What Worked in the 30's?

Greed and fear are the two most significant mover of markets; more important than sales, earnings, debt and return on equity. It is only when emotions are operating at an even keel that you can talk of fundamentals or even technical parameters to gauge which way your holdings will move. Just as rampant speculation and bubbles are inevitable, so is abandonment of common sense and simple logic. It is the latter oversight that you should keep an eye on, if you want to cherry pick investments when everyone else is jumping ship or hiding under the desk.

 

In normal corrections and bear markets, you can pick out sectors, even countries or regions which have been improperly shellacked and where you may find gems. However over the last two decades culminating into the current melt down, most markets, even asset classes have become highly correlated. So, if you thought your bank shares will give you protection, you know that didn’t happen. Gold didn’t offer you any shelter and neither did can’t-slow-down world economies like China, India or the Middle East. They are all down. The knock-on effect has not been limited to regions but also asset classes like real estate and fixed income securities like preferred shares and bonds.

 

While there is good reason for even the developing world to suffer if U.S. is in trouble as we are now a fully globalised economy, trashing income producing securities like bonds and preferred shares has been quite inappropriate. For, although stocks can under difficult circumstances chop their dividends but before a company stops paying dividends on its preferred’s or interest on bonds, they have to be in dire straits. In most cases only under bankruptcy, can a company stop or defer such payments. That leads me to believe that the current thrashing of bonds and preferred shares is excessive and assumes that many corporations including the so far solid Canadian banks will go bankrupt. We can’t rule anything out but having all banks, insurance companies and telephone utilities going into bankruptcy is expecting something even worse than the great depression.

 

To invest in fixed income products, you must first orient your thinking; it is a little upside down. The value of such securities is inversely related to interest rates, i.e. if interest rates go up, their value goes down and vice versa. Now, here is the problem, government interest rates are now nearly zero in the U.S. and 1% in Canada. And yes, government bonds both here and in the U.S. are scaling new heights. Unfortunately this boon has not filtered through to the corporations. The interest rates charged by the banks or investors are at near record highs, sometimes 6% higher than government of Canada bonds. This is awful for the economy and corporations but does represent an investment opportunity for you. The only thing you have to assume is that not all of these companies whose debt you invest in, are going under and can not pay the bills. In Armageddon, that could happen but as I have argued before the economic world is not coming to an end. Actually it is better than our situation even in the dirty thirties.

 To really understand the scope of fixed income mispricing that has happened, you need to look at a picture in chart 1. In this chart I compare corporate bond yield this decade with the US government bond yield, both with  a ten year maturity period. As you can see, corporations always have to pay more than the more secure government but the spread is usually in the 2% to 3% range. Even during the 9/11 crisis, the spread did not exceed 3% in spite of a gloomy psychology pervading the world. You may recall that the then US Fed Chairman Greenspan slashed rates to virtually nothing and the markets including corporate bonds responded smartly. 

2008 is however writing history as even the most drastic cuts in interest rates by US Fed has had no impact on corporate rates until last month. If the recent drop in corporate bond yield at the end of the chart is an indication of a final thawing of this historic mispricing, we may have finally seen the worse. This may not be an all green sign to go on and buy stocks just because there is a downturn in corporate bond yields, but I do conclude that the Fed’s efforts will eventually be successful. This success will show up first in corporate bonds. Before we discuss how to take advantage of this strategy, let us revisit what happened during the 1929 crash. 

Chart 2, shows the yields on corporate and government papers from 1928 to 1936. As you can see, this was the time when the government actually raised rates after the crash making corporate money even more expensive. It wasn’t until 1932 that they came to their senses and started cutting rates furiously and finally the corporate bond yields responded. If you had the foresight to buy these bonds when the crisis was in full bloom, you collected 11% per year in income and a final capital gain of over 50% in four years. Not a bad deal, particularly when the rest of the market just kept dropping for years. In fact, stock owners didn’t make their investment back until 1954.

So, is the current stock market malaise another opportunity for fixed income investors? Barring a full blown bankruptcies across most sectors and regions, a well diversified portfolio of corporate fixed income securities like investment grade bonds and preferred shares is likely to be a big winner.

 

There are a few things you should watch out for, particularly if you decide to invest in individual securities rather than exchange traded or closed end funds. Information on fixed income is much more difficult to get. Even most brokers or advisors may not know all the covenants (clauses like early call back, redemption, retraction, reset features, subordination etc.) You should check thoroughly before investing in an individual bond or preferred share. The most glaring and recent example of such covenants costing investors much grief is the failed acquisition of BCE. There was a little clause put in by the bond holders which required a “solvency opinion” prior to the deal. Had you heard of this before the event? Neither, it seems a lot of analysts and fund managers. So, reading the prospectus over and well is critical.

 

Alternatively, you can leave that job to a manager for a fee and either purchase the exchange traded fund or closed end funds specializing in corporate bonds and preferred shares. Some frequently traded ishares, which I own for my clients and personally are iShares CDN Corporate Bond Index Fund (XCB, TSX), iShares CDN Long Bond Index Fund (XLB, TSX), Claymore 1-5 Yr Laddered Government Bond ETF (CLF, TSX) and Claymore S&P/TSX CDN Preferred Share ETF (CPD, TSX). Each has a unique blend of securities. XCB holds corporate and government bonds of short to mid term maturity (around 6 years) and pays about 5.7% yield. While government bonds have shot up, these are still far lower than its 52 week high. XLB is a longer term corporate and government bonds which have also a lot of room for capital appreciation and income of about 5%. CLF is an interesting ladder structure using 1 to 5 year bonds which is much less volatile  yet lets you participate in income (3.5% interest yield) but the potential for capital gains is lower. CPD is a portfolio of preferred stocks paying 6.5% dividend.