Since central banks need to cut rates continually to boost their economies and the deflationary risk is becoming bigger, I reckon the stock market may not escape from the bear market any time soon, and bonds will definitely be a more attractive investment.
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Market Mood
Paul Pong
23 November 2008
In a recent comment piece, Warren Buffett encouraged the buying of US stocks. He pointed out that if investors hold cash, they will underperform the stock market in 10 years.
The fund manager of BlackRock Global Allocation Fund, Dennis Stattman, also believes the cash proportion of individual portfolios should be reduced. He says he would selectively buy Japanese stocks, corporate bonds, US dollars and Japanese yen.
Although there are a lot of uncertainties and stock markets are volatile, I agree with Mr Buffett’s and Mr Stattman’s view that cash is not king. The difference is that I believe bonds are much more attractive than stocks.
The oil price has gone down by more than half from its US$147 peak, and the risk of inflation is no longer a concern. The year-on-year increments in the mainland consumer price index and the producer price index, for October, have dropped by 4 per cent and 6.6 per cent, respectively.
Inflationary pressure has even eased in developed countries. In the US, the October producer price index has slumped by 2.8 per cent month on month.
More and more central banks have thus become confident enough about the price situation to cut interest rates in a bid to arrest recession. Actually, the risk of recession now far outweighs the threat of inflation.
The US Federal Reserve has hinted it may cut its benchmark interest rate to a historical low, possibly close to zero per cent. That unprecedented move would stimulate the bond market.
For those who have never ventured into bonds, the return is normally measured by yield. The bond price and yield are inversely related. When the yield falls, bond prices will rise, and vice versa.
The yield includes risk premium. For example, emerging-market government bonds have a higher yield than US Treasury bonds, and the yield of corporate bonds is higher than government bonds. In the past six months, as central banks cut rates, corporate bond yields did not fall, reflecting their rising risk premium.
Bonds also have different maturities and durations. The longer the duration, the more sensitive the bond is to the yield. The current yield of 10-year treasuries is above 3 per cent. If the Federal Funds Rate persists below 1 per cent, the 10-year Treasury yields may drop to 3 per cent or below, and bond prices will go up. Therefore, cutting interest rates benefits short-term and long-term Treasury bills and notes.
On the other hand, the risk premiums of corporate bonds and emerging-market bonds have risen to a high level. According to the data from Markit, the five-year CDX North American Investment Grade and CDX North American High Yield index hit their historical highs at around 200 basis points and 1,200 basis points, respectively. Two years ago, the indices were at the levels of 30 basis points and 200 basis points.
The JPMorgan emerging-market bond index - spread against the US Treasury curve - has expanded to nearly 900 basis points, reflecting investors’ worries on the solvency of corporate and emerging-market governments.
But I think the severity of the risk is less than anticipated. The spread between three-month London interbank offered rate, or Libor, and overnight interest-rate swap has begun to fall, reflecting an improvement in the liquidity situation. It is widely believed that bond risk premiums will also drop slowly, and thus bond prices will rise.
Recently, many countries released their third-quarter gross domestic product figures. As expected, the global financial crisis has spread to the real economy. The GDP in the eurozone, Japan and Hong Kong fell for two straight quarters and these economies thus technically entered recession.
From the point of view of capital structure, companies have to pay coupons to bondholders before distributing dividends to shareholders.
In a long-lasting recession, companies without sufficient cash flow have to cut the dividend, which hits stock prices.
When a firm goes bankrupt, bondholders receive the refund first while stocks become worthless. Therefore, bonds are expected to perform better than stocks in severe circumstances.
The threshold of bond investment is higher than stocks. Also, the risk of individual bonds is quite high, while bond funds can diversify the risks. Aggressive investors may invest in high-yield bond funds or emerging-market bond funds, while conservative investors may invest in US or global investment-grade bond funds.
Since central banks need to cut rates continually to boost their economies and the deflationary risk is becoming bigger, I reckon the stock market may not escape from the bear market any time soon, and bonds will definitely be a more attractive investment.
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