These are uncertain times.
Since the Sept. 11 attack on the United States, all markets have experienced volatility as investors struggle to make sense of these tragic events and interpret their reactions.
As far as the bond market is concerned, there are some important facts to consider in making educated investment decisions.
First, how has the Canadian yield curve been affected by recent events? The yield curve is a graph of bond yields plotted against differing maturities, from short to long term for bonds of similar credit.
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When yields for the shorter term are less than those of the longer term, the yield curve is said to be positively sloped.
Alternatively, when short-term yields are greater than those in the longer term, the yield curve is said to be negatively sloped.
Since the events of mid-September, the yield curve has steepened dramatically in a positive fashion as yields at the short end of the curve plunged.
The benchmark two-year bond lost 44 basis points since that fateful Tuesday, dropping a total of 83 basis points in September. This is due to investors shifting capital into the relative safety of short-term bonds. As anxious investors bid up bond prices, yields fall.
However, the mid-to-long terms area of the curve has faced heavy selling, the long end particularly, causing yields to move up.
The yield on the benchmark long bond rose to 5.88 from 5.65 since the disaster.
The selling in the long end has been fueled by the expectation of the U.S. treasury creating new supply in the form of bonds issued to raise money to offset slowing economic growth and to pay for weaponry used to combat terrorism.
As a result, the two-year to 30-year Canada spread (the difference in their yields) widened to 250 basis points from 69 basis points. That is a 2.5 percent increase since the tragedy occurred, continuing a firmly established trend that started in early September.
By understanding how the yield curve has changed, the investor can better determine advantageous investment spots along the curve.
The yield curve is so steep or positively sloped that extending a term by just one year can sharply increase an investor’s yield.
For example, the difference in yield between a government of Canada bond maturing in June 2003 and a government of Canada bond maturing in September 2004 is 68 basis points.
Clearly, positioning yourself correctly on the curve can greatly enhance your return.
Second, how have fixed income investments with a credit spread been affected compared to government of Canada bonds? This is the case in the world of corporate bonds where recent events have affected corporate credits to varying degrees.
For example, many businesses that rely directly on air travel, airlines such as Air Canada, airports such as the Greater Toronto Airport Authority, airline equipment manufacturers such as Bombardier, as well as hotel and travel businesses, have revised their business outlook or are in danger of downgrade by the rating agencies that cover companies within these sectors.
Credit risk increases selling pressure, thereby increasing yields. Remember, as bond prices fall due to selling pressure, yields move up.
Further, market volatility has necessitated a widening of bid-offer spreads as traders overcome the lack of liquidity in the marketplace. One may be able to pick up a corporate bond at either end of the cheap-expensive spectrum in this environment until liquidity picks up.
Finally, I’m certain the events of September have hurt daily business for investment dealers. Traders, erring on the side of caution, may have reverted to off-line transactions and increased the volume of over-the phone transactions.
Those attempting to get a trade through a discount broker on a busy day know how this feels.
Some trades, mainly those requiring New York involvement, are taking much longer than usual. Some traders may not have returned to work and others may be sharing phone lines.
With patience and understanding, as dealers cope with unusual circumstances due to these tragic events, things should get back to normal in due course.
Ian Morrison is a financial consultant with Wood Gundy Private Client Investments in Calgary and is licensed to sell insurance products. His views do not necessarily reflect those of CIBC World Markets Inc. This article is for information only. Morrison can be reached at 800-332-1407 or by e-mail at ian.morrison@cibc.ca.
