2010 has been a very interesting year for bonds, with the European sovereign debt crisis significantly affecting prices in that region. Another big story was with US treasuries, which have seen a huge run up in prices with plenty of investor demand during the second and third quarters of 2010, only to see a sell off in last the few months of the year. 2011 will be another year of uncertainty and investor worry in global bonds. However, things will be more moderate in North America.
2011 European Bonds Outlook & 2010 Year-End Review
In early 2010, Greek bonds as well as bonds of other European nations declined steeply, due to sovereign debt concerns. Greece had their bonds downgraded by Moody’s Investors Service to junk bond status in June of 2010.
After receiving a bailout by the IMF and Germany, Greece successfully raised €1.625 billion ($2.04 billion) in a debt auction (sales of government bonds) in July. However, massive protests and labour strikes against much needed austerity measures show that the people simply do not understand the dire situation that their country is in. We can expect Greek bonds to remain low despite the successful bond auction. The country’s financial situation is unlikely to improve much in 2011, due to the country’s internal turmoil and the population’s unwillingness to accept the much needed change.
Spain, Turkey, Portugal, Italy, and Ireland, also saw considerable rating downgrades during the year of 2010. In July Moody’s credit rating agency downgraded Portugal’s bonds, saying it expected the government’s debt situation to continue to deteriorate for at least two to three years. So far, Portugal has not experienced the liquidity problems of Greece, and has been able to raise money on international markets. In 2011, it would not be unexpected that Portugal would require some level of financial aid from the European Union and IMF. But it is unlikely to be anywhere near the level of Greece’s aid.
In early November 2010, investors sold off Ireland bonds, sending prices on 10 year bonds to a new low, and the corresponding interest rate to a new high. [Price and yield are inversely related, so as the price goes up the yield decreases] Ireland’s financial troubles continued to concern investors, who drove interest rate on the country’s 10 year borrowing to a new high. On 12/17/2010 rating agency Moody’s Investors Service, gave Ireland’s debt rating a rare and steep 5 notch downgrade, from Aa2 to Baa1 rating, sending the Irish bond prices sharply lower. Moody’s warned that further downgrades could follow if Ireland was unable to stabilize its debt situation. In 2011, we can expect Ireland’s debt situation to be unstable and uncertain. On 12/15/2010 Ireland’s parliament approved a €85 billion EU/IMF bailout package on in the face of opposition and the Fine Gael party’s threats to renegotiate the deal to force losses on some senior bondholders in Irish banks. It is likely that the Fine Gael will lead a coalition government following an election in 2011. The party said that investors who hold senior bank debt not covered by a government guarantee (around €15 billion euros), should take a share of the losses. It would not be unexpected that the bonds will see another ratings downgrade from Moody’s if the debt situation remains unstable. It is likely bond prices will continue to drop as investors shed Irish bonds, for more stable bond investments.
The Bank of Spain released data in December of 2010, showing that bad loans in Spain’s financial sector (banks, financial cooperatives, retail credit cards) rose to 5.66% as a ratio of total lending in October 2010. Total bad debts increased to 103.7 billion euros in October, compared to 101.3 billion in September. The bad loan ratio at savings banks rose to 5.5% from 5.34%. The bad loan ratio for exchange listed banks increased to 5.8% from 5.58%. Spain’s high unemployment (1 in 5 Spaniards) and worsening economy due to the bursting of a the real estate bubble, will continue to strain debt repayments in 2011. The real estate sector has remained anemic with many “ghost” cities of vacant properties in the country. The economic situation has not yet stabilized and will continue to worsen in the coming year. It is very likely that the nation will require financial assistance from the IMF and European Union. It is also expected that Spanish debt will receive downgrades by Moody’s in the next 12 months.
In December, European Union leaders agreed to rewrite EU treaties and rules, to help deal with future euro crises. During the record 7th summit held this year, they approved an amendment to the EU treaty at Germany’s urgent request to permit the creation of a European Stability Mechanism to handle financial crises from June 2013. The ESM replaces the temporary fund created in May 2010, and will be empowered to grant loans on strict conditions to member states in distress. Private sector bondholders would share the cost of any writedowns after 2013 on a case by case basis. In 2011 we can expect such discussions to continue. We can expect open issues such as debt sustainability, and potential insolvency problems prior to 2013 to be discussed. Despite its opposition from Germany and other wealthier nations (Austria, Netherlands), a euro-wide bond (e-bond) may also be discussed. I do not rule out the possibility of a European Union breakup or separation, in which case we would see bond prices in the region plummet. I wouldn’t expect this to happen in 2011, but won’t rule it out in the coming years.
2011 US Treasuries / United States Bonds Outlook & 2010 Year-End Review
Measures of underlying inflation have trended lower during the first few months of 2010, which raised fears of Japan style deflation (economically worse than high inflation). However, European debt downgrades have caused investors to move back into “safe” US treasuries particularly starting in the second of 2010, which pushed the yield closer to two year lows (prices closer to two year highs).
