The major concern for anyone investing in bonds these days is when interest rates will rise and, subsequently, when the great bond bull market that has run on with few interruptions since 1981 will end.

For now, the death of the bond bull market is difficult to foresee. Those who shun default risk and want a sustainable return continue to buy Government of Canada bonds, such as an issue due in 2027 that pays 3.51% to maturity, or provincial bonds, such as a Government of Ontario issue due in 2029 that pays 4.33% to maturity. Compared with the usual boost of 20 basis points to 30 bps for provincial bonds over federal issues of comparable maturities, the 82-bps spread says it all: fear still reigns, and the end of the bond bull market is not being discounted in current prices.

Ironically, risk is rising in credit markets, which are sustained by life support from the U.S. Federal Reserve Board. The second phase of quantitative easing has seen the Fed buy massive amounts of short-term U.S. government bonds, which has led to lower yields and, in turn, driven money into longer bonds, corporate bonds, stocks and anything else that pays more than the near zero of U.S. Treasury bills and short-term issues.

Unlike conventional, open-market Treasury operations, in which the Fed buys bonds one day and sells them back the next, the Fed is making its current bond buys final. This means that banks get to keep what amounts to free money, and anyone who wants to live on short-term interest starves. So, for anyone caught in the middle, it’s not about profit; it’s about survival.

As of late November, U.S. T-bonds paid 25 bps for a one-year term to maturity, 50 bps annualized for two years and 77 bps annualized for three years. This is obviously no place for anyone to make a living — unless you fear massive defaults in other bonds or deflation. But there is no reason to even think that major bond issuers will be defaulting.

However, David Rosenberg, chief economist and strategist with Toronto-based money manager Gluskin Sheff & Associates Inc., warns deflation remains a possibility: “U.S. personal income actually declined in September. This is a one-in-20 event, something very rare in the economy.”

You could dismiss this as professional pessimism, but bond investors have embraced the deflation/default scenario. Credit-default swaps on the sovereign debt of Europe’s “PIIGS” nations (Portugal, Ireland, Italy, Greece and Spain) were hovering at about 400 bps in mid-November. So, U.S. bonds remain a safe haven — the safest place to be in the world if you’re not worried about the greenback losing its value.

It is a costly concept, however. Accepting virtually nothing on a short-term U.S. T-bond or 1.24% on a one-year Canada T-bill has to be compared with the average dividend yield of 2.46% on the S&P/TSX 60 index and its prospects for rising stock prices. The index’s 17.7 price/earnings ratio is a little high for near-term earnings expectations, says Tony Warzel, president and chief investment officer with Rival Capital Management Inc. in Winnipeg. But it will rise in the future, he adds.

Some market-watchers may even say that the Fed has taken over as the chief investor in stocks and bonds. Derek Johnson, director of fixed-income with Toronto-based Aurion Capital Management Inc. , acknowledges the pressure to buy stocks instead of bonds: “There is no sense in owning three-year U.S. paper; there are better alternatives.”

Those alternatives are corporate issues in Canada and the U.S. Although the spreads of corporate bonds vs Canadas have tightened, Johnson notes, investors can still capture 110 bps to 150 bps over Canada bonds of a similar term and 60 bps to 70 bps over provincial bonds of a similar term.

This is not risk-free investing, however. Taking on time risk — betting that the difference between short and long rates will hold — can produce stunning losses when the market senses that interest rates will rise. Worst hit will be government bonds, which cannot benefit from the improving credit conditions that go with improved economic fundamentals.

“It will be bleak for bond investors who load up on low-yield government bonds,” says Tom Czitron, managing director and CIO with Morrison Williams Investment Management LP in Toronto.

And if inflation returns to the customary 2.5%-3% annual average, today’s premium-priced government bonds will be devastated, says Martin Anstee, vice president for investments and portfolio manager with Stone Asset Management Ltd. in Toronto: “I see bonds topping out when inflation comes back.”

The middle course is to shop for investment-grade corporate bonds that can rise in value when their issuers’ businesses improve and more money is available to cover interest.

Warns Sacha Tihanyi, currency strategist with Bank of Nova Scotia in Toronto: “Reality in the form of weak corporate earnings and weak consumer confidence could outweigh the liquidity-driven market surge we are now seeing. Monetary policy can be stimulative, but there has to be something real to support what liquidity has driven up.”

This means stocks, artificially driven up by quantitative easing, could crash. But bonds, with their guaranteed return of principal, represent a controlled risk.

That’s why the bond bull market is still alive and snorting. IE