The Irish government finally overcapitalises the Irish banks and then Portugal gets a bail out. In response, investors buy Irish bonds aggressively signaling, in my view, the end of the banking crisis in Ireland and the possibility that the periphery Euro-zone crisis ended with Portugal. A strong Euro is consistent with this reading. That being the case, there is an opportunity for all Irish savers and investors, and particularly pension investors, to earn much higher returns from Irish government bonds than can be earned from either bank deposits or An Post’s National Solidarity Bond.
Shortly before the bank stress tests were published and with a bailout of Portugal looming, the yield to redemption on Irish 10-year government bonds briefly spiked to over 10%. But the spike didn’t last and when the facts replaced the rumours, professional fund managers waded in and bought. They did so because they surmised that the threat of default by Ireland on its sovereign debt had already been well discounted.
The math for investors is as follows; an Irish 10-year government bond which was issued last year at €1 with a 5% annual coupon for ten years until redemption is now trading down 25% in value at €0.75 (time of writing). At that lower price, the running yield is 6.7% (5% / 0.75). The market is currently saying that if Ireland restructures its debt in time, investors may only get 75c back on the Euro. Even assuming that judgment is correct, then today’s investor can still pick up an annual yield of 6.7% for the next ten years.
That is well over double the cash deposit rates available from the banks in the short to medium term and well above the rates available from An Post’s National Solidarity Bond which offers an annual return of 3.95% for ten years. The mostly tax free nature of returns from the Solidarity Bond is offset by the fact that the majority of the interest is paid only at the end of the full ten year term.
In this column last week, John Looby, fund manager with Setanta Asset Management, put forward a very well reasoned argument for reading the Irish economic glass as at least half full. Ireland, he argues, is a broadly based, largely services-providing economy exporting across the globe with favourable demographics and an established hub for US corporate investment. A return of consumer confidence should unleash pent up consumer spending and lending costs should narrow boosting growth which, in turn, should solve the fiscal deficit leading to a virtuous circle of improvement. And there are many well informed investors who share Mr. Looby’s optimism and they have just voted with their wallets by buying Irish bonds. They don’t tend to dominate the media headlines but their views are just as, if not more, reasoned. They are the silent ones who determine the prices in the market place.
Equally, there are many who see Ireland’s glass as at least half empty and they argue that our fiscal crisis is forcing spending cuts, which leads to lower growth, a shrinking economy and an inevitable sovereign default on a widening debt burden. So how can the ordinary investor determine who is likely to be right?
The short answer is that he/she does not need to determine who is likely to be right. The important thing to understand is that all these informed views are already in the market prices. None of us knows the future for sure but we can at least understand what is priced in to an asset.
I contend that the risk of default in Irish bonds peaked in November 2010 when a frenzy of selling took place driving the yield to redemption on Irish 10-year bonds from 5% to over 9% in a little over three months from August to November 2010. That capitulation in prices (a spiking in yields) was typical of the end, and not the beginning, of any bear market. Since then, yields on Irish 10-year bonds have ranged between 8.5-9.5% and the rally in the past two weeks has brought them firmly back within that range. A capitulation in a market is rare and is that event when all investors rush for the exit at the same time and, so doing, price in all the bad news.
The same capitulation in prices occurred in the global stock markets between October 2008 and March 2009. After an eighteen-month period of generally declining prices, a frenzy of selling took place after Lehman’s were bust as the armageddon arguments of global depression spooked investors. But the capitulation in prices discounted all known fears and only recovery was left. And, confounding the critics, the worst fears were not realised and the recovery in global equity markets has been one of the most dramatic this century.
In terms of Irish government bonds, it appears to the InvestR Centre that, following the rally in the past two weeks, the market has made up its mind. The balance of opinion remains on the side of default but this risk was priced in last November. Despite the media headlines since, nothing new has emerged since that time to spook professional fund managers any further.
As we don’t know the future and as the risk of default remains, we must accept Irish bonds are a risk asset for the time being i.e. future value unknown. But if you can accept the Irish 10-year bond as a risk asset, then, at the current price of €0.75, it offers a running yield 6.7% for each of the next ten years or 67% over the life of the bond. If default occurs, then there is the possibility of further downside – an investor might not get back the initial cost price of even €0.75. But, with a cumulative 67% interest earned in between, the risk of some loss of capital looks acceptable. On the other hand, if Setanta’s John Looby’s more optimistic view proves correct then the bond is likely to be redeemed in full at €1 in 2020, delivering outsized returns of over 9% per annum.
