds and convert what might be a price gain in the native currency into a Canadian dollar loss.
The best strategy may be the simplest. Short-term Canada bonds are easy to use, easy to understand, and add no risk to the portfolio. In the event of a major stock market decline, they would tend to moderate losses and to provide some countercyclical compensation. What's more, bonds revert to cash on their maturity date, unlike bond funds and bond derivatives. For investors seeking security, there is none better than cash.
Andrew Allentuck writes about investments for The Globe and Mail, and reviews books on finance for globefund.com and globeinvestor.com. He is also the author of several books.