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A History Lesson

Here is a recent column from Harry Koza:

Bonds ain't what they used to be

Harry Koza

15:14 EST Thursday, Sep 28, 2006

TORONTO (GlobeinvestorGOLD) -

"You see those young bucks over there by the bar, Harry, rubbing the metaphorical velvet off their antlers?"

"Sure, dude, those two on the left are Canada traders at Royal Scotia Dominion World Capital Markets, and that other guy is some hedge fund black-box geek."

"Traders," replied my grizzled interlocutor. He grimaced. "Bonds ? they go up, they go down, how hard can it be, right?"

"Absolutely," I agreed eagerly. I know better than to interrupt an old warhorse just as he's starting his charge.

"You know what day this is, don't you? It's the 25th."

"No man, it's Friday, Sept. 29."

"Yes, that's correct, Sept. 29, the 25th anniversary of the absolute bottom of the bear market in bonds, and the start of the great 25-year bull market that is all those insolent young whelps over there have ever known."

I knew that I was about to be transported back to the glory days, when bond traders bestrode the world like colossi and became legends (some of them even achieving mythical proportions), back when traders had balls so big they generated their own gravity fields, so I took a big gulp of my Laphroig and settled into my chair for the ride.

"Sept. 29, 1981. The benchmark long Canada, the nine-halves of '01 (9.5 per cent Government of Canada bonds maturing in 2001) were trading at $54.50. Three years earlier, they'd traded at $108.

"The Bank of Canada issued a two-year bond with an 18.75-per-cent coupon, and the issue damn near failed. Everyone thought interest rates would keep going up for ever, and the bonds barely cleared the books. Five-year bonds traded on that day at a yield of 18.65 per cent, 10s at 18.14. The bank issued eighteen-halves (18.5 per cent) of '86, extendible to 1991, and you couldn't give 'em away, even with the embedded option. This was before auctions, too, and the bank paid sweet commissions on their new issues. Tell you what, though, a couple of canny accounts loaded up the truck with them and basically could've taken the next 10 years off and still outperformed everybody six ways to Sunday."

"I remember when they extended them," I encouraged. "They didn't issue 30 years then, only 20s. The new long bond in the fall of '81 was the 15 and three-quarts of '01, if memory serves. Never quite caught on as a benchmark, did it?"

"They never had a chance to reopen it. The next day, bonds actually went up in price, about three-eighths of a point, as I recall, and yields that high were never seen again. U.S. Treasuries topped out about the same time, with 10 years at 15.85 per cent and long bonds at 15.31 per cent. Ha! That's what you call an inverted curve, -54 beeps from 10 out to 30 years! And they're all obsessed with that piddly little curve inversion we've got today. Pathetic, really."  He shook his head and took a long pull at his beer.

"After that, it was easy money, if you were long. Those fat coupon Canadas were pure gold. And they traded at a huge premium to bonds with on-the-run coupons, too, like 150 to 165 beeps more. It was just around this time, too, or shortly after, that people were starting to use computers on the desk."

"Yeah, rocket science PCs with 256k of RAM, and MS-DOS on six-inch floppy disks."

"Yeah, and Bloombergs hadn't been invented yet, either. Still, someone finally figured out that those jumbo coupon bonds were worth lots more if they were cut up into coupons and resids, and the strip-bond market was born. Today it's huge ? dealers have whole desks selling 'em."

"The very backbone of RRSP bond holdings."

"Indeed. Or ought to be, at least. Anyway, bonds never looked back. Ten-year U.S. Treasury yields bottomed on June 16, 2003, at 3.07 per cent, their lowest yield in 45 years. U.S. long bonds on that day were yielding 4.14 per cent, also the lowest in 45 years. There will never be such a bull move again."

"Oh, don't say never," I demurred. "You are talking about government debt here. This fiscal probity thing won't last forever, especially if Bob Rae or Jack Layton ever becomes PM."

"Seriously, I mean it. You look at government bond yields going back to 1880 or so, and they range between 2 per cent and 6 per cent, except for those crazy years in the late 1970s and early '80s. That inflationary bear market was an aberration, like 25-per-cent stock market returns during the tech bubble."

"Which 10,000 hedge funds are still chasing."

"True. But stock returns are regressing to the mean, and so are bonds. Which is why those gormless yobs over there, with their fruity martinis and their BlackBerry fetishes, get my goat. The yield ranges they trade were just market noise in my day. I kind of miss those high-rate days."

"Yeah, I know I'd sure love to be able to load up my RRSP with government bonds yielding double digits. Still, you've got to admit it's a heck of a lot easier to carry a mortgage at today's single digit rates."

"That it is." He drained his beer and pushed back his chair. "Well, gotta go. A bunch of the old boys are getting together for the 25th anniversary of the Bond Bull, have a few pints, tell some tales ? ya wanna come?"

"Love to, dude, but I gotta catch the 5:30 back to the 'burbs. Give my best to the lads, though, and Happy Anniversary."

Harry Koza,

Sr. Market Analyst,

Thomson Financial,

36 Green Meadow Crescent,

Richmond Hill, Ontario,

L4E 3W7

905-773-0328

harry.koza@thomson.com

hkoza@aci.on.ca



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