In August the US Federal Open Market Committee stated that the Federal Reserve will help stimulate the slow & weak economy by purchasing more Treasuries, using funds from agency debt and mortgage-backed securities. Buying back Treasuries increases the money supply in the country, which is meant to help loosen credit/lending and encourage spending. This fueled bond investors’ purchase of US government debt. During the week of 8/23/2010 investors continued to buy large amounts of US government bonds (treasuries), while selling off stocks. Investors can usually buy treasuries directly or more commonly through bond funds. Bond funds had attracted US$559 billion industry-wide in the past 30 months through June 2010. Bonds returned 16% within that 30 month period, while stocks returned -26%. Investors had removed US$209.4 billion from domestic (US) equity funds, as well US$24.4 billion from funds that purchase non-US stocks. With the increase in price, the yield on the 10 year US Treasury note had declined to 2.41% in October of 2010, the lowest level since Dec 2008 (when it was less than 2.20% during the height of the financial crisis). This meant that equities had become cheap (i.e. stocks were selling for much less than they should have been) as investors retreated from the volatile stock markets in search of stability in US bonds.
On 10/5/2010 Warren Buffett, who was a guest speaker at Fortune’s Most Powerful Women Summit in Washington, had said that it is “quite clear stocks are cheaper than bonds”. He also stated that he “can’t imagine” the rationale for adding bonds to your portfolio at the then current prices. “We are following policies that unless changed will eventually lead to lots of inflation down the road”. “We have started down a path you don’t want to go down.” Despite the Oracle of Omaha’s direct warning, US bond purchasing continued, causing yields on 10 year US treasuries to reach reach near record lows at 2.17% in November 2010 (US treasuries reached near record high prices).
In November the US Federal Reserve announced it is committing $600 billion to buy more government bonds/treasuries in order to stimulate the weak US economy. This was the second massively large and unconventional program of quantitative easing (money printing). US treasury prices began to fall as investor confidence began to wane. In December, US Federal Reserve chair Ben Bernanke defended the $600-billion US Treasury bond purchase plan on national television. He said the economy was still struggling to become “self-sustaining” without government help and also indicated further stimulus may be required in 2011. In the days following Bernanke’s comments, yields on 10 year US treasuries rose sharply to a six month high of 3.27%, after prices dropped in the largest two day sell off since September 2008 (when Lehman Brothers collapsed). US treasuries continued to fall through the month of December as investors reduced their bond holdings after government data (prices and trade) suggested stronger than expected economic growth in the fourth quarter and easing deflation risk. Investors had started to put money back into US equities. The yield on 10 year US treasuries rose to six month highs (prices dropped to six month lows). Retail investors withdrew a record net $US8.6 billion from bond funds during the week ended December 15. This was on top of the US $1.7 billion of outflows during the prior week.
This downward bond trend is likely to continue, as corporate earnings are expected to continue improving at a moderate pace. At the state and local government levels, fiscal strains have been increasing, particularly with high pension liabilities. As more of these issues surface, investors will continue to push American bond prices lower, including municipal and state debt. With the stabilizing economy, investors’ appetite for US equities and more riskier assets will increase, while bond demand drops. However, it will be at a more moderate pace in 2011 than we’ve seen in the past few months (paralleling the pace of corporate earnings and surfacing state/local government problems).
2011 Canadian Bonds Outlook & 2010 Year-End Review
Canadian bonds have seen significant interest from investors worldwide. By August 2010 foreign investors had bought a significant amount of Canadian bonds. Statistics Canada said non-residents purchased $11.1 billion of Canadian securities, with the majority of the investment going to corporate and government business enterprise bonds. Non-residents invested $10.8 billion in Canadian bonds. But non-residents reduced their holdings of Canadian money market instruments by $705 million in August 2010. This data also contrasts the $995 million of Canadian stocks acquired by non-residents, and $3.4 billion of foreign securities (led by foreign stocks) acquired by Canadians.
We can expect this trend to slow to a more moderate pace in 2011, as Canadian household debt has increased to extremely high levels, at 144% of disposable income. Fiscal stimulus will also end in 2011, but the current account deficit has continued to widen. Canada’s continuing weak net exports and productivity (declines in GDP) are a concern. With record high housing prices, and affordability becoming an issue, the Bank of Canada and government may take more steps in 2011 to decelerate the housing market. Rate hikes in the second half of 2011 can be expected. The cost of borrowing is expected to continue to increase at a steady and moderate pace (i.e. bond prices to fall slightly).
Although, much capital inflows into emerging markets particularly in Asia have occurred in 2010, investors will need to watch how successful China’s taming of inflation will be in 2011. China’s central bank have again announced another interest rate rise, effective 12/26/2010 (second time in just over two months), as it stepped up its battle to rein in high inflation. Rampant inflation or too severe of a clamp down on inflation, may cause instability. China’s “ghost” cities which can house half of America’s population is just waiting to implode, if the nation cannot control its inflation in a steady manner and slow the speculation in its domestic real estate market.
This article only touches on a few issues, but it should help investors as a starting point with their own research and analysis. It is important to note that this article is meant to outline conditions which are likely to affect this specific area of investment. Keep in mind the information in this article is not meant to be a set of predictions. It is meant as a discussion of highly probable scenarios of what we can expect to see happen, based on the information available today. By knowing the likely possibilities, we can plan for them. We can also capitalize on potential opportunities, and will not be caught off guard by possible negative events. Investors should also remain flexible in their view & outlook, and change it as the influencing conditions change.
UPDATE: List of 2010 year-end summaries & 2011 outlooks:
• 12/22/2010: 2010 Year-End Market Summary
• 1/7/2011: 2011 Currencies Outlook & 2010 Review
• 1/17/2011: 2011 Mergers & Acquisitions Outlook and 2010 Summary
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