A lot of money has already been made in the bond market in this volatile economy. But as investors have rushed to the safety of government bonds, they’ve bid up prices and pushed down yields. So, for an advisor trying to balance risk and return for clients, the game is getting a lot harder — especially if you are setting up portfolios to deliver yield and security when the economic downturn ends.

Consider the yields on government bonds, for instance. In the U.S., five-year treasury bond yields — encouraged by the U.S. Federal Reserve Board’s emergency and scheduled rate cuts — tumbled to 2.65% in mid-February from 3.14% in mid-January. In Canada, a five-year bond yielded 3.35% in mid-February, which was down from 3.63% a month earlier. In both countries, bond yields are little higher than the inflation rate, which means that governments are essentially borrowing for free.

Corporations and others are paying slightly more to borrow, but not much. If interest rates fall further, especially in the U.S., bond yields could go well below the inflation rate. The result would be that governments will be forcing lenders — that is, buyers of their bonds — to subsidize the loans.

Nevertheless, government bonds and senior corporate short-term debt have had a good run of late. And although there is still money to be made, it comes at a higher risk. To make substantial gains in low-yield government bonds, you now need to take on duration risk — that is, to go fairly long. That’s because it takes a lot of coupons to add up to much when interest rates are low.

However, getting clients to take on more risk is no way to succeed in a recessionary environment. For example, default risk is soaring for high-yield bonds, a refuge for yield-hungry clients. Defaults are now likely to increase to 4.64% of bonds outstanding, up from a rate of 0.57% in 2007 and well ahead of the 3.86% historical annual average default rate since 1971, according to Edward Altman, professor of finance at New York University’s Stern School of Business. An expert on junk bonds, Altman forecasts that US$160 billion in leveraged loans and US$30 billion in high-yield debt will come due in 2008, a similar amount in 2009 and even more in 2010 through to 2013. Most of this debt will have to be rolled over, and some issuers will fail to find willing lenders.

High-yield fund managers say that some of the grief that comes from chasing yield can be avoided. They urge waiting to jump into junk. Barry Allan, head of Toronto-based high-yield specialist Marrett Asset Management Inc. , warns that now — a time of widening spreads on junk — is not the right time to enter the market. “You have to wait,” he says, “for the spreads over government bonds to widen further.”

Moreover, even when the economy does improve, some junk will continue to default, says Craig Allardyce, vice president and portfolio manager at Mavrix Fund Management Inc. in Toronto: “Junk lags the economy. It takes a while for a problem to make a company insolvent. This is an area into which I would not jump.”

There is less risk and potentially more reward in bonds that are less volatile than junk. The bond market will undergo a major change of direction in the second half of 2008, when the prospect of rising interest rates provokes a bond sell-off as bondholders raise money to buy stocks. “The Bank of Canada will then start to look at inflation again,” says Tom Czitron, managing director and head of income and structured products for Sceptre Investment Counsel Ltd. in Toronto. The implication is that as interest rates rise, the prices of existing bonds with fixed coupons will begin to fall.

For its part, the Bank of Canada has signalled that it expects an economic recovery in 2009. In the January issue of its Monetary Policy Report Update, the bank “projects that economic growth in 2008 will be weak, averaging a little more than 1% in the first half of the year and a little more than 2% in the second half. On an average annual basis, the economy is projected to expand by 1.8% in 2008 and by 2.8% in 2009.”

@page_break@Brad Bondy, a bond manager and vice president of fixed-income at Genus Capital Management Inc. in Vancouver, says that investors and advisors anticipate the Bank of Canada will concern itself with inflation once again by the end of 2008 or early 2009.

For his part, Edward Jong, senior vice president of fixed-income and a portfolio manager at MAK Allen & Day Capital Partners Inc. in Toronto, suggests that the market will begin to anticipate a return to inflation in the third quarter of 2008. At that time, the U.S. will lead the Canadian market in a return to a more robust economy. “The U.S. has been more aggressive in lowering administered rates at an unprecedented rate,” he says. “So, it will produce rising bond yields. The trend upward in rates will be more pronounced in Canada.”

Positioning for recovery implies buying corporate bonds, Jong urges. If yields to maturity on 10-year Canada bonds fall to 3% and corporate yields to maturity on AA-rated bonds are at 5%, then once the economy turns upward, the Bank of Canada will raise interest rates and the prices of existing government bonds will fall, meaning yields will rise. Yet a corporate bond will hold its price to yield of 5%. Government bonds, therefore, will produce losses as rates rise, Jong says, while corporates will hold their value.

Another strategy, he adds, is to hold floating-rate notes that are issued by the chartered banks. As interest rates rise, the floaters will increase their payouts and hold their value as a result.

Still another way to play what will be an improving economy is to buy convertible bonds. “Bonds that can convert into common stock will benefit from improvement in the underlying equities,” says Michael McHugh, vice president and head of fixed-income for Dynamic Funds Management Ltd. in Toronto. In other words, improving credit quality will outweigh the negative effects of rising interest rates.

Finally, assuming that inflation begins to pick up, real-return bonds that pay rising yields as the consumer price index rises should also be winners. Although conventional bonds will suffer from rising interest rates, RRBs will thrive. In an inflationary environment, RRBs are the place to be, McHugh says.

McHugh favours five-year RRBs. “Short RRB prices won’t decline as much as long bonds when interest rates rise,” he says. “In fact, short RRB prices should rise with increases in the consumer price index. However, weaker economic growth, the recent strength of loonie in holding down prices of imports and the reduction in the GST will suppress [RRB price] increases for a few months. But these downward pressures should abate by the end of the year.”

For advisors, the key to client profits is being in position for the recovery when it happens. IE