Sovereign & Triple AAA bonds right way to go

 

By Neil Behrmann

June, 2007:- A sharp setback in global bond prices during the past few weeks has made the vast majority of pension funds, insurance companies, traditional and hedge fund managers bearish on bonds. They fear inflation and a further increase in interest rates and thus expect bond prices to fall further and yields to surge. The pessimism of these players in the mammoth global bond market opens opportunities for investors who seek value and take the longer view.

So here's a heretical opinion. US Treasuries, German, French, British, Australian and New Zealand government bonds should be good buying opportunities in coming weeks. The basic reason for the bullish view about sovereign bonds is that a rise in yields raises the cost of medium and long term finance and mortgages. The inevitable result will be a slowdown in the global economy and inflation. Those are the conditions in which sovereign bonds and Triple A bonds thrive. Yields would drop and bond prices revive.

It is important to stress that only the best quality sovereign and AAA bonds of cash rich top companies normally perform in economic slowdowns. Credit risk on corporate and especially junk bonds increase, so they tend to underperform top quality bonds in such circumstances. Emerging market bonds are also risky during global economic slowdowns. Also, the bullish sovereign bond view does not take into account the risk of currency depreciation. Investors who buy foreign bonds should hedge against the possibility of a fall in currencies.

Before expanding on the bullish case for top notch sovereign bonds, let's examine the reasons for the recent bond slide. Since the first quarter when the sudden fall in stock markets caused hedge funds and other investors and traders to switch into bonds, the yield on 10-year US Treasuries has jumped from 4.5 per cent to 5.2 per cent, European sovereign from 3.9 per cent to 4.7 per cent and UK gilts from 4.8 per cent to 5.5 per cent. Depending on the term of the bond, capital losses in the past fortnight have been anywhere between 2 per cent and 7 per cent.

Hedge fund sellers

Bond traders and economists report that hedge funds have been caught by the surge in US Treasury and European bond yields. Hedge funds that deal in fixed income markets have been forced to dump bond derivatives. Latest data of the Commodity Futures Trading Commission show that in the week ended June 5, the net bull position on 10-year US Treasury note futures and options tumbled by 94,000 contracts from around 293,000 contracts to around 199,000 contracts. This is an indication of what has been happening as most of the activity has taken place on the much bigger over-the-counter (OTC) markets. The strain on highly leveraged hedge funds is considerable. Illustrating the scale of OTC credit derivative trade, the Bank For International Settlements' June 2007 quarterly report shows that the market for credit default swap derivatives expanded by 42 per cent in the second half of 2006. Notional credit default swap amounts outstanding surged to around US$28.5 trillion at end-2006 from around US$20 trillion in the first half of 2006 and around US$10 trillion in the first half of 2005.

There is thus good reason to believe that the extent of loss-incurring highly leveraged derivative trading and borrowing has caused panic in bond markets. Hedge funds and other speculators trade on small margins. So small percentage price declines cause extensive losses.

Reasons why sovereign quality bonds will perform

The short-term traders who have been forced to dump bonds enable bargain hunters to purchase bonds on a long term view. The longer the life of the bond, the bigger the potential price rise or fall of the security. So prudent investors, playing safety first, are buying two to five-year government bonds instead of 10, 15 and 30-year bonds. Bond bears have put forward the view that the global economy will continue to expand and accelerating inflation will cause a rise in interest rates. But there are also numerous reasons why medium and long term sovereign bond prices could soon bottom out.

The global real estate boom should come off the boil as the cost of mortgages rises. The construction industry and US housing starts have already begun to decline. This, in turn, has led to lower consumer confidence and spending.

The decline in global economic growth rates will ultimately prick the commodity price bubble. Once prices fall, inflationary expectations will abate. To prevent recession, central banks could stop raising rates or even let them fall. This would boost bond prices and lower yields.

Current high bond yields, or the increase in long-term interest rates, will raise the cost of debt-financed leveraged private equity and management purchases of corporations. This would end the mergers and acquisition fever and stifle the equities bull market. Money would thus shift to the safety of sovereign bonds.

It will pay to be a market heretic.

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