Monthly Commentaries

Time to exit long term government bonds – November, 2007

November was an astounding month. The daily movement we saw in all markets was greater than anything in recent memory. Even the Canadian dollar experienced three days where it moved over 2.5 cents – movement not seen since the 1995 Quebec referendum. By the end of November U.S. markets had lost just over 4%, the TSX was down almost 6.5%, and the Canadian dollar erased all of its October gains. The drop in 10-year U.S. bond yields to a meager 3.8% was an underreported but significant move in the capital markets. At the end of June U.S. 10-year government bonds yielded 5.3% and market participants were increasingly concerned about possible inflation risks. As the scope of the problems in the asset backed market came to light, the yields relentlessly slid lower.

The current 3.8% yield means that after taxes and inflation investors are earning a negative return. Yet, it seems investors can’t get enough bonds. From our perspective, this drop in yields has been due to three factors. First, there has been a flight to the safety of government bonds. Investors want to hold government bonds and wait for volatility to subside. Second, hedge funds that follow trends have piled on to this trend hoping for the move to continue. Finally, the managers of mortgage backed securities need to buy government bonds to hedge the movement in their mortgage bonds. The combination of these factors has pushed bond yields to levels last seen in 2003, when overnight rates were 1.0% (today overnight rates are roughly 4.4%).

The only way for bond investors to make significant money from this point forward is for the U.S. economy to drop into recession and deflation. Although we continue to worry about potential deflation, we don’t see this combination of factors coming into play. It may seem counterintuitive but investors should shun the safety of government bonds and increase their exposure to equity markets. The equities in the Toron portfolio are at the cheapest levels we have seen in years and now bonds are at the most expensive seen in years. Often the best move in markets is the one that feels the least secure. Arthur Heinmaa, CFA Managing Partner