Bonds: the race to the bottom
By
Tim Price Sep 25, 2009
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The financial crisis that erupted in 2007 began in the bond market. It's likely to end there, too. This is because in 'saving' the global banking system, governments injected huge sums of money into it that they don't actually have. That money will have to be borrowed. Since most Western governments are already running massive deficits – British public sector net debt, for example, stands at more than £800bn – there may come a point when investors simply say 'enough', and refuse to buy government bonds at any price.
The UK government bond, or gilt, rally has arguably only lasted this long because the government has coerced the Bank of England to buy bonds issued by the Treasury, via the magical money-printing process known as quantitative easing. This particular form of recycling is not sustainable. Gilt yields have also stayed low because many investors have been too scared by the banking crisis to invest elsewhere. But all good things must come to an end. Evidence of economic recovery would be bad for gilts, as it removes the 'flight to quality' bid for them in the market. Evidence of inflation would be even worse. But the flood of future supply may end up being worst of all.
Most bond-market participants are large institutions, such as pension funds and insurance companies. In keeping with standard institutional practice, these investors do not necessarily act in entirely rational ways. Bond indices, along with most bond funds, allocate the greatest weight in their portfolios to the largest issuers of debt. If you give this even a moment's thought, it is absurd. By definition, the largest issuers of debt are the biggest borrowers – the most heavily-indebted entities. Another way to look at it is to regard the biggest borrowers – including America and Britain – as among the least creditworthy. So with Western governments in ferocious competition with one another to sell their bonds, bond investors are engaged in a race to the bottom in terms of creditworthiness.
Another wrinkle to the bond story here is that the Investment Management Association Sterling Corporate and Strategic bond fund rules allow fund managers to invest up to 20% of their funds into high yield or speculative junk. This may not sound a big risk, but it is. Such an allocation to sub-investment-grade bonds might represent 50% or more of the overall risk of such funds. Yet now is precisely the time to be fearful of credit risk. We are experiencing the toughest economic conditions for several generations, in which investors in junk are likely to see the highest default levels and lowest recovery rates for decades.
Separately, the US Securities & Exchange Commission (SEC) last week passed rules to tighten supervision of the credit-ratings agencies after the disastrous role they played in the credit crisis. As SEC chairman Mary Schapiro put it, in a masterpiece of understatement, reliance on credit ratings "did not serve investors well" in recent years, as triple-A rated securities turned out to be toxic. The state of California also upped the ante by announcing subpoenas for the major ratings agencies Standard & Poor's, Moody's and Fitch, for giving "stellar ratings to shaky assets".
Investors searching for income given the miserable yields on offer on cash deposits are understandably looking further afield. Emerging-market bonds are popular. But alarmingly, they've never been more expensive compared to investment-grade debt (the JP Morgan Emerging Market Bond Index, with a poor average credit quality of BB, only offers around 4% over investment-grade government bonds) at a time when many emerging-market issuers face solvency problems precisely because of the credit crisis.
So where can bond investors put their money? Happily, there's an alternative. Investment-grade bonds issued by solid creditor nations, such as Qatar (the world's wealthiest country in GDP-per-head terms), have been overlooked compared with sovereign bonds issued by heavily indebted nations. This is partly because they're not familiar enough for government bond funds, too small in terms of the index to interest institutional managers, and too high quality to qualify for emerging-market funds.
Stratton Street Capital LLP are advisers to a new fund, the Wealthy Nations Bond Fund, which launched last week. It invests only in investment-grade credits issued by countries or firms within them (normally with a state guarantee), which the managers, Andy Seaman and Mark Johns, believe have the greatest ability to repay their debts. The fund is available in USD, EUR or GBP form, and targets a gross redemption yield of 8%. Given the creditworthiness of its investments, that strikes me as a great opportunity. The minimum investment is £10,000 and the annual fee 1.25% (although there is also a performance fee once returns rise above 8% in any one year). For more, call 020-7766 0820. In the interests of full disclosure, PFP Wealth Management has invested in this fund on behalf of our clients.
• Tim Price is director of investment at PFP Wealth Management. He also edits
The Price Report investment newsletter
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