This isn’t very contrarian advice. I’m recommending that you pile into a market that is already up 17% in the last three months. But for good reason.
You see, there is an opportunity in corporate bonds that is not going away any time soon. Despite its considerable success already, it could be the best investment you make this summer.
“The trade of 2009”, as we dubbed it in January, has done just as we had expected…
Let’s recap on the case for corporate bonds:
- Investment grade (IG) company debt, or corporate bonds, is a safer bet than stocks.
- While not quite as safe as government bonds, they do pay significantly higher yields, with some IG bonds yielding 9% a year – nearly 10 times the central bank rate.
- This market was “priced to extinction” at the end of last year. Corporate bonds were so cheap, because of the fear of default, that not only did the bonds offer a massive yield, but also the potential for double-digit capital gain.
These opportunities in corporate bonds remain intact.
But something else is developing now. The capital gain is beginning to accelerate to the point that some in the industry, including Solus fund manager Kevin Doran, believe it’s time to prepare for an “asset price bubble.”
Bubbles are normally bad news. However, rather than warning you take your money and run, we think this is an opportunity here. In our view, there is still a long way for the corporate bond boom to go…
The Bank is forever blowing bubbles
The Bank of England (BoE) has created a great opportunity...
The BoE’s 125 billion plunge into the bond market (via its Asset Purchase Facility) creates what economists call a “musical chairs” scenario. It happens something like this…
Professional investors typically have a certain desired cash allocation in their portfolios, say 5%.
The BoE buys assets from those professional investors.
Those investors, having swapped their bonds for the Bank’s cash, now find themselves with too much cash.
With interest rates so low, they want to keep that cash allocation at the low level.
Hence, in order to restore their cash allocation back down to 5%, the investor will buy other assets (read – corporate bonds) with the excess cash. The excess cash is passed on to the investor they buy from and the cycle continues.
This “forced” demand has led to rising corporate bond prices.
It is a plan that has worked a treat so far this year and as long as the quantitative easing program continues, and the Bank continues to be an active player in the market, we can continue to enjoy these gains.
Nonetheless, we must acknowledge that with this upswing in prices, the market is not as cheap as it once was…
“Shrinking spreads” are a growing threat
Now for the science bit...
Corporate bonds, like stocks, can become overvalued. However, unlike stocks, they don’t have a price-to-earnings ratio to tell you whether or not there’s a good upside still to go. But you needn’t worry, because there is a simple way to tell if bonds are too pricey or still cheap enough to represent an opportunity. It’s called the spread…
The spread is the difference between the yield on corporate and on government bonds.
And this “risk premium” has shrunk significantly.
At the height of the downturn, investors were receiving an extra 4.63% for investing in corporate debt over government debt. In practice, this meant the average corporate bond (say, for Tesco) was 7.63% if the government bond yield was 3%. But now that extra yield has shrunk to 2.84%. So an investor is receiving 5.84% instead of the 3%, a significantly lower premium.
But fear not, because while the premium has tumbled, the spread is still more than 1% wider than the average one year ago. And, for as long as the Bank of England is buying and interest rates are low, the outlook for corporate bonds will continue to be rosy. We believe that it will be a long time before the bank rate rises, with the UK likely to follow the lead of the US, which is showing no immediate signs of rate rises.
When we last looked at this idea in The Right Side on 4 March 09, we talked about Richard Woolnough’s M&G Corporate Bond fund. In the 4 months since then it is up 8.1%. The conditions continue to favour this type of investment.
Best wishes,
Theo Casey
For The Right Side
Editor’s note: Theo Casey is the investment director of The Fleet Street Letter. In February he recommended another bond fund that has not only outperformed Richard Woolnough’s M&G fund but also pays a higher yield. Theo still rates this a “buy” as a way to play the “bond bubble”. To access the in-depth report on this fund, alongside the team’s other outstanding recommendations, click here.
Note: Your capital is at risk when you invest in shares; never risk more than you can afford to lose. Please seek independent financial advice if necessary.
