Market Review: Bonds set for a fall?

• Tweet

Guardian Trust Funds Management managing director Anthony Quirk gives his views on the state of the markets.

Wednesday, October 2nd 2002, 3:56PM

by Anthony Quirk

This market summary is provided by Guardian Trust Funds Management. To see how the numbers stacked up for various markets around the world in the past month and over the year, visit our Monthly Market Reveiw here

As suggested in last month’s commentary (click here to read previous article) the global sharemarket gains of August were not sustained into September. In fact, the markets turned ugly again with global shares down over 11% for the month, the largest monthly fall since August 1990. Some markets were even worse than this, with Germany down 25% for the month! The perilous state of Germany’s economy was covered last month and a nail biting election outcome did not help investor sentiment.

 

However, there’s a silver lining on every cloud and in this case it is the strong bond market performance (in the developed world) for the year to date.

 

Portfolio diversification helps cushion the fall if one sector “falls out of bed” and so it has proved with bonds. While not able to make up for all of the global sharemarket declines global and domestic bonds have undergone massive rallies. For example, the US 10-year yield fell to 3.66% by the end of September. This is 175bps down from its recent peak in April; over a 30% fall in yield. New Zealand bonds have also rallied, with the 10-year bond going from 6.9% to 6.0% in the last six months.

 

In fact, US 10-year bonds hit their lowest level since 1958 in late September. Such substantial interest rate falls mean that bond investors have enjoyed significant capital gains. For example, (hedged) global bonds returned 4.9% for the September quarter and NZ bonds 3.9%.

 

So what has driven such a strong bond market performance?

 

Basically, bond managers are happiest when everyone else is depressed; as most equity investors are at present about the world economy, sharemarket values, poor corporate earnings, a possible war etc etc!

 

In essence, bonds usually provide a “safe haven” in any turbulent financial, political and economic environment. In such situations cash or bonds are “king” and there has been significant switching by some investors out of shares in recent times.

 

This move into bonds has moved yields down with the most extreme example being Japan. This country has been in recession for the past decade with (effectively) negative inflation. This has lead to the yield on 10-year Japanese Government Bonds (or JGBs) falling to as low as 1.0% in mid-September, after being at 1.45% in early June. By month end there was a spike back up in JGB yields. This is mainly due to the Japanese Central Bank’s “unusual” action of buying Japanese shares to prop up the sharemarket and therefore aiding sick Japanese bank balance sheets (most of which are highly exposed to equity values).

 

However, investors also need to be mindful that a rise back up in yields has the potential to generate capital losses. Some investors struggle with the concept of how you can lose capital on “safe” investments like bonds. However, anyone who experienced the bond market of the mid-1990s remembers only too well that you can make capital gains and losses on bonds. For example, the return from NZ bonds for each of the 1993 and 1995 years was over 13%, while the return in 1994 was –2.8%.

 

So what are the chances of a big jump in bond yields and a potential repeat of the bond losses of 1994?

 

One of the following scenarios could bring about capital losses for bond investors:

 

• Far from moving into a double dip recession, the US emerges with a strong economic recovery, with a significant sharemarket rally and with the Federal Reserve having to lift rates consistently through 2003.

 

When making their predictions in late 2001 quite a few economists believed this was possible but have gradually pared back their US and global growth expectations. The US economy may well recover through 2003 but it is unlikely to be strong enough to cause a “bear market” in bonds. For this scenario to have maximum impact the sharemarket also needs strong corporate earnings to lift and suck money out of the bond market. While some lift in corporate earnings through 2003 is probable it is unlikely to be earth (or bond) shattering.

 

• The US (with or without UN endorsement) does go to war with Iraq, with this dragging on and more and more bombing occurring. This, in turn, lifts oil prices to over US$50 a barrel and also causes the US fiscal deficit to blow out. In turn, inflation levels lift strongly throughout the western world, which is bad for bonds.

 

The simple counter argument to this is that in times of war investors run to bonds, as was the case in the Gulf war in the early 1990s and that a high oil price would depress world growth in any case. The more complex counter argument (which is being used by the US Government) is that Iraq would be over thrown quickly, resulting in Iraq lifting to full oil production, thereby bringing down oil prices.

 

In short, the chances of a repeat of the 1994 bond market “crash” are remote but there are risks inherent in bonds at their very low (by historic standards) levels. At present investors are saying they still prefer this risk to that of the sharemarket but such sentiment can swing quickly.

To see how the numbers stacked up for various markets around the world in the past month and over the year, visit our Monthly Market Reveiw here

Anthony Quirk is the managing director of Guardian Trust Funds Management

Anthony Quirk is the managing director of Guardian Trust Funds Management.

« Iraq, oil and global financial markets

King builds an empire »

Commenting is closed

 

Printable version

Email to a friend