Turbulence in the Bond Market

February 4, 2011

Last week, Standard & Poor’s downgraded Japanese government bonds to AA-minus, from their previous rating of AA. On the very same day, the U.S. government announced that the federal budget deficit would likely climb to $1.5 trillion in 2011, a hefty hike from the $1.29 trillion of 2010. While neither announcement was unexpected, they both point in the same direction: the governments of major economies are facing excessive levels of debt. How can they deal with this?

First, they could cut expenses and balance their budget. This is the painful process Canada chose in the 1990s, after it was downgraded by the rating agencies. But there is no guarantee that a major economy following the same path would be as successful as Canada was with this approach. And if it were unsuccessful, it could result in a return to recession, accompanied by deflation—a scenario that would increase the value of long-maturity bonds.

Second, they could engineer an increase in inflation by creating an excess money supply. However, this is easier said than done. The U.S. Federal Reserve has been trying to boost money supplies for months now, with little effect on inflation. However, if it eventually succeeds, this could damage the value of long bonds.

Third, they could keep piling up debt, until a default and a restructuring of its obligations become unavoidable. In this case, government bonds would be damaged directly through a reduction in their face value or coupon.

In summary, government bonds are not risk-free. Depending on the policy choices made by governments, investors could face inflation, deflation or a default (however, this last situation is unlikely). Each scenario impacts on the value of government bonds in different ways.

Given this reality, what is a reasonable strategy for Canadian investors?
1- Diversification is king. Investors used to consider a highly rated government-bond portfolio to be the safest possible investment. Not anymore. A well-diversified combination of government and corporate bonds is safer.

2- We tend to favor short-maturity bonds, since the appreciation potential of long bonds (in a deflation scenario) is outweighed by the risk of depreciation in the event of a sustained rise in inflation. Simply put, since 30-year Government of Canada bonds yield 3.75%, there is more room for yields to increase (leading to price decline) than to decrease (leading to price gains).

3- Hedging against political risk. By investing in Canadian, U.S., International and Emerging Market equities, an investor can protect (however imperfectly) his or her portfolio against an isolated political decision that could damage the value of the securities from one particular country.

Of course, this strategy is only a rough guide and should be adapted to each investor’s specific situation. PWL Capital’s advisors are experts at delivering customized portfolio strategies to investors.

Raymond Kerzérho

Chairman of the Investment Committee
and Director of Research
PWL Capital Inc.