The answer to the headline just might apply to the broader ‘what is going on in the stock markets?’ Ditto for the gold prices and bitcoin and so on. Trying to make sense of any asset price is more than tricky business these days. Nothing seems to make sense. The velocity of price movements is unprecedented at times. Things will likely become more normalized in the near future. Hopefully this post helps to frame what the heck is going on with Canadian bonds?
I understand how bonds are supposed to work. I’ll admit I often (recently) don’t understand how they work.
Mostly, the issues are largely due to margin calls, traders, a lack of liquidity in underlying bonds and future expectations. Of course the risk of the various bonds is factored in. Bonds are priced. They do not trade in robotic fashion based on yields and changes in yields or bank of Canada rate setting.
Margin calls. Borrowed monies.
Mostly what I hear from experts is that margin calls have been forcing the hand of many. It would be very alarming to most investors the extend that borrowed monies plays in the market and the market moves. When assets such as stocks fall in quick order those margins can be at the ‘centre of things’. Ya gotta pay the man. Those ‘investors’ will have to sell most anything that is working well enough to pay up.
They’ll sell bonds, gold, bitcoin, a kidney, their condo. Whatever it takes to scrape together monies. They’ll have to sell some of those stocks too. That has been driving many of the waves of stock market selling and the violent moves to the downside. And again, margin has also put pressure on bonds in recent weeks.
It’s a violent negative feedback loop. Selling for margin calls begets another round of selling for margin calls.
Most of us investors pay the price for how margin distorts the markets. When I wrote the stock markets are ridiculous, I guess that’s what we were talking about. We can apply that ridiculousness to the bond markets at times as well.
And bonds of all types can be part of the arsenal of hedge funds and other traders. They can and will move massive sums that move the markets in violent fashion. And then another trader can move in to react to attempt to capitalize or hedge. While many of us are attempting to invest for the longer term, and be patient, the prices are often at the mercy of traders. And certainly fund managers and pension fund managers can also get in on the act.
Long term investors and short term investors collide.
It’s your job to ignore the traders. Obviously that’s not easy. In fact, it’s never been more difficult.
Here’s an example of a carry trade brought to my attention by Arthur Salzer of Northland Wealth Management.
As for selling govies to fund purchases of corporate debt – it’s called the carry trade. The key is to have out of the money puts (which reduce return) but provide insurance should spreads widen too far.– Arthur Salzer, CEO of Northland Wealth Management
Of course most of us will go ‘what?’. Arthur could give us a million of ’em.
And not all of the ‘blame’ goes to the traders. On the corporate bond side, companies and those who rate the bonds bear some responsibility.
Companies have been borrowing excessively for stock buybacks due to low interest rates. Many companies should have been downgraded to non-investment grade due to lack of covenants and leverage ratios. However, like last time, bond rating agencies believed management and didn’t downgrade as investors reached for yield. It appears the time of reckoning has finally come after an extended cycle.– Arthur Salzer
Arthur then went on to mention that bond holders are now running for the door. They can’t get out fast enough at times.
Bond markets have their own ideas.
The market prices have not behaved, perhaps as expected on the shorter and longer ends of bond markets. I checked in with friends at BlackRock. They run the iShares ETF operations as you likely know. This is in response to bond activity the week ending March 13. Many Cut The Crap Investing readers are wondering why bond funds are not ‘going up when stocks go down’.
Two things worth highlighting with respect to the performance of bond ETFs this week: first, the action in interest rates had shorter-term rates falling but long-term rates rising. Even in normal markets this type of interest rate scenario would cause declines in bond ETF prices. Secondly though, bond ETF prices were reflecting widening spreads and lack of liquidity in provincial and corporate bonds.– BlackRock
This from our friends at BMO ETFs …
When we look at bond yields, it’s important to look at the entire curve and not just focus on Bank of Canada announcements that mostly impact the short end.
We use the 10 year Bank of Canada bond as a proxy for the wider bond market, as it is close to the term and duration of the market.
Yields reached their lows on March 9th, and have since increased. As such bond pricing peaked on March 9th and have since declined. The move to yields on March 9th to just over 50 bps appears overdone for the short term and has since retracted. As bond yields are very low, the market has already priced in a lower expectation of future growth.
Overall, you can see the yield curve steepening, as short term rates have declined on the back of Bank of Canada intervention.
We should keep in mind that even good bonds do not always offer that inverse relationship to stocks in the short term. There’s no guarantee that bonds will always work. For risk managers we might favour those mid to longer term Treasuries. Especially US Treasuries. I wrote on the treasuries on February 1 in how to prepare your portfolio for the coronavirus outbreak. You’ll see those shiny gold bars in that post as well.
Bond ETFs continued to price the bonds.
There was concern that bond ETFs could suffer in periods of panic bond selling. In fact, bond ETFs continued to trade and price even as the bond markets froze up. Many read or heard of bond ETFs selling at a discount to Net Asset Value, NAV. Quite simply the market makers who price the ETFs had their own idea as to the actual value of the underlying bonds.
But as in the financial crisis the bond ETFs continue to provide liquidity as bond markets did not.
This from BlackRock.
This market stress was felt not only in the sharp declines in stock prices (trading in Canada and US was halted twice upon triggering a market-wide circuit breaker), but also led to a significant erosion of liquidity in the bond market. Higher quality securities (treasury bonds, Canadian gov’t bonds, provincial bonds) traded with much wider spreads than normal and corporate bonds were barely trading at all.-BlackRock
Last week, market prices of fixed income ETFs have acted as a price discovery mechanism, and provided transparency into where fixed income exposure can trade (given limited trading in actual bonds).
These are crazy times for stock and bond markets to state the obvious.
Friends at BMO ETFs also offered this article from ETF Trends.
Here’s the price discrepancy chart. ETF vs underlying index.
When are we back to ‘normal?’
Once we shake out all the margin holders and the traders calm down, we move back to normal? Let’s hope so. As my Mom would say (though not an investor or trader) … everything comes out in the wash.
Market corrections are certainly a cleansing.
On the shake out, Arthur Salzer had also offered …
Usually takes a couple of weeks (or less).
Any selling after that is only panic selling – which isn’t as bad as strong hands come in to take these positions. This builds a stable basis for the next bull market. This process can take time if the underlying fundamentals have changed (or the market thinks they have changed).– Arthur Salzer
Normalcy will return. At some point we’ll be able to buy assets that more reflect their long term value. But make no mistake the perception of long term value has changed. And the potential of a recession and short term value of stocks and bonds will demand a reset.
As I’ve been stating for weeks and weeks. Be patient. Stick to your plan. If history repeats there is incredible opportunity when there is the perception of increased and dramatic risks. Of course, one needs the time horizon and the tolerance for greater risk.
Thanks for reading. Be safe. Stay home and practice that social distancing. Ironically, that’s the best way to help your portfolio, and your neighbours.
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I hope this post helps to answer … ‘what the heck is going on with the Canadian bonds?’