In the months following Lehman Brothers’ implosion, investors stampeded into bonds, with U.S. Treasuries the issue of choice. Since then, market watchers have repeatedly warned of an impending slaughter, as interest rates would eventually have to rise.
While that rise may be inevitable, it is not coming any time soon, according to Shane Stuck, vice-president, senior portfolio manager, fixed income at Sentry Investments.
“We’ll be in a zero interest rate environment for a very long period of time,” he said on Tuesday, at Sentry Investments Roadshow in Toronto. “The Fed has already told us they aren’t going to move interest rates until 2013. That’s just a waypoint; I think it’s going to be a considerable time after 2013 before you see the Fed move.”
Following on the heels of QE2, the Fed launched “Operation Twist” under which the central bank buys long bonds and sells short bonds. Stuck doesn’t expect this to prime the economic pump. Companies that won’t borrow when the 10-year Treasury yields 2% probably won’t borrow at 1.75% either.
“The biggest risk for fixed income investors right now is inflation. Inflation is going to come from the Federal Reserve,” he said.
“I think they’re setting up for the next policy move, which I think is going to be Ben Bernanke saying ‘We’re comfortable with 5% or 6% inflation.’ Just the sheer statement of a central bank saying that should get the inflation juices flowing.”
While this may sound shockingly high, Stuck pointed out that the U.S. inflation rate is already running at 4%, while Canada’s is 3%.
It could be the “cure that kills” though, as the resulting inflation would transfer wealth from savers to borrowers. Not coincidentally, the largest borrow is the Treasury itself.
“I spent my first six years in this industry working with a chap named John Crow at the Bank of Canada. I have a strong appreciation of how difficult it is to bottle that genie once it’s set loose.”
He pointed out that yield-seeking investors will be disappointed with returns on Canada and U.S. government bonds or cash. In such an environment, investors must remember why they have made the investments they have.
For investors, the best bet is to opt for shorter duration bonds, which limit interest rate risk. His own fund is targeting a 3% average maturity. Large coupons allow the investor to redeploy capital into higher paying new issues, should interest rates rise.
Corporate debt is also more attractive than U.S. or Canadian government issues. He points out that corporate fundamentals remain strong, as the “near death experience” of 2008 taught the value of holding cash on the balance sheet. That has helped hold the global corporate default rate to just 1%.
“I don’t think it does anybody justice to focus on just 1% of the global credit market, i.e. Canada. Any investor who ignores the emerging market space on the fixed income side does so at their own peril.”
In defence of regulation
Stuck said investors should breathe a sigh of relief that global regulation appears to be imminent. While many multinational banks have decried closer scrutiny, he pointed that they have little credibility.
“People ask ‘How could Greece hold the world hostage?’ To me, what we’re seeing is that classic pusher-junkie relationship, where we focus way too much on the junkies and we don’t focus enough on the guys that push,” he said. “What we should be asking is ‘What bank in their right mind would lend 11 million people $500 billion?’ It’s insane.”
Put in that light, more stringent banking regulation is the obvious remedy, with a global mechanism required to solve the European problem.
“It’s pretty clear this is pretty high on every nation’s agenda. What does it mean for you and me? It means the world doesn’t end,” he said. “They will contain the risk; I’m quite certain of this.”