Ridge Hill Capital's  Instablog

With global financial markets in disarray…… many investors were disappointed to find that their bonds were susceptible to the same downturn as equity investments.  Clients of Ridge Hill were pleased to note that their bonds appreciated in value during the recent turmoil thereby providing timely risk diversification.  During 2006, Ridge Hill concluded that the large segments of the Canadian bond market no longer provided the risk diversification expected during uncertain times. 

Ridge Hill investment strategy….. in  2006, influenced by secular and cyclical factors discussed below, purchases of Government of Canada bonds with maturities no greater than 5 years were implemented.

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Secular factors…….

1. Increase in the percentage of Investment Grade Corporate bonds: (as represented by the DEX Total Return Canadian bond index) Secular changes in the Canadian bond market saw the percentage of Investment Grade bonds rise from 11% in 1988 to over 27% in 2006. 
2. Corporate Rating Migration effect: A study entitled “Migration behavior of Long-Term Bond Ratings of Corporate Bond Issuers” Fall 2001, Canadian Investment Review, by Kryzanowski & Ménard concluded “Most issuers are expected to have different bond ratings at the end of a 10-year horizon, and high-quality debtors are more likely to migrate to lower than to higher bond ratings”.
3. The deteriorating quality of Investment Grade bonds (from an investor’s viewpoint): Investment Grade bond quality eroded over 20 years as the indenture (with protective covenants) was replaced with the debenture (devoid of any material protective covenants). 
4. Maple Bonds: From 2004 to 2007 the development of the Maple market (foreign issuers, mostly US and European banks, in the domestic Canadian dollar bond market) introduced an element of unknown credit risk (in Ridge Hill’s opinion) decreasing the quality of the Investment Grade Corporate bond sector within the Canadian bond market.
5. The increase in interest rate risk:  With the secular decline in interest rates , duration, a measure of interest rate risk, reached 6.6 years in early 2006 (see below)

Cyclical factors….. Global monetary authorities were busy raising short term interest rates during 2005 & 2006 causing Ridge Hill to eliminate clients exposure to investment grade corporate bonds. Higher short-term interest rates cause the slope of the U.S. yield curve to flatten materially. Historically, a flat yield curve leads to a slower rate of profit growth; deteriorating credit quality and wider credit bond spreads.

Yet credit spreads were relatively stable and even narrowed in 2006. Each Fed tightening rations credit and encourages some degree of savings; this is the goal of interest rate hikes. Market participants, and indeed historical experience, are well aware that the end of Fed tightening cycles leads to wider credit spreads. Stable or narrowing spreads indicate that Markets tend to discount the effects of Fed tightening early in the cycle, and catch up subsequently.   This is a fairly common early-stage response – spreads similarly ground tighter alongside a less accommodative Fed in mid-1987, late 1988, early 1994, mid-1997, and late-1999.

What happened? ......... As expected by Ridge Hill, the table below the short term Federal Government sector (under 5 yrs) provided the best return (8%) and risk combination (lowest duration) over the last year (ending Jan 30/2009).  Ridge Hill’s expectations of the negative combination of secular and cyclical factors can be observed through the one year performance of the long term (greater than 10 yrs) Corporate DEX bond index return of minus 11.8%  which compares to the S&P/TSX one year return of  minus 31.77% .

Observations ….. The increased weighting of investment grade corporate bonds, tendency of corporate ratings to decline through time, coupled with a lessened protection for investors produced a positive correlation between the Canadian bond market and the equity market.   This correlation was compounded by heightened interest rate risk preventing certain segments of the Canadian bond market from being the risk diversifiers that investors looked for in these uncertain times.  Indeed, “Not all bonds are created equal!”

Despite these observations …. Investors have been fleeing the stock market and into   investment grade and high yield bonds.   Goldman Sachs (Credit Strategy: The Credit Line March 9, 2009) recently changed its estimates on downgrades and default forecasts.

