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Know when to fold 'em
Profit taking in bonds may be prudent

Last week's column gave a run-down of the theories shaping our bond market. This week, we'll shift gears to my thoughts on what investors should do with their bond holdings today.

Interest rate trends

As noted last week, today's interest rate structure has an embedded expectation of higher rates in the future. That's not a hard pill to swallow given that interest rates are at forty-year lows. At the same time, I do not expecting rates to rise fast and furiously.

Current interest rates on Canadian bonds and treasury bills can be viewed at the Bank of Canada's website, on its "rates" page.

Yields on short, mid, and long-term bonds have risen in Canada over the past year, by 0.77, 0.23, and 0.27 percentage point over the past twelve months. (Actually, rates dropped like a stone after 9-11, and then rose from November 2001 through March 2002; before subsequently falling significantly between March and November of this year.)

The sharp drop in rates since early spring has been a nice shot in the arm for government bonds - one of the few safe havens in this difficult market. And it really just caps a longer-term downward trend that has been underway for some twenty years. (I admit I was premature in expecting a rate hike early this year.)

U.S. interest rates are so low that there simply isn't much room to fall; though rates haven't fallen as much domestically. I was wrong early this year, but that makes further falling rates that much more unlikely going forward - particularly if you think the economy will even make a modest recovery.

Bottom line: It would be prudent to consider taking some money off of the table from profits made in government bonds. The streak is unlikely to continue at its recent pace.

Corporate spreads

One of the things many investors keep a keen eye on is the gap between yields on corporate bonds, as compared to government bonds (i.e. corporate spread). It really represents the "risk premium" that the market is placing on the credit worthiness of corporations. As the spread widens, it's usually a sign that investors are nervous about credit quality and opting instead for the safety of government bonds. That's exactly what we've experienced.

In Canada, the "corporate spread" is about 50 per cent higher than its historical average over the last business cycle. In the U.S., the gap is even larger due to the more severe economic downturn experienced by our American neighbours.

This may be a sign that corporate bonds are undervalued. Sure, the economy can get worse and corporate bankruptcies could accelerate; but my gut tells me the worst is behind us.

Corporate bonds are riskier than government bonds; so limit exposure to no more than about 30 to 50 per cent of total bond exposure. Also, investing in corporate bonds through a mutual fund is the best way to invest in this class of bonds. Good funds include TD Canadian Bond, Trimark Advantage Bond, and PH&N High Yield Bond ($25k minimum).

Money flows: then and now

What do behavioural trends tell us about the fate of the bond market? My guess is that it's signaling an end to the bull run on bonds.

If you're a typical Canadian investor, you've been shunning stocks and socking your savings away in bonds - but that's a more recent trend. For the three years ending December 31, 2000 mutual fund investors put more than $5 billion in domestic and foreign bond funds - about 4.5 ten per cent of total net mutual fund sales. During that same period, stock funds dominated - grabbing fully 80 per cent of the money flowing into mutual funds.

However, as would be expected, poor stock market performance has rained on that parade. In calendar 2001, bond funds accounted for nearly ten per cent of all money invested in mutual funds (while stock funds' market share halved). Further, during the first nine months of this year, nearly 30 per cent of all new money invested in mutual funds was directed to bond funds.

For the first nine months of this year, money invested in bond funds rose 80 per cent; while stock fund sales were nearly cut in half. Trouble is, mutual fund investors have traditionally had poor timing - particularly with bond funds.

Recommendation

I'm not trying to build a case for a roaring stock market going forward. In fact, I think there exist many individual stock opportunities, despite the still expensive stock indexes. However, government bond yields have fallen so much because investors have bought them in droves to hide from other riskier assets.

As a result, current government bonds look expensive at this time, compared to both stocks and corporate bonds. For more aggressive investors, I would suggest reducing exposure to government bonds, in favour of corporate bonds and, to a lesser extent, stocks. For more conservative investors, reducing government bond exposure remains a good idea, but putting the proceeds in a combination of cash and corporate bonds may be a better idea for the more conservative crowd.

I realize whenever I try to give timely advice, it amounts to some form of market timing. However, my advice usually relates more to valuations, and the relative opportunities available, rather than simply looking at charts and graphs.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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