Yield Signs: Fixed Income. The bond market has spoken: Harper's not the bogeyman
February 3, 2006
Lately, much has been made of the bond market's predictive power, how the shape of the yield curve can forecast recessions or incipient stock market booms or the level of next year's hemlines in Milan, for all I know. Besides the army of traders and salespeople just trying to clip a nickel or an eighth on the way through, there are hordes of highly paid rocket scientists attempting to read the ebb and flow for signs and portents: technical analysts scrying their charts; econometrists doing whatever the hell it is they do; strategists surveying for the right spot on the curve. Whatever.
Thing is, it's like trying to read the entrails of goats, attempting to digest the chaos that drives the tsunami of information, and, as traders like to say about economists or chartists that make a good call, "nobody's ever right three times in a row." Just ask those "Dow 30,000" guys -- mind you, they weren't even right once.
But there are times when bond yields are great indicators of what's going on in the world. By way of illustration, consider the long Quebec/Ontario roll. It may sound like some strange kind of sushi -- "I'll have some tekka maki and a couple of those long Quebec/Ontario rolls, maybe an order of poutine on the side" -- but it isn't. The long roll is selling long-dated Quebec bonds to buy long-dated Ontario bonds, or vice-versa.
Quebec bonds trade at a higher yield than Ontario bonds, mainly because Quebec has a debt-to-GDP ratio of 44 per cent, much higher than Ontario's, but also a little because of the whole sovereignty thing. You remember, that really, really scary thing from which just a few weeks ago, Paul Martin said only he could save us, or maybe he was just talking about Sheila Copps re-entering politics. Anyway, in early December, just after the campaign started and the Martin campaign was warning the electorate, "Apr?s moi, le deluge," you could sell an Ontario 30-year bond, and buy a Quebec 30-year bond, and pick up 19 basis points in yield. Just last summer, it was only pick 13.
A basis point on a 30-year bond is worth about 16 cents in price, or $16,000 on $1- million in bonds, so if you're a trader swinging around chunks of 20 million, you're talking real money. Now, pick 19 on the long roll seemed ridiculously cheap, once you considered that the next Quebec provincial election is two years away, and besides, there's no guarantee that the P?quistes can beat the provincial Liberals in a fair fight anyway, so the threat of another referendum any time soon is ephemeral at best. The spread widening had a lot of domestic traders scratching their heads with one hand while pushing buttons on their Bloombergs and screaming, "mine," into the phone while they lifted offers. Meanwhile, institutional investors offshore, panicked by the prospect of separatism rearing its ugly head, were doing their usual GMO (get me out!), which is what helped the roll widen in the first place.
Now that the furor of the election has passed, the ripples caused by the media storm have calmed down, and by today, if you had bought long Quebecs on the roll at pick 19 basis points last month, you could sell them to buy back your long Ontarios at around give or take 12 beeps, pocketing the difference. Say you had done the trade $20-million a side, you'd have made $224,000; since, if you were a trader and could do this size, you only had to put up a fraction of the value of the trade as margin, your rate of return was huge.
While you and I can't transact cheaply enough to do this kind of thing, or do the size (well, maybe you can, but it's well out of my investment bracket), the point is that the market has reacted to the outcome of the election, and it is saying, basically, that maybe Stephen Harper isn't that scary after all, and that maybe he'll be good for inter-provincial relations. And after all, the bond market is never wrong.
Now for something completely different. People -- laymen, that is, not Bay Street's priests of Mammon, but regular folks -- often tell me that they don't really understand the bond market. That's okay, I usually reply, neither does anyone else, least of all me.
But now, help is finally at hand. Veteran bond trader W. H. (Hank) Cunningham, the king of retail bonds, has written a book, called, appropriately enough, In Your Best Interest: The Ultimate Guide to the Canadian Bond Market. It's published by Dundern Press, and available in bookstores everywhere. It's a tour of the bond universe, aimed at the individual investor. Hank, who has been in the bond business pretty much since the Pleistocene age, explains everything from how to strip a bond to how the yield curve works, from duration to laddering, from asset-backed securities to distressed debt.
It's a handy tool for anyone looking to invest in fixed-income securities, and sheds light on what, for most people, is a particularly opaque part of the investment world.
Harry Koza is senior Canadian markets analyst at Thomson Financial and a columnist for GlobeinvestorGOLD.com.