Putting clients into U.S. Treasury bonds, which pay, on average, 20 basis points more than Government of Canada bonds for both mid- and long terms, is looking more attractive despite the U.S. economy’s well-known problems.

Another reason for investing in U.S. Treasuries is that the U.S. dollar is gaining respect. The greenback has been soaring, as global investors flee from the potential default of the sovereign debt of Greece and other European countries, boosting the US$’s exchange value dramatically in spite of what will be record U.S. bond issuance this year. Although US$2.4 trillion of U.S. Treasury bonds are going to be offered in 2010, they are now seen as the ultimate refuge in the event that those European defaults take place.

At the heart of the problem — a potential default by Greece, which could become the Lehman Brothers Holdings Inc. of the global bond market. A crisis is at hand, for Greece needs to sell 53 billion euros (about $75.6 billion) worth of bonds this year, the equivalent of about 20% of its gross domestic product.

The European Union, struggling with the crisis, may figure out a way to bail out Greece. But then there would be the rest of the so-called “PIIGS” countries — Portugal, Italy, Ireland, Greece and Spain — to deal with. A default by Greece could generate a contagion effect, causing other bonds to tumble. As all the PIIGS countries use the euro, that currency could be pushed down and force the European Central Bank to intervene, but only if it could get the support of other central banks.

At the time of writing in mid-February, Germany’s chancellor, Angela Merkel, says she may be ready to help out Greece. Her voters and her governmental opposition are not so sure, for German workers have had their retirement benefits cut even as Greek workers have had theirs enriched. Not only that, but Greek workers have already been striking against proposed austerity measures.

The moral hazard is that the need to bail out more countries has to be balanced with the idea that one default could imperil the entire EU monetary system — even though Greece, whose GDP accounts for only 2.5% of the EU’s — is, in and of itself, a minor problem. And for Germany, which has the resources to stabilize Greece, the question is whether it would be asked to bail out others.

If nothing is done, EU member countries’ finance costs will rise. If Greece is rescued and other countries are helped to meet their debt obligations, the cost will be borne by German and other European taxpayers.

With all of that, the flight to the US$ and to U.S. T-bonds is understandable. As well, even if the EU does fix the Greece problem, the wider problem of excess public spending in many countries will drag on for months, perhaps years.

“We really do not know when the US$ will stop its rise,” says Patricia Croft, chief economist with Royal Bank of Canada’s global asset-management division in Toronto. “But the problem includes contagion. If you extrapolate the present problems of the euro and the PIIGS countries, then you have to worry about the outlook for the future of the euro itself.”

For now, at least, the world’s currency markets have decided to overlook the four horsemen of the monetary apocalypse supposed to doom the US$: the tax deficit, the war deficit, the trade deficit and the slowdown of the economy when stimulus programs end. The first three work directly against U.S. T-bonds; the last implies reduced tax revenue, weaker balance sheets and, by implication, lower corporate bond prices.

These challenges all seem minor compared with what could happen to euro-denominated debt if the euro itself, just 11 years old, crashes in value as investors flee what they see as a sinking monetary vessel. And that’s why money is moving out of troubled European economies and into what the world sees as the safest of all havens: U.S. T-bonds.

The problem, however, is coping with prospects for interest rate rises that will push down prices of existing corporate bonds. Yet, increases in interest rates in countries with weak balance sheets are all the more likely as investors flee from their bonds, dropping their prices and raising interest rates. For now, fate seems to be that Europe-related crises will be positive for U.S. T-bond prices.

@page_break@Corporate-bond yield spreads over U.S. Treasuries have widened to 164 bps. That means that average 10-year, investment-grade corporate bonds now pay 5.3% compared with 3.6% for Treasuries. Moreover, bond offerings from companies in Brazil, Korea and India have been cancelled as investment houses sense that they could get stuck with debt that might be met with a cool reception by potential investors.

The new-found security in U.S. Treasuries shows that anxiety is winning vs long-term economic fundamentals. Bond investors who are playing the risk trade are concentrating on U.S. T-bills, which are immune to duration risk and are all about supply and demand.

How you can play the new mood of the market for your clients is the key question. Marc Stern, vice president and portfolio manager with investment advisor PWL Capital Inc. in Montreal, says it is important not to lose sight of the reality that interest rates cannot go anywhere but up: “The Government of Canada has moved into a deficit position, which is not good, but we are less worse off than the U.S. So, a conservative inves-tor should stay short and stay with Canadian bonds.”

Government of Canada bonds remain an island of tranquility, a fact reflected in lower perceived risks. Ten-year Canadas yield 3.4% to maturity compared with 3.6% for 10-year U.S. Treasuries.

Says Christine Horoyski, senior vice president for fixed-income with Aurion Capital Management Inc. in Toronto: “Canada bonds appear a safer place to be.”

That said, says Camilla Sutton, currency strategist with Scotia Capital Inc. in Toronto: “If the flight to quality continues, a trade into U.S. T-bills can still be profitable.”

She warns that on a yield basis, there is hardly any money to be made. But if an EU member state did default, U.S. Treasuries would be immensely profitable to holders.

But that’s only the bond side of the story. The play is in the currency. “In the near term, as the US$ strengthens, the Canadian dollar will not be able to rally,” Sutton suggests. “The US$ will outperform the euro, the Aussie dollar, the loonie and [the British pound] sterling.”

The rise of the US$ will stop only when fears of sovereign defaults subside. Then, the fiscally stronger position of Canada will push up prices of Government of Canada debt.

“On a relative basis,” Sutton says, “the C$ remains strong — fiscally and in terms of economic growth — and that, for retail investors, is where to stay.”

That said, it is not inconceivable that bond vigilantes could try to take on the monetary monster of the world — the greenback itself. That would presumably mean shorting the US$ and U.S. T-bond futures. But is picking up 20 bps on yield and a potential gain on a currency swap worth the risk?

“I continue to have a bias in favour of Canada,” Horoyski says. “If you worry about sovereign risk, you rush back to what you know. The [International Monetary Fund] and the EU will resolve the sovereign debt issues, but there is still political posturing and wrangling. U.S. bond yields are going to rise, and there is not enough yield premium to justify incremental political risk.”

That means risk-averse clients should stay with Canada bonds. However, for investors with a taste for risk or for limiting the damage that a European default would have on a portfolio of European stocks, buying U.S. Treasuries could be appealing.

The riskiest play is probably going long on deeply discounted Greek state debt, which recently has traded at junk-bond levels. If the EU does bail out Greece, those bonds could pay a handsome reward for today’s gloom. But the market isn’t betting on it. IE