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Bond of the Week: 5 July 2013

Bond prices: Low enough?

    

The much-anticipated and highly influential US Nonfarm Payroll was released earlier today.  At 195,000, the number was better-than-expected. It immediately excited the equity bulls and sent stock prices to an upward march (link). But in this bullishness over unemployment, one casualty stands out: Bonds.

The US 30-year Treasury Future, updated just after the release of the jobs data, shows a decisive downtrend reassertion. It slumped nearly two points minutes after the data release, adding to the fourteen-point drop over the previous six weeks (see below). New long-term price lows are likely to bring more momentum sellers into the market. The orderly downtrend can easily turn riotous.

What next? Are current bond yields high enough to tempt investors?  Are there bargains to be had in the bond market?

No doubt, many well-informed readers are aware of the extended weakness in the ORB market over the past two months. The FTSEORB Index captures this state of affairs (see below). From a peak of 110.6, the index is currently trading beneath 104 - a decline of 5.8%. The severe decline in US bond prices today would probably hold it down further. (Note: I recommended some downside hedging in bonds two weeks ago.)

Drilling down to individual retail bonds, I notice that, compared to the pricing back in March, many bonds are now offering yields in excess of 6% (link). If the US yield curve continues to rise, these ORB yields would probably drift higher.

A quick check of the Sterling Yield Map show a few interesting issues. Enterprise Inns 6.5% 2018, recommended as a take profit/sell on 10 May 2013 here, is now offering investors a tempting yield of 7% once more.  The Provident Financial 7% 2020 offers a yield of 6.2% - not too bad considering the risk. The Provident Financial 7.5% 2016, with just three years to maturity, is offering a yield of 5.9%. In comparison, the three-year gilt yield gives investors a paltry yield of 0.6%!

So, should we dive straight in and mop up as many corporate bonds as possible? No!  

After years of market watching, I have developed a great respect for price momentum. A security/asset surfing on strong price momentum will override all other considerations. Valuations become hard to determine. Strength begets strength; weakness leads to further weakness. Think of the Nasdaq bubble – and its subsequent collapse.  

Given that bond yields are soaring in the US, I suspect it will drag most other government bond yields higher. The rally will also depress corporate bonds. Should I fight this trend? Well, not until the upward trend in yields loses momentum. Patience is needed whilst waiting for bargains to appear.   

View: The bond bears are having a field day after the release of the US job data. This weakens the already fragile US Treasury market. Amidst this frantic selling, I would be wary of ‘bottom fishing’ in the government bond market as the sector’s weakness could easily extend. That said, I suspect that the US central bank would not let this situation get out of hand. At some point in the future, the downtrend in government bond prices will slow and reverse. I stand ready to buy. But what would I buy? The first choice that springs to mind right now is short-maturity, high-yielding corporate bonds. An example is the unrated Provident Financial 7.5% 2016, which offers 530bps above gilts.  Another choice is Places For People 5% 2016, whose yield of 3.56% is a full 290bps above the 3-year gilt yield.  The shorter maturities on these securities limit the duration risk. I would only look to buy long-maturity corporate bonds when the government bond yields lose their upward momentum.  


Dr Jackson Wong

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