MARKET NOTES
The global ‘cheap energy’ drive will buoy natural gas
BY SHIVVY ARORA
Of course, a great profit strategy is to invest when an asset’s price is "beaten down", but has clear potential to rise. One commodity fits into this category and is hot in the making right now: natural gas.
Globally, governments are on an aggressive drive to cut carbon emissions. This bodes well for natural gas. It’s the cleanest-burning fossil fuel. And in the mission to reduce carbon emissions, natural gas will become more popular.
The chart below shows the one-year performance of the First Trust Natural Gas Index Fund (ticker: FCG), an ETF of companies that derive revenue from the exploration and production of natural gas. This year, FCG is up by 24%. Investment in natural gas tends to rise when oil prices go up - when oil becomes expensive, cheaper energy sources are favoured. You can see that the ETF surged by close to 30% in May alone.
Natural gas is on track for higher demand...
If you would like a larger version of the graph above please click here
Source: Yahoo Finance
Last year’s record-high gas production and the sharp cut in industrial demand led to a severe oversupply. It pushed gas prices below the $4/MMBtu mark this spring from their July 2008 peak at above $13.
But this will change.
Another factor that could lead to rising prices is the low ‘rig count’ - the number of rigs drilling for natural gas. Falling natural gas prices have led to a 57% fall in this figure to 687 from a Sept-08 peak of 1,600. This puts pressure on supply... and should lead to a favourable correction in gas prices.
Also, as oil prices surge, gas becomes more popular. And since its outlook is linked to industrial demand, expect to see this environmentally-friendly fuel rally when the economic recovery is here.
The Daily Reckoning – The ghosts of 1930
London, England
Wednesday, 1 July 2009
Last night, we went to an awards ceremony for the magazine publishing industry in Britain. Our title, MoneyWeek, had been nominated as “best weekly business magazine.”
It was a sparkling affair... with hundreds of attendees dressed in black ties and gowns. There were showgirls too – dressed in a pert ‘20s style... somewhere between the Great Gatsby and the Zeigfeld Follies. Short, tight dresses with shimmering fringes... hats with feathers... the girls served champagne and did dance numbers.
“I see the publishers association has chosen a ‘20s theme,” began the emcee. “What the f*** is wrong with you people? Don’t you know what came after the ‘20s? The ‘30s!”
It doesn’t seem like the ‘30s... yet. Ask the man on the street and he will tell you what he’s heard on TV: the worst of the crisis is over.
“June 29 (Bloomberg) -- Wall Street’s largest bond-trading firms say the worst may be over for investors in Treasuries after government securities posted their biggest first-half losses in at least three decades.
“The 16 primary dealers, which trade directly with the Federal Reserve and are obligated to bid at Treasury auctions, forecast the benchmark 10-year note yield will finish the year little changed at 3.58 percent, after rising from 2.21 percent at the end of 2008, according to a survey by Bloomberg News.”
Stocks will keep going up until 2010, says John Dorfman. The “crisis management” phase is behind us, says Jeff Immelt.
But this only reminds us of... 1930. Let us wake up the ghosts just so we can laugh at them:
“The spring... marks the end of a period of grave concern... American business is steadily coming back to a normal level of prosperity,” Julius Barnes, Head of Hoover’s National Business Survey, March 16, 1930.
“We are now near the end of the declining phase of the depression,” the Harvard Economic Review, November 15, 1930
In 1930... as in 2009... the average fellow thought the crisis had passed.
“Well... depression wasn’t so bad,” he said to himself.
There are only two forces in nature Yu Faz reminds us – expansion and contraction, up and down, love and hate/fear. “All forces must remain in balance.” Is it possible that the credit expansion that began after WWII and lasted until 2007...taking the debt to GDP ratio from about 150% to 360%... has contracted in the space of 24 months? Have the mistakes of the Bubble Epoque been corrected already? Are household balance sheets back in balance?
The markets continue their daily hum...
Read on for more Reckoning on oil… Genghis Khas… Bernie Madoff… and why this “conspiracy theory” is good for the gold price...
To read the Daily Reckoning in full, click here.
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