Bonds are a hated investment right now. Recently Bill Gross, the head of PIMCO, the worlds largest bond fund, dumped all his US treasuries. And that’s a very, very big deal.
This is the guy that described UK gilts as “sitting on a bed of nitro-glycerine”. When he speaks, the bond market jumps to attention. They even call him ‘Mr Bond’. So when Mr Bond bails out of Western government debt – well, let’s just say it doesn’t help their popularity.
There are two major reasons bonds aren’t in fashion today: the credibility of borrowers and interest rates. And right now that second point presents a great opportunity for the private investor.
Would you lend your money to these guys?
The first thing behind a bond price is its credibility. A bond is a loan. And the key to any loan is the creditworthiness of the debtor (see here for a very helpful introduction to the basics of bonds).
Whether you give your cash to a corporation, government, or a mate down the pub – the big question is – will you get your money back?
On the European scene, the so-called periphery countries seem to have lost credibility. This is what Gross is on about – and it’s interesting to note that he includes UK debt in this category.
Investors demand nearly 13% for a ten-year loan to Greece. That is a hell of lot more than investors demand to be paid to lend to the German government right now.
But only a few years back, Greece could borrow at around 4%. For every €100 you lent them, you’d get paid €4 a year in interest. And it’s important to realise that this €4 a year was and still is fixed. It can’t be changed.
But now the City boys reckon Greece should pay 13% interest. And who would pay full price for a bond paying out 4% to maturity, when markets demand 13%?
Well, nobody. The price of the bond has plummeted as investors demand ever higher yield. Today you’ll get less than half your money back on those €100 bonds. So second-hand prices of Greek bonds have tanked.
That’s why Bill Gross has been dumping UK and US bonds – he questions the credibility of these nation states.
But the credibility of the borrower isn’t the only thing that influences bond prices.
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The City is wrong on bonds
I started working life on one of the City’s busiest bond dealing floors. And if I heard it once, I heard it a thousand times “Interest rates up, bonds down. Interest rates down, bonds up” – that was the mantra.
Why is that true? Well take your €100 bond paying 4% again. Because European rates have moved sharply lower since the credit crunch, the bonds of stalwarts like Germany have moved sharply higher. That guaranteed 4% looks great versus the new bonds issued at 2%. As market yields fell, the bond prices had to move up.
And today this is why so many investors are convinced that bonds are poised to go down. Investors are confident that rates can only go up. Heck, in the UK we’re at half a percent, how can they go anywhere but up? And they assert that bonds can therefore only move down.
But – and this is crucial -it’s not rates that determine bond prices, but rate expectations
You see, I agree that rates will go up (how could I not!), but I just don’t think they’ll go up as hard and fast as the market expects.
Right now market expectations are that rates start to go up by the end of summer and continue climbing. Expectations are that we’ll be back to ‘normalised’ rates (where they outstrip inflation) within two or three years.
And these expectations mean that bond prices are subdued (remember, rates up means bonds down). But here’s the thing – what if rates stay down at heel for a few more years? What if we don’t get back to ‘normalised’ rates any time soon?
For heavens sake, rates have been pegged to the floor for two years. The central banks are determined to keep them there – and frankly the economy is in such a pickle that rates will have to stay down longer than over-optimistic City analysts expect.
The City has consistently (and wrongly) expected rates to move up faster than the Monetary Policy Committee has delivered.
And I think expectations are still running ahead of themselves.
Rates will remain pegged to the floor – and that means bond prices are too low. Why? Because the market is pricing in rate rises too aggressively.
Where you can find a high-yielding bond
You can buy decent five-year corporate bonds paying out 5% today. I wouldn’t turn my nose up at that. By all means focus on the credibility side of things, but as for interest rises messing up the trade, I’m not too worried.
Sure, inflation may erode some value, but what’s the alternative if you want low risk? Sit on cash? If I’m right on rates, then that’s going to be even worse.
A few weeks ago I mentioned how private investors can now buy bonds just like the professionals. I said that I’ll keep readers updated if a great new bond issue comes along.
And nothing has come along just yet. But bear with me, I haven’t forgotten. I’m sure it won’t be long now – we’ll find a great bond to tuck away for your portfolio. And I think you’ll not only get a great interest rate, but there’s a good chance you’ll see some capital appreciation on your investment too.
• This article was first published in the free investment email The Right side. Sign up to The Right Side here.
Your capital is at risk when you invest in shares – you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.
Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.
Managing Editor: Frank Hemsley. The Right Side is issued by MoneyWeek Ltd.
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