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Andrew Allentuck

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A strong bond

Andrew Allentuck

In the midst of the global meltdown of financial markets, investors can be torn between selling out while they can, hanging in for the time that markets stabilize, or playing the incredible volatility that has produced phenomenal gains in shares of financial services companies. Mortgage lender Washington Mutual saw its shares rise 42 per cent on Sept. 19 while shares of Citgroup rose 22.7 per cent, shares of investment bank Morgan Stanley rose 20.7 per cent, and shares of the lion of Wall Street, Goldman Sachs, rose 20.2 per cent.

Investors can try to follow up these gains, but the odds are against continuing mega-gains. At mid-day on Sept. 22, Washington Mutual was off 19 per cent while shares of Barclays Bank, a huge British bank, were off 14 per cent.

Investors who want safety pick bonds. After all, a good bond will return your money one day, a promise no stock can make. The problem is that the money may be worth less if inflation erodes its value. Even in bonds from governments that can print money, there is no absolute saftety.

The Sept. 7 rescue of U.S. mortgage giants Freddie Mac and Fannie Mae and the proposed purchases of controlling interests in global insurer American International Group Inc., the related ban on short selling of nearly 800 financial services companies, and the expansion of bank licensing to Morgan Stanley and Goldman Sachs — all measures designed to stabilize world capital markets, have led the bond market to wobble.

Credit markets breathed a sigh of relief at the measures, but pumping in $700-billion (U.S.) into banks by buying up assets that they could not sell has led to fears that creating so much liquidity and selling it to bond markets will force bond prices down and bond yields up. The bonds will have to be sold cheaply to get buyers to bite.

Now the issue is whether taking on the potential burden of issuing $5-trillion in debt, the value of the complete books of business of American mortgage insurors Freddie Mac and Fannie Mae, will drive up interest rates and drive down the prices of existing bonds. Not all the bonds in their portfolios will default, but many will. The final price tag is unknown. On the other hand, the deleveraging process that involves selling off overpriced stocks and derivatives will be deflationary by shrinking the broadly defined money supply.

The problem is made more complex by differing definitions of inflation and deflation.

Inflation is usually taken to mean gains in the consumer price index. Deflation can be a decline in the CPI, which is seen as a bad kind of price move that indicates serious economic contraction. Or it can be steady CPI numbers accompanied by hard to measure improvement in quality of goods. For example, one can say that computer prices have been on a deflationary slope for the last two decades as prices for processing power and data storage, speed and connectivity have tumbled faster than those things have increased. This is the good kind of deflation.

For now, credit markets are judging the actions to save the banking system as inflationary. Bond yields have risen by 25 basis points in the U.S. and 26.5 basis points in Canada on each country's benchmark 10-year bond. Yields move opposite to prices.

Prices are likely to decline and yields to rise in the short term as central banks strain to sell the first hunk of rescue debt, that $700 billion (U.S.) of bonds. Getting the market to digest close to a trillion in fresh bonds will tend to force down prices and even to push out corporate bonds — a process known as disintermediation. As a result, corporate bond prices will tend to rise, thus pushing down prices of credit-sensitive bonds.

For the longer term, the U.S. Treasury's obligation to fund its potential commitment to buy up to $5-trillion of defaulted mortgages from Freddie Mac and Fannie Mae will result in creating more money. That is inflationary and when the public sees the process happening, inflationary expectations will rise further, says John Carswell,

president of bond specialist Canso Investment Counsel Ltd. in Richmond Hill, Ontario.

Investors can buy bank bonds now. For example, bonds from Canadian banks are selling at low prices that boost their yields. A bank of Montreal 6.17 per cent issue due in 2018 carries a 240 basis point boost in yield over the 3.56 per cent Canada bond of the same term making for a 5.96 per cent return to maturity.

Sensitivity to anything that could even remotely default has created other bond bargains. High quality quasi-government bonds that were sold off in the rush to safety are now in bargain territory/ For example, 10-year Greater Toronto Airport Authority 4.85per cent bonds due June 1, 2017 have been priced to yield 5.5 per cent to maturity, about 200 basis points over Government of Canada bonds of the same term. And Canada Mortgage Bonds (CMBs) guaranteed by the Government of Canada such as the 4.80per cent issue due June 1, 2012 has been priced to yield 3.47per cent to maturity, the boost due to the fact that the bonds have the word "mortgage" in them.

Suggests John Carswell, "it's safe enough to be invested in those GTAA issues, in federal bonds with terms of 3 to 5 years and in Canadian federal agency bonds." For example, government-guaranteed CMBs such as the 3.95 per cent issue due June 15, 2013 have recently offered 62 basis points yield boost over Canada bonds. When the present credit crisis ends, these bonds sold with deep discounts and high yields should generate hefty capital gains, Carswell suggests.

For now, bond traders are watching the inflation numbers with caution, cutting their portfolios' sensitivity to interest rate changes. There is not a lot of heroism in staying in short bonds and treasury bills due in a year or less. On the other hand, t-bills and short bonds won't leave you bleeding if interest rates do rise.

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.

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