Shorter-dated bonds still good choice

by Levi Folk | June 24, 2007

A rise in bond yields to more normal levels appears to be underway, and that means bond investors should continue to invest in shorter-dated bond securities over the medium to long term. Bond prices could rally for cyclical reasons over the near term if the U.S. housing market drags the economy down, but the long-term trend appears to be negative, and that could have repercussions for risky assets globally.

It has been widely reported recently that U.S. bond yields broke above a 20-year declining trend that represented a bull market for bond investors. Bond yields have been abnormally low in recent years due to a massive flow of U.S. dollars into U.S. treasury securities by foreign central banks -- what has been referred to as the global savings glut by Federal Reserve Bank chairman Ben Bernanke.

Bond yields shot up roughly 75 basis points in the short span of a month between May and June. Part of this reversal is simply a reaction by bond investors to stronger economic growth in the United States . But more importantly, there is anecdotal evidence that foreign demand for U.S. treasuries is faltering. That is very important given that roughly US$2.1-trillion, representing near half of all holdings, of U.S. treasury securities is held by foreigners -- Japan and China accounting for almost half that amount. The Financial Times reported "a distinct lack of Asian buyers" at Treasury auctions during the recent rout.

On May 21, China announced it would invest US$3-billion of its foreign exchange reserves to secure a 10% stake in Blackstone, a U.S. private-equity firm. While this is small change in consideration of the US$1.2-trillion in foreign exchange reserves held by the Peoples Bank of China (PBoC), it is a piece of a bigger sum -- $300-billion -- that is earmarked to be invested more aggressively by its newly created sovereign wealth fund. Apparently, the PBoC has reached the conclusion that it should diversify away from U.S. treasury securities.

Japan, Russia and India are also rumoured to be setting up sovereign wealth funds to deal with burgeoning U.S. dollar reserves, according to the Economist newspaper. Estimates for the size of these funds globally are reported to reach a staggering US$2.5-trillion by year’s end.

China has amassed its arsenal of dollar reserves by managing a fixed exchange rate. As dollars have flowed to China from the United States via the trade account, the PBoC has steadfastly resisted the upward pressure on its currency by buying dollars and selling renminbi. The problem with this strategy is that it is inflationary, as evidenced by the domestic stock market bubble and by rising property prices. Eventually, China may be forced to allow its currency to appreciate more quickly than it has done.

The Gulf countries are also finding that dollar pegs are inflationary due to massive dollar revenues from oil production. They, too, have amassed large dollar reserves in recent years. The move by Kuwait to abandon its dollar peg earlier this year is another possible harbinger of higher bond yields. The country could not control inflation while maintaining a currency tied to the dollar. It may be only a matter of time before other Gulf currencies follow suit. Inflation in UAE and Qatar is running at double-digit annual rates. Without the anchor to the dollar, these countries’ central banks will be less inclined to hold dollar reserves, and that means fewer treasury holdings.

These forces are undoubtedly negative for the U.S. bond market and there are implications here for risky assets in general. A rise in bond yields could be the beginning of the end for the current credit cycle, which has been very supportive of prices for riskier bonds and even equities. Spreads on riskier securities such as high-yield bonds would likely widen if bond yields continue to move higher over the next few months and years. These spreads over treasury yields have been very tight since the start of 2004 as borrowers have demanded meager compensation for assuming the added risk over government bonds.

More likely, this story will continue to play out over the next few years. However, the recent spike in yields suggests it is probably underway. Investors should take profits on bond rallies to position their portfolios appropriately. A normalization of bond yields is underway as demand for foreign securities by foreign central banks is directed away from U.S. bonds on the margin.