Corporate bonds have soared in value since the market hit bottom this past spring. The reason? The liquidity crisis that sparked the market meltdown has largely abated. But can the corporate bond rally last?

In the nine months ended Sept. 30, the DEX universe bond index gained 5.6%. Driving most of that return was the astonishing 15.1% gain in the index’s corporate bond component, which is the equivalent of three ordinary years of 5% average returns packed into just three quarters. Bond mavens are not convinced this rally is over. In fact, there are many investment-grade bonds that offer significant yield premiums over government issues of the same terms.

For example, an investment-grade YPG Holdings Inc. 6.5% bond due July 10, 2013, has recently paid 5.8% to maturity, which is 377 basis points over a Government of Canada bond of similar maturity.

YPG publishes Yellow Pages phone books, which some regard as a dying industry. Yet, the bond’s term is less than five years and the investor gets both strong return to maturity and good income in the meantime.

Similar returns are available for bonds from Fin-ning International Inc., a major Caterpillar equipment dealer, and grocer Loblaw Cos. Ltd. Each is an out-of-favour issuer with problems — the global recession in Finning’s case, and the 1,000-pound gorilla called Wal-Mart Stores Inc. for Loblaw. But both bonds are strong, investment-grade debt issues.

Good bonds at low prices encourage the confidence of debt-market mavens. After all, with short-term deposits at banks and treasury bills generating returns well below 1%, and money market funds producing similarly bleak returns, investment-grade corporate bonds have been a relatively safe place to invest. Still, with bond prices having leapt so far so soon, it is appropriate to wonder if the bond run will continue. In short, will bond investors who are considering putting cash into debt now be too late to join the party?

It is a given that optimism has ruled in the bond and stock markets since investor expectations hit bottom on March 9. Globally, stocks are up even more than bonds. The MSCI world index is up by 24%, in U.S. dollars, in the nine months ended Sept. 30. In high-yield debt, which is the most credit-sensitive part of the bond market, spreads have fallen to a recent level of 750 bps over U.S. treasury bonds from 1,600 bps at the end of 2008. High-yield issues highlight credit concerns and, as a result, they are the bellwethers of the bond market. They have abated a great deal.

“The high-yield spreads have eased from panic levels to levels that are typically seen in recessions,” explains Chris Kresic, senior vice president and head of fixed-income for Toronto-based Mackenzie Financial Corp. “As economic conditions improve, spreads will continue to tighten.”

Moody’s Investors Service Inc. has forecast in a report issued at the end of September that global defaults, a trailing indicator of the market, will fall — but not before rising to 12.5% of all speculative-grade outstanding bonds from a recent rate of 11%. This drop in defaults is due to occur sometime in 2010, the report predicts.

On a short-term basis, rising default rates could send corporate bond prices down. Says Vitek Verma, vice president of Canso Investment Counsel Ltd. in Richmond Hill, Ont.: “Falling consumer demand and continuing problems with regional banks and specialized lenders in the U.S. that were not rescued by the Federal Reserve Board and the U.S. Treasury will be behind the weakness of corporate bonds.”

Moreover, defaults will increase in the short term as shaky structured products, such as collateralized debt obligations that were issued in the easy credit days of 2005, 2006 and 2007, come due for payment in the next few months, says Michael McHugh, vice president and portfolio manager with Dynamic Funds Ltd. in Toronto.

There are also worries about the economic recovery’s foundation, as the broad economy continues to lag the recovery in financial markets. In the U.S., a Bureau of Labour Statistics report released on Oct. 3 revealed official unemployment at 9.8%. Add in what is often called “concealed” unemployment, which includes former workers left off the lists because they have given up seeking jobs, and the true rate could be twice the official number.

@page_break@Bank of Nova Scotia’s economics department forecasted on Oct. 2 that unemployment numbers will continue to hamper the recovery. That report calls for average unemployment rates of 8.9% in Canada and 9.7% in the U.S. in 2010. These numbers will tend to restrain central banks’ moves to raise interest rates. Short-term rates are due to stay low under these conditions.

In the still-struggling economy, there is likely to be a continuing haven in investment-grade bonds. These offer reasonable returns for taking on what amounts to moderate risk. Defaults will eventually decline as the economy recovers.

And once defaults begin to drop, bond prices are likely to move up across the board, Kresic suggests: “The strong rise in bond prices on a year-to-date basis is not so much a bubble as a correction of the sharp sell-off of 2008, when corporate bond prices fell as investors fled from default risk.”

In his view, the investment-grade corporate bond market remains a good place to be, with some insulation from macroeconomic issues as well as protection from the default problems that plague high-yield debt. Investment-grade bonds can still gain value as the recovery moves ahead, even if high-yield bond defaults temporarily rise as predicted.

Good bets for safety and yield are public utilities, whose regulators guarantee their revenue. As well, McHugh notes, selective purchases of bonds issued by banks and other financial services companies with restored liquidity, and also cable operators with high levels of recurrent revenue, offer security.

There are also potential buys in telecommunication companies such as Manitoba Telephone Services Inc., in leveraged property developers such as Brookfield Asset Management Inc. and in the underperforming power generator TransAlta Corp. Each company has its unique challenges, but all have strong credit ratings and can improve their performance as the economy recovers.

However, it is necessary to be sure that the bonds you help your clients pick still have some potential price appreciation remaining, Kresic says: “The astute bond investor picks his battles with care.” IE