The bond market is undergoing the biggest sea change in decades. It’s a process that will make bond allocation and selection tougher for financial advisors than it has been in many years. The reason, of course, is the global increase in interest rates.

The causes are varied, but yields are rising and prices of existing bonds are tumbling. In Canada, the Bank of Canada has signalled that it is prepared to start raising rates at some point in June. When the central bank acts, it will put the final nail into the coffin of one of the best bond markets in history.

“We are at the end of the bond bull market,” declares Michael McHugh, vice president and portfolio manager with Dynamic Mutual Funds Ltd. in Toronto. “Our yields have bottomed following a 30-year secular decline.”

For advisors, the problem is in managing bond portfolios that may show red ink as prices of existing bonds fall.

One alternative, of course, is to shorten terms and durations and then move back into mid- and long-term bonds when interest rates have finished rising. Short-term bond ladders with maturities ranging from one to five years can easily achieve that. Yet, as McHugh says, the process of yield appreciation will take years.

In the new world of global credit, there are risks of inflation and default that have not been seen in decades. If the recovery persists, inflation will return.

In the Canadian bond market, with the yield on 30-year Government of Canada bonds at 4.07%, there is not a great deal of protection from rising inflation.

“Investors see the threat of inflation out there,” says Brendan Caldwell, CEO of Caldwell Invest-ment Management Ltd. in Toronto. “And, if we judge by the 169-basis-point spread between the 2.03% yield on two-year Government of Canada bonds and the 3.72% yield on 10-year Canadas, then investors are saying that there is still a lot of risk of a return of inflation.”

There are several reasons for rising yields in virtually every part of the bond market. They all indicate how precarious the buy-and-hold bond investing strategy will become in the coming months.

Government debts have risen as a part of the recent economic rescue process. With the credit crisis now in the past, there is now a fiscal crisis to deal with.

That fiscal crisis is evident in government balance sheets drenched in red ink. Greece’s sovereign bond crisis and what are assumed to be looming crises over government debt in Spain, Portugal, Ireland, Italy and even Britain will force up interest rates on sovereign debt.

The market will price in default risk and issuers will have to pay dearly to get their new debt sold. Interest rates on corporate debt, which are always set as a spread over government debt, are due to rise as a consequence.

Default risk is substantial. Greece — which, at the time of writing, has been promised a $61.4-billion rescue package by European Union finance ministers and the International Monetary Fund — is not out of the fiscal woods quite yet. (All figures are in U.S. dollars.)

Greece owes $400 billion against an annual gross domestic product of $340 billion. It has raised income and consumption taxes, a process that slows its economy and makes debt repayment harder.

In that light, the record of sovereign defaults tracked by Ugo Panizza and Eduard Borensztein of the International Monetary Fund in a working paper entitled The Costs of Sovereign Defaults, published in October 2008, is illuminating.

The report has identified 74 sovereign defaults between 1981 and 2004, including Argentina’s global record-setting $81.8-billion whopper in 2001, Paraguay in 2003, Uruguay in 2003, Ecuador in 1999 and Venezuela’s defaults in 1990 and 1995. Greece’s debt morass is anything but rare.

There is also persistent credit risk in the corporate-bond market. Corporate balance sheets are recovery-dependent. The economic recovery should offset some of this weight, but, as McHugh says: “There is a lot of uncertainty about its durability and its strength.”

Canadian government bonds are like deer in the headlights, ready to be run down as interest rates rise. Yet, provincial bonds still offer a significant premium over Canadas, Caldwell says.

His preference is Ontario provincials, recently priced to offer 40 bps of yield over Canadas of similar terms. Says Caldwell: “They are liquid, the Ontario economy is strong, and the provincial balance sheet is going to get stronger with rising tax revenue.”