Friday, March 29, 2024
 
Columnist
Martin Hennecke
Martin Hennecke
Chief economist at The Henley Group mwh@thehenleygroup.com.hk
"There is a lot of discussion on whether there will be another equity market downturn."

Bond strategy as inflation specter emerges
09/11/2009


There is a lot of discussion on whether there will be another equity market downturn.

Most analysts who understand that the United States and Europe haven't really fixed their economic problems, but rather just plastered money over any crisis that emerged, are now warning of another down-wave in global markets.

As the equity and commodity crash last year took most investors by surprise, we may be witnessing a different surprise this time, which could well be a "cash crash" rather than a stocks crash.

In other words, we could see rapidly and significantly rising inflation due to unsustainable national deficits particularly in the West.

This is an environment in which commodities and to some extent even equities (mostly representing tangible assets such as land or natural resources) would actually tend to move up, whether the economy recovers or not.

The smartest investors seem to be preparing for just such an "onslaught of inflation" (Warren Buffett, February 2009) and "a very early stage of an endeavor to move away from paper currencies" (Alan Greenspan, September 2009) and ultimately "a general flight from currencies" (George Soros, October 2009).

Perhaps this is why Buffett has just exchanged a major chunk of his cash for the physical assets of a railway line. Some investors would be already well prepared for such an inflationary scenario with positions in precious metals, commodities and selected China equities.

So, let us look at the risks and opportunities of the bond/fixed interest sector.

In an environment of rising inflation and interest rates, investors would want to avoid holding bonds with long maturities and a fixed-interest coupon as they would be most vulnerable to a sharp selloff if inflation and rates goes up.

Better options would appear to be short-dated, inflation-linked or convertible bonds ¡V preferably in the healthier Asian economies.

Short-dated bonds are less at risk from inflation and rate increases than long-term bonds, so they may be suitable as one portfolio element.

The return potential would be relatively limited though, unless one chooses higher yield/lower credit rating corporate issues.

Inflation-linked bonds, in theory, would be the perfect investment solution in a rising inflationary environment.

Unlike ordinary bonds that pay fixed interest/coupons, the coupons and value of inflation-linked bonds will rise in line with the official inflation rate, hence they should be more attractive.

But the downside is that governments have a tendency to understate the official inflation rate (which is used to calculate the return on inflation-linked bonds), compared with the actual inflation as experienced by typical (investor) households.

Convertible bonds appear particularly attractive in this environment of potential high volatility, where both another short-term deflationary crunch and a sudden upsurge of inflation are very possible scenarios.

Convertible bonds are hybrid securities combining a corporate bond with an equity conversion option.

Hence they do offer a good degree of downside protection should there be another sudden market downturn, due to the bond element.

At the same time they have no upside limit due to the embedded equity conversion option, and would benefit if the markets continue to move up. Obviously though, convertible bonds are subject to higher volatility than ordinary short-term bonds.
 


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