Is the Year-long Bear Market in Irish Government Bonds Over ?

When the equity bear markets of 2007-09 ended in early March 2009, the familiar sign of market capitulation was evident - that event where investors throw in the towel and sell irrespective of value for fear that markets might keep falling. No one rings a bell at the bottom of bear markets but the fact is that equity markets have been recovering ever since and capitulation by investors at that time indeed marked the bottom.

At the start of November 2010, the yield on Irish 10-year government bonds was circa 6.6% but by Thursday 11^th November it had ratcheted up to near 9.2% before ending that week at circa 8.15%. These are big moves in bond yields! Such sharp price falls (rising bond yields) in such a short space of time may well have signalled capitulation – an acceleration in the trend as investors in Irish bonds threw in the towel and, in so doing, priced in all the bad news and more.

With the strong recovery in Irish bond prices since, I believe capitulation is exactly what we witnessed and why the probability is therefore high that it most likely marked the end of the year-long bear market in Irish bonds. So what started the panic among investors in Irish government bonds between early and mid November? Investors pretty much knew the size of the Irish banking bail out and what it was likely to add to the government’s debt since late summer. I do not accept Morgan Kelly’s arguments recently in the Irish Times that there is a hidden mortgage time-bomb in the Irish banking system - the facts simply do not support his claims. And the size of the government budget deficit, while scary, has also been known for some time.

The most likely cause of the panic has been the change in the risk appetite for Irish sovereign debt among overseas fund managers following two occurrences (i) Angela Merkel’s comments that private investors in periphery Euro-zone bond markets may have to share the pain of any eventual sovereign debt restructuring and (ii) the Irish government’s own decision to only partially redeem some of Anglo’s subordinated debt (rightly or wrongly). In short, overseas investors were suddenly confronted with the prospect of sovereign debt losses in Ireland. The statement from the leading European countries at the G20 summit in Seoul on Friday, 12^th November provided reassurance that Ireland has support from Europe and that Merkel’s comments did not relate to existing debt. Irish bonds rallied strongly on that same day and held those recovery gains this week.

In assessing the value or risk, investors need to look at some figures and stay away from the headlines. A benchmark Irish Government 10-year bond was issued in January 2010 at €100 with an interest coupon of 5%. It was trading at €79.3 near the close of business on Friday last. At that price, the annual yield is 6.27%. And if the government repays the €100 at maturity in 2020, a capital gain of circa €21 is also on offer, providing a combined yield to redemption of close to 8.12% (annual coupon plus capital gain).

By pricing the bond at €79.3 when there is a government guarantee that it will be repaid at €100 in 2020, investors, in aggregate, are saying that any restructuring of Irish government debt could shave 20% off the amount owed. Is this realistic? I think it’s fair to say that none of us know for sure.

But a 8.12% yield to redemption is an equity-like return and it appears to me that investors are now being adequately compensated for the risk of default. After all, if only €79-80 is repaid in 2020, today’s investor still gets the annual income of 6.27% which on its own is still well ahead of current bank deposit rates.

In the current very uncertain environment, I class Irish government bonds as a risk asset and if you are prepared to take some risk then I believe you have been presented with the buying opportunity. More cautious investors might average in over a period of time. Reading today’s media headlines tells you what is going on but it does not tell you what is priced in. While no one rings the bell at the bottom, I believe a silent bell went off on Friday 12^th November – but only time will tell whether this is indeed so!