Bonds are due to be transformed as the world economy recovers. Today’s most sought after credits — government bonds, particularly short terms — will wind up as also-rans as corporate credits take centre stage.

So, clients should be thinking about potential bond purchases and should be prepared to buy, probably in the spring, before it becomes clear to everyone else that the economic recovery is starting. The signals to watch for are a decline in interbank lending rates and a revival of the commercial markets.

The stage for recovery is already being set. Central bank rates have fallen to 50-year lows, to 1.5% in Canada, to 0.25% in the U.S. and to 1.5% in Britain. But corporate debt, at 8% on average, is paying more than the historical return of stocks. This inequality can’t go on forever.

Getting ready for the turn of the market requires a mindset that is ready for the turn. And it’s that change of attitude toward risk that is the tough part. As Patricia Croft, chief economist with RBC Global Asset Management in Toronto, notes: “The bond market [now] is all about risk aversion.”

There are many risks. Corporate defaults are still rising; the credit crisis is not over, by any means; and yields on safe government bonds continue to fall. And then there’s the prospect of a few quarters — or, perhaps more, if you are a pessimist — of deflation. That means reduced corporate earnings and less money generated to cover interest due on corporate bonds. Government bonds with no credit issues grow in relative value in a deflationary environment.

Monetary policy-makers are struggling to avoid deflation by getting the global economy moving again. There is a global race to cut central bank rates to as close to zero as markets will think credible. But not quite zero. If rates actually get there, monetary policy has run out of fuel — and the markets will know it.

Economists think this will work, although when it will happen is far from clear. According to Aron Gampel, deputy chief economist of Bank of Nova Scotia in Toronto, it may not start until mid-2009 — at the earliest. The bond market, he says, will move into a new phase three to six months before trailing economic indicators such as retail sales and consumer confidence turn upward.

On balance, he thinks, the move will happen later in 2009, coincident with the beginning of economic recovery. “When the fear factor moderates,” he says, “the corporate market will be ready.”

A return to risk-tolerant investing has to happen. Notes Jeff Rubin, chief economist of CIBC World Markets Inc. in Toronto: “Aggressive central bank cuts have pushed real interest rates into deeply negative territory at the short end of the yield curve.” In his view, that can’t last.

However, the prospect of deflation could keep rates low longer than most experts expect, warns Edward Jong, senior vice president at Toronto-based bond manager MAK Allen & Day Capital Partners Inc. and portfolio manager of frontierAlt Opportunistic Bond Fund.

But assuming deflation doesn’t last, says Jong: “The market has to move back to providing a net positive return for holding debt. It is inevitable.

“As the Government of Canada 10-year bond rate approaches 2% from its current level of 2.9%, the economy is bound to find some traction,” Jong adds. “Corporate bonds will look more attractive. I would be a buyer at that time and wait for real gross domestic product and other lagging indicators of performance to catch up. I would be early; that’s the time for the best pickings.”

Those who recognize the opportunities will be able to pick bonds with yields to maturity that will be at post-Second World War highs.

Migrating out of riskless government short bonds into longer issues that are sensitive to interest rate changes and to credit concerns requires that investors balance the possible gains with the potential losses. (Investors should note that both rating agency downgrades and actual defaults rose in 2008.)

But when the recovery comes, interest rates will rise and bond credit quality will improve. Then corporate debt prices will be more sensitive to credit quality gains, explains Jong, and prices should rise.

Rotating out of riskless government debt to risk-bearing corporate debt and inflation-linked bonds is a timing problem. Spreads on corporate debt, from AA-rated bank senior debt to junk, are at historical highs. U.S. corporate debt yields, for example, were about 600 basis points more than the U.S. 10-year T-bonds in early January.

@page_break@Those levels provide sufficient premiums for defaults, says John Carswell, president of bond strategy and management firm Canso Investment Counsel Ltd. in Richmond Hill, Ontario: “You are being paid for the risk and the wait to recovery.”

More worrying for corporate bondholders is the declining recovery rate on distressed debt — that is, bonds in default. November data from Moody’s Investors Service Inc. indicate declining recovery rates, particularly on subordinated debt.

But that doesn’t mean avoiding corporate debt. It is reasonable to buy it, even now, but you should stay with senior debt. In a deep recession, the bottom of which is not even in sight, it does not pay to trawl the bottom.

The canary in the coal mine of bond defaults will be trends in high-yield bonds. Barry Allen, president of Marrett Asset Management Inc. , a Toronto-based specialist in the high-yield market, says it is too early to plunge into junk. “The Merrill Lynch master II high-yield index, which is the base index of the business, is now at 1,642 points over treasuries,” he says. “Its yield, 21.8%, is an historical high.”

But that is not a “buy” signal — at least, not yet — because, Allen says, the credit market remains very much challenged.

A leading indicator of risk acceptance would be a decline in the London interbank offering rate — LIBOR, for short — which is the price banks charge one another to borrow U.S. dollars overnight. “When the LIBOR rate falls to 25 bps,” says Mario De Rose, a fixed-income strategist with Edward Jones & Co. in St. Louis, “that would be a signal to switch from risk avoidance in government bonds to risk acceptance in investment-grade bonds.”

By early January, the LIBOR had already fallen to 44 bps from 164 bps in the midst of the credit crisis.

The move in bond prices that will result from closing spreads will be huge. As the recession deepens, the potential gains on recovery grow. The old saw that “the night is darkest before the dawn” will be prophetic when markets return to normal and inflation re-emerges as a concern for investors. Then, having inflation-compensating bonds such as corporate debt, U.S. Treasury inflation-protected securities, real-return bonds and junk will be appropriate — even potentially hugely profitable.

To get ready for the recovery, De Rose suggests that your clients should stretch out maturities. “The average investor could move from hiding in short-dated governments,” he says, “to 30% in a ladder of one- to five-year government and investment-grade bonds, rated A or higher to provide liquidity.

“[That 30% would] take advantage of rising current yields,” adds Re Rose. “Then, 40% in governments and investment-grade corporates with terms of five to 15 years, to optimize risk and return over time. And 30% in long bonds to get the biggest bang for the buck, as markets begin to price up the future stream of bond interest payments.”

In the high-yield market, in which risk gets a better reception, Allen suggests the signal will probably be in reduced spreads on bank bonds.

If the market reads an upturn on bank debt as a “buy” signal, it will be time to move into a range of credit-sensitive bonds.

When this happens, investors could put 5% in high-yield bonds. Today, Allen notes, U.S. high-yield bonds are paying 21.5%, according to the Merrill Lynch master II high-yield index.

TIPS, which are the U.S. equivalent of Canadian RRBs, now pay the same as U.S. five-year bonds: about 1.5%-1.7%.

“But, if you think that inflation will return, “ says De Rose, “it’s a good time to buy inflation-linked bonds because you are getting inflation protection for free.”

De Rose suggests a 5% portfolio allocation to RRBs. IE