“The recent sharp deterioration of US and global economic growth poses an increased risk to credit quality. We forecast that the 12-month trailing transition rate from Investment Grade to High Yield will increase to 7.5% (6.3% previously) by the end of 2009 from a current level of 2.7%.  Our new forecast for the 12-month trailing HY default rate is 13.9% (10.3% previously) by the end of 2009 with a peak of 14% in the second quarter of 2010.”

These forecasts mirror the experience of the Great Depression where High Yield default rates were 13%.  Forecast like this should give investors  pause .

What should an investor do?  …. If an investor is determined to buy investment grade corporate or high yield bonds they should read the trust indenture.  The importance of protective covenants was most evident late in February 2009 when GE Capital initiated a tender and consent offer for certain U.S. senior debt issues from old indentures that had a negative pledge.  A negative pledge is:

“A covenant in a bond agreement whereby the borrower agrees not to pledge any assets if such pledging would result in less security for the agreement's bondholders.”

Once these issues are redeemed, GE Capital will have the flexibility to issue secured debt that ranks ahead of the outstanding senior unsecured debt.  This would be a negative development for bondholders as an unexpected and costly (to existing debt holders) certain level of subordination will be introduced.  Investors should learn more about and look for protective covenants, particularly the “Debt Incurrence Test”, Financial Ratio Maintenance Test”, “Change of Control Clause” and “Negative Pledge” covenants.

An Alternative from Ridge Hill  …. Ridge Hill Capital is positioning individual clients bonds in a “barbell” scenario relative to the economic outlook in order to minimize the  credit/interest rate exposure.  “Deflation now and inflation in the next 5 years economic outlook” can be achieved by  purchasing GICs under five years barbelled with 10 year Manitoba Real Return bonds 1.738% dated Dec 1, 2018 to yield 3% (approximate price around 90$).

Opportunity in real returns bonds currently … Earlier in 2008 many investors  focused on inflation, driving the price of real return bonds up (and yields down).  For example Government of Manitoba’s real return bonds were valued at 1.8% real yield.  Since then, falling prices have enabled investors with an opportunity to obtain inflation protection without much premium.  For example the Manitoba’s real return bonds have fallen 8$ with the real yield risen by over 1.2% over the last year

In any scenario real return bonds … are attractive vehicles in RRSPs when real yields are above 3% as their return is above the long term real rate on nominal bonds.  According to the 2008 Credit Suisse Global Investment Returns handbook, historic real returns from 1900 to 2008 are as follows: for T-Bills (+1.6%); bonds (+2.6%); equities (+5.9%) (see figure below):

Conclusion … Famous economist John Maynard Keynes was fond of saying “When the facts change I change” .  Secular negative trends for the Canadian bond market have not altered in a few short months.   Cyclically, investment grade corporate bond premiums of 350 bps over Government bonds in the 5 yr maturity are historically high and unprecedented, much like the depressed level of the stock market, and may “appear” cheap.  But the nominal coupon of 5% doesn’t provide much cushion in the event of downgrade and default forecasts coming to fruition should the recession linger.   The Canadian economy has joined the world recession as Merrill Lynch Canada estimates that:  

“The January trade figures were so bad that our Q1 GDP tracking is now close to -10% (q/q saar), which would be the largest decline (by nearly a factor of two) since StatsCan’s quarterly series began in 1961.”

Data like this should give an investor pause and reserving their bond allocation for risk diversification and capital preservation seems the conservative thing to do.

Investors have been fleeing the equity market to investment grade and high yield corporate bonds in spite of the fact these bonds move in the same direction as equities!  Bonds should be risk diversifiers, not exacerbate misery.

Its different this time for bonds? … not since the great depression has negative economic data and forecasts turned so quickly and become so pessimistic.  In past recessions it always looks worse before the dawn providing an opportunity but it may be different this time.  Investors should hold short term bonds/GICs as their bond allocations..   

Shift in asset allocation … Long term real yields of 5.9% for equities support moving up the capital structure and purchasing corporate bonds ahead of equities.  Investors are best served with investment grade bonds and high yield bonds allocated as part of the equity or risk allocation.