Brent Sheather: Are we there yet?

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In the mid to late 1960's the Sheather Family regularly made the painful trip in a Morris 1100 from Whakatane to see the grandparents in Waihi. It seemed to take forever and before too long the back seat passengers inevitably started asking "are we there yet?" It is a similar story for local long dated bond investors who have in the last 12 months endured the pain of seeing the value of their long bond holdings fall as interest rates have risen. Many will be wondering hopefully whether the local bond market has arrived at a new equilibrium level yet.

To cut to the chase the view is a qualified "no" but, if history is any guide and, using the Whakatane/Waihi pilgrimage analogy, we are probably entering the Karangahake gorge, a dangerous and windy road if ever there was one but nevertheless, just outside of Waihi.

There is no denying that in the last 12 months interest rates, particularly on longer term bonds, have moved up sharply. However, when most commentators say that interest rates are going to rise they usually mean US interest rates - and if you look at the long term history of US interest rates they certainly are at the low end of their historic average but then again so is inflation not to mention growth.

This is an important subject for investors, firstly because bonds typically represent a big part of investment portfolios and secondly because history is full of examples where even government bond investors have lost large amounts as interest rates have risen. Thirty or so years ago people referred to US government bonds as "certificates of confiscation" because prices had fallen so much in a period of rising interest rates.

Let's trace the journey thus far: since the US 10 year bond yield bottomed in July 2012 at 1.47 per cent the yield has more than doubled to the current level of just below 3 per cent thereby delivering a loss of around 10 per cent to bond holders. Nasty! See here. The question before the panel today however is whether NZ's interest rates will continue to rise with those of the US?

In the same time period our 10 year bond yield has risen by 47 per cent from 3.22 per cent to the current level of 4.7 per cent. This compares to a 104 per cent rise in the US bond yield. What will happen next.... historic correlations might be of some use here - check out the graph which compares US 10 year government bond yields with NZ 10 year government bond yields.

At the moment NZ bond yields are 1.7 per cent higher than US bond yields, having averaged a margin of 1.5 per cent above US interest rates since 1993, getting as high as 3.0 per cent above comparable US yields in 2008 and actually going below US rates by 0.5 per cent in 1994. NZ's inflation prospects are arguably no worse than those of the US and NZ's government borrowings as a percentage of GDP are much more favourable than those of the US so it is conceivable that US interest rates may rise further without local interest rates following them.

Conceivable yes but is it likely? There are opposing forces. The US benefits from getting the risk free bid because Uncle Sam is perceived to be about the best credit there is and NZ has a far less impressive history in controlling inflation than the US has. But that is the rear view what matters is the road ahead and NZ bonds offering a real yield well above that of US bonds must look attractive to US pension funds especially given we haven't been doing any quantitative easing.

An alternate way of getting a view as to whether local long term bonds offer value at present is to compare their returns with inflation. With NZ 10 year government bonds yielding 4.7 per cent and inflation forecast to be around 2 per cent that looks a reasonable real return relative to international alternatives. However since 1993 NZ 10 year bond yields have averaged 6.2 per cent and inflation 2.2 per cent so that means the average spread over inflation has been 4.0 per cent which is quite a bit higher than the current 2.7 per cent spread so, if history is any guide, and that itself is anyone's guess, NZ 10 year bond yields could rise a bit further ... but then again they might not.

How does the current 1 per cent spread of US bonds over inflation compare with the US historic data? Martin Feldstein, Professor of Economics at Harvard, in an article the other day, forecast that US interest rates were going to keep rising. He said that at around 3 per cent long term US government bonds only offer a real return of 1 per cent and past experience suggests that a 2 per cent real rate of return is required meaning that US 10 year bonds will go to 4 per cent.

He is actually more bearish than that when he says that "the large budget deficit and the rising level of the national debt suggest that the real rate will be higher than 2 per cent and nominal rates could rise to 5 per cent". Being a Harvard professor he has a good knowledge of history and points out that the US 10 year rate doubled from 4 per cent in the 1960s to 8 per cent in the 70s. Those were however extraordinary times with the Vietnam war highly inflationary. Mr Feldstein stresses the fact that the greatest risk to government bond holders is, besides default, that inflation will rise pushing up interest rates on long term bonds and he thus suggests inflation indexed bonds as an option which would of course protect against inflation but do not protect against a rise in real interest rates.

The future, as always, is uncertain. We could have inflation or we could all be looking in the wrong direction and deflation might be round the corner. The key to owning a bond portfolio and sleeping at night is to avoid sticking your neck out too far but instead adopt the strategy employed by fund managers who have one eye on duration risk and the other on career risk. When they make presentations to clients they sound confident, implying they know where interest rates are going, but in reality they don't so they hedge their bets by having some short term bonds in which case they will look clever if interest rates rise and some long term bonds just in case they fall.

Now we will finish with something humorous from the Extremely Bad Timing File. Nigel Tate, Grand Wizard of the Institute of Financial Advisors (IFA) was reported the other day as saying, in an article entitled "Take Any Chance To Build Public Image", that "NZers had a bad impression of advisors because of stories like Ross Asset Management" and "advisors needed to take every opportunity to turn that around". Good stuff from Nigel but barely 24 hours later one of his IFA disciples was charged by the Serious Fraud Office and the Financial Markets Authority for allegedly stealing $3m of client's money. As they say, "Karma is a Bitch".

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request.