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Spectre of inflation divides the bond world

Whether inflation rates rise or fall, long-term corporate bonds are an asset class to consider

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When the second wave of COVID-19 hit India in May, the popular Indian Premier League cricket was in full swing. It was called off as infections spread to players and support staff. Many players stepped forward to help. Some donated to international charities. One formed his own charity and asked for donations. Another formed a group of volunteers arranging hospital beds and oxygen cylinders. Individuals chose a way to help that gave them satisfaction.

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Investing is similar. Investors choose bonds, stocks, mutual funds, ETFs and real estate based on personal preferences. A comfortable mix of assets can provide not only returns but also peace of mind. Chasing returns is stressful, but remember that someone will always make more than you do, so keep your expectations realistic.

Investment decisions become harder when inflation is on everyone’s mind.

Canada’s annual Consumer Price Index, or CPI, rose to 3.6% in May, its fastest acceleration in a decade. The American CPI was hotter, rising 5% from a year ago, its largest annual gain since 2008. Central bankers believe these numbers are transitory because of the low base effect and the sudden reopening of the economy that has caused a scramble for commodities. Shipping bottlenecks, too, have added to price pressures.
Many investors are not convinced by this argument, however. They believe that massive fiscal and monetary stimulus will create inflation. Product and labour shortages are here to stay.

This is the ongoing debate in the bond world. One side believes that inflation will stay around 2% as it has since 1991. The other side believes that the central banks will lose control and inflation will return to the runaway levels of 1971 to 1981.

It is important to pay attention as interest rates consist of two parts, inflation and “real” interest rates. The real interest rate is the difference between nominal interest rates and inflation. All things being equal, higher inflation should translate into higher interest rates.

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But it is difficult to predict the path of inflation. And even if one has a working crystal ball, where should interest rates be? Real rates have been negative in Japan and the Euro zone for some time now. This means that inflation has been higher than what an investor receives on a government bond. Not only that, a large number of government bonds globally are also negative yielding!

Inflation and long-term corporate bonds

Even as the macroeconomics are overwhelming, long-term corporate bonds need to be considered in an inflationary scenario. These bonds are issued by investment-grade companies and their terms are longer than 10 years. During the first quarter of this year, as inflationary fears caused long Canada yields to increase by 0.76%, the FTSE Long Term Corporate Bond Index fell by 8.3%. It is not for the faint-hearted!

The current valuation on long-term bonds is attractive. A historical charting of the spread or excess yield of long-term corporate bonds over government bonds since 1976 in Canada gives an average excess yield of 1.33%. Prior to the credit crisis of 2008, a period of almost 30 years, the corporate bond spreads traded 1-2 standard deviation tighter than the average. The tightest level was 0.26% over government bonds achieved in 1980. Since the credit crisis, the average has been higher. The spreads, currently at 1.58%, have rallied hard from March of last year but remain above average levels. Can we go to the historic tighter level experienced for 30 years? It is possible.

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Long-term corporate bonds are a broad investing asset class that includes amortizing bonds that partially pay principal that can be reinvested if interest rates are climbing. Since they pay down principal, their “duration” or effective term is shorter than a bullet bond. Certain corporate bonds carry a lower coupon and become discounted once interest rates go higher. These bonds exhibit convexity, meaning they do not fall as much when interest rates go higher.

These discounted bonds become attractive for investors because of their tax effectiveness. Long-term corporate bonds have also been “stripped” by investment dealers. All the semi-annual coupon payments and the principal payment is available to buy separately. These strips offer higher yields than the underlying corporate bond and are also at a discounted price.

Performance during inflationary periods

An article in the Wall Street Journal, “Inflation Forces Investors to Scramble for Solutions” by Sam Goldfarb, explains the performance of different asset classes during inflationary periods going back to 1973. A high (defined as a rate greater than 3%) and rising rate of inflation was not good for U.S. mid-term Treasurys. If you are convinced that the inflation rate is going higher, then commodities is the place to be.

However, a few other scenarios of falling inflation or mildly rising inflation were not bad for bonds. This was in the context of U.S. mid-term bonds, but the trend would be similar for Canada and long-term bonds, too.

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    Inflation a headscratcher for investors

On March 31, 2021, the yield on the FTSE Long Term Corporate Bond Index stood at 3.54%, compared to the FTSE Long-Term Federal Bond Index at 1.96%. It is useful to convert this yield into P/E multiples by dividing into 1. The long-term corporate bonds have a P/E of 28x, and for the long-term federal bonds it’s 51x. These are expensive levels.

But compare this to the equity indices. The P/E of the TSX is 23x, and for the S&P 500 and NASDAQ it’s around 37x. The Dow Jones Industrial Average is at 29x. Corporate bonds rank senior in a capital structure of a company compared to preferred shares and equity. So, in a default scenario of a company, its bonds should salvage more than preferred shares and equity.

The coupon payments of a bond are fixed, while the cash flows for an equity investor can grow over time. Matt Levine reported in Bloomberg recently, however, that in a broad benchmark of U.S. stocks known as the Russell 3000 Index, there are 726 companies whose earnings do not cover their interest payments. That is 24.2% of U.S. companies!

Rise of zombie companies

Equity investors remain oblivious to default risk. But who can blame them? Levine writes further that these zombie companies are up an average of 30% this year, and 41 of them have doubled since the beginning of the year.

As inflation goes higher, interest rates climb, long-term bonds fall and equities go higher. This is the logic. The correlation between stock and bond returns, however, needs to be evaluated. Paul J. Davies writing in the Wall Street Journal presents a historic correlation chart. The negative correlation between stocks and bonds is a recent phenomenon since the late 1990s. It is highly likely that, going forward, stocks and bonds will move in the same direction.

The contributions by cricketers, in their own way, helped bring down the number of COVID cases in India. Investors should also consider the risks of inflation when building their portfolios. They should also consider the risks of deflation. Long-term corporate bonds are an asset class to consider.

Vivek Verma is a Portfolio Manager at Canso Investment Counsel Ltd. in Richmond Hill, Ont. He was awarded his CFA charter in 2004.