The present environment of falling interest rates represents an opportunity for fixed-income investors to capture gains generated by rising bond prices.

But it is vital to get the timing right because the more rates fall, the more that existing bonds with fixed coupons will rise in price. For instance, a 1% drop in interest rates could produce a 30% gain in the price of a 30-year strip. At the same time, failure to lock in rates implies losses of current income, meaning that the 1% drop in rates will cost $1,000 a year in forgone interest on a $100,000 bond.

Rates are headed downward into a territory that has not been visited since the dot-com meltdown in 2001. In this market, the key is making sure your clients understand just how far rates may fall.

Simultaneous announcements on Jan. 22 by the U.S. Federal Reserve Board and the Bank of Canada, which moved overnight rates down by 75 basis points and 25 bps, respectively, set the stage for what the market takes for granted — more rounds of cuts in 2008.

Already, the Fed cut the overnight rate by a further 50 bps on Jan. 30.

That more cuts will come is almost a certainty. Says Brad Bondy, vice president of fixed-income at Genus Capital Management Inc. in Vancouver: “The cuts were not a surprise. There was an expectation that the Fed had to act.”

The Bank of Canada was also expected to make a cut. The 25-bps drop on Jan. 22 was an acknowledgment of the need to cut, says Tom Czitron, managing director and head of income and structured products for Sceptre Investment Counsel Ltd. in Toronto.

Bank of Nova Scotia’s deputy chief economist, Aron Gampel, explains further: “The U.S. economy is probably going into a deeper and more protracted slowdown. But there will be a recovery in 2009 that will result in a steeper yield curve, with rising long-term interest rates that reflect future growth expectations at a time when short rates are still anchored by low central bank rates.”

And where the U.S. goes, he adds, Canada will follow.

LOW RATES IN SHORT TERM

Meanwhile, interest rates at current levels are not sustainable, Gampel says: “Rates may go down for a time, but the biggest risk for the bond investor is that there will be higher yields on 10-year and longer bonds over the next 12 to 15 months.”

In other words, bond investors have to pick their maturities with care in order to avoid losing in future what they may be gaining now.

Bondy figures that Canadian rates could go down to 2%-2.5% by the end of 2008. By yearend, U.S. rates, he says, could go down as far as the 1% they hit following the tech bubble’s implosion and the events of 9/11.

Low rates mean easy money, which is just lighting the fuse of another banking crisis. Market-watchers know it and, they figure, so do central bankers. “There is an awareness that when the Fed cut rates back in 2001 to rescue the U.S. economy after the dot-com bust, it went too far,” Czitron says. “Indeed, that easy money was the genesis of today’s problems. I hope that the Fed has learned a lesson and that it will not cut below 2.5% and that the Bank of Canada will not go below 3.5%.”

So, how can your clients play falling rates?

A year ago, the yield curve, which is as good an oracle of the future as anything, was inverted, a sign that there would be a recession, Czitron says. Now, a U.S. recession is at hand. However, the yield curve has since lost its inversion and steepened, signalling a recovery to come in nine to 15 months, he adds.

For your clients, the trick will be to walk a tightrope, picking up gains as rates fall and avoiding falling off the tightrope when rates start to rise. The best bet in government bonds, Czitron says, is to stay in mid-term bonds due in five to 10 years.

“We expect more cuts,” he says, “but staying out of long bonds removes the risk of major losses when rates start to rise.”

Bondy agrees: “There will be more pressure on short rates, so go for five-year terms. That protects current yields and avoids the risks inherent in taking a bet on 10-, 20- and 30-year interest rate trends.”

@page_break@CREDIT RISK

Edward Jong, senior vice president for fixed-income at MAK Allen & Day Capital Partners Inc. in Toronto, is willing to go longer, however. He says that inflation need not be part of the current outlook.

“I am willing to go out to the long end of the curve, and even in strips in which duration is equal to the term,” he says. “I think there is value at terms of 15 years. Inflation is not a problem in Canada, so I am not worried about being exposed to the long end of the yield curve.”

There may be merit in taking some credit risk. Chris Kresic, senior vice president for investments at Mackenzie Financial Corp.in Toronto, suggests that by buying corporate bonds now under pressure, you can avoid the need to make perfect calls on interest rate trends. Interest rate boosts on corporate debt over government bonds are so large that mis-estimates of interest rate trends will fade in significance.

Kresic notes an investor can buy an A-rated Bank of Montreal 5.75% bond due Sept. 26, 2022, that yields 5.5% to maturity. That offers 170 bps of yield over a 10-year Government of Canada that yields 3.75% to maturity.

For a little more risk, you can buy a Merrill Lynch & Co. Inc. Canadian dollar-denominated bond, rated A+, with a 4.5% coupon due Jan. 30, 2012, that pays 5.95%. This offers 230 bps over a Government of Canada four-year bond that pays 3.45% to maturity. And even though there are problems in financial services, Kresic notes, these are solid bonds from solid names.

BANK STOCKS

Finally, your clients can buy bank stocks. They are so depressed now that their yields, which range from 3.9% for Royal Bank of Canada to 5% for CIBC and 6.3% for Bank of America, are better than bond yields. These high yields reflect investors’ apprehension about bank earnings. But there is money to be made by venturing where some angels fear to tread.

The risk is worth taking, Czitron says. “This is one of those markets in which you buy bank stocks and go away,” he says. “In a year and a half, you will come out just fine — even though you will have some Maalox moments.” IE