Fixed Income  

Superman, Superbonds

This article is part of
Fixed Income Strategies - March 2014

Outwardly a normal human being, the original super human has used his remarkable abilities to protect and serve the people against foes like Atomic Skull, Lex Luthor and General Zod.

Toiling against adversaries, and the dreaded Kryptonite, there have been moments when all has seemed lost only for him to fight back and topple his enemies.

Bonds have followed a similarly remarkable path. Although perceived as dull, their super powers have shielded savers from the volatility of stock markets, helped them accumulate wealth, guarded returns from the effects of deflation and even paid a handy, regular income (something not even Superman could do!).

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But, just like Superman, bonds have faced challenges.

Those unlucky (or lucky) enough to be part of the bond market shocks in 1979 and 1994 will know just how quickly things can turn around. In 1979 the US$1bn bond underwritten for IBM was hailed as a corporate finance master stroke, yet it is now considered one of the biggest underwriting fiascos of all time.

The 1994 bond massacre is remembered for the sudden hike in interest rates, which led to a 200 basis points rise over nine months, and the bankruptcy of Orange County coupled with the ripple effects that were felt in Mexico. These events hammered investors at the time and wrong-footed the bond bulls when they were firmly in their stride.

The villain’s (heroes to some) were the US Federal Reserve (Fed) Central Bankers of the time, namely Paul Volker in 1979 and Alan Greenspan in 1994, although their powers fell short of General Zod and Bizarro.

Superman’s other perennial challenge is Kryptonite, the radiation of which significantly weakens the Man of Steel, neutralising his super powers. The Kryptonite for bonds are rising interest rates and inflation. Rising rates will lead to a fall in bond prices and potential capital losses for bondholders while inflation erodes the all-important yield of a bond.

So Superman and super bonds, what’s next? As we enter a rising interest rate cycle, and with many commentators signalling the end of the 30 year bull market in fixed income, could bonds be rendered surplus to requirements?

Well, despite both bonds and Superman experiencing bouts of weakness from their kryptonite nemeses, both have bounced back and enjoyed long periods of superior returns.

The creators of Superman, the late Jerry Siegel and Joe Shuster, developed a character that forms part of our popular culture 80 years on; equally impressive is fixed income’s track record of delivering returns with low levels of volatility in core asset classes. In fact the US aggregate index has delivered a negative return only three times in the past 38 years.

While we may be at a low point in the investment cycle, the reality is that we are still in a highly levered economy that is vulnerable if borrowing rates rise too quickly.

Deflationary effects, which are potentially threatening Europe and the wider global economy, are reminiscent of Eradicator, the villain set on turning Earth into a new Krypton. And unlike many of Superman’s short-term threats, Eradicator was a lingering one that needed to be addressed with a proven antidote.