These are strange times in the credit-sensitive bond market. Good corporate bonds are being treated like lepers, while iffy corporate bonds that customarily trade in the high-yield market are still getting respect, if perhaps a little less than usual.

Take the case of a bank famous for good management. “Wells Fargo, a well-run, large U.S. bank, had to pull a Canadian-dollar financing when,” says Tom Czitron, managing director and head of income and structured products at Sceptre Investment Counsel Ltd.in Toronto, “even at 180 basis points over Government of Canada bonds of the same 10-year term, it was not selling. A year ago, that kind of spread was what BB — subinvestment-grade — bonds needed to get sold.”

Bank bonds have been taking a lot of punishment lately, notes Craig Allardyce, vice president and associate portfolio manager at Mavrix Fund Management Inc. in Toronto. “In the past six months, five-year bank bond yields have soared from about 50 bps over Canadas to 120 bps, with spikes to 150 bps.”

Five-year Government of Canada bonds, which were 4.8% before the crisis broke in August 2007, have recently yielded 5%.

The market for Canadian bank debt seems to assume that no bank will default, Allardyce says. Yields on five-year bonds from CIBC, which is thought to have $1.8 billion in potentially naked exposure to U.S. subprime mortgages, are only 12 bps over yields on five-year bonds from Royal Bank of Canada, which is thought to have far less exposure to the subprime mortgage problems.

Even if spreads widen a bit more as the crisis winds on, Allardyce says, in a couple of years, the current market will be viewed as a golden period for buying Canadian chartered bank bonds.

Walter Sillicz, vice president of Winnipeg-based investment dealer Wellington West Capital Inc. , agrees: “The banks’ bonds look like a good buy where they are priced now. Canadian bank bonds are solid investments, and at these prices, they are buys. Spreads can widen and prices can change, but these are solid institutions. If you hold the bonds to maturity, you will get your principal back with a good return. Most of the risk in trying to forecast prices is a trader’s worry because they have to get both sides of their deals right.”

U.S. bank bonds pose greater risk because some major lenders have much larger subprime mortgage exposure than any Canadian chartered bank. The increased risks are reflected in U.S. yield spreads. For example, the five-year bonds of New York’s Citigroup Inc. due Feb. 21, 2012, are priced to yield 5.15% to maturity; in comparison, a five-year U.S. treasury yields 3.43%. That 172-bps spread exceeds anything yet seen in Canada.

Citi has already written off $14.6 billion of its capital and will wind up with reduced assets and reduced income as a result. Nevertheless, the huge spread on Citi five-year bonds is a gift to buy-and-hold investors who believe that Citi will survive the present crisis — as it did every previous financial implosion, according to Allardyce, including the disintegration of hedge fund Long-Term Capital Management LP in 1998, the Enron Corp. disaster and the dot-com meltdown.

“Citi, the world’s largest financial institution, is too big to fail,” Allardyce says. “It is a counterparty to so many deals that if it failed, the world’s financial system would be in serious trouble.”

Citi bonds, like those of other U.S. megalenders, are, therefore, bets on faith. If you believe in the survival of the biggest, Allardyce concludes, then those bonds are a buy.

“Until the market sees an end to the crisis, bonds from senior U.S. banks and the Big Five Canadian banks will remain in a buyer’s market, Allardyce adds. On his current shopping list are U.S. and Canadian bank bonds, bonds from financial institutions such as Winnipeg’s Great-West Life Assurance Co. and from Sun Life Financial Inc. and Manulife Financial Corp. , both of Toronto, as well as bonds from regulated utilities such as Hydro One Networks Inc.

Spreads on all of these credits have widened dramatically. All have strong balance sheets and abundant income to cover interest obligations — the critical factors in assessing these bonds. But the market has beaten up the good along with the bad.

@page_break@Corporate bond spreads will start coming down when there is less fear of further writedowns by financial institutions and when the rates that financial institutions charge to lend to one another — which have risen dramatically in recent months — return to normal, says Michael McHugh, a portfolio manager at Dynamic Mutual Funds Ltd. in Toronto.

However, the worst of the crisis is not over, for there are expectations of more writedowns to come, says McHugh. But if you buy good-quality bank bonds and issues from large life insurance companies and hold them to maturity, he says, there will be attractive returns.

“The good institutions have been tainted by the financial market turmoil along with the ones that are not so good,” McHugh says. “The knack in this market is to buy the bonds of the banks and lifecos, and [those of] industrial and other companies that have not been impaired.” IE